McDonald's (MCD) Stephen J. Easterbrook on Q2 2016 Results - Earnings Call Transcript

| About: McDonald's Corporation (MCD)

McDonald's Corp. (NYSE:MCD)

Q2 2016 Earnings Call

July 26, 2016 11:00 am ET

Executives

Chris Stent - Vice President-Investor Relations

Stephen J. Easterbrook - President, Chief Executive Officer & Director

Kevin M. Ozan - Chief Financial Officer & Executive Vice President

Analysts

Brian Bittner - Oppenheimer & Co., Inc. (Broker)

David Palmer - RBC Capital Markets LLC

Brett Levy - Deutsche Bank Securities, Inc.

David E. Tarantino - Robert W. Baird & Co., Inc. (Broker)

Nicole Miller Regan - Piper Jaffray & Co. (Broker)

Andrew Charles - Cowen & Co. LLC

John Glass - Morgan Stanley & Co. LLC

Joseph Terrence Buckley - BofA Merrill Lynch

Jason West - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Jeffrey Bernstein - Barclays Capital, Inc.

Jeff D. Farmer - Wells Fargo Securities LLC

John William Ivankoe - JPMorgan Securities LLC

Operator

Hello and welcome to McDonald's July 26, 2016, Investor Conference Call. At the request of McDonald's Corporation, this conference is being recorded. Following today's presentation, there will be a question-and-answer session for investors.

I would now like to turn the conference over to Mr. Chris Stent, Vice President of Investor Relations for McDonald's Corporation. Mr. Stent, you may begin.

Chris Stent - Vice President-Investor Relations

Hello, everyone, and thank you for joining us. With me on the call are: President and Chief Executive Officer, Steve Easterbrook; and Chief Financial Officer, Kevin Ozan. Today's conference call is being webcast live and recorded for replay by webcast.

Before I turn it over to Steve, I want to remind everyone that the forward-looking statements in our earnings release and 8-K filing also apply to our comments. Both documents are available on www.investor.mcdonalds.com, as are reconciliations of any non-GAAP financial measures mentioned on today's call with their corresponding GAAP measures.

And now, I'd like to turn it over to Steve.

Stephen J. Easterbrook - President, Chief Executive Officer & Director

Thank you, Chris, and good morning, everyone. Midway through 2016, I'm encouraged by the progress we've made in turning around our business and the way we've challenged legacy thinking, acted with greater urgency, and shared successes more quickly across markets. These actions underlie the positive momentum that continued in second quarter, marking four consecutive quarters of positive comparable sales growth across all segments and franchisee cash flows at all-time highs in many markets.

More specifically, global comparable sales increased 3.1% for the quarter. Operating income was up 3% in constant currencies, and earnings per share was up 1% in constant currencies. Excluding the impact of the current and prior year strategic charges, earnings per share for the quarter was up 13% in constant currencies.

As we enter 2016, we expected quarterly results to be variable throughout the year. Our top-line performance in second quarter, while positive, reflects slower growth, due, in part, to challenging conditions in several countries.

I'm encouraged that we continue to win relative to our QSR competitors in key markets around the world. In the U.S., our comparable sales gap versus the QSR sandwich segment was consistently positive and averaged 130 basis points for the quarter, despite softer industry growth. Our balanced focus on All Day Breakfast, value and relevant promotions, including MONOPOLY, contributed to top-line performance.

In Australia, Canada and the U.K., we are gaining significant market share within the IEO segment and, in particular, relative to our traditional QSR competitors. Our formula for success in these markets is consistent: commitment to running great restaurants, coupled with initiatives that create customer excitement across our menu, promotion and value offers, all supported by strong alignment with franchisees.

Early last year, we put the customer back at the center of everything we're doing. That mindset ignited our turnaround and continues to guide our decision-making, as evidenced by the enhancements we are making to the All Day Breakfast menu in the U.S., the leadership moves we've made around sustainability, and the significant progress we're making to create a more modern customer experience as part of the Experience of the Future.

Over the past few quarters, we've heard from customers looking for more choice in the All Day Breakfast menu. Those with muffin sandwiches on the menu asked for biscuits. Those with biscuit sandwiches on the menu asked for muffins. We listened, worked through the operational challenges, and this fall, we'll begin offering muffins, biscuits and McGriddles all day in all U.S. restaurants.

Under the broader food quality umbrella, we continue to take a leadership stance of sustainability because it's the right thing to do for our business, society and the world at large. In Canada, we are breaking ground in the beef industry with our recently concluded sustainable beef pilots, part of our work with ranchers and larger producers around the globe to measure and track sustainable beef from farm to fork. Sustainability matters to our customers, and it matters to us.

At the same time, Experience of the Future is quickly coming to light in key markets around the world. For example, in Canada, over half of our restaurants have been fully converted. The U.K. is almost 40%, and France is at nearly 25% with table service in about 80% of restaurants. This marks significant progress from where we were just three months ago.

Customers are noticing the steps we're taking to build a better McDonald's. The most recent customer satisfaction scores reflect improvements in seven of our nine largest markets. In the U.S., we are seeing further evidence of improved brand perceptions according to a recent YouGov report that measures consumer perceptions across 1,400 brands. McDonald's was ranked fourth most improved brand across all brands measured, and the most improved within QSR.

We're taking smart risks to address what matters most to customers. We're also being smarter about our structure and resources and prioritizing our activities to deliver the greatest impact. This includes putting more restaurants in the hands of dedicated franchisees, getting us closer to the customers and communities we serve, and unleashes more entrepreneurial spirit, risk-taking and innovation across the system, ultimately accelerating growth.

At the same time, we're further streamlining how we operate. We're in the midst of rightsizing our organization, taking a critical look at how we can reduce layers to be more agile in our decision-making. We also recently announced the relocation of our corporate headquarters. Our new location will support greater collaboration and innovation, help us better attract and retain talent and move us toward a more modern, progressive culture with the added benefit of reducing costs. These are all important steps forward in our journey to building a better McDonald's.

With that context, let's now turn to performance highlights in our major markets. Beginning with the U.S., comparable sales for the second quarter increased 1.8%. Whilst modestly positive, this growth was not as strong as the last two quarters. This is due, in part, to the recent softening of the IEO industry, which experienced minimal growth for the trailing 12-month period ending in May at only 40 basis points.

The All Day Breakfast platform continues to contribute to top-line momentums that draw new customers into our restaurants and creates additional reasons for existing customers to visit more often. It's also delivering bottom-line growth, with restaurant-level cash flows up for the third consecutive quarter. Franchisees are excited about the platform and its future growth potential. And the next phase of All Day Breakfast, which I mentioned earlier, was voted in with an overwhelming approval rating exceeding 99%.

With food, we continue to enhance quality perceptions around our core menu. And we're being more vocal about the improvements we've made. Just last week, we launched our new brand campaign called The Simpler the Better, which highlights the progress we've made in the areas that matter most to our customers. And we'll have even more news to share in the coming weeks.

Value remains a top priority in the U.S. Franchisees have embraced the McPick 2 value platform at both the national and local levels. We're tapping into the flexibility this platform provides in terms of products and price points to enhance our appeal to a broader population of value-seeking customers, which is increasingly important given softer IEO industry trends.

Although the progress we've made in the U.S. is encouraging, our most significant opportunity continues to be bringing customers into our restaurants more often. As such, we are actively exploring new ways to increase the frequency of visits from our loyal customers and win back customers we've lost.

Let's now turn to the International Lead segment. Second quarter comparable sales increased 2.6%, with four of the top five markets delivering positive comparable sales for the quarter. France was the exception, with results that were relatively flat. Whilst the recent Brexit vote has created uncertainty in the U.K. and across Europe, our business remains strong. And we are confident in our ability to manage through the change.

Having operated in these markets for over 40 years, we're accustomed to dealing with external challenges and believe we are well-positioned to seek out the opportunities it provides to build upon the strength of our U.K. business. And, in fact, the U.K. market's long track record of success continued into second quarter. Compelling promotions, limited time offers, such as the relaunch of Big Flavour Wraps, and positive performance from Experience of the Future restaurants drove growth in both average check and guest counts, with guest count volume breaking all-time monthly highs in April and May.

In Canada, our continued focus on lunch, along with successful marketing campaigns and positive performance from their Experience of the Future restaurants, drove solid sales and guest count momentum into the second quarter.

The performance of All Day Breakfast in Australia is mirroring the success in the U.S., driving incremental sales while providing customers with even more reasons to visit McDonald's. In addition, we continue to fuel growth in more established platforms like Experience of the Future and McCafé. We're introducing new customizable flavors and ingredients supported by engaging marketing and promotional campaigns to create energy and excitement for our customers.

Sales were slightly positive in Germany for the second quarter. With a heavy concentration of price conscious customers, value remains a critical priority. The new pricing structure we rolled out in February continues to perform in line with expectations. And McPick 2 for €5, which we launched in May, resonated well with customers. However, these initiatives weren't enough to mitigate ongoing guest count and market share declines.

Macroeconomic challenges persist in France. We're enhancing our appeal to customers by offering more compelling options at lower tiers of our menu. We're also pursuing growth opportunities at the premium end through engaging promotions and limited time offers, including the recent New York Street Food Event, which successfully drove sales of premium burgers and wraps.

In the High Growth segment, second quarter comparable sales were up 1.6%, driven by positive performance in China and Russia. Despite a challenging environment, including aggressive discounting by competitors, China's comparable sales were up 2.1% for the quarter. We continue to gain significant market share in IEO and, more specifically, from Chinese QSRs, whilst undertaking meaningful cost savings initiatives to enhance profitability in this important market.

In an effort to give customers more reasons to choose McDonald's, we've introduced appealing new products like the chicken snack sharing box. In addition, we're expanding our delivery business by tapping into growing digital channels, as well as other vendors, to offer added convenience to Chinese customers.

In Russia, comparable sales remain positive, driven, in part, by successful promotions that showcase compelling, affordable menu options across multiple dayparts and product categories. Results may be volatile moving forward, given continuing macroeconomic uncertainties and lower consumer purchasing power.

I'm encouraged by our continued progress. We're creating a better McDonald's, ones that customers will recognize as modern and progressive and a true global leader. Whilst we've come a long way, we recognize there is much more to do. That's why we remain committed to executing our turnaround plan through the end of the year. For now, we remain focused on continuing to win within the QSR segment as we give customers more reasons choose McDonald's. At the same time, we are taking steps to build upon the progress we've made as we chart our long-term strategic path forward within the broader $1.2 trillion informal eating out market. I am confident McDonald's will generate long-term value for both our system and our shareholders.

Thanks. I'll now turn it over to Kevin.

Kevin M. Ozan - Chief Financial Officer & Executive Vice President

Thanks, Steve, and good morning, everyone. As follow-up to Steve's remarks, I'd like to cover the key performance drivers for the quarter, provide an update on our outlook for the second half of 2016, and outline the recent progress we've made against our financial initiatives.

Starting with the performance drivers for the quarter, for the quarter as a whole, we're pleased with our efforts to effectively manage restaurant profitability, particularly in light of the industry trends and economic factors that we've experienced in certain markets. With more than 80% of our global restaurants franchised, the largest driver of operating income continues to be our franchise margins.

For the quarter, growth in global franchise margins was led by the U.S. and the International Lead markets. Franchise margins totaled $1.9 billion, a 6% increase in constant currencies and contributed about $100 million to our global operating income growth for the quarter.

Growth in global company-operated margins also contributed to quarterly results, as margins rose 150 basis points, with China leading the overall improvement. In the U.S., company-operated margins increased by 30 basis points for the quarter, as positive comparable sales and favorable commodity costs more than offset the investment we made last July to raise crew wages and enhance benefits for our restaurant employees. Given the magnitude of this investment, the improvement in second quarter margins is a noteworthy achievement for our U.S. business.

Moving on to G&A, our second quarter expenses increased 2% in constant currencies, due to higher incentive-based compensation as a result of our year-to-date performance, as well as costs associated with our biennial owner/operator convention in April. Excluding these items, G&A would have decreased.

Looking ahead, third quarter G&A levels will remain elevated, due to our sponsorship of the Summer Olympic Games in Rio next month. Taken together, the cost of our worldwide convention and the Olympics are expected to total about $25 million, or roughly 1% of our G&A in 2016. For the full year 2016, we continue to expect G&A in constant currencies to be 1% to 2% below prior year spending levels, excluding changes in incentive-based compensation and any impact from changes in timing of certain refranchising transactions.

Global operating income for the quarter totaled more than $1.8 billion, up 3% in constant currencies, reflecting roughly $230 million in strategic charges recorded during the quarter. These charges were comprised of non-cash impairment related to our ongoing refranchising in Asia and Europe and G&A initiatives, as well as the decision to relocate our corporate offices.

Diluted earnings per share for the quarter declined $0.01, which included $0.20 related to the strategic charges and $0.02 in negative foreign currency impacts. As a reminder, in second quarter 2015, we had strategic charges of $0.04 per share related to restructuring. Excluding the impact of the current and prior year restructuring charges, earnings per share for second quarter 2016 were up 13% in constant currencies.

Turning next to menu pricing and commodity costs, in the U.S., commodity costs declined 4.5% during the second quarter. Looking to the second half of the year, we expect commodity costs to remain favorable, maintaining our outlook for the segments' full year basket of goods to be down 3.5% to 4.5%.

Commodity costs for the International Lead segment were down about 1% for the second quarter and are expected to remain relatively flat during the second half of this year.

Where possible, we source products in local currency to minimize cost fluctuations. And our suppliers also hedge a portion of foreign currency exposure. So at least in the near-term, we don't expect Brexit to significantly impact U.K. commodity prices.

While we are benefiting from favorable commodity costs around the world, we are facing rising labor costs in many of our markets. As a result, we are carefully balancing price increases with a focus on maintaining our strong value proposition, which remains a key pillar of McDonald's brand, to drive guest counts. In the U.S., second quarter pricing year-over-year was up about 3% compared with food away from home inflation of 2.6%.

Given the widening gap between food at home and food away from home inflation in the U.S., we continue to track both of these metrics very closely. As it stands, food at home is projected to increase modestly from relatively flat to up about 1% for the full year, while food away from home inflation is projected to increase between 2.5% and 3.5%.

For the International Lead segment, while price increases vary by market, year-over-year increases for these markets averaged 1.5% to 2%.

Next, I'd like to provide an update on the impact of Brexit and our global foreign currency outlook. As I mentioned, we don't expect Brexit to have a significant impact on our near-term commodity prices in the U.K. And, as Steve noted earlier, we also haven't seen a significant change in consumer demand in the U.K. since the vote. While the long-term impact of Brexit is uncertain, in the near-term, the most significant impact on our business will be currency translation.

We view our geographic diversification as a key competitive strength. For perspective, the U.K. represents about 10% of consolidated operating income and the Eurozone collectively represents about 25%. Given recent currency fluctuations, foreign currency translation is now expected to have a more significant impact on our reported results than previously estimated. Based on current exchange rates, we project foreign currency translation to negatively impact our earnings per share by $0.02 to $0.04 in the third quarter and $0.09 to $0.11 for the full year. As always, please take our currency guidance as directional only, because rates will change as we move throughout the year.

Beyond the currency impact, we continue to expect variability in quarterly results, due to increased volatility in the evolving global economic and geopolitical landscape, as well as uneven prior year comparisons.

It was just over a year ago, beginning with the announcement of our turnaround plan in May 2015, that we began reshaping our business, from our organizational structure and restaurant ownership mix, to our capital structure and the strategic allocation of our resources around the world.

We've taken decisive actions to pursue each of these opportunities, and we continue to make meaningful progress. In the past six quarters, we've refranchised about 850 restaurants, including over 160 in the second quarter. The large majority of restaurants refranchised to-date were sold to existing conventional franchisees. Overall, our global refranchising efforts are moving along as expected, and we're pleased with the progress we've made to-date.

It's important to keep in mind that due to the unique nature and scope of the refranchising activity underway, the more complex, larger refranchising transactions do take time. We remain committed to our refranchising strategy and the benefits that will be realized by moving to a more heavily franchised system for McDonald's globally.

From a G&A standpoint, we remain on track to achieve our net annual savings target of $500 million by 2018, with the vast majority of the savings expected to be realized by the end of 2017. As Steve noted, we are in the midst of transforming our organization. We expect to share more detail on the role that our organizational restructuring is playing in reaching our G&A goal as part of our third quarter earnings update.

Relative to our capital structure, 2016 represents the final year of our three-year $30 billion cash returned to shareholders target. During the second quarter, we repurchased $3.4 billion of stock, bringing our year-to-date share repurchases to $7.1 billion, or 57 million shares. In May, we completed a $2.7 billion accelerated share repurchase program and also entered into a new $2.6 billion program, which accounted for a significant portion of the share repurchase activity completed during second quarter.

Through June 2016, the cumulative cash returned under our three-year target stands at $24.4 billion, and we are on track to complete the remaining amount during the back half of this year.

We've delivered positive results over the last four quarters, not just from improving efficiency and working to reduce costs, but, most importantly, from top-line growth as we've made strides improving the customer experience. These results reinforce my confidence that we're focused on the right things.

We're also making good progress on all of the actions we outlined last year. We're actively refranchising restaurants, building stronger G&A discipline, and returning more cash to shareholders. The strategic changes we're making and the actions we've taken over the course of the last year are positioning us to optimize our business operations and deliver sustained, profitable growth.

Thanks. Now, I'll turn it over to Chris to begin our Q&A.

Question-and-Answer Session

Chris Stent - Vice President-Investor Relations

Thanks, Kevin. We will now open the call for analyst and investor questions. [Instructions] The first question is from Brian Bittner of Oppenheimer.

Brian Bittner - Oppenheimer & Co., Inc. (Broker)

Thanks for taking the question. Two questions, one on the U.S. industry and one on your guys own U.S. business; on the industry, your outperformance against the industry this quarter is very similar to last quarter, which suggests the entire industry saw a huge deceleration, around 350 basis points. So what do you believe, sitting in your seat looking at the United States, what are the two largest drivers of the softening in the IEO trend? And do you see it continuing into the rest of the year?

And secondly, on your own business, when you look at lapping All Day Breakfast in the fourth quarter, how are you thinking about the ability to sustain positive trends here as you lap that? Is extending the All Day Breakfast menu enough or are there more initiatives required in your mind? Thank you.

Stephen J. Easterbrook - President, Chief Executive Officer & Director

Hi, Brian. So on the first one, on the industry, well, clearly, it's been fairly well documented on the consumer slowdown across most consumer segments, to be honest with you, through the second quarter. And therefore, we are very mindful of our competitive position, the competitive gap. So it was important to us that we maintain that competitive advantage and fought for market share. We're not immune from what's happening in the outside world at all, but nor are we letting that deflect our focus on what really matters to us and our customers.

I think the general sense is there's a couple of things at play. I mean, first of all, there is a widening gap between food away from home and food at home, where the commodity decreases are being passed through by the grocers. So the food at home, there's value to be had for families there, whereas eating out, there is a price inflation environment. So that's a small part of it.

I think generally, there's just a broader level of uncertainty in consumers' minds at the moment, both trying to gauge their financial security going forward, you know, whether through elections or through global events, people are slightly mindful of an unsettled world. And when people are uncertain, when families are uncertain, caution starts to prevail and they start to hold back on spend.

And for a business like us, I mean, clearly, we generate a lot of our own business directly, but also we do benefit from people moving around, going to the malls, driving around, going on vacations. And if people are reining in their spend across broader categories, that will have a little bit of a flow-through to us as well. So we're mindful of it. It just means we've got to be closer to our customers than ever and adapt and make sure that we're building compelling plans in the short-term as well as the long.

In terms of sustaining trends, well, clearly, we plan to grow our business. But at the same time, we're not trying to do that on a quarter-to-quarter-to-quarter basis. We are mindful of the short-term, but we have our eye aligned (28:19) on the long-term. And we believe we've got a number of the right drivers in place to give us sustained long-term growth here in the U.S.

Our value platform, we continue to learn. So for a McPick 2 for $5, for example, we had our second national campaign in May. And we learned more about it in terms of the items we could have within the bundle and how we position that, all the way through to some of the early markets where we're testing out the Experience of the Future in the U.S., where we're making a significant and exciting rollout program in Florida and certainly within New York as well, which we believe the results there may mirror what we're seeing elsewhere in our other major markets, provide a very exciting opportunity across the next few years in the U.S. as well. So mindful of the short-term, we're going to fight for share, but also, we don't want to lose the strategic direction that we believe is right for long-term.

Chris Stent - Vice President-Investor Relations

Next question is from David Palmer of RBC.

David Palmer - RBC Capital Markets LLC

Thanks. Good morning. Steve, you had some comments about improving consumer perceptions in most of your major markets. Does that include the U.S. and what measures are getting better? Where does the opportunity still remain to improve? And then which of your initiatives do you think are really going to help you get where you want to get with your brand, with the result for, I would imagine, being traffic getting better from here? Thanks.

Stephen J. Easterbrook - President, Chief Executive Officer & Director

Thanks, David. Yes, so if I was to be U.S. specific, I referenced earlier the YouGov latest poll on brand perceptions. We've made really encouraging progress. And I believe that's because as well as trying to drive the business in the immediate term, we've also made the investments and the commitments around food, food quality, sustainability, the employment proposition, where not only did we move pay for our hourly paid start, but also a far broader enhanced range of benefits, including training and education opportunities for them. And with a brand like McDonald's, everything you do communicates. So the better you move on every single consumer touch point, then the broader halo on the brand starts to improve.

So we're encouraged. We've got plenty of plans to maintain that momentum, but it's nice to see it being recognized by consumers. Part of that comes out of the basics of running better restaurants, and we've maintained a 6% year-on-year improvement in overall customer satisfaction. When I look into the detail there, we've made the progress on the areas that the team had intended to make the progress.

So we spoke in the past about an attention to order accuracy, particularly in the drive-thru. Our accuracy has improved. The quality of the food perception has improved. Friendliness improved, all by the order of about 6%, including speed of services as well. So I believe the day-to-day customer experience also enhances the brand and also just drives that immediate satisfaction.

In terms of going forward, what's important? I'd say a couple of things. I mean, clearly, continuing the journey we are around food and food quality, both investing in the ingredients, the recipes, and the items in the restaurants as well as the perception, better explaining what's in our food, where it comes from. And so that's where The Simpler the Better campaign starts to focus. It chronicles the big meaningful moves we have made and, I believe, signals the direction of travel for us going forward.

And, as I say, I'm not going to disclose anything more about it, but there will be more news to come, which we know is going to be powerful on the customer agenda and very, very strong for the brand as well.

The other element that I'm excited to introduce, that we will be introducing increasingly in the U.S. because we've seen it work elsewhere in our major mature markets, is rolling out the Experience of the Future, which is a fundamentally different experience for the customer. And a lot of that does involve technology as well as the service experience as well. Any of the interactions that customers have with the experience of McDonald's, whether it's coming into the dining area or going through the drive-thru, how can we take out the long value-added processes and just made it a smoother, more enjoyable and easier experience for customers?

So the introduction on of self-order kiosks, the development of our mobile app so you could order in ahead and just check in when you get into the restaurant; it takes out many of those human interactions where complications can arise and just makes it a smoother experience for customers. We are seeing a good pickup in sales as we roll this out across the U.K., Canada, Australia, and early days, but also in Germany as well. So we know we're on to something. We know customers respond well, and certainly it breathes new life into our restaurants and into the brand.

Chris Stent - Vice President-Investor Relations

Next question is from Brett Levy of Deutsche Bank.

Brett Levy - Deutsche Bank Securities, Inc.

Good morning. If you could give us a little bit more insight into how you're looking at the structural margins, especially in the U.S., as you've regained some of your lost footing, what do you think are realistic margin expansion targets? Assuming more modest same-store sales in the flat to up 2% or if you were able to reaccelerate to 2% or greater, how should we really be thinking about it, given the current labor and COGS outlook?

Kevin M. Ozan - Chief Financial Officer & Executive Vice President

Yeah, thanks, Brett. It's Kevin. You saw in second quarter this year, we were able to actually grow margins 30 basis points in the U.S. with the 1.8% comp sales, which we were certainly pleased about. As you know, long-term margins are a top-line game for us. We need to grow comps in order to maintain and improve margins, but what we were able to do this quarter was effectively manage the restaurant profitability as well. So while commodity costs were more favorable this quarter, our management of what we call controllable costs, both on the food side and the labor side, was better this quarter than prior quarters. And so we're pleased that we're doing a better job of managing running the restaurant, but also managing the profitability of the restaurant.

Going forward, we've always said that we need about a 2% to 3% comp in a normal inflationary environment. That probably hasn't changed much, and there certainly isn't anything structural that would prevent us from getting back to kind of where we were on high margins in the U.S.

Chris Stent - Vice President-Investor Relations

Next question is from David Tarantino of Baird.

David E. Tarantino - Robert W. Baird & Co., Inc. (Broker)

Hi. Good morning. I wanted to come back, Steve, to the commentary around speed of service. I think you mentioned that that had improved, at least from a perception standpoint, but could you give an update on where you are on that front? And it seems like such an important factor when you think about how much of the business goes through the drive-thru. What are the keys to improving that going forward?

Stephen J. Easterbrook - President, Chief Executive Officer & Director

Yeah, thanks, David. You're absolutely right. I mean, the reality is the customer experience is critical in just our underlying business momentum. Speed of service has predominantly improved, largely because we've got the accuracy element of service far better. So we've enhanced the training, some of the operational procedures through the drive-thru. And you may have heard me talk about a program we called Ask, Ask, Tell, which is a way of really ensuring we both took and then delivered the right order day-in, day-out to our customers. Once you get your accuracy right, then the whole drive-thru lane just operates far smoother.

We also made significant changes to the merchandising in the drive-thru, with more tailored and focused merchandising menu boards, which, again, just made it easier for customers to order and identify the products they want, but also easier for our teams to take and get right.

So I think there's a lot of work that's gone on. The real devil in the detail, down to the font size on the order receipts to make sure our teams who are collecting the orders can gather the right items. But also, there's a lot of work we're doing in the future where we believe we can also enhance service, speed and accuracy and get technology to do some of that heavy lifting for us. So whether it's voice recognition in the drive-thru speaker posts, all the way through to ordering ahead via either the Internet or the app.

Now, we have elements of this going on around the world. I'm not sure we're going to pull them all together here in one market, but we are going to take those learnings and see how the customer responds to some of the capabilities we're introducing. And clearly, if the response is strong, we can bring that in and that will help, again, further enhance speed of service.

I mean, all the way to we have markets where we have curbside collection for our orders. I mean, if you actually order that ahead via the Internet, you can actually just go and on to curbside. And therefore, when you think about it, you've got one satisfied customer who is ordering and collecting and paying exactly how they want. That's also one fewer car going through the drive-thru, so the existing drive-thru lane runs smoother. So we're looking at this from a number of different directions. I'm definitely not underestimating the day-to-day operation improvements the chains have done so far, but also we're looking at innovation in the future to try and keep it smoother and easier for customers, and just easier for our teams to get right.

Chris Stent - Vice President-Investor Relations

Next question is from Nicole Miller Regan of Piper Jaffray.

Nicole Miller Regan - Piper Jaffray & Co. (Broker)

Thanks. Good morning. Wondering how do you benefit, or not, from the Summer Olympics. And is there anything you want us to be aware of in the third quarter relating to that for modeling purposes? Thanks.

Stephen J. Easterbrook - President, Chief Executive Officer & Director

Well, I mean, for us, there's a brand association with sports. We've been a long-term sponsor of the Olympics. So we have some fun and engaging initiatives going on, particularly in and around Rio and working with our partners down there, Arcos Dorados. I wouldn't say there's anything material that's going to impact our business trends. We'll have some fun with it in certain markets where there's promotional activity, where there's tie-ins and allows consumers to get a little closer to it. And you can expect to see us with a little piece of that across the U.S. as well, but I wouldn't see it materially impacting our business one way or the other. It's just a brand reinforcement that we're committed to, to global sport to supporting participation at local community levels, just like we are with football or soccer around the world with our FIFA partnership.

Chris Stent - Vice President-Investor Relations

Next question is from Andrew Charles of Cowen.

Andrew Charles - Cowen & Co. LLC

Great. Thank you. Given the 3% pricing in the U.S. this quarter, which is at the midpoint of the food away from home inflation outlook, how should we think about your willingness to let price roll off? Steve, you called out the differential between food at home and away from home creating pressure on the top line. And if I can sneak one more in there, Steve, you called it out in your prepared remarks, but there was no mention in the release of the MONOPOLY promotion in April and the Angry Birds promotion in May. So is it fair to categorize June as the strongest month of the quarter for U.S. same-store sales?

Stephen J. Easterbrook - President, Chief Executive Officer & Director

Well, I will speak to a couple and Kevin may want to add to that as well. When we look at the average check increases, so kind of the gap between top-line sales and our guest count momentum, I mean, clearly, price is a differentiator, but so is also the product mix, the bundling of items within each purchase. And one thing I would want to say is that when we have offers redeemed through the global mobile app, we see an average check increase. When we see breakfast items bought during the main daypart, we also see an average check increase. So part of it is not just price-driven, it's actually product mix and bundling-driven.

I don't particularly want to talk to the monthly trends, because we've got away from that, so I don't think, honestly, that's very valuable. I guess what I would say across the quarter is there wasn't really a deeply meaningful trend one way or the other. We consistently performed and we consistently outperformed the market. And if I look at the competitive gap week-to-week-to-week, which clearly we do, we had a pretty consistent outperformance right across the 13-week period.

I don't know if, Kevin, you want to add anything to that.

Kevin M. Ozan - Chief Financial Officer & Executive Vice President

I'll talk about some the pricing stuff you mentioned, Andrew. Related to kind of what rolls off, I guess what I would say is in the second quarter, we had some pricing from the prior year that rolled off and we didn't replace all of that. And you can probably expect similar for the rest of this year, again, partly because of that widening gap between food at home and food away from home inflation. So we're certainly keeping a close eye on both of those metrics because it's really important for us to focus on maintaining and growing guest counts.

Stephen J. Easterbrook - President, Chief Executive Officer & Director

Sorry, I'm just coming back on MONOPOLY and Angry Birds result. I think it's really important for a business like ours and a brand like ours to create energy and engagement amongst our customers on multiple fronts. And clearly, standing for everyday value is important, certainly, but also, so is some fun and some engagement. And that's the role that games like MONOPOLY play or meaningful promotions like Angry Birds. It just provides some excitement and some buzz around the brand.

And we do have a, I would say, competitive advantage that we are able to attract many of the best partners in the world because of our size and scale matching theirs. And like a recent example of the work in Japan, so I'm thinking with Pokémon Go is a great example, where clearly we're a preferred partner and it's been a fun program. It's doing great things for the business. And customers respond to that, both at a day-to-day level in the restaurants, but actually, they recognize that we're a leadership brand and we attract leadership partners.

Chris Stent - Vice President-Investor Relations

Next question is from John Glass of Morgan Stanley.

John Glass - Morgan Stanley & Co. LLC

Thanks. Just back on the U.S. sales, you're still in an early phase of a turnaround. So one could argue that your gap to the industry should still be widening and it didn't this quarter. I wonder – just a couple of questions, one is, do you think the change from a Dollar Menu to the bundled value had any adverse impact on transactions and the way people think about the brand? And clearly, as you're very well aware of, the fourth quarter and early 2017 comparisons are more difficult. Do you think just adding to the breakfast all day menu is sufficient to lap those or are there other things you're thinking about that are more profound, you just don't want to talk about today? I think you mentioned something about loyalty. Is this the time that a loyalty program would fit into the marketing plan, for example?

Stephen J. Easterbrook - President, Chief Executive Officer & Director

Hi, John. I think on value, is there a trade-off in transactions having moved away from the Dollar Menu? I think there is, yeah, absolutely. We recognize that. That doesn't come as a surprise to us. What we wanted to do is work hard to still have a compelling everyday value proposition in our restaurants. And that can take the form of many things. So we've gone with the McPick 2 platform. And, again, just to step back and remind why we believe this is strong, is because it's grounded in what customers tell us is most important for them, which is choice and flexibility. We're not locking them into a certain price point, nor are we locking them into a certain selection of bundled items.

So we believe that choice and flexibility is right for our customers and gives us flexibility and new news as we return to these programs across a year. Sometimes, they'll be at a national level. If it's not national, it'll be locally reinforced in the marketing windows in between. So we're continuing to learn. We've only been national with McPick 2 for $5 twice now. And again, the local co-ops are being worked on their variations of particularly the McPick 2 for $2 or at a value price point. So we're continuing to learn and evolve that. But is there a transaction trade-off? Yes, there is. We knew that. We planned for that, but we still believe we have an everyday value proposition.

And again, it's not just McPick 2. I mean, there's local promotional activity in the co-ops (45:12) on an ongoing basis, whether it's a $1 drink promotion, for example, all the way through to the offers we're now offering through the global mobile app. We've had 12 million downloads of that. We've got 8 million registered users on the app. And clearly, the offers and the frequency card on there are driving over the (45:33) interaction.

In terms of quarter four, clearly, we know the, if you like, the quarterly cycles we're on. We believe the enhancement to All Day Breakfast will help reinforce the baseline momentum, as does running better restaurants, as does reinforcing value. The team is certainly working on other activities. There is nothing in particular to share today, but I would say that we are playing the long game here.

We're mindful of the quarters, but we're not going to manage it by quarter. We believe we're getting the right fundamental foundations and platforms in place to reinforce the long-term success and profitability of McDonald's. And we have consciously expanded our business plans and our activity away from just a product and price-led program, which we had been somewhat joined to in the past. And we believe that the brand-enhancing long-term perspective, as long as we're winning the short-term market share fight, is a good combination for us.

Chris Stent - Vice President-Investor Relations

Next question is from Joe Buckley of Bank of America Merrill Lynch.

Joseph Terrence Buckley - BofA Merrill Lynch

Thank you. You mentioned Pokémon Go in Japan; just curious if there are opportunities besides Japan for Pokémon Go. And then, wanted to ask as you lap last summer's wage increases in the U.S., what do you expect to see in wage inflation in the U.S. kind of in the back half of the year versus what you've seen in the first half of the year?

Stephen J. Easterbrook - President, Chief Executive Officer & Director

All right. Joe, I'll take the first one, because I'm more knowledgeable about Pokémon than I am about the detailed financials. I'll let Kevin deal with that one. So our relationship with Niantic really has been driven by our Japanese team. It's a global phenomenon, clearly, and they're working really hard to roll it across a whole bunch of different markets around the world with, again, great success. We'll keep talking to any leadership partners around the world, so nothing else to say, no other speculation to add to it, but we're certainly enjoying what it's doing for our business in Japan at the moment.

Kevin M. Ozan - Chief Financial Officer & Executive Vice President

Regarding labor costs, minimum wage, et cetera, you should expect to see kind of not a big bang like you would've seen in 2015 related to one significant effort, if you will, to raise wages at one time. We certainly are mindful of wage increases in various states throughout the country. One of the pluses that we've seen from the efforts that we've taken, as Steve mentioned, both on the wage side as well as the benefit side, is that our crew turnover is down year-over-year. So we've seen some benefits on the labor availability side, if you will, from the actions we've taken. I think it's fair to say labor pressures will likely continue in a lot of countries around the world, including the U.S., but there aren't any specific plans to have a one point in time where we significantly increase.

Chris Stent - Vice President-Investor Relations

Next question's from Jason West of Credit Suisse.

Jason West - Credit Suisse Securities (USA) LLC (Broker)

Yeah, thanks. Just a tactical question and then a bigger-picture question, just on the pricing that you guys quote, the 3% in the U.S., is that net of the discount that you're offering on McPick 2, like say, when it's a 2 for $5 for things like Big Macs or is that just the gross pricing? And then just bigger picture, I guess, as you guys step back and look at the impact that McPick 2 has had on the business and All Day Breakfast, do you get a feeling that there's initial trial there that's difficult to sustain, which is somewhat the way it sounds on the outside a little bit, or are you not really seeing that sort of dynamic playing out as much? Thanks.

Stephen J. Easterbrook - President, Chief Executive Officer & Director

I'll take the second one, Jason. So McPick 2 and All Day Breakfast, they have both followed pretty much the curve that we would've expected. I mean, whenever you launch anything and put national support behind it, you have a launch volume. And then you kind of settle into a more ongoing run rate. I've got to say we're pretty happy with how both of those have played out. And they have continued into the out quarters, if you like. From the All Day Breakfast launch in October of 2015, we're now almost lapping that, that time and it's continuing to give us strong incremental sales, strong incremental margin and cash flows and incremental visits as well, and the same with McPick 2. So I think these are now platforms that are just going to continue to work hard for us at that kind of steady-state ongoing level.

Kevin M. Ozan - Chief Financial Officer & Executive Vice President

And, Jason, that 3% is a gross price increase.

Chris Stent - Vice President-Investor Relations

Next question's from Jeff Bernstein of Barclays.

Jeffrey Bernstein - Barclays Capital, Inc.

Great. Thank you very much. Actually, just two follow-ups to what was mentioned earlier, one, Steve, you mentioned the market share gains and it seems like it's stabilized in the U.S. relative to last quarter. I'm just wondering whether you could talk a little bit about the largest international markets; whether you'd say based on whether you're looking at food at home or the informal eating out market, just however you look at it, trying to see whether there's any big winners or losers in your largest international markets.

And then the other follow-up was just for Kevin. You mentioned the return of cash, and I think we're all well versed in the bump in leverage and the big bump in the repo that you've done over the last 12 months. But with this three-year period being close to done, and now as we look out over the next, presumably, three-year period, is there any reason, at least directionally, to assume any meaningful change in that $30 billion, whether up or down? Or maybe what metrics would lead you to make that decision? Thanks.

Stephen J. Easterbrook - President, Chief Executive Officer & Director

Hi, Jeff. So when we look at market share certainly across our major markets, we look at both IEO, but also then QSR. And depending on your competitive set, they have different merits, depending on which country you're looking at. But if I was to take IEO, we have made strong gains, I would say, across in U.K., Australia, China and Canada. And we feel good about our position within the broader marketplace. Even more encouraging is in the nearing competition, the QSR market share, where we have made some substantial gains in U.K., Australia, China and Canada.

And I think as part of the turnaround, we have really focused on making sure that we win in the most immediate competitive set we are. This is part of the modern, progressive burger company ambition, which is make sure we're strong and dominant in our immediate sector. And then we start to take IEO share as we broaden the experience. I believe the Experience of the Future will have us fight into an increasingly strong position in the broader IEO. In the immediate term, it was getting the basics of the business right so we win QSR market share. And I've shared over a number of these calls and meetings we've had about some of the successes in Australia and Canada, for instance, but the customer experience is noticeably different than it was three to four years ago, both from the designs of the restaurant, the introduction of technology, the substantially enhanced front-of-house hospitality that we now offer, all the way through to providing more options to customize your food by self-order kiosks, for example, in the dining areas. And now we're extending that to table service.

So if a customer was to walk in now versus two, three, four years ago, it would be a noticeably different experience. And I believe that's both winning QSR share and IEO share. And those are the sort of ideas that with the new structure we have, we're looking to move and are moving very, very quickly between markets.

Kevin M. Ozan - Chief Financial Officer & Executive Vice President

And then, Jeff, related to your cash return question, as you indicate, obviously, over the last year or so, we've had an adjustment of our capital structure by taking out some more leverage and returning that via share buyback to shareholders. Going forward, we haven't stated any target, but certainly our overall capital allocation philosophy hasn't changed, which means you should expect that over the long-term, we would return all free cash flow to shareholders, that's a combination of dividends and share repurchase, while still maintaining kind of that BBB+ credit rating, which is where we are right now.

Chris Stent - Vice President-Investor Relations

Next question is from Jeff Farmer of Wells Fargo.

Jeff D. Farmer - Wells Fargo Securities LLC

Thank you. Just a question on your longer-term operating income margin opportunity, so looks like your guidance points to franchise restaurant ownership moving to I think it's almost 95% by the end of 2018. I think you stand at roughly 83% today. You've seen dramatic margin expansion in the past, following some of these aggressive refranchising efforts. Going back and looking at – the model looks like in 2007 and in 2008, you did see some really, really impressive margin expansion, again, I think after you developmentally licensed and refranchised more than a couple thousand restaurants. So with that precedent, what operating income margin level – and again, I realize you're not going to give me a specific number or even a tight range, but when you guys move to a 95% franchise mix, how different do you think the operating income margin of McDonald's will look in 2018 as compared to what it looks like today?

Kevin M. Ozan - Chief Financial Officer & Executive Vice President

Yeah, Jeff, it's Kevin. Couple things, one, I believe we expect to be 93% by the end of 2018, with 95% longer-term. So I just want to make sure everyone gets that. As you know, the way it works when we refranchise, we'll pick up franchise margin dollars. Effectively, we're swapping company-operated margin dollars for franchise margin dollars, and certainly then spending less G&A and capital to generate those franchise margin dollars.

So as you state, that was certainly accretive to operating margin back historically when we've done that. We would expect similar – that we would also be able to improve operating margins going forward, based on the activity. As you indicate, we're certainly not going to throw a number out there, but, generally, one of the main reasons we're doing that is because of the stability of both the cash flows and the operating performance going forward. So we've got a stable revenue stream that we'll collect and a predictable model that allows us to manage the business pretty effectively.

Certainly on a free cash flow basis, you should expect that it would be accretive, because, as I said, we're generating more income, more cash flow, and not spending as much capital.

Stephen J. Easterbrook - President, Chief Executive Officer & Director

I would say just as a broader philosophy on the fundamentals of not just the turnaround plan, but our growth strategy beyond, Jeff, is that with the ownership strategy, this is around us being able to focus our time and our attention and our resource on the areas and the markets that make the largest contribution and also our talent. So we're going to place our talent in the areas that drive growth. We can place our capital in the markets where the returns are stronger and, at the same time, liberate one of the fundamental DNAs at McDonald's, which is to have 100-plus of our 120 markets owned and operated by franchisees and developmental licensees, because they are closer to the customer and closer to their local culture. So we believe we're going to get that balance right, which will certainly enhance our efficiency and effectiveness, not just as an operating business and drive long-term growth, but also our financial returns as well.

Chris Stent - Vice President-Investor Relations

The last question's from John Ivankoe of JPMorgan.

John William Ivankoe - JPMorgan Securities LLC

Hi. Thank you very much. And maybe a little bit of a follow-up or maybe good timing from the previous question, it does look like you guys are choosing developmental licensing, perhaps even over conventional franchising as we kind of read what we read in the press and how you've discussed the business.

So with that being said, there were a few different references to G&A, I think, by both Steve and Kevin in your prepared remarks. Maybe there's some commentary coming on the third quarter. The first G&A cut announced, I think, was $300 million and then it was $200 million. Is your mindset that there could be another type of G&A tranche to come out, perhaps as significant as the first two that you've discussed? And secondly, as we start to focus on free cash flow, especially as we get into 2018, are you prepared to help us think about what the long-term CapEx of a kind of a post-refranchised McDonald's would look like?

Kevin M. Ozan - Chief Financial Officer & Executive Vice President

Yeah, John. Let me talk about the whole deal of developmental licensee versus conventional. So as we talked about last year, we effectively took a restaurant-by-restaurant and market-by-market approach to look at kind of the best way of franchising in our mind. And what you'll see is, and generally in our major significant mature markets, that's the U.S. and International Lead markets, you'll see more of the conventional franchising, which is what we do in the U.S. So you would have seen some more conventional franchising certainly in this quarter and there will likely be further franchising like that.

In countries, certainly in certain parts of Asia and Europe, where either it's a little bit more volatile from an economic and political standpoint and/or a partner can help us accelerate growth and grow faster than maybe we're willing to put in capital right now, those situations, you will likely see us using that developmental license model that we've used successfully for many years in a lot of the countries.

All of the transactions that we have planned right now were taken into consideration when we came up with that $500 million of G&A reduction. So the $500 million contemplated all of the transactions that we have kind of in our plans at this point. So none of those activities will, in and of themselves, drive further G&A reductions. That doesn't mean that we're not going to continue to look for efficiencies and run the business in a disciplined manner, but you shouldn't expect that because we complete a franchising transaction or anything along those lines that that would trigger automatically a further or additional G&A cut in addition to the $500 million.

Chris Stent - Vice President-Investor Relations

We're near the top of the hour, so I'll turn it over to Steve, who has a few closing comments.

Stephen J. Easterbrook - President, Chief Executive Officer & Director

Thanks, Chris. And, again, thanks, everyone, for joining us this morning. I want to re-emphasize our focus on putting the customer at the center of everything we're doing, from the food we cook to the conveniences we offer, to the service we provide. That mindset ignited our turnaround last year and continues to guide our decision-making. We're moving the right direction, with four quarters of growth, with growth across all four segments in each quarter. But there is more work to do. And that's precisely why we remain committed to executing our turnaround plan through the end of the year.

I'm encouraged by the way we're creating a better McDonald's and excited about the opportunities ahead. And I'm confident we will continue to aggressively take actions to strengthen our business and reassert our leadership position as the modern, progressive burger company in the global IEO industry. Thanks to all of you, and have a great day.

Operator

This concludes McDonald's Corporation investor conference call. You may now disconnect.

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