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McDonald's Corporation (MCD)

Q2 2007 Earnings Call

July 24, 2007 11:30 am ET

Executives

Mary Kay Shaw - VP of IR

Jim Skinner - CEO

Matthew Paull - CFO and Corporate Senior EVP

Analysts

Joe Buckley - Bear Stearns

David Palmer - UBS

Jason Ralph - Deutsche Bank

John Glass - CIBC

Jeff Bernstein - Lehman Brothers

Paul Westra - Cowen & Co.

Glen Petraglia - Citigroup

Jeff Omohundro - Wachovia.

Victoria Hart - Merrill Lynch

Mark Wiltamuth - Morgan Stanley

Steven Kron - Goldman Sachs

John Ivankoe - JP Morgan

Virginia Chambliss - JP Morgan

Matt DiFrisco - Thomas Weisel

Joe Buckley - Bear Stearns

TRANSCRIPT SPONSOR
Wall Street Breakfast

Operator

Hello and welcome to McDonald's July 24, 2007 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, (Operator Instructions). I would now like to turn the conference over to Ms. Mary Kay Shaw, Vice President of Investor Relations for McDonald's Corporation. Ms. Shaw, you may begin.

Mary Kay Shaw

Hello, everyone, and thank you for joining us today. With me on our call today are Chief Executive Officer, Jim Skinner; and Chief Financial officer Matthew Paull. This conference call is being webcast live and recorded for replay via phone, webcast and podcast.

As always, the forward-looking statements which appear in our earnings release and 8-K filings also apply to our comments. Both the earnings release and our 8-K with supplemental financial information 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 would turn it over to Jim Skinner

Jim Skinner

Thanks Mary Kay. Good morning everybody. Thanks for being on the call. As evident by our quarterly results, the fundamental strength and momentum of our global business in continues.

Every area of the world is contributing with strong profit worldwide results. Matt’s going to take you through the numbers in a few minutes. But what I want to talk about today is how we will continue to drive these trends. Let me start by saying, I am optimistic and confident, about our ability to capture the opportunity in the market place. Clearly our systems collective focus and alignment around the Plan to Win continues to be the right operational plant. Additionally, our ability to take up idea scale and execute it, this is our competitive advantage and a key driver of our growth. For example, we have adopted tiered menu platforms around the world; ensure learning in success since last quarters.

The premium Chicken Selects, and value price Snack Wraps which are popular in the U.S. are now driving strong incremental sales in both Germany and the U.K., Breakfast and convenience are two more examples of our replicate skill and execute strategy. In Asia Pacific, Middle East Africa breakfast is now in more than 70% of our restaurants.

The recent McGriddle breakfast sandwich launched in Japan is helping generate strong momentum. And the recently introduced western-style breakfast in China is driving breakfast count sales increases of about 50%. Extended hours are now in a third of our restaurants in APMEA. In China, half of our restaurants are running 24 hours operations and they are generating same store sales 6% of other national average. Together breakfast and extended hours are significant contributors to the double digit comp sales we are seeing in this area of the world.

In the U.S., we are aggressively going after the $60 billion beverage industry with the focus on coffee. We added credibility in this arena now with lots of premium coffee last March. Today, premium coffee sales are up 20%. This credibility gave us brand elasticity to expand further into specialty beverages. Currently, we are testing a wider range of offerings including hot and cold drip coffee beverages an espresso-based coffee and ice beverages. We are encouraged by the preliminary results. Including these specialty offerings, total coffee sales are up more than 30%.

Further operations and consumer testing will determine our timeline for a national rollout. And in line with our replicate scale execute strategy, it wouldn’t surprise me to see these products in other international markets over time.

One last example of this strategy and action is our global promotion of “Shrek the Third”. The promotion began in May in the U.S. and launched at markets throughout Europe and APMEA in the summer. Today it has been hugely successful in driving Happy Meal sales, and we are confident the program will continue to drive sales such as it rolls out in additional international markets through October.

Using our license characters to promote our food choice and variety while encouraging physical activity, has also positively positioned our brand with key stakeholders and consumers.

Moving forward, we will continue to scan our system in the market place for what's working, scale it and deliver superior execution in our restaurants. Last month the top 35 leaders of our global business convened to review and calibrate our strategic approach in business plans for 2008 through 2010. These plans leverage our competitive advantages and focus our researchers around key growth platforms that would drive our business in every area of the world.

Specifically, we are aligned around developing new branded food and beverage products and growing sales of existing products. Growing sales at our drive-thrus by expanding capacity and enhancing the customer experience, growing our business today product expansion by continuing to extend our build breakfast and fulfill new customer’s needs in the organization, and we will continue to grow sales and profits through new platforms.

I am confident these are the right plans to generate growth, and I am also confident in our leadership and their ability to execute in their market places and increase sales and profits. To lead and support these efforts, I would drive direction against a few critical areas. First is menu development, our track record over the last several years’ shows success with salads, chicken and coffee, just to name a few.

No paragraph break

Yet we have an opportunity to enhance us towards some processes in food development, increase our speed to market and intensify impact.

Next is restaurant re-investment, and ensuring the right place and level of reinvestment by balancing the needs of our customers, operators and children. We must optimize our projected $1.9 billion CapEx spend in 2007 and continue to deliver superior returns.

Third is continuing our financial discipline with an eye towards growing our free cash flow. Initiatives to build sales and optimize margins are obvious contributors. Additionally, we are leveraging our strength as to franchise or with world class franchises to increase the reliability of our free cash flow growth.

In the U.K. and Canada, we have made solid progress towards a goal of increasing franchise ownership to at least 70% of restaurants. And we will soon closing on the previously announced transaction in Latin America that we saw with the franchising of 1,600 restaurants to a developmental licensee.

Both efforts demonstrate our commitment to improve consumer relevance to local ownership, wealth, and building corporate cash flow through a more stable rent and royalty system.

And on the related topic, I want to briefly touch on our capital structure as I know it’s of interest to you. We recognized the financial strength of our business is growing and getting stronger, at the same time we also know that credit markets are friendlier especially to a business model like ours. As such, we periodically discuss our capital structure and financial strategies with the Board to determine the amount and form of cash we should return to shareholders.

As you know, we look at various alternatives and project their impact on the strength of the business, our credit ratings, our franchises and our suppliers. Currently, we are preparing to discuss these topics with the Board and are exploring all of our options

What I can reinforce is not new notes; we are still committed to return at least $5.7 billion to shareholders in 2007 and 2008.

In closing, you’ve heard say before that McDonald's is a learning organization, by giving you a peak out of the depth into our strategies and areas of opportunity going forward. I hope it’s clear that while we are pleased with our current business performance, we are not satisfied with the status quo. We are focused on and committed to developing and executing the strategies that will provide sustained profitable growth for our system and shareholders.

Thank you and now turn over it over to Matt.

Matthew Paull

Thank you, Jim and good morning everyone. As Jim just outlined today’s real news is the underlying strength and momentum at global business. These transitions of virtually all in our Latin America business to a developmental license, positions us to further leverage this momentum.

For our customers it will help us become even more convenient and more locally relevant. For our shareholders it will reduce volatility and contribute to improved returns as a result of having a less capital intensive business model with a substantial, reliable and growing royalty strength.

As indicated in April the approval of the Latin America transaction resulted in a second quarter impairment charge. The substantially non-cash impact of $1.31 per share is comprised of $1.33 per share of impairment expense which includes about $830 million for the difference between the net food value of the business. And $700 million in expected cash proceeds. It also includes $780 million in accumulated currency translation losses.

This was apparently offset $0.02 benefit because we stopped depreciating these assets in mid-April in accordance with the accounting rules on assets held for sale. Including the total net impact of $1.31 we reported a second quarter loss per share of $0.60. Excluding this, second quarter earnings per share from continuing operations was $0.71, up 27% from last year.

As per our tax rates, after adjusting for the impairment charge and a minimal tax benefit from our Latin America transaction the effective tax rate for the quarter was 34.2% bringing our year-to-date rate to 32.4%. We are currently in the midst of our IRS tax audits and therefore are unable to provide full year guidance until its resolution.

Now turning to our ongoing operations, we achieved strong earnings growth on record revenues of more than $6 billion in the quarter up 8% in constant currencies, total margin dollars from McDonalds restaurant, grew 12% in constant currencies to about $2 billion. About one third of these margin dollars were generated by company operated restaurants. As a percent of sales , McDonald margins were strong up some 150 basis point to 17.6%, this increase was primarily driven by improvement in Europe and Asia Pacific.

In Europe, sustained strong sales growth throughout the segment contributed to margins rising 200 basis points, the U.K. and France were the main drivers of these increase. European beef and chicken cost were relatively flat in the quarter, which is also our outlook for the full year in Europe.

Broad based improvement in Asia Pacific drove a 220 basis points margin increase. China was clearly a leader here with strong comparable sales growth fueled by breakfast, extended hours and a relevant menu featuring premium core and value offerings.

While for maintaining its focus on the customer, the U.S. achieved strong margin levels at 19.5% despite in an inflationary commodity and labor cost environment in the quarter. Chicken, which is up 9% in the quarter and dairy were the main commodity cost pressures we experienced, while beef cost declined nearly 3%.

For the year in the U.S. we continue to expect beef cost to be flat to slightly down, while chicken is to be up 4 to 5%. While the U.S. business navigates through the current cost environment, its priorities will continue to be offering great value, driving customer traffic and delivering strong margin performance.

I also want to point out the 200 basis points of the improvement in Latin America margins was driven by double digit comp sales growth in Brazil, Argentina and other markets, while the elimination of depreciation contributed 300 basis points. The other two thirds of the $2 billion in total margin dollars is from our rent and royalties stream, less occupancy expenses due to the franchising side of our business. As a percentage of revenues, franchise margins increased 50 basis points to 81.5%. Franchise margin dollars are a steady and reliable driver of our free cash flow. We expect free cash flow will continue to grow as we evolve to a more properly franchised less capital-intensive structure. Our Latin America transaction represents more than two thirds of the restaurants we targeted for conversion to a deal structure. This single transaction results in the percentage of franchise restaurants world wide increasing to 77% from 74% at year-end 2006. As for the remaining market on our list are currently thinking. It may take a year or two longer than originally contemplated. Throughout this process our goal has been to make sure that we have the right license fee. If the market is in good condition for transfer and that we optimize the long-term profitability and reliability of our cash flow.

Our teams in the UK and Canada are making good progress towards our goal of having more than 70% of the restaurants in the East markets franchise. In the UK, the percentage of franchise restaurants increased from 37% at year end ’05 to 47% today. We are on track to have 50% over UK restaurant franchise by the end of this year and 55% by the end of next year. In Canada, we have increased our franchise percentage to 66% and are well on our way to meeting or exceeding the 70% threshold. These efforts will enhance the continued growth and reliability of our free cash flow, the primary source of the cash that we return to shareholders.

Year-to-date through June, we repurchased nearly 36 million shares for $1.7 billion as a part of our previously communicated commitments to return at least $5.7 billion to shareholder in ’07 and ’08.

Our priority remains to create long-term profitable growth for all stakeholders, by sharpening our systems alignment around and focus on our customers in our restaurant we are confident we can continue to deliver strong results.

Now, on a much more personal note I want to share some of my plans with all of you. When I accepted this job more than 6 years ago, there were certain things, I wanted to help this company accomplish. Gratefully through the hard work of the people who comprised the McDonald system, we have made very good progress. The company and the McDonald three-legged stool are at least strong today as at any time in he last two decades. When Jim became CEO in 2004, we discussed then, that I expected to work for three or four more years. Well that time is almost up and I want all of you know that I plan to retire in the near future. I have spent a significant portion of my time in this job investing with all of you in the investment community. And I have enjoyed every minute of our interaction. It is important to me that you understand why I am retiring from McDonald. This is not about me wanting a bigger job at McDonald’s. I have a wonderful job and this company and this CEO have been extraordinarily good to me. This is not about me going to work for some other company it is all about what I want out of my life. I have always dreamed of going back to a college campus to teach and because of all that McDonald’s has done for me, I can now afford to do so. When Jim and I discuss this, we decided we wanted to be very transparent regarding the search for my replacement. We have some very strong internal candidates, who will also be interview and external candidates in the next few months. We expect that it will take at least several months to identify the best and effect a smooth transition. So in all likelihood, you have to put up with me at least until the end of the year. Now, I know that Jam want in to comment. Jam.

Jim Skinner

Well, thank you, Matt. And I truly mean that, thank you. You continue to make a remarkable contribution to our business. You helped us turn this business around. Thanks to our emphasis on operations excellence and marketing leadership, and of course financial discipline. Our system and our shareholders owe you huge debt of credit to you for your commitment, your passion. You helped us be better, not just bigger and now as you announce your decision to pursue a life long dream, you leave McDonald on business high in a position of continued success. We forth for continued success and I know, and saying obviously when I say that Matt, (inaudible) from his financial expertise is owed to you and his vast experience.

There are lots of benefits in the left tangible qualities; I know that I certainly have. Matt is a great listener, a deep thinker, a strong communicator and has been a great thought partner to me. As it pertains to his future role, quite frankly, we have all benefited from Matt’s privilege for years. And so, it’s with obviously mixed emotions that applaud Matthew decision as we mentioned Matt makes his announcement with several top candidates for inside and outside the McDonald system.

We will take our time that’s needed to find and transition his successor. Matt’s has also made it clear he will be available to us beyond his official retirement date, while I hope that won’t be necessary. Certainly, considering his intellectual capital that he brings to the table he has offered certainly, as we assured.

Before I close my comment about Matt, I would like to emphasize the fact that McDonald management team remains in lined our plan to win, we will continue to stay course and remain as committed to the financial discipline that has helped us turn our company around.

Matt you are a great executive. You are retiring with class and dignity. You are a great friend and I wish you and Ilene the best with the next chapter of your life. And again thank you for your many contributions to the McDonald’s system.

Matthew Paull

Thank you, Jim.

Question-and-Answer Session

Operator

Thanks. I will now open up the call for questions. (Operators Instructions). The first question is from Joe Buckley from Bear Stearns.

Joe Buckley - Bear Stearns

Thank you. I wanted to ask you a question on margins both on the U.S. side and the European side. First on the U.S. margins, second quarter narrowed despite pretty good same store sales increases, the margins been down a little bit year-over-year. We've basically seen peak levels in the U.S. And then with respect to Europe, curious if you could sort of layout for us going back several years ago that sort of the goals on margins, whether European segments fits in to that? Where you think you are in terms of the margin recovery process? And before I get cut off; Matt wish you the very best on your retirement from McDonald’s.

Matthew Paull

Hi Joe, thanks very much. I will comment on U.S. margins and then get to Europe. On U.S. margins, we have said for quite sometime to maintain our margin percentage in the U.S. we need a 2.5 or 3 point comp. And in the cost environment we see right now in the U.S. obviously that was not enough because we produced a 5 point comp and we did not further grow margins.

I don’t want to leave you with the impression that we have peaked. We are, in my view, in an aberrational cost environment to give you some idea. The cost increases that we're seeing and the effect they have I think you will agree that it is, it is not norm. So just some examples, you all know that our beef and chicken sales are about at equal levels in the U.S. these days, a 5% movement in the price of beef or chicken cost of 20 basis points. So if chicken was up 9% and beef is down 3 that’s hurt us a bit. In addition, cheese was up 14% in the quarter and a 5% movement in the cost of cheese cost us 15 basis points, but on top of that because of minimum wages used in the states which started hitting in the third and fourth quarters of last year, we've seen labor cost increases are almost a 100 basis point at the store level. So with all that as background obviously a 5% comp was not enough in this particular cost environment, but we view this as being an aberrational constant environment and the brand has pricing power. We raised menu prices roughly 3%, we were able to do that while keeping guest counts growing. And we don’t think that we peaked but we think that given the cost increases we're seeing this year, it may be for the year we peaked. But in future years, I'm very confident U.S. margins could go higher. And 19.5 is a nice number, if we ended up settling at that number for a year, I could easily live with that.

Mary Kay Shaw

Thank you,

Matthew Paull

And I want to get to the European issue. Europe thought it was a really nice number, 18% is a good number. But when you look at the phase above it, Russia and France are very strong. UK still have their ways to go, we've seen improvement there but about half of the improvement we've got in the UK came from the re-franchising and we know that the UK is still very far away from where it was a few years ago. We're not ready to set new goals. We still have not reached the overall global goal that we set three or four years ago, which is to get back to an annual global company operated margin of 16.9. We’ll see where we are when we may close this year we might be there, and if we get there, then we will talk it over and then obviously set new goals. Thanks John.

Operator

The next question is from David Palmer at UBS.

David Palmer - UBS

Hi congratulations Matt, on a great career. Sometimes you tell us what the company margin gains in Asia were due to China, and how much the gains in Europe or it is, the U.K. You are kind of touching on it there a little bit. Could you perhaps give those numbers if they are handy, or if there is any way to add some texture to the margin gains in Q2? And just one more small one that is, with regard to the cash back to share holders and the leverage question that people inevitably have, are we are going to get into a bigger discussion in that, only in the fall at your big meeting in November? Thanks

Matthew Paull

I will deal with the Europe issue and you want to talk about…

Jim Skinner

David, good morning

David Palmer - UBS

Good morning, Jim.

Jim Skinner

The basis point improvement in China was 400 basis points, and we are very delighted with where we find ourselves in China right now. We are growing new stores more profitably and really driving the growth there to the leadership that we have in the market place. We are actually looking at our resources there and the infrastructure and our opening levels to see whether we can ramp that up overtime and pick up the pace, because the story continues to get stronger. But and the headline is that we have got to be able to make sure that we get the right locations and the right operating excellence to deliver relevance for our consumers. That’s the number one goal, and we are in it for a long term, but we are very pleased to find ourselves and we had substantial profit increase in the market.

Matthew Paull

And just, David, Europe about 75 basis points or so of the improvement in Europe’s margin. 75 of the 200 came from the U.K. and about half of that was from re-franchising, about half of the 75, that’s gives you a perspective there.

Just trying to go back to China for a second, we’re particularly proud of the marginal performance in China and the operating income improvement, because as I am sure you’ve read there are commodity cost pressures in China which are significant, and in spite of that we had a substantial increase in our margins in China. And I think the last part of your question had to do with the timing of when we talk about cash being returned to share holders.

It is as Jim mentioned in his prepared remarks, a Board matter and we don’t want to recruit our Boards ability to weigh in our midst not only as to what we are going to do with the timing. So our normal timing is sometime in the fall recovery, and they are peeping into that. Thanks.

Operator

Next question from Jason Ralph at Deutsche Bank

Jason Ralph - Deutsche Bank

Yeah, thanks a lot. First, if we can talk a little bit about what you are seeing on the comps in the U.S. and Europe in terms of ticket versus traffic, are you seeing any, I guess in the U.S. more importantly any response, when your prices up, any changes in terms of the mix on the menu here people making towards the dollar menu, et cetera.

Matthew Paull

Jason, this is Matt, I’ll take that. And globally what we’ve seen for the quarter is and this is true on almost every area expect maybe Asia, we stand between 50% and 60% of the sales growth coming from guest counts, between 50% and 60% in just about every area of the world for the quarter.

Asia with somewhere between 70% and 80% coming from guest counts. And in terms of recent trends, we have seen a little bit more movement in the U.S. towards guest counts that is still again for the quarter, the U.S. was right around 60% of the sales growth was from guest counts. And we had a very healthy relationship. We have seen, maybe a little bit more of movement in the direction of our Snack Wraps. The Dollar Menu in the U.S. has trended at almost the exact same percentage, somewhere, between 12% and 15% for the last three or four years. It's never gone outside of that range. We are seeing a little bit more uptake on the Snack Wraps and those are the trends we are seeing today. And some of that maybe influenced by gasoline prices and disposal incomes. And we are very much like the balance we have between gas comp growth and sales growth.

Operator

Thank you. The next question is from John Glass, CIBC.

John Glass – CIBC

Hi, thanks, good morning. You talked in your comments about optimizing CapEx over the next couple of years and historically it looks you’ve spent about half on maintenance and then half on growth and it seems like the maintenance components of it, whether it’s the U.S. tree model or the fact that you are selling Latin America, if you don’t have that, isn’t going to be there going forward.

So, my question is are we going to enter a period here, we believe that capital expenditures could flatten out or even decline versus prior years or does inflation and things like other growth initiatives offset that reduction in the maintenance. If in fact that’s what we are going to see?

Jim Skinner

Well, John, I can just comment on that and Matt may want to weigh in, but we've been spending of our 55% of the CapEx on reimaging in the portfolio. It still has a ways to go before we reach the reimaging of the entire portfolio. So I don’t expect that balance to change a lot over the near-term and the remainder, of course, was on new openings and then rebuilds and remodels.

And so, I think the balance will stay about the same and it’s possible we could have a slight reduction, but I wouldn’t necessarily say that it is in the strategy.

And then, John, your reference to inflation is one of the factors that's clearly helping our results, but also effect CapEx. The EURO is off late it's a $38 and some change this morning, and that has an effect. So, if you were to index this for inflation of our currencies, I think we’d expect CapEx to be flat, but because those inflation and especially because of currency values in Europe I would expect it to go up.

Operator

Thanks. Next question is from Jeff Bernstein, Lehman Brothers.

Jeff Bernstein - Lehman Brothers

Great. Thank you very much. Just in terms of the company operated of course follow on to prior questions. We did some modest pressure on the food and paper line after each three quarters of leverage? Even with the talk of the significant pressure on commodities, we are surprised not to see greater pressure on that particular line item.

I just wondered if you could talk about the operating structure and your ability to protect margins in the current environment and then just kind of a follow on to that, as you look up to 08, should we expect greater pressures as you renegotiate annual contracts or your protective based on your supply of ingredients agreements, I should say. Thanks.

Jim Skinner

I will make a kind of -- we have very good supply chain. Around the world we tend not to take shortcuts. We have a lot of dedicated suppliers who understand how important it is to protect the brand name and do things the right way. Having said all of that we do have some opportunities that might not be available to everybody, a good example in the U.S. with chicken. If you look, I think we said chicken costs were up in the quarter 9% for the year. We think they are going to be up 4% or 5%.

And out of the way we get there is we are using a lot of white meat from the bird in the U.S. and we have been exporting the dark meat and the value of dark meat in Asia is higher than it’s ever been. And so we get a lot of credit in our cost structure for the fact that we are selling the dark meat to Asia. And if you look all around the world you will see that our people on our supply chains are very creative, at finding ways without sacrificing food safety to keep cost down. So in China with very significant increases in chicken prices, we managed to keep the food and paper percentage at a reasonable level.

And regarding ‘08, we generally don’t hedge more than a year ahead and the biggest single hedge that we've probably make is on beef, where we tend to hedge about 25% of our beef cost and a part of the reason we do that is so that we can go to our franchises and say we're protecting the food and paper cost on the double cheese burger and its important to keep it on the dollar menu. But we never go beyond a year and probably beef is the single biggest hedge that we make.

Operator

Next question is from Paul Westra.

Paul Westra - Cowen & Co.

Hi good morning and a this is for you Matt as well. I have sort of a follow-up question on your capital structure, I guess just straight out of it. Is it safe to assume that you are no longer officially expected to maintain your current capital structure, they noticed into this mornings 8K that language was removed from the K. I think it was in the first quarter and there were comments of the context in the board. So are we just waiting sort of then find out how much with respect to potentially lever in one.

Matthew Paull

Paul, thanks for the question. I think my comments were really meant to say that we're not weighted to our capital structure right at the month, we never have that but we do review it with the board, it’s a relationship that we have with the board in the decision making their own capital structure that we review every year. And as I said we're taking a close look at it right at the moment and we expect that any of those decision were made and of course time will go on the next few months and normally it happens around September, and the expectation is that any decision we have made about that time.

Paul Westra - Cowen & Co.

Okay. Thank you

Operator

Next question is from Jeff Burns at Citigroup.

Glen Petraglia - Citigroup

This is actually Glen Petraglia from Citigroup, Thanks, in terms of our yield additions I think if I looked at my past date case correctly you’ve lowered your net unit addition expectations for this year a bit, maybe if you could talk about what’s driven that and I think some of the things that have been I had seen in the past that suggested that perhaps you would be rather sitting up. Your unit growth whether it be U.S. or internationally and I’m a bit surprised to see your planned edition this year down a little bit.

Matthew Paull

Glenn what that is all about is really what’s happening in one country. In Japan, they had about a hundred almost all satellites meaning very small stores, so they decided to close. That was not in the plans coming into the year, so there’s nothing to do with the gross additions. It has to do with the fact that our closings of some very small units, very low volumes came up recently and that’s what explained this 100 unit adjustments.

Glen Petraglia - Citigroup

Okay if I get this chance –.

Matthew Paull

Sorry about that.

Operator

Oh yeah I guess you get cut off. But we’ll put you in the queue again. The next question is from Jeff Omohundro, Wachovia.

Jeff Omohundro - Wachovia.

Thanks. Just a quick update please on the POS system rollout, and if you’re still seeing, what are actually improvements that were previously discussed?

Matthew Paull

The POS system rollout were up to about 10,000 stores globally, but very little has touched the U.S. at this point, its 100 or 200. And the order accuracy improvements that we discussed were what we say in a laboratory setting. We have not measured it yet in the stores we've rolled it out but we are very confident that its makings the crew’s job easier and if it makes the crew’s job easier there is a very good chance that we are doing a better job with our effort here. Overall mystery-shop scores are better around the world by a fairly significant amount but we still know we have a long way to improve.

Operator

Our next question is from Victoria Hart at Merrill Lynch.

Victoria Hart - Merrill Lynch

I am calling in for Rachel Rachael. I just want a follow up on your previous comments on the CapEx plans in which although re-franchising has taken ways, I’ll expect that some CapEx would fall out. Can you kind of guide us a little bit better as to what you would expect there more normalized rate or in the re-franchising, the out structure complete and then a little bit more on the re-imaging if 55% of the CapEx is on reimaging, where does our profit stand, which markets are benefiting from re-imaging and how much longer it would take to complete the process?

Matthew Paull

Victoria, we’ll give you a point of view here. I would say that the normalized rate is about where we are now and that it’s true that we are probably doing away with the need to invest $90 or $100 million a year in Latin America, because of the dealing of that market. We’ve taken up the number of rebuilds for planning in the United States. The rebuild is where you have a piece of real estate, you like the location, but you need a completely new building.

So we are doing almost 300 rebuilds this year, versus 200 last year, and our expectation is that we are going to continue rebuilding the store base and when it comes to re-imaging, I believe that the model we are evolving towards is to touch the system once every ten years in terms of remodeling. We haven’t committed to that firmly, but I don’t think we are going to reach a point of time where we are done, because when we reach that point of time it might be time to start on the stores we began with.

So we are thinking this through, we think maybe once every ten years, about 10% of the system per year might be the right answer. For this year we are only targeting to do 1,900 or so remodels, and it’s possible that we’ll bring that number up per year to closer to 10% of the system and every market in the world benefits where they have mature restaurants, they need to re-image. And so, it sort of spread across the globe and you look at Europe and United States in particular relative to the re-imaging dollars.

And this is an issue we study very carefully. It's very hard to connect exactly, what’s happening in the business to re-imaging, but we think it's very important part of brand relevance. And we think it has distinguished us from competitors in the eyes of our customers.

And lastly, just one factor and that I'm sure most of you aware. When we look at in the last 20 years and probably up until the mid 90s, we were spending in excess of 20% of system wide sales on the company's CapEx that ignores what the operators were spending in CapEx. And now you are look at where we are trending, we’re running between 7% and 8.5% of system wide sales, is what we are spending on CapEx.

So, we have made a big adjustment. None of us are trying to tell you that $1.9 billion is a small number, but relative to system wide sales, it's much smaller than several and the number I gave you really isn’t on system wide sales, it's really on revenues. But if you look, if you track our revenues and CapEx as a percentage of those revenues, you see it's going down dramatically over the last few years. Thanks.

Operator

Thank you. The next question is from Mark Wiltamuth at Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

Hi, good afternoon. Question for Matt. I am sure you watched all the securitization franchises happening at the other restaurants?

Matthew Paull

We sure have.

Mark Wiltamuth - Morgan Stanley

I am curious, if that could that play a role for you or is that just not an avenue that investment great companies head down? And as you are looking at the international markets are there any restrictions or difficulties in securitizing in international franchises?

Matthew Paull

Mark, I’m going to answer the first part of your question and I think that will deal with the second part. We have looked at it, and we have concluded it makes the most sense when you got a company that is not investment grade and if the are borrowing cost and flexibility issue. So if we were to do something in the area that Jim described, I do not expect currently that it would be in the form of securitization. And since we have given you that answer, it doesn’t make sense to say about what it will look like globally. Thanks.

Operator

Next question is from Steven Kron, Goldman Sachs

Steven Kron - Goldman Sachs

Great, thanks. Matt, congratulations, best of all Q.

Question on pricing, just follow up on that. Matt you mentioned a pricing of 3%. Can you just put some context around how that compares to maybe what you guys had priced in the past and any thoughts going forward, particularly given, it seems though you guys have been able to maintain the type of mix on the menu and product mix that you had hoped for. So it seems to be a little push back on the priceing. Might we see that go higher?

And if I were to slip one more in there, can you just maybe Matt also comment on the remaining of your stores that are delayed, a little bit beyond your expectations? Is this just a question of not finding the right individual or are you having a difficult time getting that evaluated, you guys think should get out of that?

Matthew Paull

Steve, if I get started up on the pricing in United States, it’s very consistent with what we do typically year-to-year depending on where inflation might absorb in the economic environment overhead. This year at 3% it’s very consistent with our pricing models and as we look at, we don’t typically simply take whatever cost issues are in front of us and pass it through the menu.

And we have a very well robust menu pricing process that leaves us with proper conclusion regarding maintaining that value relationship with our customers in the pricing and so some of that off course is reflected in terms of the cost, but most of it is really about maintaining the relationship of their customers and allow them to understand the value you experience at McDonalds and continue to visit. And we're not releasing a lot of pushback I think on that pricing, you said that. I don’t know that we really seeing any pushback prospect on that 3% pricing. Relating to guest counts, actually guest counts are up a little bit.

Steven Kron - Goldman Sachs

And then Steven, on the DL issue just a little background, the biggest block of restaurants that were targeted as the DLs. We are about to close on in Latin America. We've learned a lot as a result of this transaction and one of the things that we've learned is we don’t want to put ourselves under too much time-pressure, if we intend to do it right and believe me we intend to do it right and specially to select a right licensee.

Having said all of that, I do want to point out, that if you look at the last page of the supplemental release and this doesn’t even yet reflect what we're about to do in Latin America, you'll notice that year-to-year we're up 564 franchise restaurant and down 203 company owned restaurants, so even without the effects of Latin America, we're making progress, some of that was dealing of other markets. Its not that was re-franchising some existing we can't goes without using DL and again from perspective the remaining markets in our list carry a combined book value in the neighborhood of 500 million and we said as recently a couple of quarter ago, we expect to receive about half of that proceeds from what is left on the list is not really significant. Thanks

Operator

Next question is from John Ivankoe - JP Morgan

John Ivankoe - JP Morgan

Thanks. A question for you, I guess Jim and it’s a follow-up to your comments you said that you alluded to on China in your prepared remarks. Year-over-year look like you’ve opened about 50 stores and in this current quarter you opened about ten, obviously comp sales done good margins are good and you mention that you wish that you could open stores quicker then you’ve been. Is there anything that is changing in the relatively near term to allow Trans store development to accelerate from recent levels?

Matthew Paull

Well, there is nothing specific at the moment or it was in the fact that as I said one of the things we did in our planning meeting in May was to take a look at the revenue generators and what they would research properly as a company to drive the growth over the long term. And certainly, openings of new restaurants in those markets that we have targeted with the great returns we are getting and the great opportunities here in China was one of those. And so we are looking at that right now. We have another couple of sessions coming up with the top 12 people in the organization, just to take a look at how we will resource to really drive the revenues that you saw of course into long term growth.

Openings in China is one of them, we are planning a hundred a year now, and the question is whether not we could ramp that up substantially, particularly on a base of 800 restaurants, which for us at Mc Donald’s is a fairly substantial growth in itself. The most important thing is quality, profitable sites that we are bringing on, numbers don’t matter if they are not quality profitable, new unit sales growth. And then whether the infrastructure, the organization can drive the operations excellence in those restaurants because it takes people to get that done. We have to develop the real estate properly then you have to operate these restaurants, it’s not about just getting promoted. And so whether our staffing is appropriate whether we have enough research and that we think we do currently. But the question is whether we could ramp it up some of the future and we are looking at that right now.

Operator

Thank you the next question is from Virginia Chambliss from JP Morgan.

Virginia Chambliss - JP Morgan

Thanks. I had a follow up question to the discussion on evaluating the capital structure, I am just curious if you can give us any guidance on how much lower in your credit rating you might be comfortable in going. Thanks.

Matthew Paull

You know Virginia, we’ve said publicly that we know we can run the company well if it’s something other than an A rating, but we are going to wait until we’ve discussed this with our board before we comment. But I think we can safely say we are not talking about anything below investment rates.

Operator

Thank you, the next question is from Matt DiFrisco of Thomas Weisel.

Matt DiFrisco - Thomas Weisel

Thanks. In respect to the comments that you have talked about on the Snack Wrap and premium roast coffee in the U.S. helping. Should we also assume then, that you saw most of your or there is a shift to greater sales distribution to pre-noon hours in the breakfast time, I am sorry can you hear me?

Matthew Paull

I didn’t hear the last piece of that

Matt DiFrisco - Thomas Weisel

Well I was curious on the breakfast mix as a percentage of over all sales, in particular in the U.S. market and given that premium roasted coffee and the Snack Wrap seem to be successful and conducive to pre-noon hours, I am just curious if you are seeing, the distribution of your U.S. sales shift more and what they stand right now as far as breakfast, lunch and dinner?

Jim Skinner

They really haven’t shifted much as an overall percentage just because of the size of the numbers first of all, some movement as Matt said to the Snack Wrap but on an overall basis the breakfast business continues to grow at about the same rate and the rest of the date wise the percentage breakdown is about the same, including the extended hours, which the extended hours really on an overall basis and not adding a lot to this same store sales growth and yet it’s incremental. And so I think the percentage has remained about the same.

Operator

Thank you. The next question comes from Joe Buckley.

Joe Buckley - Bear Stearns

Thank you. Soon as we go back to the developmental licensing because the 8-K outlook section did you indicate that there might be some deals this year but Matt it sounds like you were pushing expectations on that out of it.

Matthew Paull

Yeah Joe, if we left that impression. We didn't mean to adjust anything, except to say whatever it is we had in mind, it might take a little longer. So, we weren’t trying to imply that we think we are going to get something done this year.

Joe Buckley - Bear Stearns

Other than the closing of the existing deal.

Matthew Paull

Other than the closing of the existing deal.

Joe Buckley - Bear Stearns

Thanks.

Operator

Next question is from David Palmer.

David Palmer - UBS

Hi guys. Could you perhaps go over the timing and rollout of the new kitchens in Europe? And perhaps, give us some color of as to what that might mean in terms of enabling more innovation, better innovation, anything with regard to the cost that just overall what it might mean for Europe? Thanks.

Matthew Paull

Right now David, I think the number in Europe is around 1,600 restaurants here. The bridge operating platform which as you know facilitates the opportunity between products that are go direct and those products that are prepared in advance. It simplifies the operations, improves quality enhanced with the work environment. And about 50% of the European restaurants have Pub or rollout pub by the bridge operating platform by the end of ’07. And we expect that the majority of restaurants in Europe will have it by the end of ’09. And it does give us the flexibility to do things as I mentioned in the advert side of the business and create more flexibility.

Operator

Thank you. The next question comes from John Glass, CIBC.

John Glass - CIBC

Hi, thanks. This quarter Burger King pushed into late at night for the first time nationally and also did some value promotion to breakfast or value menu breakfast, did you feel an impact from either one of those businesses, either in absolute or maybe in a kind of mix shift or ticket shift as a result of it?

Matthew Paull

No.

John Glass - CIBC

Okay. Thank you.

Matthew Paull

Thanks John.

Operator

It looks like we are out of questions, so I will turn it back to Jim who has a few closing comment.

Jim Skinner

Well, thank you guys for being on the call. In closing I just want to reiterate what I said at the beginning of this call that our business is strong and we are looking to future with one goal in mind building in our momentum. We will continue to leverage our competitive advantages namely our ability to scan our system for what's working, replicate the initiatives and scale them around the world for maximum consumer and business management. Coming off our 2008, 2010 plan review I can say with the utmost confidence that our people and our plans are aligned around the right consumer initiatives to create growth into the future. And we remain committed to the financial discipline that supports our growth strategy of being better and not just bigger, and it will enable us to continue to deliver sustained profitable growth for our system and shareholders. Thank you.

Mary Kay Shaw

Thank you.

Operator

This concludes today's conference we do thank you for your participation.

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Source: McDonald's Q2 2007 Earnings Call Transcript
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