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McDonald's Corporation (NYSE:MCD)

Q3 2007 Earnings Call

October 19, 2007 11:30 am ET

Executives

Mary Kay Shaw - VP of IR

Ralph Alvarez - COO

Matthew Paull - CFO

Analysts

Steven Kron - Goldman Sachs

Jeff Bernstein - Lehman

Larry Miller - RBC Capital Markets

David Palmer - UBS

Glen Petraglia - Citigroup

Jason West - Deutsche Bank

Andrew Barish - Banc of America

John Ivankoe - JP Morgan

John Glass - CIBC

Joe Buckley - Bear Sterns

Paul Westra - Cowen

Jeff Omohundro - Wachovia

Larry Miller - RBC

Jake Bartlett - Thomas Weisel

Operator

Hello, and welcome to McDonald's October 19, 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).

And now I would now like to turn the call over to Ms. Mary Kay Shaw, Vice President of Investor Relations for McDonald's Corporation. Ms. Shaw, you may begin.

Mary Kay Shaw

Thank you. Hello, everyone, and thank you for joining us today. With me on our call are Ralph Alvarez, Chief Operating Officer and Matthew Paull, Chief Financial Officer. 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 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 will go ahead and turn it over to Ralph.

Ralph Alvarez

Good morning everyone. It's a great time to be in McDonald's. Our business is strong around the world for the every area contributing to growth and posing positive comparable sales and transaction accounts. And we have tremendous opportunity ahead of us. I will begin today's comments with the quarterly results and discuss the strategies that are driving momentum. Then Matt will take you through the earnings per share numbers and provide details about the Boston Market transaction and our capital structure.

Our management team is very pleased with our results and can assure you that performance this quarter is due to McDonald's continued focus on the plan to win. Our strong sustained momentum is due to our winning strategy of being better and not just better.

We are running better restaurants and have become more efficient given the evolution of our kitchens to provide consumers with even greater choice and variety. Operational excellence enables us to capture additional sales from customers who are recognizing our service improvement and rewarding us for it. Equally important, we have system line alignment behind one plant, a compelling benefit for company our size.

In addition, our decentralized organization is a competitive advantage, because it enables each area in world to implement aggressive, locally relevant strategies that ensure our brand will appeal to their customers. They have the flexibility to emphasize different business drivers for their specific market conditions. These drivers fit for them what we call the common success factors. They are branded affordability. Platforms that offer everyday predictable prices, here in the US you know that as Dollar Menu, greater variety in menu choice. Building on our strong core menu to provide customers with additional food choices that they didn't expect to get at McDonald's, better operations creating a more satisfying experience, expanded convenience, which helps our customers access our brand where, when and how they want to and our ongoing reinvestment programs make it our restaurants the most contemporary and best places for both our customers and for our employees.

As we go through our third quarter results, you will see that all areas of the world are succeeding due to their local deployment and execution of the common success factors that apply to their marketplaces. For now let's talk about operating income and margins. Driven by strong comparable sales, our revenues increased 3% in constant currencies in spite of the Latin America transaction and refranchising of restaurants in the UK and Canada. In the US, Europe and Asia/Pacific, Middle East and Africa, the revenues were up 6%, 7% and 13% respectively in constant currencies.

Operating income for the quarter reached $1.5 billion, up 13% in constant currencies. Our consolidated franchise margins were up 110 basis points to 82.3%.

Now, in the phase of a more challenging worldwide commodity and labor environment we are pleased to report consolidated company operating margin increased a 100 basis points to 18.3%. This margin expansion is a result of healthy sales growth and a good balance between traffic and average check increases and we remain committed to further improving margins as we continue to grow our sales. Let me now provide the details about how each area of the world has contributed to our success.

First Europe, Europe had a strong quarter with comp sales up 6.5%. Franchise margins increased 80 basis points to 79.4 and company-operated margin improved 120 basis points to 19.5% the highest level in seven years. This improvement was driven by strong sales across the segment, ownership changes in the UK and supply chain efficiencies. This was also partially offset by increased labor cost and to a lesser extent commodity cost.

These are impressive results especially when compared year-over-year as Europe was up against its best performing quarter from 2006. Nearly all countries in Europe posted strong numbers. We are having consistent performance across Europe beyond the big three markets of France, Germany and the UK. Notably, Russia, Italy and Spain are countries with strong results and the ability to contribute more over time.

The European business has achieved these outstanding results with their continued focus on three core strategies. Upgrading the customer experience, enhancing local relevance and building brand transparency. We continue to attract customers by featuring a variety of premium products, combined with compelling value options. The good example is Europe's expansion of the chicken category, including new chicken products at various price points such as the Snack Wraps at an entry level in the UK and Germany. Chicken Selects at the core level in Germany and the Chicken Gourmet and Chicken Mythic sandwiches at premium price points in France and many other countries. France is also experiencing success in terms of innovating a rather fourth tier of menu pricing with their combination of Le Petit Plaisir for small pleasures offerings. This strategy is being exported to other markets in Southern Europe with comparable success.

Separately, our reimaging work with best-in-class restaurant designs coming out of our European design studio is also resonating with customers. In addition to new restaurants openings with designs, almost the fourth of the European restaurants, 1,500 of them, over the past five years have been re-imaged and are adding to overall brand experience.

Now, let's turn to the US. In the US momentum continues with third quarter comp sales up 5.1%, marking 54 consecutive months of positive increases. Performance is especially impressive when put into the context of a drop in consumer confidence and the higher gas prices that are impact the overall industry. US franchise margins for the third quarter were up 90 basis points to 83.2%, driven by the strong sales mentioned above. Company-operated margins remained high at 18.4%, but did decline 60 basis points versus the same period last year. This was primarily due to wage increases and commodities.

We have adjusted prices by approximately 3.5% over the last year. Still below the food away from home inflation index and we will continue to make adjustments, but do so only with the long-term health of the business in mind.

As a result, we continue to outpace the compensation with strong traffic growth, significant market share gains and growing restaurant cash flow. While we have more pricing power than ever before, our comprehensive value strategy enables us to achieve results while meeting consumer needs for everyday affordability and convenience.

Our three-tier menu approach provides consumers with the range of menu options. It starts with $1 menu value platform, which is now been in place for five years, and continues to bring in consumer while looking for ways to stretch our wallets and encompasses the higher end with premium salads and sandwiches.

Another important part of the value proposition in the US is the addition of Chicken Snack Wraps. The August introduction of the Chipotle Barbeque Snack Wrap further extends this product line, and is selling significantly above target. By staying in the course, we will continue to build consumer loyalty and grow our customer base. We will leverage these gains with additional rollout of new products from our strong menu pipeline.

In terms of the drivers behind the quarter's US results, breakfast and beverages continue to feel that growth, as we provided more choice and variety. We have continued to capitalize on the strong foundation we built with last year's successful introduction of Premium Roast Coffee.

Overall coffee sales, both Premium Roast and Ice coffees contributed to the sales increases. The creditability we have established in coffee propels us to further expand our tests of specialty coffees such as cappuccino, lattes and mochas.

Also driving US continues to be the added convenience we offer customers to extended hours.

Late night, early morning and 24 hours the gains in market share we've had this year have strengthened our competitive position.

Our US business has a strong plan in place and the best owner-operators in the industry to execute against it.

Now, let's turn to Asia-Pacific, Middle East, and Africa. Robust sales growth in all major countries in Asia-Pacific including Japan, Australia and China, resulted in an 11.4% comp for the quarter, the highest in 10 years.

Franchise margins for this area in the world are strong at 88.4%. In the phase of increasing labor and commodity cost, company operated margins still improve the 190 basis points to 15.8%. This improvement was primarily driven by strong sales, guest counts and improved operating performance in South Korea, Ankara, Australia. EMEA is achieving these results due to their strategy of our everyday predictable value coupled with day far expansion into breakfast and conveniences like extended 24 hours drive-thru and delivery.

Now, let me give you some specifics from our three largest business units there. Japan has achieved 20 consecutive months of positive comp sales and broke several previous sales records are leveraging the popularity of many line extension such as EBI Filet-O and Mega Teriyaki.

Our team in China has relaunched breakfast simplified our valued platform and continue to promote the range of proteins we offer, chicken, beef and fish. No other quick service restaurant in China offers such a broad variety.

Australia has recently driven double digit comp sales growth for the focus on big burgers, breakfast and coffee, they have also benefited from an expansion into 24 hours a series of smart price increases.

Now, I would like to switch and talk about our worldwide ownership strategies. McDonald's previously announced plans to reduce the number of company operated restaurants by putting more of them into the hand of local owner operators and qualified entrepreneurs.

As we look to optimize our business under the Plan to Win we will continue to evolve our ownership mix by making changes in those markets where it makes more sense, either traditional franchise agreements or development of licensees.

Today, I want to take a moment to update you on the progress we are making as part of this strategy to evolve our ownership to best serve our business needs, our shareholders and our customers.

In the last 12 months, we have reduced the percentage of company operated restaurants around the world by 5% or 1,200 units from 27% down to 22%.

In UK, the percentage of company operated restaurants decreased by 3% this quarter, bringing the total to 53% of the restaurants under company management.

We have also made progress in Canada with a comparable 3% reduction, so that 33% of the restaurants are now company operated.

Also in the third quarter, we successfully close the transaction to franchise restaurants in 18 Latin American countries. We are pleased to report the transition to convert these restaurants were seamless for our customers, employees, suppliers and franchisees.

Our Latin America business had another impressive quarter with comp sales up 18.3%. With new capital and local entrepreneurship, McDonald's Latin America has a very bright future.

And now, let me turn it over to Matt.

Matthew Paull

Thank you, Ralph and good morning everyone. Despite a challenging consumer and cost environment, we've strengthened our business build our momentum and delivered solid results with operating income of 13% in constant currencies to $1.5 billion.

Third quarter earnings per share were up from $0.68 last year to $0.89 this year, the $0.89 includes $0.83 per share from continuing operations an 18% increase in constant currencies over '06 and $0.06 per share representing an after tax gain of $69 million on the sale of Boston Market which closed in August. We received proceeds of about $250 million from this sale. The sale of Boston Market is consistent with our singular focus on driving growth at brand McDonald. The capital gain on Boston Market allows us to utilize a greater amount of our capital loss on the Latin-America transaction which also closed in the quarter this resulted in a $0.04 per share tax benefits. However, this tax benefit was offset by additional charges related to the Latin America transaction of $53 million.

Our effective tax rate of 31% in the third quarter reflects this tax benefit without it or the additional charges our tax rate would have been 33.3% for the quarter. The IRS tax audit I mentioned last quarter is nearly complete and we hope to come to a final agreement soon, until we do so, we cannot provide tax guidance for the coming quarter or the full year.

Since Ralph addressed the operating results, I'll just touch on a couple of miscellaneous items for the quarter. Other operating income was higher in the third quarter than in ‘06 primarily due to higher equity pick up on our Japanese and US affiliates, higher gains on sales of company operated restaurants primarily in Canada where we franchised 21 restaurants and lower asset disposition costs and other miscellaneous expenses in ‘07.

In constant currencies, G&A declined 1% in the quarter partly due to $25 million decrease in Latin America as a result of the DL transaction. This morning I also want to discuss our commodity outlook and share some of our thinking related to our capital structure.

Given our menu variety, there are many different commodities that we carefully monitor. In the US, dairy and to a lesser extent chicken were the primary drivers that increased commodity costs in the quarter. Dairy, including cheese, was up 20% to 30% in the quarter, chicken was up 3% and beef was relatively flat. For the year, we expect dairy to be up 14% to 20%, chicken to be up between 4% and 5% and beef to be relatively flat.

In Europe, third quarter beef costs were down 4% while chicken was relatively flat. We continue to expect beef and chicken costs to be flat in Europe for the year. We are evaluating the current commodity costs environment.

In general, most commodities are cyclical in nature. Historically those cycles have been somewhat predictable. Today, however, we are seeing the beginning of a shift in the demand/supply balance in many areas of the world that could change these cycles and our ability to predict longer term commodity costs. This shift as most of you know is driven in part by growing interest in biofuels, which is increasing demand for corn and soy and is likely to exert upward pressure on other commodities including beef, dairy and poultry.

Higher demand for dairy and protein in China is also contributing to this pressure. We will continue to leverage our scale, global supply infrastructure, and effective risk management practices to help deliver predictable competitive prices for our restaurants in a rapidly changing environment. We believe we can continue to manage consolidated company operated margins while driving customer visits and sales given our diversity of products, dayparts in countries, the value our menu offers, our pipeline of premium and higher margin products, the convenience of our restaurants, and our enhanced pricing power and improved consumer relevance. We will update you further on our '08 outlook at the Analysts Meeting in November.

Now, turning to our capital structure. In September, we announced our intent to return $15 to $17 billion to shareholders by dividends and share repurchase in 2007 to 2009. This is about double the $8 million we returned from '04 through '06. When we set this target, we considered all of our sources of cash including cash from operations, cash from our balance sheet, our ability to increase leverage and the proceeds of the Boston market sale.

Most importantly, this announcement reflects our confidence in our continued business momentum and the strength and reliability of our cash flow as we continue to evolve to a more heavily franchise less capital intensive business model.

We expect to take on from incremental debt to reach this target. The actual amount and timing of incremental debt will depend on business and market conditions and our intent to retain a strong credit rating. We are not giving specific guidance, as we want to retain maximum flexibility.

As most of you know, when making capital structure decisions we consider how the rating agencies look at leverage which is different than what appears on our balance sheet. The biggest difference is as most of you know is that credit rating agencies view operating leases as a future cash commitment and therefore consider it a part of total adjusted debt.

Typically, the rating agencies use a factor of 6 to 8 eight times rent, when converting leases to debt. Accordingly, they arrive at a total adjusted debt figure that's much higher than what is on our balance sheet. Regardless of whether we agree or disagree with this perspective, it's something we need to consider and manage in our global business and making capital structure decisions. The real headline here is that our actions to strengthen and build our business by being better not just bigger have combined to strengthen our free cash flow, a substantial amount of which will be returned to shareholders.

In closing, we are confident that our plan to win will continue to drive McDonald's forward and deliver even greater value for our customers, our system and our shareholders. Thank you, and now I will turn things over to Mary Kay to begin the Q&A session.

Question-and-Answer Session

Mary Kay Shaw

Thanks Matt. I will now open the call up for questions. (Operators Instructions). First question is from Steven Kron at Goldman Sachs.

Steven Kron - Goldman Sachs

Hey, thanks. Good morning everyone. Question on the US margins, I guess I am just trying to reconcile the 60 basis point decline. I recognize there is a bunch of different pockets here, namely the commodity and the labor side of things. But, I guess as I look at the commodities these being flat enough to guidance for the year, chicken up for the quarter and expected to be up for the year, but not an unreasonable amount. And I know cheese was the big outlier here. But, I would have expected, given the increasing mix of what I would expect to be higher margin product and around 3% and 3.5% price increase that we could maybe defend the margins little bit more. Can you speak to it little bit more specifically, and do you think going forward this 3.5% that you now have in the menu can protect margins a little bit better?

Ralph Alvarez

Yeah. Hi, Steven.

Steven Kron - Goldman Sachs

Hello.

Ralph Alvarez

Getting back to you on that, in the third quarter on the US business we were very aggressive on our marketing concern going in to the summer both the drop in consumer confidence and what was going on with GAAP prices and took a strategy to protect and grow traffic during that time. And so, if you look at our marketing calendar, the amount of weight we put on Dollar Menu advertising, the aggressive launch or extension of Snacks Wraps, attractively priced drinks, sweet ice tea, soft drinks and ice coffee. We did that on purpose to build traffic at a time that we felt there is going to be some risk. Those items also have a small effect and being diluted on the margins beside the items that we mentioned.

The labor had a little bit more impact then the food, because there was a minimum wage increase and some of that ripples through, for much higher than minimum wage our price point of view. But the all states moved their reserve also and so we had little bit of that ripple and that takes over time. But, the headline is, we are comfortable at margins over the long-term. We are not going to manage it over the short-term, especially the pricing side of the equation. We believe that's an important one to spread out over time and we will continue to do so.

Matthew Paull

And Steven, as you would here probably our November 13th at the Analyst Day meeting. We are very excited about some of the premium products in the US pipeline. And it is very important to keep guest counts up when you have those kinds of products in the pipeline. Thanks.

Ralph Alvarez

For notification, we talked about having about 50%, 55% of our sales growth coming also in guest counts versus average checks, it was closer to 70% this quarter.

Steven Kron - Goldman Sachs

In United States?

Ralph Alvarez

In United States

Mary Kay Shaw

Thank you. The next is from Jeff Bernstein at Lehman. Jeff are you there?

Jeff Bernstein - Lehman

Yes, I am. Can you here me?

Mary Kay Shaw

Yes.

Ralph Alvarez

Yes.

Jeff Bernstein - Lehman

I guess my question, you guys mentioned the labor cost, which obviously impacting you worldwide just looking for your thoughts by region I know in the US you would seem to be in a minimum wage driven Do you think to be in the minimum waste driven and I think pressure would begin to ease as we look into '08 based on this lap the state increases. And I guess the federal won't be lap until mid year. Just wondering if you could talk about the impact in US as we look to '08 and perhaps separately how you see labor pressures playing out in Europe and EMEA in coming quarters, in other words, mention its limiting profitability in each region? Thanks.

Ralph Alvarez

Yeah, and in your labor and managing the labor pressures, if something we have on a regular basis, it’s been a little bit more intensively US as the minimum wage the national minimum wage finally got adjusted. We think we are in a cycle where those increases now in the US will be fairly normal there were some states that took big increases, Michigan is an example they went up a $1.80 overnight. And so, if we cycled on those now, it won’t be or you are going to have flat increase. It's not going to be flat, you are going to have increases but they will be at inflation rate. And so, when we have that, then we are fine on margins.

In Europe, Europe has always had, managing wages there is a big issue. Things like what we've done with our BOP operating platform make us more productive. Some reinvestments we are doing in July through over there right now, also have not just customer benefits but productivity benefits. And so, we’ve seen is, their headwinds when we talk about it because it doesn't let you better stay completely from the price increase you took but they are at a fairly normal rate of growth at this point.

Jeff Bernstein - Lehman

Thanks.

Ralph Alvarez

Yeah. Asia, I am sorry. On Asia-Pacific, we're having some higher increases in places like China in the geographies that have great GDP happening, that middle class is growing fast. We have that in our models, and so labors are much more percent of our cost of doing business in those marketplaces, and so when you get a large increase here in the wages, it's on a very low base. And so on an overall basis, as long as we continue to drive the comp sales are doing will grow margins.

Mary Kay Shaw

Thank you. The next question is from Larry Miller at RBC.

Larry Miller - RBC Capital Markets

Yeah. Thanks, guys. Ralph, you guys have added a lot of new products in the past few years, and I think you plan on adding a lot more over the next couple of years. The beverages and I guess the Southern Style Chicken sandwiches. And to my recollection, I can't recall that you've really removed anything. So, I am just curious, can you help me understand what you are doing from an operations perspective, to handle the increased complexity, and not jeopardize any kind of speed or service?

Ralph Alvarez

Yeah, absolutely, I am going to go to Europe and Asia, the other places, they are putting in either Made for You or BOP, so Made for You is what we are putting in all of Asia, British operating platform is also putting in Europe, what we mostly complete, but not by the end of '08, by mid '09 gives us the menu, the operation of the ability to handle more menu complexion. That combined with the POS improvements that allow us to take the orders up and more complex menu easier and then have those pop-up in the back for our kitchens to get ahead of the game. It actually opens up the possibilities for us to handle more products.

The other piece we did all around the world is, we did remove low selling items, they are not important because that's why they were low selling. But we have been very careful to not, we reset five size of the price, five size of drinks. We are down to three on each of those, significant benefit on the operating side.

And in Europe, things like the Big Tasty, Chicken Mythics that have help sales a lot. Don't take in and out. We don't keep them in. We bring them in for 8 to 12 weeks, get a big benefit and then bring them back the next year when the customers look forward to it. But if we kept that on the menu, under the bridge operating platform, on an everyday basis, it would have, it would be a challenge. We monitor this closely through our operations metrics, and we are running better restaurants. We are faster; we have better accuracy, than we did last year, significantly more than we did three years ago. And that's the check in bounce.

Mary Kay Shaw

Thank you. The next question is from David Palmer at UBS.

David Palmer - UBS

Thanks. On Europe, you mentioned the bridge operating platform. I was just wondering, just given the fact that I think you are going to be done the big three markets there, this quarter and the fourth quarter. Is that a big deal for '08? Is that a real big enabler? And I guess, two more smaller questions. Could you update us on the reimaging that's going in the UK? And where are you going with that, and how far you are alone. And third, last is Russia. That's been such a fantastic market for you guys, really great returns might be the best in the world. Is there any chance that you can meaningfully accelerate your unit growth there and how might you think of that? Thanks.

Ralph Alvarez

Sounds like you've read The Wall Street Journal. First on BOP, getting completed on BOP, it will make a big difference in Europe in the big three markets. As I mentioned, some of the product promotions we've done, we literally cannot, we can't overlap them, in some cases we'd like that beef and chicken promoted at the same time, off the balance on the menu. But we can't, because we wouldn't execute it will. And so, it does open up the possibilities. We invested in our European Food Studio, we moved that to Munich, made a big investment and both people and facility in order to strengthen our future food pipeline. And so, we've done that in anticipation of being able to have BOP to be able to execute against it. So, I wouldn’t say, I think '08 will be good, I think it will really reap more benefit out of that towards the end of '08 and into '09, as we get through the testing of the products and get them out there.

Relative to the UK, we are going to do 130 reimages this year in the UK, we just said it yesterday. And with the significant impact on our high street locations, they are not highest volume locations, but because it’s all inside, obviously we don’t have drive-thrus. And because of the amount of foot trapping they are going far to those restaurants. There is significant brand implication and we are seeing that traction.

So, we will do a comparable number next year. Actually, we may accelerate a little bit more next year in the UK. Try to get close to 200, is what we think, we can execute well, within both the capital budgets that we've allocated and just the contractors and our people. And so at that point, we'll start getting close, where you start getting critical mass, and the brand has a different look, and when we’ve seen that in other countries, where it has been to US or France or Germany. We see our brand scores accelerate that gives us pricing flexibility and menu flexibility and so pretty encouraged by that.

In Russia, we have great business with really strong management. It's all [Paul McCockill] and when it looks like we could grow faster, we are adding 30% to 40% to our business every year right now in number of restaurants and we got to grow all that management internally. And so, we will grow as fast as we can do restaurants well. And we've pushed them, but we are not going to get ahead ourselves there. We have a strong pipeline of real estate, and it takes in some cases three years to get our real estate done there, especially for our drive-thru locations.

But, right now we think the pace that we have of 30% to 40% growth a year is a good number to be able to manage it from account point of view. Interesting enough is as we are growing at that pace our comparable guest count growth in our existing restaurants and were new restaurants are averaging at, both continue to go up. And so, the marketplace is absorbing it very, very well and that's definitely encouragement.

Matthew Paull

And when it comes to the financial picture in Russia, on a per restaurants basis it's the most profitable market we have in the world. And when you look at our returns you are right, David, it is also the highest returning market in the world. So, we are doing everything we can to move our growth along in Russia. Thanks

Mary Kay Shaw

Next question is from Glen Petraglia at Citigroup

Glen Petraglia - Citigroup

Good morning. Just as a quick follow-up to that. I was hoping you could maybe comment on what sort of sales lift you are getting in the UK when you remodel a restaurant?

And then just secondly, with the commodity environment, and with labor environment as it is here in US, is there any thought or is there any perceived need to maybe change the price point for the Dollar Menu. I know, obviously, one of your competitors had done it couple of years ago and was unhappy with the result. But, I was hoping you could maybe comment on that?

Ralph Alvarez

Okay. On the UK, above 5%. We are getting slightly higher increase in our High Street locations, because it's all customers that are inside you walk by the restaurant and it's 5% in the drive-thru location. So, we are very happy with the impact. You know that the brand implications are even more important overtime.

The Dollar Menu, we believe we need to hold on Dollar Menu. It's really from a consumer point of view we have great equity, it's less than 14% of our sales. Some of our other competitors had 25%, 28% of their sales on their value menu, they were much more dependent on it and had much higher impact to their markets from it. So, maintaining it is something we believe it's so important. We continue to test our alternatives, not just in US, but around the world where, especially in more inflationary places how to move off of a set price menu. But, for the time being we have the room in our business, we have a rich product pipeline, and for the US for the next two to three years, and we believe having traffic in the restaurants I get to see that pipeline is the winning combination.

Matthew Paull

And Glen, from time-to-time we are opportunistic in hedging some of the commodity cost that go into making a double cheeseburger, which is the number one item on the Dollar Menu. So, in many years we will lock in those costs ahead of time, so we can tell our operators exactly what the food and paper costs will be. Also, we've been very successful with the Snack Wrap, which has clearly taken some margin pressure off the Dollar Menu.

Ralph Alvarez

Yeah. Overtime, we've kept the Dollar Menu, but we did move the majority of the US and we do this on a local market-by-market basis based on the needs of the consumers. But, when we first started it was medium fry and medium drink, in most cases now those are small fry, small drink. And so, items like that actually have a big difference and being able to sustain it.

Mary Kay Shaw

Thank you. The next question is from Jason West at Deutsche Bank.

Jason West - Deutsche Bank

Yeah. Thanks everyone. You mentioned a couple of times challenging consumer environment, first, I just want to clarify that's just the US that you are referring to. And secondly, if could just talk about, have you seen any change recently. We are seeing some pretty weak numbers in September from some competitors in the US. Have you seen any change recently in the US consumer environment? And then in Europe kind of same question, I think stronger there relative to the US. And how you compete the comps in Europe that have been very strong now for over a year?

Ralph Alvarez

Yeah. In the US consumer confidence is slightly down, but we have not seen an impact. You have seen the numbers in our business. As we do mentioned, we did adjust some of our marketing and made sure we counteract what are perceptions out there. We do believe that today with our convenience play in the US were much more of the business that people need to have than it is bearable, but they can decide to have or not to have. So, destination, when you have destination of business it's a different standard. When you have much -- have a bigger piece of your business being driven by convenience, you are part of people's everyday solutions. And if we are the best value for that everyday solution, we believe we'll win. And so, that's the piece in the Europe, the economy is strong in Europe.

The only place where we had some impact was in Germany, because of the VAT increase that they needed to do based on the rules of the European Community to balance their deficits and that had an impact on retail sales and we felt some of that, even though we've managed pretty well through it this year. But, the rest of Europe, the economies are strong.

Matthew Paull

And regarding the challenging consumer environment that was only a US based comment that we were making. And one of the things that Ralph and I were talking about before the call was the importance of the Dollar Menu in terms of the value perception our brand enjoys. When you go into a grocery store these days to buy the ingredients to make a meal at home, I think most consumers have the impression that inflation is higher than the government is admitting. So, when those same consumers come into our restaurants and they see the Dollar Menu that's been there for four or five years now, it gives us great pleasure for providing every day value.

Also, I think, Jason, one of your questions had to do with, are we seeing any impact from the challenging consumer environment, the higher gas prices? We have some stores of small number in highway locations and in lower income neighborhoods and we intend to see a little bit more reliance on the Dollar Menu in those stores. But, it's a fairly small percentage of the US space. Thank you.

Mary Kay Shaw

Thank you. Next question is from Andrew Barish of Banc of America.

Andrew Barish - Banc of America

Hi guys. Just taking into the US business little bit more. Industry data in US I mean, traditional lunch, dinner has not been a robust day-part. In fact, maybe flat to down. Your commentary on the US sales, I think over the last year or so is really focused on kind of breakfast and non-traditional day-parts. I mean, what do you attribute that to and are you concerned about it continuing or is it really just kind of lifestyle changes of Americans, and that's kind of driving people in to the restaurants at different hours than the traditional kind of lunch at noon and dinner at 6 'O clock.

Ralph Alvarez

Yeah. I do think its lifetime changes as a part of it. And we've adjusted, that's why you see us focusing on some of the snack business, beverages its destination versus just complementary to the sandwich purchase and increasing our product pipeline for breakfast. But our lunch and dinner business is up also.

And just breakfast is up more and late night stuff more, but the other two are healthy both on sales and on traffic. And, but there is no doubt when you do the cross section and look at the all industry data that the higher growth is coming in the off hours and there's a business to be have there and we are going to capitalize on it.

Operator

Thank you. The next question is from Rachael Rothman at Merrill Lynch

Mike Feng - Merrill Lynch

Good morning guys. It's actually Mike Feng in for Rachael. Couple of questions first on BLAs. Could you talk about, you have some language in outlook section at 8-K that says, the company will continue to pursue the sale of certain existing markets to development of licenses over the next several years. The original planned BLA converts were for [200] stores which should leave roughly 600 by the end of '08. Is that's your plan or do you plan to do more stores but over a longer period of time?

Secondly, could you talk about the kind of feedback you are getting from franchisees about the margin pressures and the pricing increases by competitors given that some QSRs are picking much greater pricing? Thanks.

Matthew Paull

Hi, Mike. This is Matt. I'll deal with the development of licensing issue. The biggest transaction we needed to get done and we completed in this quarter which was Latin America. There are still quite a few markets on our list, but we wanted to give ourselves more time to do this the right way, to be sure the market is in shape where we can get a decent surprise for any restaurants we might license. And to be certain that we end up with a partner who believes in the business, has a rather deep pocket and has patience and so a couple of quarter ago we said, this will take us little bit more time to get it done the right way. But all those stores and countries are still on our list.

Ralph Alvarez

Yeah. On those franchisees and margin pressures, they're feeling. You see on couple of margins, reflection of what the franchisees have in their P&L's, but the overall cash flow it's still up. Not at the rate, obviously that we had the last two or three years. And so it's a constant debate around, and it's one of the most important things we do to decide how do you price to the consumer, to still have traffic growth, but to grow margins and we are not here to debate. We have great usually, this is only an art, kind of guess that it.

Basedon your experiences, we've got a lot of science around this now, on sophisticated pricing tools, that let us know what happens, when you move prices on one item, where the customers trade to, what's the impact on margin, what's the impact on traffic. And we have that data down for the individual restaurant. And that's why we go into the market places, you will see every restaurant priced differently and it's getting to that perfection on pricing. And so, that's what we use and we'll continue to manage it, but it's a long-term strategy, not monthly or quarterly strategy.

Mary Kay Shaw

Thank you. And the next question is from John Ivankoe at JP Morgan

John Ivankoe - JP Morgan

Thank you very much. There have obviously been some articles recently, not only about beverages but also McDonald thinking about doing some new working of its drive-thrus in the US. Certainly, as lunch is obviously very busy and breakfast is very busy. Do you think it's necessary to actually redesign, the physical plan at some point, to push through more capacity and is that something that may become a system-wide effort in relatively near term?

Ralph Alavrez

First, I do think it's necessary. We are doing over 60% of our business through drive-thru, and the average is closer to 65% for those restaurants that have drive-thrus. And in many cases, those booths are five foot wide and we've got a lot of products and those customers who drive-thru are less forgiving on problems, because they can't come back to the counter and fix them. And so, we are very concerned with order accuracy issues, wrong orders are slowing down the drive in which in most cases have a single point of ordering. And so, we are working through those pieces. I have read all the articles that are out there too. That's the reason we are doing extensive testing. We are in 1500 restaurants with some form of this beverage initiative with different variations in the drive-thru, with 85% of those restaurants which has been franchisees, and we will get to the solution, but its investment not just a beverage strategy, its really, eventually its a long-term investment no different than reimaging the dining room and the business where its going.

Mary Kay Shaw

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

John Glass - CIBC

Thanks. In part of the answer you may have answer this in part, but Ralph you mentioned you are compelled to continue to extend the coffee test. What are you waiting for? Is it just, is it that bottleneck of the drive-thru and is it reasonable at this point to expect an impact from specialty coffees in '08?

And if you could also talk about other constraining factors for example, I understand there is equipment that's needed, is that a bottleneck? Is franchisee buying a bottleneck, is there anything else that we should be aware of?

Ralph Alavrez

Hey John, those are all the pieces. We are literally in the middle of this, as you know we put in a very, four years ago, now rigid new product testing protocol where we go to different markets, get diversity of geography, diversity of customer base and of the type of restaurants we have, probably get effect in this area.

We do believe that all these issues have solutions. So, we are not hitting anything that you would sit there and say the equipment can't keep up from a service point of view that would have been the case with espresso machine equipment fours ago. Today, they can deliver at the speed and recovery rates that can make it happen.

It's making sure that when we put this in how it ties into our POS, what customers really want as an offering, we are not going to offer it, we get into this business that the breadth of products that stockers offer but we have to offer enough of a breadth that you are destination point. And so what is that breadth, what's our pricing, those are the pieces that we are working through. We've got the product quality consumer acceptance piece figured out. And now it's the operational pricing how does it fit into our restaurants and what are the overall economics that come out of it, that we are working on very closely with our franchisee body and we won't go until we are ready to do it the right way.

Matthew Paull

And John, in the United States alone it is a $60 billion market price. And if we can find a way to do this, if the speed, convenience and value you expect from McDonald then do it through the drive-thru is all different counter, we have a duty to our customers, our operators and our shareholders to pursue it. So we are going to look at it very carefully. Thanks

Mary Kay Shaw

Thank you the next question comes from Joe Buckley, Bear Stearns

Joe Buckley - Bear Sterns

Thank you. First a follow-up to Ralph, you mentioned 1500 restaurants that you are testing some form of beverages, and could you elaborate a little bit more on that, and talk about the different things that maybe in test there? And then a question for Matt on the comments on the commodity cycles, McDonald's always had a very unique supply system. Do you foresee any changes in the way you source food, and elaborate a little bit more on your comments, because I found them interesting, but I am not quite sure where you are headed?

Ralph Alvarez

John under 1300, but what we are trying to do is get a variety of areas. So, espresso-based drinks have significantly different volume per capita today across the U.S. Obviously, number one would be Seattle, but when you go in to some of the middle America, it's a newer phenomena, newer meaning last three, four, five years. And so part of what we wanted to do is get a breadth of testing that allow us to understand both, how consumers will use to the drinks, because they use it differently. Their knowledge of the variety you got to offer.

And then the other pieces are our buildings. We have a lot of different building, a lot of different kitchen layouts. And business comes at different rates and differentials. We want it a high volume, lunch driven businesses or breakfasts, and then be able advertised. So, you got to have enough scale in the market that you can get on TV, and put enough ads. And that's why the numbers 1300, it's between 1300 and 1500, we are in some stage of roll out, build restaurants right now. And all markets don't have the same test, because if not it's just an early roll out.

Matthew Paull

John well regarding my quicker comments on commodities, let me first start by passing on my sympathies on Joe Torre I know you are big Yankees fan. But back to commodities, what I was referring to is in the normal course of things, when the price on the commodity goes up, supply reacts to produce more supply and the price adjusts. And we have not seen that happening, in some areas of commodities. It's probably, because some of the government rules have just been created subsidies and eventually this will work its way out. But, while the markets are in the process of working things out, all we know is that our unique supply chain approach and our unique suppliers give us a competitive advantage that nobody else has in the industry. So, we will get through it. We hope that government kind of stay out of all these. Let markets figure it out for themselves, but, we are very confident we will be able to manage through it. Thanks.

Mary Kay Shaw

Next question is from Paul Westra at Cowen.

Paul Westra - Cowen

Great, thanks. There may be a question or two left. I think you mentioned the G&A savings. There was a question about on Latin America, I think you made a mention to $25 million for this quarter. Is that a good run rate for the year $100 million of ultimate savings, that you had a $160 million last year? I wonder what you would expect that number to bend down to on an annual basis?

Matthew Paull

Paul, when you look at Latin we licensed the market on August 1st. So, one third of the quarter we still had that G&A, two third we did not. So, you should not multiply that $25 million number by four, because you come up short than what the number should be. The guidance we've given in the past, that we continue to stand by is that we'll save about $125 million of the G&A in Latin America. We're still as an organization serving Latin America, still have some G&A, we'd expect their savings versus that $160 million to be about a $125 million on an annualized basis. Thanks.

Mary Kay Shaw

The next question is from Jeff Omohundro at Wachovia.

Jeff Omohundro - Wachovia

Thanks. Just the question about marketing, as you look out into 2008 with the Olympics coming just wondering how you re integrating that into the plans, maybe just a general overview on that? Thanks.

Ralph Alvarez

Sure. We've been out actually looking at plans for last two weeks. From a China point of view, we are making a significant bet. We believe that we can leverage our involvement with the Olympics in a big way for our emerging business in China. And everything we are doing there is all about allowing for our crew, our customer to access the Olympics, lure to be able to go to the Olympics. And we have some creative ways that we have done with our crew is just selecting the best crew from each restaurant, and they are ones who would work. We have four restaurants at the actual Olympics Village and they are the ones who have to work at the village. And then, we have some customer type of programs that we are doing.

The rest of our advertising around the Olympics in China, we will use to communicate in a way that we believe that will make us more locally relevant and basically when China wins, you win type promotion that ties us to the Chinese Olympic game.

In the rest of the world, we are just putting different plans together. And it will be based on what they do and make it look relevant. We do know its going to be one of the biggest Olympics ever, because viewership projections are high. And so, with Europe just presented us this week, and they have got some unique ways they are going to leverage the Olympics. Mostly supporting core food, so it's not promotional, it's supporting core food, and using the Olympics to tell a story

Mary Kay Shaw

Thank you. The next question is from Larry Miller at RBC

Larry Miller - RBC

Yeah. Hi. Just had two quick follow-ups. Matt, I think you guys are an AAA or A rated company. Are you guys targeting an optimal credit rating or an optimal credit structure? I mean how do you how do think about that? And then secondly, may be you guys can talk about this. It sounded like you reacted really quickly on a change in marketing as the consumer took a dip in September, how quick can you guys react in terms of changing your marketing plan?

Matthew Paull

Larry, on the capital structure issues, when we went through the announcement we made in September, I'll just share our thinking with you and hopefully that will address your question. We wanted to try to find a way to reinforce that we believe in better not just figure that it's working that we are going to be a company that relies more on franchising and relies less on capital to grow. And we thought pumping the dividend and saying we are in a position to generate a lot of cash and we are churning an awful lot of that to shareholders.

We thought that's what we wanted to do. But we wanted to do it in a way that didn't financially weaken our system as compared to our competition. We have the best franchisees in the world at Mc Donald's. One of the reasons is that they like our brand, we think there's many. But one of them is that we are financially stronger than anybody else we compete with. We wanted to maintain that difference between us and the rest of the competition.

So, when we put together our analysis we weren't focusing on a specific credit rating. We were willing to take our rating down a little bit in fact one of the agencies did adjust us down one notch. But we wanted to stay much stronger than our competition, because we want to have flexibility to deal with the opportunities that might come and I'll let Ralph deal with the marketing issue

Ralph Alvarez

Yeah. On the marketing issues, Larry, we can move pretty fast if it's a product. If it's a new product then we won't, because we've learned that being disciplined on the rollout and the training at the restaurant level, and ensuring that we have that in place with such a distributing system. We can't move as fast, but if it's a product that we already have or if it's some other promotion, we can move pretty fast.

Our operators, as you know our marketing fund is a separate entity that we all contribute into ourselves for our company restaurants and operators for theirs. So we have an empowered board of operators that can make decisions very fast.

Mary Kay Shaw

Thank you. The next question is from Matt DiFrisco at Thomas Weisel

Jake Bartlett - Thomas Weisel

Hi this is Jake Bartlett in for Matt. I just had a quick question on drive-thrus in the UK. Could you tell us what percentage of the UK stores total system have drive-thrus?

Ralph Alvarez

It's between 50% and 60%. And it's where our growth has. The reality is that first 400 locations were all in lined up. And so, when we have 1,300 restaurants there, we still have the significant amount of high sweep, which is the way people shopped in the UK. But as the society there has changed, its more of the big box type retailers, we've moved our business that way. And as they move to having conceptions on highways, we are also doing that.

So, you'll see that percentage grow overtime to be more drive-thru. Interesting enough, it is our highest drive-thru percent for those restaurants that have drive-thrus. So, we are at 55% and growing and for those restaurants that have drive-thru, and what percentage comes to the drive-thru. So, the consumer uses it. We got to wait for retail establishments to catch up and that's how we'll grow our business there.

Mary Kay Shaw

Looks like we have one final question from Joe Buckley at Bear Stearns.

Joe Buckley - Bear Stearns

Thank you. First, Matt, thanks for your thoughts on Joe Torre. I have got question on the international coffee initiatives and the McCafe's. We talk a lot about the US and what you are doing. But, what's going on in Europe and Asia, I guess primarily with coffee?

Ralph Alvarez

Yeah. Coffee is a big part of one of our common success factors, but we are leveraging it different in different places. And we don't have one set formula. So, if you go from I would say the extremes as Australia and Germany, where we have strong coffee cultures without any strong players, and we decided to be very aggressive in our McCafe development. And to a certain extent we are putting McCafe's everywhere we have the ability to physically put in our restaurants. And have a full coffee experience, the whole gamut there, and be very successful.

So, Australia is pretty much there, Germany will be at the 400 McCafe's by the end of this year and another 100 next year. And the rest of the world, we have some McCafe's also, but we are definitely leveraging the coffee strategy starting with strong drip coffee first, Premium Roast, and then various accessible, the different expresso-based drinks.

With a high focus on convenience in the US and in APMEA. So, the US's convenience is drive-thru. Our customers believe a product that we offer needs to be offered both in drive-thru and front counter in the US. It's a critical part of our brand. And in APMEA we do a lot of kiosk and on-the-go, especially we have high density, and so we are leveraging it there with convenience being a very big driver.

Mary Kay Shaw

Thank you. We are out of time and questions. So, I will turn it over to Ralph for few closing remarks.

Ralph Alvarez

Okay. In closing, we are pleased with our performance for the third quarter and believe we are on track to achieve a record year, both for our system and our shareholders. Although, we are proud of our recent business performance, I can assure you we will not allow success to make us complacent.

Our management team is determined to get even better in executing against our plan to win. We are in a great business with tons of opportunity, and we are confident in our ability to continue to deliver results by leveraging successful initiatives from one market, and replicating and scaling them to others ends of the world. Doing so will enable us to deliver solid results for the remainder of the year, and accelerate momentum in to 2008. Thank you, and have a great weekend.

Mary Kay Shaw

Thank you.

Operator

Thank you. And this does conclude today's conference. We thank you for your participation. At this time you may disconnect your line.

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Source: McDonald's Q3 2007 Earnings Call Transcript
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