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McDonald's Corporation (NYSE:MCD)

Q2 2008 Earnings Call

July 23, 2008 1:00 pm ET

Executives

Mary Kay Shaw - Vice President, Investor Relations

Ralph Alvarez - President, Chief Operating Officer, Director

Peter J. Bensen - Chief Financial Officer, Corporate Executive Vice President

Analysts

Steve West - Stifel Nicolaus

David Palmer - UBS

Steven Kron - Goldman Sachs

Joe Buckley - Banc of America

Jeff Bernstein - Lehman Brothers

John Glass - Morgan Stanley

Larry Miller - RBC Capital Markets

Jason West - Deutsche Bank

John Ivankoe - J.P. Morgan

Tom Fort - Telsey Advisory Group

Matt Difrisco - Oppenheimer

Rachael Rothman - Merrill Lynch

Mitch Speiser - Buckingham

Analyst for Keith Siegner - Credit Suisse

Paul Westra - Cowen & Company

Jeff Omohundro - Wachovia Capital Markets

Howard Penny - Research Edge

Operator

Hello and welcome to McDonald's July 23, 2008 investor conference call. At the request of McDonald's Corporation, this conference is being recorded. (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

Thank you. Hello, everyone and thank you for joining us. With me on our call today are Chief Operating Officer, Ralph Alvarez, joining us via phone from New Zealand; and Chief Financial Officer, Pete Benson.

Today’s conference call is being webcast live and recorded for replay via phone, webcast, and podcast. Before I turn it over to Ralph, I want to remind everyone that as always, the forward-looking statements in our earnings release and 8-K filing also apply to our comments today. Both documents are available on www.investor.mcdonalds.com, as are reconciliations of any non-GAAP financial measures mentioned on today’s call with their corresponding GAAP measures.

And now I’ll turn the call over to Ralph.

Ralph Alvarez

Thank you, Mary Kay and good afternoon, everyone. We are pleased to report that our solid business performance continues and every area of the world is contributing to our growth. In the second quarter, comparable sales increased 6.1%, consolidated company-operated and franchise margins grew for the 10th consecutive quarter, and consolidated operating income excluding the impact of the 2007 Latin America transaction increased more than $240 million, or 17%. That’s 9% in constant currencies.

We’ll start by talking about the strategies driving our momentum, then I’ll share some highlights about the business in our primary segments, the U.S., Europe, and Asia-Pacific, Middle East, and Africa, or APMEA, as we call it. Pete will then go through the numbers in greater detail before we open it up for Q&A.

The entire McDonald's system is aligned and executing our Plan-to-Win. Our ability to continue building our business in every area of the world is a direct result of our better, not just bigger strategy and our capability to execute that locally. Our momentum is driven by five factors that are contributing to our success in every market.

The first is branded affordability. Everyday, predictable low prices are what customers expect from McDonald's. We pride ourselves on being able to provide good value for the money at every price point.

Menu variety and beverage choice is a second driver. Our food pipeline has never been richer. We’re developing products our customers want.

The third success factor is better restaurant operations. An ongoing focus on the fundamentals has improved the customer experience and strengthened brand trust.

Convenience and day part expansion is the fourth factor. We’re serving customers when and where they want McDonald's -- with more than 31,000 restaurants located where people live, work and shop, it’s easy to make us a part of your daily life.

And finally, ongoing reinvestment -- we strive to provide a relevant modern restaurant experience, especially as our customers’ needs continue to evolve. And while we continue to make strides in each of these areas, we believe there are opportunities to do even more.

With that said, I would like to share a few details on how each area of the world is contributing to our success today and positioned to drive results into the future.

In the U.S., we continued to deliver solid results by growing our customer base. Comparable sales for the quarter were up 3.4%, of which 75% came from increased guest counts. And operating income was nearly $800 million, an increase of 6% over last year.

We generated solid results despite a slowing economy, demonstrating McDonald's is well-positioned to perform in these challenging environments. Our three-tier pricing strategy contributes to that success, and the dollar menu, which represents about 14% of sales, is an important part of this strategy. Support for the dollar menu remains strong throughout the U.S. system, in spite of commodity and other cost pressures.

As we balance increasing costs with the need to provide value to our customers, we continue to test other options, as we have since the dollar menu was first introduced over five years ago.

Although we expect our value offerings to evolve over time, any future changes will be guided by our thorough testing processes and of course, mainly by the consumer. And while value is an important part of our foundation, it is only one of the drivers of our business. Our growth strategies of breakfast, chicken, beverages, and convenience continue to deliver results.

During the second quarter, we launched a Southern Style Chicken Sandwich and a breakfast version on a biscuit. Both products have proven popular with our customers and also, the Chicken Biscuit is a key contributor to breakfast sales, which remains our fastest growing day part.

Our second big driver during breakfast hours has been beverages, especially coffee. Total coffee sales continue to increase, led by iced coffee, which is in 12,800 restaurants today. We are very pleased by the growth and momentum of our premium drip and our specialty coffees. Specialty coffees is just one element of the combined beverage business and it’s currently in more than 1600 restaurants.

Throughout 2009, we will add smoothies, frappes, bottled beverages, and energy drinks. The implementation of the entire line of beverages in these fast-growing categories will move us from providing drinks that complement our food to becoming a beverage destination, and the related optimization of the drive-thru area of our kitchen will benefit operations and sales throughout the day.

Overall, we are very pleased with our results in the U.S. and are optimistic about the opportunities ahead.

Now let’s turn to Europe, where we also had another strong quarter. Our top line sales and guest counts are strong and have increased across the segment. Comp sales for the quarter were up 7.4%, on top of a 7.8% increase for quarter 2 ’07, and operating income increased 13% in constant currencies.

Europe’s overarching strategies of upgrading the customer and employee experience, building brand transparency, and enhancing local relevance continues to deliver results. European customers are embracing our three-tier menu approach.

From the launch of the premium M burger in France and Germany to expansion of the Petit Plaisir value platform to countries like Portugal, Switzerland, and Italy, we are offering products that meet consumers’ needs regardless of how much is in their wallet.

We also expect convenience will continue to drive business. More than 70% of our European restaurants offer some form of extended hours. Comparable sales during these hours are outpacing the rest of the day and we continue to leverage this opportunity. In addition, nearly half of our European restaurants now have drive-thrus and drive-thrus represent 45% of sales in those restaurants. And given our track record in the U.S., we believe this business will continue to grow at accelerated rates.

Reimaging is another key component of our strategy. Since the beginning of 2003, Europe has reimaged over 2,000 restaurants to provide a more relevant and contemporary experience for customers. Germany continues to make progress against its goal of reimaging all of its restaurants by the end of 2009. Many of these include a McCafé, a separate upscale area that offers specialty coffee and desserts. These contemporary additions are helping build our credibility as a coffee destination.

The U.K. is also planning to reimage another 200-plus restaurants in 2008 and 2009, with an emphasis on our drive-thru locations now. It is important to note that our business in the U.K. remains strong. Even in spite of declining consumer confidence in the U.K., our sales, our guest counts, and our margins continued to grow in the second quarter and were a strong contributor to our overall results. We are optimistic about the European business and especially our big three markets of France, Germany, and the U.K., which represent two-thirds of our operating income in Europe.

At the same time, we will keep an eye towards Russia, Europe’s high potential market, where we are in our fifth year of consecutive double-digit monthly comp sales growth. With 143 million people but only 195 McDonald's restaurants today, Russia remains a significant growth opportunity.

We are confident our emphasis on convenience, menu choice, and value will continue to meet the changing and growing demands of the European consumer.

Now let’s turn to APMEA. We delivered an outstanding quarter, with comparable sales up 8.8% on top of a 10.9% increase in second quarter last year, and operating income increased 22% in constant currencies. Margins are up, income growth remains strong, and returns have increased significantly during the last three years.

These results have been driven by strong performances in Australia and China, and positive results in most other markets. Australia continued to deliver impressive results. Their recent introduction of Crispy Chicken across all price points has been very successful, exceeding our expectations. This market success is also the result of our continued focus on operations improvement and momentum at breakfast, driven by Espresso Pronto coffee and a series of menu extensions. And Australia is seeing the benefit of having reimaged nearly all of their restaurants, with the majority including a McCafé.

In Japan, sales and guest counts continued to grow, despite a flat and formal eating out market. We are taking market share. The addition of several new items to the YEN100 menu, including premium roast coffee, chicken, and desserts is resonating with our customers, and it’s even easier for customers to go to a McDonald's that’s open when they want it -- more than 1300 restaurants in Japan are now open 24 hours.

Now turning to China, one of our high potential markets, we are quickly scaling best practice initiatives, including extended hours, breakfast, and value. Today nearly three-quarters of China’s restaurants are open 24 hours. Comps continue to grow during these hours and we expect that trend to continue. The benefit of extended hours can also be seen in our breakfast business, which has grown to 7% of China’s sales, a 50% increase since the launch in early 2007. We expect this day part will continue to grow as customers discover the great taste and convenience of breakfast at McDonald's.

As we approach the Beijing Summer Olympics, excitement continues to build. In addition to the four restaurants that we built to feed the athletes, media, and many spectators, our 942 local restaurants are also sharing in the fun with games and food promotions. The Olympics are a great opportunity to support the world’s greatest athletes, while celebrating our people and building our brand. We are proud to be a part of it.

One last topic that is generating a great deal of interest is commodity cost. Like everyone today, we are experiencing significant increases. However, we believe we have a competitive advantage in both our ability to leverage economies of scale and our global supply chain. Our menu is also very diversified -- no single commodity makes up more than 15% of our overall food bill. And our margins are among the highest in the industry, and they are bringing significant dollars to the system.

Our globally diversified business is an unparalleled advantage. It positions us to deliver in all types of operating environments. I am pleased that we have been able to grow market share and maintain high margins in this environment. Our strength continues as the global comparable sales trend is even stronger in July than in June, and we are confident in our ability to continue to deliver results as we manage the business for the long-term.

And with that, I would like to turn it over to our Chief Financial Officer, Pete Bensen.

Peter J. Bensen

Thank you, Ralph and good afternoon, everyone. Once again, our global business has delivered strong quarterly results. Consolidated margins are up, we’re controlling G&A, and earnings as well as returns are strong. All in all, I am very pleased with these results.

Second quarter earnings per share from continuing operations were $1.04, a 44% increase after adjusting for the impact of the 2007 Latin America transaction. These results included a $160 million non-operating gain, or $0.10 per share from the previously announced sale of our minority interest in Pret A Manger, a U.K. based quick-service sandwich concept.

Strong comparable sales increases around the world helped drive total margin dollars to $2.2 billion in the second quarter, up 5% in constant currencies. Franchise margins represented about two-thirds of this amount and accounted for nearly all of the increase.

As a percent of revenues, franchise margins increased 80 basis points to 82.3%. This percentage benefited from last year’s Latin America transaction but was partly offset by the impact of our refranchising strategy. Let me clarify that last point. Since a significant number of our locations around the world are situated on lease sites, as we refranchise restaurants we are transferring more lease sites into our franchise restaurant portfolio. This impacts margin percentages because lease expense and occupancy costs shifts from company-operated to franchise margins.

For owned sites, there is no corresponding operating expense for the land. Accordingly, although our franchise margin dollars grow and the stability of our cash flow improves as a result of refranchising, our franchise margin percent is negatively impacted. The impact on company-operated margins is just the opposite.

Company-operated margins as a percent of sales rose 10 basis points to 17.7%, driven primarily by strong sales growth worldwide, offset by rising commodity and other costs. Before going into company-operated margins by area of the world, let me discuss how we look to optimize margins over the long-term.

We use a multi-faceted approach on both the sales and cost side of the margin equation. On the sales side, we’ve been successful at driving customer visits and increasing market share as we balance price and product offerings. Our strategic approach to menu price adjustments considers consumer sensitivity, as well as the local competitive and economic environments.

And by offering a three-tiered menu featuring relevant value, core, and premium products, with each tier receiving appropriate marketing support, we enhance sales and profits.

For example, in the U.S., our current national Big Mac promotion, at regular price, I might add, complements a local market focus on attractively priced beverages. This balance helps drive traffic and delivers solid margin performance.

On the cost side, productivity and commodities are key areas of focus. We continuously work to enhance the efficiency of our restaurant operations. This includes leveraging new diagnostic tools to enhance restaurant profitability, breakfast and drive-thru optimization efforts, and introducing new equipment, such as a fryer that uses less oil and energy.

As for food, we managed our grocery bill like a portfolio, seeking to achieve the best overall results. Our goal here is to remain competitive and predictable.

Our comprehensive approach to restaurant profitability and margins, incorporating price, product mix, and cost management, gives us flexibility to continue to optimize performance around the world. This approach has proven successful, as exemplified by the U.S., where we continue to deliver company-operated margins that are among the best in the industry. U.S. company-operated margins were strong at 19.1%, down 40 basis points from last year, primarily due to cost headwinds that offset solid comparable sales and guest count growth.

For the quarter, beef cost in the U.S. rose 2% and chicken was up 6%. For the full year, our outlook for chicken is to rise in that same 5% to 6% range, and for beef to increase 8% to 9%.

We will continue to focus on driving customer visits while maximizing the benefit of strategic price adjustments to deliver strong margins and operator cash flow.

Moving on to Europe, strong comparable sales growth contributed to company-operated margins of 18%, the same high level as last year. Our robust sales performance was offset by inflationary commodity and labor cost pressures throughout Europe. For the second quarter, beef prices in Europe rose 6% and chicken increased 8%. Our full year ’08 commodity outlook is for chicken to be up 7% to 8% and beef costs to rise 8% to 9%.

Despite growing unease over the European economy, we are confident we can continue to drive sales and traffic while effectively managing the cost side of the margin equation.

In APMEA, continued strong comparable sales in virtually every country contributed to the company-operated margins rising 140 basis points. Australia led this performance with its new chicken offerings and longer operating hours, helping to extend its string of double-digit comp sales increased to 12 months. China also performed well in the quarter, with double-digit comparable sales increases and margin expansion. Breakfast, extended hours, and relevant promotions contributed to this result.

G&A control continues to be an area of focus across the entire organization. In the second quarter, G&A was up 1%, but declined 3% in constant currencies, as lower expenses in Latin America offset costs related to our biannual worldwide owner-operator convention.

And we continue to generate a significant amount of cash, and repurchased nearly $800 million of stock and paid a dividend of $420 million in the quarter.

On a final note, we continue to make progress toward our goal of refranchising 1,000 to 1,500 restaurants over the next few years. In the first half of this year, nearly 300 company-operated restaurants were franchised, bring the worldwide percentage of franchised restaurants to 79%.

As we continue to become more heavily franchised, combined operating margin becomes a more appropriate measure of our overall business profitability. Not surprisingly, this improved significantly, rising 320 basis points, excluding impairment and other charges, to 26.7% in the first half of 2008.

This quarter’s strong results are a testament to our global strategy, the Plan-to-Win and its ability to deliver long-term sustainable growth. The Plan-to-Win grounds us in what matters most to our customers and creates a framework nimble enough to adapt to their ever-changing needs and preferences. I am confident that as we continue to execute against this framework, our customers, the system, and our investors will continue to benefit.

Thank you. Now I will turn it over to Mary Kay to begin our Q&A.

Question-and-Answer Session

Mary Kay Shaw

(Operator Instructions) The first question is from Steve West, Stifel Nicolaus.

Steve West - Stifel Nicolaus

I just had a quick question on -- maybe a clarification on the commodities. You are talking about the commodities being up about 2% as far as the beef in the second quarter. On your outlook for ’08, you talk about the beef in the U.S. being up 8% to 9%, but last quarter you talked about it being up about flat. Can you talk about what the big difference is that happened in the quarter that made you change your outlook so much? Thanks.

Peter J. Bensen

We’ve seen a lot of volatility in the beef market. Some of it we think is short-term but there’s been a spike recently. We’ve seen Russia ban exports from Latin America. That’s causing Russia to buy more U.S. beef and generally, we’re seeing a lot more activity with the weaker dollar in countries wanting to buy U.S. beef, so it’s putting a lot more pressure.

We expected Russia to come into the U.S. market some time next year but this has happened a little bit sooner, so it’s a few things that have hit us relatively recently and beef is 15% of our mix in the U.S. and we feel confident our supply chain will mitigate the impact as best they can.

Mary Kay Shaw

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

David Palmer - UBS

Congratulations on the first half of the year. I wanted to ask you about your earnings algorithm, so to speak. You signaled something, maybe it was a year ago when you first started telling us to focus on overall profit margins and dollars, and for our modeling purposes, and I know internally you think pretty far out, should we think that there is a change in your earnings algorithm going forward where your company restaurant margins are relatively stable, even as you execute the game plan in the U.S. and Europe, and you are really left leveraging the overhead to drive earnings. Is that what’s kind of broadly going on here?

Mary Kay Shaw

Pete, do you want to take a stab at that one?

Peter J. Bensen

David, I think essentially when last November we shifted toward a view of the combined operating margin, essentially that was an acknowledgement that as we have fewer and fewer company-operated restaurants, those margins become less and less a driver of our profitability, and that as you indicated, as we are rebalancing the portfolio and shifting toward a more franchise organization, looking at the impact of our total operating income, which also includes our focus on controlling G&A spending is probably the best way to look at it. So I think that’s a fair way to say.

Mary Kay Shaw

The next question is from Steven Kron at Goldman.

Steven Kron - Goldman Sachs

Thanks. I was wondering if we could just drill down a little bit more into Europe. Given the very strong 7.4% same-store sales for the quarter, margins at the company level flat year over year, I was wondering if you could just drill down and talk a little bit about how did traffic develop in the same-store sales? Was there a negative year-over-year mix shift, maybe a little bit more on the value menu which pressured margins, and is there a disparity between the company same-store sales and the franchise same-store sales, which may be pressuring or keeping the company margins at bay?

Mary Kay Shaw

Ralph, do you want to take that one?

Ralph Alvarez

We were very aggressive in Europe this year, making sure that we continued to drive traffic, so traffic is about half of the sales and that’s where we want it. The margins being flat, we had slightly more impact on the commodity costs in Europe in the second quarter than we did in the U.S. But the other thing you have in Europe is labor rates change as inflation goes up, many of those mandated by government. And so you had, and it’s in our comments, both labor and cost pressures that increase those. And we saw a little bit more of that even in our market in Russia, which is all company. So still very strong margins but our goal actually for the quarter was to try to be at about flat margins because of the amount of market share we are taking. Our company restaurant sales versus franchise are pretty close. That’s not the reason for any kind of difference.

Mary Kay Shaw

Thank you. The next question is from Joe Buckley, Banc of America.

Joe Buckley - Banc of America

Thank you. I wanted to go back to the commodity comments again. If beef is going to be up 8% to 9% full year in both the U.S. and Europe, what does that imply for the second half? And maybe in conjunction with that, if you could talk about pricing in -- well, I guess in the U.S. because Europe might be too complicated across so many markets.

Peter J. Bensen

Obviously you hit it that the beef costs will be higher the second half of the year than we experienced in the first half, and again we have a lot of confidence that our supply chain folks will help to mitigate the impact as best they can, but the reality that we are all dealing with is that we expect them to be higher in the second half of the year.

In terms of pricing in the U.S., we look to that food away from home index as kind of a guiding point to not exceed when we are doing menu price increases, and we use a strategic pricing tool to tell us which items we can do and which are going to have the least amount of impact on transactions and traffic growth. So for the -- through June, our pricing in the U.S. has been up a little over 4%, and that is below the food away from home index in the U.S.

As you mentioned Europe, it gets a little harder with 40 countries but with the exception of Russia where Ralph indicated inflation is maybe a little bit higher there, we are in the 2% to 4% range around the major countries around Europe.

Ralph Alvarez

Just to add on the pricing there, Joe, there is no doubt -- you know, we see that food away from home number continues to grow because of what’s going on with the grocery bill. Still, food away from home is significantly below what the cost of groceries are in the grocery store and that provides price elasticity. And we have been able to take that on a pretty regular basis, and so I think you will see a little bit more of that.

The other piece we’ve done in the U.S. is if you look at our marketing calendar here the last three, four months, it’s been full margin chicken sandwiches and full margin Big Macs, while still having the strong value underpinning but making sure that we do that also as we go through.

Mary Kay Shaw

Thank you. The next question is from Jeff Bernstein at Lehman Brothers.

Jeff Bernstein - Lehman Brothers

Great. Thank you. Shifting gears to the coffee program rollout, which has gotten a lot of attention of late, I think, Ralph, you mentioned being pleased with both the premium drip and the specialty coffee thus far. I’m just wondering if you could give a little more color in terms of perhaps the best and the worst markets. I know it’s still early on but kind of high level, perhaps a discussion on what it would actually take to break even. I know you gave certain sales expectations. Perhaps some franchisee thoughts, just kind of get a feel for how the program is going, perhaps the pace of growth over the next 12 months. Thanks.

Ralph Alvarez

Again, it’s gotten more press than it deserves, to tell you the truth. We’re in 1,600 restaurants on the specialty coffee side. That is only one piece of the combined beverage business. That’s why we call it that. There’s sweet iced tea, there’s the iced coffee, there’s smoothies, there’s frappes, there’s bottled drinks, and some other pieces to that that make us a destination for beverages. And that’s really what we’re after.

And then within that is a complete change to our drive-thru booth and operations so that we can deliver our current menu better, which has grown a lot, and this beverage menu, and in a labor efficient way. So that’s really the whole piece and as far as the specialty coffee items, right now we are tracking ahead of what we projected in the test markets that we are in. Specialty coffees, the hot specialty coffees are seasonal, so in the summer you are not going to sell as much as you do in the winter. So if you had our sales now and you see what we are selling in sweet tea and iced coffee and the cold beverages, of course that’s what’s driving our -- is part of what’s driving our business and that’s the balance that we are looking for as we go forward.

We’re very excited about this whole piece as a combination to everything else we do, but coffee is only one piece of that and specialty coffee is only one piece of the coffee equation.

Mary Kay Shaw

Thank you. The next question is from John Glass at Morgan Stanley.

John Glass - Morgan Stanley

-- a couple of times your advantage of the size of your supply chain in keeping costs lower than peers. Can you give some specific examples of that? Are you just pushing more of your costs back to your suppliers, or are you able to source globally, for example, for the U.S.? What is it other than just scale that makes your supply chain different maybe than your peers?

Peter J. Bensen

I’ll give you a little perspective, for example, from last year. The basket of goods that we buy for our restaurants, the produce price index for that basket was up 8.5% and we experienced back door increases of less than 4% to our restaurants. So how does the supply chain accomplish that? It’s a variety of things. It’s working with suppliers to strategically hedge certain items. It’s locking in to some fixed cost contracts that can help preserve the cost. It’s working with suppliers to maybe rationalize and consolidate facilities. It’s looking at opportunities to purchase in different parts of the world where we maybe before were just purchasing something locally.

So it’s a variety. A lot of these suppliers have been suppliers to McDonald's for several years and leveraging those relationships in these various ways is a very effective way and in the primary way that our supply chain accomplishes this.

Mary Kay Shaw

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

Larry Miller - RBC Capital Markets

If I could just follow-up on that question and then ask a question; what I’m particularly interested in is how you guys buy beef and chicken, and if you can remind me how you do that, and is there any kind of step functionality with corn, because corn is usually rolling over a little bit?

And then the second part of that question is that you had given us some guidance on what it would take in terms of comps in the U.S. and Europe to run flat margins. Can you update that given the increase in commodity costs? Thanks.

Peter J. Bensen

Larry, I’ll answer the comp piece first and then maybe Ralph will give you some more texture on how we buy beef around the world, but we used to say 2% to 3% was about the comp that we needed to hold margins or grow margins, and that was in a normal commodity environment which obviously we’re not in, and so we’re probably double that amount now in terms of our need to grow comps but we’re confident that with our ability to go to the menu board and the price elasticity we have and our supply chain that’s working on controlling those costs, that we’ll continue to look at this and balance the equation as best we can.

Ralph Alvarez

On the beef and chicken, we do it differently in different places but those are both commodities that we more and more have become vertically integrated, with suppliers that take it from -- basically from farm to final processing. We also aggregate our commodity cost buys from different countries and then our processing suppliers take advantage of that combined buy that we did for the system as a whole.

These are our two most important proteins that we buy and we have really gone to consolidating processing plants, consolidating all the way back in the food chain and we believe that’s a significant strength for our system.

Mary Kay Shaw

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

Jason West - Deutsche Bank

Thanks. I believe you touched on it a bit, Ralph, just on the value menu outlook for the U.S. I have to think that with the price increases going on across the restaurant landscape that the value menu has got to be more and more attractive, and I would imagine you are seeing some mix down to that. I’m just wondering what your thoughts are there. I mean, how close you guys may be to changing the pricing on that and if you see that as a major pressure point as we move forward here.

Ralph Alvarez

Jason, the surprising piece is we have not had -- the value menu has not, the percentage of sales has not grown significantly but the cost implications of having that value menu have, when you see what’s going on with beef and chicken. And so we’ve been out there testing. There’s more elasticity. You know, the way dollar menu looks today won’t be the way it’s going to look next year. In this current environment, we’ve got to make sure we are pricing smart, not just pricing low. But we’ve got numerous tests out there with franchisees. We’ve got consumer research and we’ll make the move at some point when we know how to make that move in a way that continues to drive traffic. And during these times, continuing to grow traffic is the most important piece and so that’s what we’ll focus on. But you’ll see some -- there will be some type of change in what that looks like and our U.S. team is hard at work on that.

We have a lot of experience with this around the world because we have more -- other places that are much more inflationary and so we’ve got a pretty good understanding on how to move from our experiences in Asia, Europe, and Latin America.

Mary Kay Shaw

Thank you. The next question is from John Ivankoe, J.P. Morgan.

John Ivankoe - J.P. Morgan

Thanks. Most of my questions have been asked and answered, but I did have a question on bridge specifically in Europe, the bridge operating platform. Just an update in terms of where that is in the rollout, if it’s nearing completion and just in terms of company stores, I mean, if there’s any margin benefit that might be possible from that system as we move in ’08 and ’09.

Ralph Alvarez

The bridge operating platform is the kitchen platform that we are doing in Europe. We’re 70%, 75% completed, and the major countries will be done by mid-’09. Some of the countries are almost completely done.

The biggest benefit to the bridge operating platform is not labor efficiency but it’s ability to handle more menu complexity, and so the chicken strategies that we’ve been so successful with, along with some of the beef products that we are working -- if you go to Europe now, in some cases we can only do those promotional because we can’t sustain that complex a menu in our old kitchen, and so that’s the biggest benefit that we get, the operational improvements and the flexibility to continue to have a more diverse menu.

Mary Kay Shaw

Thank you. The next question is from Tom [Fort] from Telsey Advisory Group.

Tom Fort - Telsey Advisory Group

Thank you. Can you talk a little about the pricing environment, as far as the competition goes? I know for example in the QSR space, someone rolled out a lower price point value menu. In addition, I feel like there’s a lot more promotions going on that involve free product. So can you talk a little about the competition there and how that may or may not affect your efforts?

Ralph Alvarez

We look at having balanced, attractive pricing throughout the menu. If you look, we do limited one-time discounts and have been for the last six years, and that’s why we believe so strongly in one of our drivers being a branded affordability everyday predictable low prices is the key.

Others are jumping in and out of discounts and we prefer to have something that our regular customers get to experience every day, and it’s working, and it’s working and we see it in our trend lines and in our guest count growth.

Mary Kay Shaw

Thank you. The next question is from Matt Difrisco from Oppenheimer.

Matt Difrisco - Oppenheimer

My question is with respect to the U.S. comp. I’m a little confused. I think you said earlier in the call that 75% of the same-store sales gain was traffic driven, yet pricing is around 4%, so I guess there must be a negative mix shift going on in there but you are not seeing a significant move in percent of sales toward the value meal, or towards the dollar meal?

Ralph Alvarez

There’s a few factors that work in there, Matt. One is our breakfast business is growing faster than our rest of day, and breakfast is a lower average check than rest of day. Second is our growth in beverages, which has been a big focus for us, is also a lower average check because in some cases, those beverages don’t come with a full meal, depending on what time of day it is. And so that also gives a little depression.

And lastly, in general, even with our full price menu items that we’ve been advertising, we have not been focused on our most expensive items during these economic times. So all those items create a little bit of a shift down, even if it isn’t a significant move up on dollar menu. And we think that’s been healthy. We’ve taken the price increases, as we mentioned in that 4% range, and that helps the margins but not necessarily do we want our average check to go up by that during these times.

Peter J. Bensen

And Matt, just to clarify one point -- Ralph talked about the 75% coming from traffic. That was the quarter. For the year-to-date, it’s about 60% of the comp was driven by traffic, so 60% year-to-date is more in line with the 4% price increase.

Mary Kay Shaw

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

Rachael Rothman - Merrill Lynch

Can you guys talk a little bit about the structural changes that you are making to the drive-thru and how that will help you improve your speed of service, or as you said, run the restaurant more efficiently? Maybe are there any opportunities for you to do more extended hours or what specifically are the changes to the drive-thru and how will they impact your business? Thanks.

Ralph Alvarez

As our drive-thru business has grown over the years, it really is one of the places we have not done a lot of change in the actual drive-thru booth. So our changes are about making the booth almost self-sustaining to be able to deliver the products that are there. Today, in many cases, you’ve got to walk 10, 15 steps to go get a different type of drink, a salad because we don’t have refrigeration right there, we have it on the front counter -- you know, all those items, and then as you add these new beverages, the only space we would normally have would have been to put those behind the front counter. And again, it’s not efficient for drive-thru.

So what we do is we take the drive-thru, we optimize it. We put in drink systems on the carbonated side that make drinks automatically right off the register when it’s rung up and then for the rest of the items, literally somebody only has to move a step or two to make every beverage we have, or to pick up a sandwich or to pick up French fries. And so it’s that efficiency that will give us both productivity and order accuracy improvements as we go forward. So that’s the piece we’re doing.

As far as the open extended hours, et cetera, it’s not a benefit that way other than productivity wise, again we end up being much more efficient with a much tighter space to work in.

Mary Kay Shaw

Thank you. The next question is from Mitch Speiser from Buckingham.

Mitch Speiser - Buckingham

Thanks very much. First on the commodities, the last quarter and previous to that, you did mention cheese. Could you give us an update on your cheese cost outlook?

Peter J. Bensen

Sure, Mitch. In the U.S. for the year, we think cheese is going to be up about 21%, and in Europe we think about 25%.

Mary Kay Shaw

Thank you. The next question is from Keith Siegner from Credit Suisse.

Analyst for Keith Siegner - Credit Suisse

This is actually Karen [Holstat] on the call for Keith. Looking at the Southern Style Chicken, it seems like there was a pretty significant marketing push behind that in May, and we were just curious how sales have trended since that marketing has tapered off?

Ralph Alvarez

We did -- again, this was a product rollout that was both for breakfast and lunch, and so it got even more of a significant push, especially the breakfast side of the equation, where chicken and breakfast is something that was not as common on two-thirds of the country. And so the performance of both sandwiches have exceeded our expectations and our sales trends are strong.

Mary Kay Shaw

Thank you. The next question is from Paul Westra at Cowen.

Paul Westra - Cowen & Company

Good afternoon. Most questions asked and answered, but Pete, if you can clarify your comments on the -- I guess the PTI inflation rate of some of the products and what your spread is for your back-of-the-house actual costs. My question is your guidance for beef of up 8% to 9% or so here, is that the commodity cost or is that your back-of-the-house expectation? And then related, given the double-digit spike we expect here, I guess, or you are implying in the second half, is that going to -- is it safe to assume that’s going to lead you to take probably more pricing that you would have normally?

Peter J. Bensen

Paul, just to clarify, that 8% to 9% I was talking about is our expectation of our backdoor costs right now. But again, this is a volatile market and hopefully that won’t all come true but that’s what we see right now.

And as Ralph mentioned, this is a component of everybody’s grocery bills going up and in that environment, there’s probably a little more price elasticity. But at the end of the day, beef is 15% of our product mix, so while it’s an issue and it’s something that we will watch after, it’s not -- there’s a whole other part of the business that’s not impacted by that; our breakfast business, our chicken business, et cetera.

Mary Kay Shaw

Thank you. The next question is from Jeff Omohundro at Wachovia.

Jeff Omohundro - Wachovia Capital Markets

I’m just wondering if you could give us an update on the China development outlook and in particular, perhaps an update on Sinopec and how they are contributing? Thanks.

Ralph Alvarez

Our China development is going well. As we have said earlier in the year that we would open 125 restaurants this year, we will hit that number, probably exceed it. The first half of the year, we have a much more balanced number of openings coming across. We opened 18 restaurants in June, as an example. And so it’s contributing well.

Sinopec continues to be a piece of our development but it’s not a significant piece of all those openings that we are doing, because those deals take longer to work out, you know, both companies having to develop the site and getting the drive-thru permits and so forth.

Mary Kay Shaw

Thank you. The next question is from Howard Penny at Research Edge.

Howard Penny - Research Edge

Thanks very much. It wasn’t too long ago that expectations from McDonald's senior management was for 2% to 3% comp growth, and Pete, you alluded to earlier that you needed 5 to maintain margins. Is that a number that you can maintain, that 5% comp growth?

And then secondly, just on the discounting in coupons, there was a fairly healthy drop of coupons. I think you called it a crave and save here in the Northeast where you are getting two for one, buy one get one free Big Mac and a few other products. Was that a national thing or was that just local here in the north? Thanks.

Peter J. Bensen

Howard, the coupons are definitely a local thing, so as you know, 60% or so of our advertising in the U.S. is done in our local advertising co-ops and they use various techniques to respond to local competitive and economic situations, so -- and really, because we are 85% franchised in the U.S., a lot of those co-op decisions are made by the franchisees.

Regarding comps, you know, we have given our long-term outlook at to gross sales, 3% to 5% with half of that being from comps. And again, that’s a long-term look over time. That doesn’t contemplate the commodity environment and the inflationary environments that we are finding ourselves in in certain of these markets. So to the extent that -- we still think that’s the right model for us to look at and the right targets to be looking at, but certainly in times when all costs are going up significantly, I think our expectations will increase as the costs are increasing significantly.

So it’s really not ’08 guidance, it’s not a specific year’s guidance, but it’s just a longer term look at how we think about the business.

Mary Kay Shaw

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

David Palmer - UBS

Thanks. Some other global consumer companies have seen some slowing in consumption in places like Eastern Europe, and one would expect to see in places like the U.K. and Germany, some changes in consumer patterns. Are you seeing anything that has you standing more vigilant these days in markets like this? Any change in buying patterns? And to the degree that you are maintaining traffic growth, what do you think is working for you these days? Thanks.

Ralph Alvarez

We have not seen a slowdown, but are very vigilantly looking at it because economic conditions affect business. Our business is strong in the U.K., in Eastern Europe, and I believe it’s a combination of the fact that we have put in strong, predictable, branded affordability and we have good mix of promotions across the different price ranges. Plus in those different marketplaces, we significantly improve the quality of our restaurants and our operations, and that’s given our brand -- if you look at our brand scores in the U.K., they’ve gone up significantly and that’s definitely changed the trajectory of our sales trendline.

Mary Kay Shaw

Thanks. Another question from Larry Miller at RBC.

Larry Miller - RBC Capital Markets

Ralph, can you talk about how the franchisees might feel? You know, they are clearly getting pinched from some of the same cost issues that everyone, and that you are talking about on this call, and how do they feel about getting behind some of these larger programs to drive sales over the next year to two years? What are they telling you?

Ralph Alvarez

Well, they are concerned, and rightly so. We’re seeing commodity cost increases that we haven’t seen in a lot of years, so the balance of being able to take price increases on a more regular basis but still below what’s happening out there, and doing that well is something that luckily, we’ve gotten pretty good at over the last two, three years.

From a promotional point of view, we’ve got to be much more careful in balancing, driving traffic while maintaining margins and that’s the work that we are doing with the franchisees, and then eventually still having a very strong branded affordability menu but what sits on that menu will look different than now because it has to be profitable.

The number one metric we look at for health of the system is individual restaurant guest count growth and profitability, because as a franchisor with 80% of your restaurants franchised, those two things have to be growing for the brand to be doing well and for your franchisees to continue to invest.

Mary Kay Shaw

Thanks. A question from Tom Fort from Telsey.

Tom Fort - Telsey Advisory Group

Thanks for taking my second question. You said before that the challenging economic environment in the U.S. that in past times has meant perhaps a drag of comps of 100 basis points to 200 basis points, and I wanted to know if there was anything different about the current weakness that would suggest that maybe the drag is higher than 200 basis points?

Ralph Alvarez

On what, Tom? I’m sorry, drag on our comp sales?

Mary Kay Shaw

I think what he’s talking about is what we said in -- I think it was the year-end call, maybe. We said we thought the economy might hurt us by one to two points.

Ralph Alvarez

Let me answer that. I think what’s different in these for now in the current situation is unemployment is still not a big number, and that’s one of the most important things for the economy, so people are employed, yes. There’s other issues of inflationary pressures and some of the other items that are affecting disposable income, but in general we are pretty close to full employment and because we are such a strong price value, combined with for us, dealing with the gas price piece, the fact that we are very close to our customers with our distribution, we’re not seeing the impact that we would have seen in previous years during times I guess when you would have had a higher unemployment and maybe not the ability to pass on cost increases.

Mary Kay Shaw

Thank you. Another question from Jason West at Deutsche.

Jason West - Deutsche Bank

Thanks. I just want to follow-up again on the beef question, just give the magnitude of the change on the outlook there. How fluid is that number, given that corn has come back a lot? I think some of the spot beef pricing has come down a bit -- I mean, could that number come back down pretty significantly over the next few months, or is that now more of a locked in number for the rest of the year?

Peter J. Bensen

Jason, that is not a locked in number for the rest of the year. We constantly get updates on these costs and they move as the markets move in some of these cases. So like I said, I’m hopeful maybe they’ll come back but the reality is sitting here today, this is our best look at what we think for the rest of the year.

Mary Kay Shaw

Okay, we have one last question, another repeat from Mitch Speiser.

Mitch Speiser - Buckingham

Just another question on food costs -- any thoughts about the O&I cost outlook? Several or a few restaurant companies out there have said expect more of the same in ’09. Are you seeing the same thing?

And if I could just slip in a second question, with that 4% pricing in the U.S., is that just the company-owned stores? Any comments on what maybe generally franchisee pricing is? Is it above that level or below? Thank you.

Peter J. Bensen

In terms of ’09 costs, Mitch, we aren’t ready to predict what’s going to happen to pricing in ’09. Things are pretty volatile but I would say that I think the -- after going through a long period of relatively stable food costs, that our expectation is that this higher level of commodity and food cost is probably with us for the foreseeable future. A good part of this is being drive by global supply and demand that will take a little while to settle out.

I know there is some -- there are some financial speculators that are in some of these markets but a good part of this is the overall global supply and demand that will probably be with us for a little bit.

Ralph Alvarez

The pricing, the number we quote is system, both company and franchise and our price increases between the two of us are pretty comparable, actually.

Mary Kay Shaw

Okay, thanks. We are out of questions and about out of time, so I’ll go ahead and turn it over to Ralph for a few closing comments.

Ralph Alvarez

Thanks again for joining us this afternoon. As we said, we are pleased with our strong performance for the second quarter and remain optimistic about our ability to deliver results for the remainder of 2008 and beyond. Thank you and have a great day.

Mary Kay Shaw

Thanks a lot. Bye.

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Source: McDonald's Q2 2008 Earnings Call Transcript
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