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McDonalds Corporation (NYSE:MCD)

Q1 2006 Earnings Conference Call

April 21st 2006, 11.30 AM

Executives:

Mary Kay Shaw, Vice President, Investor Relations

Michael Roberts, President, Chief Operating Officer, Director

Matthew Paull, Chief Financial Officer and Corporate Senior Executive Vice President

Analysts:

David Palmer, UBS Warburg

Mark Kalinowski, Buckingham Research Group

Steven Kron, Goldman Sachs

Jeffrey Bernstein, Lehman Brothers

John Glass, CIBC World Markets

Larry Miller, Prudential Equity Group

Joe Buckley, Bear Stearns

Rachael Rothman, Merrill Lynch

Andrew Barish, Bank of America

Peter Oakes, Piper Jaffray & Co

John Ivankoe, JP Morgan

Presentation

Operator

Hello and welcome to McDonalds; April 21st 2006 investor relations conference call. Operator instructions. I would now like to turn this conference over to Mary Kay Shaw, Vice President of Investor Relations. You may begin.

Mary Kay Shaw, Vice President, Investor Relations

Thank you. Hello everyone and thank you for joining us today. As many of you know, we like to give you the opportunity to hear from various members of our management team on these calls, so with me today are Chief Operating Officer, Mike Roberts, and Chief Financial Officer, Matthew Paull. Jim Skinner is traveling on business. This conference call is being webcast live and recorded for replay. As always, the forward-looking statements which appear in our earnings release and 8-K filing also apply to our comments. Both the earnings release and the 8-K with supplemental financial information are available on our website, at www.investor.mcdonalds.com, as are reconciliations of any non-GAAP financial measures mentioned on today’s call with their corresponding GAAP measures. With that, I’d like to now turn it over to Mike Roberts.

Michael Roberts, President, Chief Operating Officer, Director

Thanks, Mary Kay. Good morning and welcome. I’d like to being by saying that I’m very pleased with our progress in Q1. YTD global comp sales were up 5.2% with more than half of that comp attributed to increased guest counts. Additionally, margins improved across all geographic segments of the business, the first time this has occurred on the company margin in two years. That said, we know the opportunities in front of us and we’re intent on building on our momentum. This momentum continues because our plan to win is working and because our system is more aligned than ever before, our operators, employees and suppliers. This alignment will continue at our upcoming worldwide convention where our entire system to come together to talk about how we can create even more success in our future.

In the United States, YTD comps sales are up 6.6%. Results are being driven by new food news, like spicy chicken, premium coffee; conveniences like extended hours, Arch Cards , Cashless. Our ongoing reimaging work, which continues to create a more relaxing, relevant and modern experience for our customers and of course Monday we launched the Asian salad. We’re also laying a solid foundation for the future with the continued development of a food pipeline, which includes the exploration of even more chicken options, additional beverage choices like juices and flavored water and more breakfast variety, like a Big Burrito.

Breakfast continues to be a big driver for us, and our improved coffee is adding to the momentum of our breakfast strategy. Additionally, we’re adding more fun, excitement and buzz to our restaurants, through promotions that touch our customers passions, including our Pirates of the Caribbean online game and a fitness CD that comes with the purchase of our new salad. Also, this quarter, Canada is building momentum in sales and margins, with comps up 8.5%. With the leadership of Ralph Alvarez and Louie Mele, the Canadians have placed a greater emphasis on quality, service and cleanliness, the promotion of our core food and an overall review of the ownership mix of our restaurants. In Europe, YTD comp sales are up 2%, which is progress given the fact that the QSR market there is down. That said, we’re intent on enhancing our customers’ experience by improving QSC, by strengthening lines with more chicken and premium beef sandwiches, by continuing our leading-edge reimaging work through new décor, enhanced lighting, decreased kitchen noise and music by (date party?) and by solidifying our pricing strategy with a combination of everyday low price, core products and premium products.

Now a little more detail on our big three markets in Europe. First, momentum continues in France, with some of the highest margins in the world. Results are being driven by a combination of Le Petit Plaisir, their value menu, premium burgers like the Big Tasty, and chicken products like their Mythic Sandwich and through ongoing reimaging that enhances both the inside and the exterior of the restaurant. Additionally, France remains our best practice as it relates to telling our story. Jean-Pierre Petit, CEO of McDonalds France, holds live internet chats with our customers and with our crew. He conducts open doors so our customers can see how our food is prepared and served and he dedicates a significant amount of his advertising spend to print ads on quality, opportunity and our charity. The good news is this model is now spreading to other parts of the world.

Related to Germany, Einmal Eins, their value menu, continues to drive results and shows that the power of a value menu and the power that that can have when balanced with premium burgers and chicken. Additionally, our team continues to respond to customers taste buds with ethnic flavors in sandwiches like Chicken Cordon Bleu and the TexMex Burger. In the UK, while we continue to face challenges, this is a very profitable market. In 2005, our operating income was well over $200 million, representing almost 6% of McDonalds’ total operating income. There, we’re focused on premium burgers like the Quarter Pounder Deluxe, increasing relevance by reimaging an additional 100 restaurants this year, enhancing the Pound Saver menu and offering relevant promotions, like the World Cup Ticket competition that customers play via their cell phones, beginning next week. As we previously announced, we are reviewing our ownership structure in the UK. We closed 25 high street restaurants where the lease costs were so high it not longer made sense to operate there. In addition, we’ve already refranchised 25 restaurants and planned to refranchise another 25-35 between now and the end of the year. The owner-operators there are very excited about this opportunity to own more restaurants.

Looking at Asia-Pacific, Middle East and Africa, YTD comp sales are up 4.1% and momentum continues in this part of the world. I was just there, in fact, and saw some of the great progress we’re making first-hand. We’re connecting with customers there by continuing to improve our quality, service and cleanliness with the most improvement in the area of friendliness and accuracy. By offering new food news, including the expansion of the successful Rice Burger from Taiwan to other markets including Singapore, Hong Kong and testing in China. Espresso coffees in Australia and additional kid’s choice like corn in china and breakfast like the thick toast in Australia. And by delivering innovative promotions. This year, Hong Kong continued their momentum, with Jack the Dipper, a character they’ve created to build buzz around our McNuggets. China continues to represent enormous opportunity for McDonalds, with comps up YTD. We’re growing the business there through food relevance, with the chicken burger and the spicy chicken filet. Drive Thru expansion, compelling everyday value and telling the story of the quality of our food, where we’re running quality print ads in the recently launched askme.com, a public information website dedicated to food safety and the quality education of all of our guests.

Finally, in Latin America, YTD comp sales are up 15.3%, driven by a comprehensive quality service improvement plan, the launch of the Big Tasty and continued focus on everyday affordability. Related to marketing, Mary Dillon is making significant progress on improving the relevance with the next generation of i’m lovin’ it, on media innovation – which includes looking at different ways we reach our customers – and on building relationships with moms, including innovating around the future Happy Meal. While we’re focused on driving results today, we also have our eyes firmly fixed on the future as we continue building even deeper relationships with our customers and greater alignment with our operators, suppliers and employees.

Thank you all, and now I’d like to turn it over to Matt Paull, our CFO.

Matthew Paull, Chief Financial Officer and Corporate Senior Executive Vice President

Thanks very much, Mike, and good morning everyone. At McDonalds, our business strength is tied to brand strength, making our brand and the restaurant experience more relevant to our customers is essential to building the business, and we believe we are doing just that. We had a solid first quarter, reinforcing that our strategy of growing by improving our existing restaurant and focusing on the five Ps continues to be the right strategy for McDonalds. The global comp sales numbers we delivered this quarter contributed to improved margin percentages across all segments, both franchise and company-operated margins were up 100bps and 70bps respectively. Franchise margin dollars neared $1 billion in Q1, making up almost two-thirds of worldwide margin dollars. McDonalds company-operated margin dollars increased $53 million over Q1 2005.

In the United States, company-operated margins as a percent of sales increased 40bps to a strong 18.3%, driven by positive comparable sales. We had some help in Q1 from relatively flat commodity costs, partly offset by higher utilities, labor costs and increased promotion costs, specifically relating to our launches of coffee and spicy chicken. For the year, we expect costs for beef and chicken to be relatively flat and cheese to be down. Overall, utilities are anticipated to increase for the year and labor costs will be up slightly due to a higher average hourly rate.

Returning now to Europe, company-operated margins were up 10bps in Q1. Strong sales in France and Russia and improved performance in Germany helped offset performance in the UK and labor pressures throughout Europe. Labor pressures are expected to continue. Beef costs were relatively flat in Q1 and are expected to be flat for the year. France, Germany and Russia all delivered company-operated margins, however Europe’s company-operated margin was reduced by about 70bps due to UK results. Mike just highlighted our initiatives to improve performance in the UK and we are confident we will get there over time.

Moving now to Asia Pacific, this segment generated a 140bp improvement in company-operated margins. This was driven by strong results in Australia and improved results in Hong Kong and China. Australia continues to drive transactions with locally-relevant menu options like Espresso Pronto Coffee and a range of seven deli-choice sandwiches. Regarding China, I was just in China three weeks ago and was very excited about what I saw. We are offering customers locally-relevant menu options like the ones you heard Mike describe, and we’re also excited about the current test of products like the rice burger, which features spicy chicken or beef, with red cabbage and lettuce on toasted sticky rice instead of a bun. We are becoming a more convenient option for our Chinese customers, through better site selection and Drive Thru expansion.

Adding Drive Thrus the way we at McDonalds do Drive Thrus has brought a unique convenience to the market. Although building a restaurant in China with a Drive Thru costs 30-50% more, or about $200,000 more, we are achieving 50-80% higher sales volumes, clearly a very good investment. In 2004 alone, there were 2 million more cars on the road in China than in the prior year. Both car ownership and traffic are growing in China at explosive rates, with plans to add many more Drive Thrus in the next few years, we are poised to capture the opportunity.

G&A for the quarter increased at a rate which is much higher than the rate we project for the full year. Some of this is due to the timing of certain expenses like the Olympics. In Q2, we expect G&A to increase mostly due to the timing of our biannual operator convention. For the year, we continue to expect G&A to decline as a percent of revenues and system wide sales. Now I’d like to discuss quarterly EPS. Q1 2005 EPS was $0.56 including a $0.13 benefit from a favorable tax settlement. Q1 2006 EPS was $0.49 including several items that on a net basis cost us about a penny in EPS. The charges in the quarter total $86 million on a pretax basis, or about $0.045 per share. They include $42 million, or about $0.02 per share related to our previously announced review of restaurant locations in the UK resulting in the closing of 25 high street restaurants. $29 million, or about a penny and a half per share related to the buyout of certain franchises in Brazil. $8 million, or less than $0.005 per share related to the sale of a small market in Europe to a developmental licensee, and $7.5 million or less than $0.005 per share from asset right-offs in Asia-Pacific, Middle East and Africa.

On a constant currency basis, without these items, operating income was up 14%. On the income side, we reported a non-operating gain of $0.035 per share from the IPO of Chipotle and the concurrent sale of a portion of our Chipotle shares. In our January call, we described our developmental licensing, or DL strategy, which we planned to implement over a three-year period in some 15-20 countries representing about 1,500 restaurants. Remember, DLs as we call them, has been a successful part of our international strategy for 15+ years, and we already use a DL structure in 32 countries.

In 2005 alone, two countries representing 325 restaurants were moved into a DL structure. In a DL ownership structure, the local entrepreneur uses his or her capital, real estate and local knowledge to build the brand and optimize results. In a DL, unlike with a conventional franchise, McDonalds collects only a royalty, investing no capital. We are making progress on this strategy, in Q1 we signed a letter of intent to DL one of our smaller markets in Europe. As previously mentioned, we recorded a small impairment loss to developmentally license this market. As we have said, our goal with the DL strategy is to optimize sales and profitability in the long run, not necessarily to maximize proceeds in the short run.

The strategy puts restaurants in certain overseas markets in the hands of local entrepreneurs, who can keep them locally relevant and growing without the use of our capital. We are making progress in other countries as well, but it will take time to find the right candidates and to negotiate and finalize arrangements. Though we are aggressively pursuing this strategy, accounting rules on impairment do not allow us to record possible future losses on asset sales until we conclude we are both likely to complete a sale within 12 months and have a reasonable idea of the final sales price. With the signing of the letter of intent for the small market in Europe, we crossed the accounting threshold for that DL market in Q1.

In closing, the year is off to a good start. As always, you can expect this team to take absolutely nothing for granted. We will continue to work our plan to win for the benefit of our customers, our shareholders and the McDonalds’ system. Now I’ll turn the call over to Mary Kay.

Questions and Answers

Mary Kay Shaw

Thanks, Matt. I will now open the call up for questions. Please press *1 if you have a question, and *2 to remove yourself from the queue. To give as many people as possible the opportunity to ask questions, please limit yourself to one question. We’ll come back to you for follow-ups as time allows. Our first question is from David Palmer at UBS.

Q – David Palmer, UBS Warburg

Hi. Matt, and Mike, congratulations on the quarter. I wanted just to ask kind of a theoretical question. I was thinking, it seems to me you have four options with every restaurant these days. You can operate them, you can franchise them, you can license them and of course you can just simply not own them. You can just sell it. I was wondering if you could give us some insights into your decision process about these options, in particular I was wondering about hurdle rates and when you think about the returns for a restaurant, you may be considering for ownership or perhaps even refranchising or licensing, do you consider regional overhead and even a market-rate return for the real estate in assessing the earnings of the restaurant? I realize you’re a global company, if you want to use an example that would be fine too. Thanks very much.

A – Matthew Paull

David, I’ll take the first crack at it, then Mike will probably want to comment. First of all, when we’re deciding how to own and operate restaurants, staying locally relevant is very important. But I want you to know that we have different hurdle rates for different parts of the world, which are a function of risk. We look at borrowing costs in different countries, we look at the environment we’d be operating in – what kind of legal system is there, are property rights respected, can we execute our brand the way we want to. We assess that risk, and the people in Oak Brook assign a hurdle rate to every market we do business in. Obviously, in some parts of the word the hurdle rates are much higher than in others. We also consider regional overhead and so we definitely have different hurdle rates for different parts of the world. In looking at different markets, we also look at how much risk is there relative to the upside in the market. So we’ve gone on record as saying we’re extremely bullish in China and even though we’re not earning the kid of return there that we earn in the US, we’re very optimistic that returns which are probably high single/low double digit today are going to grow very fast. We see a lot of potential and so we’re not applying an overly drastic hurdle rate to the situation in China. In other parts of the world we have a very high hurdle rate to justify further investment.

A - Michael Roberts

The only thing I’d add, David, is that you look at the markets that we’re going to be growing in, as Matt said, their hurdle rates are high here but the bulk of our openings this year will go to Australia, China, France, Russia, Spain and the US. In those markets, we’re showing significant movement in margins.

Mary Kay Shaw

Our next question is from Mark Kalinowski at Buckingham.

Q – Mark Kalinowski, Buckingham Research Group

Hi. I just wanted to ask about the share repurchases and their effect on the diluted share count. I was disappointed that the diluted share count in the Q1 income statement wasn’t down more from the Q4 levels given all the money that was applied to share purchases in the quarter. I just wanted to understand better why that was, and perhaps going forward, maybe if the share repurchases aren’t having a meaningful effect on the diluted share count, it might make more sense for McDonalds to meaningfully raise its dividend yield to the 3%+ range. I just want to get your thoughts on that. Thanks.

A – Matthew Paull

Mark, it’s Matt. We don’t think that you nor we will be disappointed by the time we get to the end of the year on the share count issue. We’ve said last year at our analysts’ meeting and we’re still committed to it; that we’re going to return $5-6 billion to shareholders in 2006/07, we have reserved the right to be flexible on how much in each year and how much takes the form of dividend versus share repurchase. None of that has changed. Let me comment a little bit on what’s going on. We used to grant options to employees at a much higher rate than today. If you looked at 2004 and 2005 together, our employees exercised options and turned them into shares for a total of 60 million additional shares out there in 2004 and 2005. The annual grant we did in 2005 was, I believe, 7 million shares roughly, six tenths or seven tenths of a percent of the outstanding share base. We’ve brought down the grants. Employees are exercising options that were granted many years ago. We’re starting to be much more aggressive about share repurchase and I think by the end of the year, this will come together and you’ll see some meaningful reduction. We bought back $1 billion worth of stock in Q1, we were a little bit disappointed ourselves about the sequential decrease in the share count. Part of what you’re seeing is driven by Q4 activity on the part of our employees, we’re going to continue to be aggressive in Q2 and again by the end of the year, we don’t think you’ll be disappointed with what happens to the share count. Thanks.

Mary Kay Shaw

Thank you. The next question is from Steven Kron at Goldman Sachs.

Q – Steven Kron, Goldman Sachs

Great, thanks. Good morning. A quick question on the developmental license agreements. Matt, you mentioned and you wrote in the 8-K that you don’t expect a material impact in 2006 and I’m just wondering, he emphasized that it’s going to take time, wondering whether kind of progress to date in identifying these candidates might be proving to be a bit more difficult in some of these regions, or is this kind of tracking as you planned?

A – Matthew Paull

Steven, it’s definitely tracking as we planned. Just for perspective, we mentioned that we DL’d two markets in 2005 that had 325 restaurants. We began that work about 2.5 years ago, a full two years before we got the market DL’d. It takes some time to find the right partner, we’re on track, we believe we’ll get this all done within the three years, and we have other countries that are moving along rather quickly. We think it’s absolutely on track. If we were in a hurry to do this, we would end up with the wrong partners and in the long run the business would be hurt. The people doing this work have done it in 32 other countries, they know very much what they’re doing and in the long run we think this will be a good thing for our shareholders and for brand McDonalds. Thanks.

Mary Kay Shaw

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

Q – Jeffrey Bernstein, Lehman Brothers

Great, thank you very much. Specifically on Europe, I know we’ve heard on a number of occasions, it’s difficult to come up with a timetable for the UK turnaround. I’m just wondering what kind of targets you’ve set, or what measures you look at to assess your ongoing turnaround efforts, especially if you look to 2006. I’m just wondering if you could talk about the balance between driving traffic, perhaps through discounting, versus tolerance in terms of potential margin deterioration? Thanks.

A – Matthew Paull

Well, Jeff, in terms of our comps in Europe, they were some of the strongest we’ve had in 2005, well over 2%. I think the strongest in 10 years. And to begin the quarter up 2% is very encouraging. France continues to lead the way with all of their activities related to the five Ps. Germany now has made a major move with the Einmal Eins and new food news and the UK is back focused on Quarter Pounders with Cheese, the relaunch of their pound saver as well as their reimaging work, including some refranchising of restaurants. And so, the overall margin in Europe improved QoverQ, and we’re optimistic about that area. Russia continues to outperform all of our expectations, so the combination of France, Germany and Russia and the movement that we’re seeing as well in the UK now with their focus on improving QSC and their calendar related to new food news gives us optimism about the rest of this year.

A - Michael Roberts

Jeff, the measures we look at, they wouldn’t surprise you. We look at our F-Trex(?) scores from polling customers on their experience at McDonalds and their impressions of the brand, margins, returns, growth and guest counts. We like what we see in all of Europe and we see the beginnings of some progress in the UK, but we still have a long way to go. And the issue of couponning, the two markets that probably did the most of that back in 2004 and 2005 were the UK and Germany. The UK will be couponning about half as much as it did in the prior year and Germany maybe not at all in 2006. So we’re relying less on couponning, we’re trying to build loyalty the right way. Thanks.

Mary Kay Shaw

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

Q – John Glass, CIBC World Markets

Good morning. My question is on the US product pipeline. This year it seems that the new product introductions are front-end loaded, at least the ones we know about today: coffee, spicy chicken etc. I guess, is that accurate? And why did you choose to cluster them that way? Mike, are you suggesting that maybe some of the new products you’re testing now may be available for rollout in the second half? Or are they maybe 2007 events?

A - Michael Roberts

John, as you know, we’ve got a very robust pipeline that we’ve been working on there for four years. We probably have 20 products in test now in the US and I’m very encouraged with all the movement they’ve had on chicken. You’re absolutely right, John, we launched the spicy chicken, our new coffee and our breakfast platform, and Monday we launched the Asian salad. Three very, very important products for us and we continue to look at Q3 and Q4 and our test sells, to see what’s possible. But, John, you know, with all the new food news, with extended 24 hours, Cashless now, gift cards, the dollar menu, our reimaging, there’s a lot of reasons to visit McDonalds in addition to all the new food news. Lastly I tell you, part of what we’re doing I think much better there now is that we’re relaunching. We’re reintroducing products that we launched a year ago, so you know, we just launched premium chicken. It’s hard for us to understand this, but even after three years, some 40% of our customers don’t know we have salads with Newman’s Own dressing, which tells us there’s a really important thing that they need, which is the continual mentioning in our marketing plans of the products we already have. Looking at the rest of the year for the US, they have products in test. We’ll see what develops here, but they’ve got a lot of products they launched the last two years, that they can re-hit.

Mary Kay Shaw

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

Q – Larry Miller, Prudential Equity Group

Thanks very much. First, if I could just follow up on the share count. Maybe you seem to imply the actual share count at the end of the quarter might be much lower. Do you have that number handy?

A – Matthew Paull

Larry, I’m not going to get into a discussion on numbers. The message I’m trying to send is that some of the things that show up in the Q1 numbers might be the result of things that happened in Q4 2005. If we had employees exercise options in Q4 2005, on average, those new shares were only outstanding for a part of Q4 2005, but they were outstanding for all of the Q1 2006. It’s a very complicated computation and I don’t want to, over the call, try to get into the details. But I assure you, by the end of the year, you will be satisfied with the amount by which we’ve reduced the share count.

Mary Kay Shaw

The next question is from Joe Buckley at Bear Stearns.

Q - Joe Buckley, Bear Stearns

Thank you. A couple of questions on the US. In the quarter, US operating income was up 17%. It looked like your margin dollars were up about 11% or so. It sounds like you spent a little bit more on SG&A, so I’m wondering if you could close that gap? And maybe at the same time talk about the US check experience, and if you would maybe some of your product mix experience over the past six months or so?

A - Michael Roberts

I’ll deal with the SG&A issue. Joe, we were a little bit concerned at the growth in SG&A in Q1. We went back over our plans for spending, we’re very satisfied that by the end of the year, the relationship of our SG&A increase to our sales increase will be healthy. We target that we don’t want our SG&A to increase more than 70% of our sales increase globally. We think we’re on track to have that kind of a year. We were very concerned by the front-end loading of the SG&A this year, but it’s mostly driven by the Olympics and when our convention is taking place. So I think you’ll see a good relationship there.

A – Matthew Paull

Joe, I’d just add, our average check is up. As you know, over 50% of our comp the last two years is derived from our chicken play now, the coffee that we launched along with our breakfast platform, not only its increased coffee sales but our breakfast day part is increasing, so the combination of all three is very good.

Mary Kay Shaw

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

Q - Rachael Rothman, Merrill Lynch

Hi, good morning. Can you just remind me, because I’ve forgotten, what percentage of your stores in the US are currently operating with extended hours? What percentage have been remodeled. And I believe you have Cashless everywhere – is that correct?

A – Matthew Paull

Yes, Rachael, we have Cashless everywhere. We have over 13,000 now, almost all of our restaurants are on some form of extended hours. Nearly 4,000 of those are on 24 hours, either 7 days a week or at least Friday and Saturday nights which in some markets is a really important play for our operators. By the end of this year, we will have reimaged in the United States over 5000 restaurants.

Mary Kay Shaw

Thank you. The next question is from Andy Barish, at Bank of America.

Q – Andrew Barish, Bank of America

Going back to the UK and its potential improvements, you actually saw in the way you guys talk about the margin impact, about half the impact in Q4. You mentioned about 70bps of an impact on European margins overall and it was about 150bps in Q4. Was that purely the actions you’ve taken that showed up in Q1, or have those not really shown up in terms of store closures and refranchising yet?

A - Michael Roberts

The actions we’ve taken really haven’t shown up yet. And you’re right, the drag on Europe’s results from the UK has lessened fairly significantly. We’re encouraged by that, but we’re still not anywhere close to being happy with what we’re producing.

A – Matthew Paull

Andy, we’re excited about their focus on our core menu in the UK. We’ve got the double cheeseburger, we’ve got the double QPC, combined with the Pound Saver menu, they just finished Monopoly, it’s the first time they’ve run it in about 11 years. We’re encouraged by the progress there on the calendar and they’ve got a very assertive calendar for the rest of the year, with a bigger Big Mac, some ‘I’m lovin it’ desserts over the summer, free Coke glass promotion with an EVM in August and this is our core menu. And I’m really encouraged by this.

A - Michael Roberts

Andy, one last thing, in the UK we’ve seen some very nice activity surrounding opportunities at McDonalds. We’ve received some nice coverage and it’s a part of making sure that we position the brand in the right place.

Q – Andrew Barish, Bank of America

A quick follow-up on toasted deli over there, you didn’t mention that, Mike?

A - Michael Roberts

Well I think delis are doing reasonably well over there, Andy. I’m not overly impressed with how well we’ve rolled that out there. The UK consumer you know loves sandwiches, we made modifications to our delis in Canada and I’m excited about that possibility. The UK is focused now on our core menu, including breakfast. And breakfast is doing better over there.

Mary Kay Shaw

The next question is from Peter Oakes at Piper Jaffray.

Q – Peter Oakes, Piper Jaffray & Co

Mike, you mentioned up front when you were discussing Europe, that the QSR market as a whole is down there. That’s something that’s been discussed quite a bit, at least as far as Germany for a number of years, but you characterized Europe as a whole QSR market being down. I’d be curious, if you could delve into that a little bit more as to what other geographies you’re seeing that kind of macro pressure in? Is it weather-related etc., that can distort Q1. Also, Matt, I think you mentioned you’re starting to get better coverage in the UK – can you add a little more color what you mean as far as some of the media support and how that’s swinging in that direction?

A – Matthew Paull

On the media issues, in all of our restaurants now, there are posters that describe the kinds of flexible schedules and opportunities we give our crew. We’ve seen a lot of favorable coverage of that. Coverage that we might not have received a few months ago because the media in the UK was looking to find a negative story. So we’re encouraged that we’re receiving a little bit fairer treatment on some of these issues. We still have a very long way to go.

A - Michael Roberts

Yes, and Peter, I would just tell you that globally, the IEO is growing, roughly in the neighborhood of $35 billion per year. Overall, the QSR market is growing. In my mind, we’re competing more and more in the IEO market, vis a vis our products, and on the look and feel of our restaurants. I would tell you that Germany is a great example, even in a very difficult market with unemployment high and inflation high etc. They’re posting very solid results, which is an indication to everybody in McDonalds that when we do what we can do best, which is focus on our plan to win and our five Ps and our customer with a very solid, everyday low price platform, plus new food news, plus reimaging plus McCafé, that we can do very well.

Mary Kay Shaw

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

Q – John Ivankoe, JP Morgan

Thanks. I know you mentioned extended hours, which great, but I mean could you talk about other speed of service or operational initiatives that might be out there to increase throughput at the stores or traffic at the stores from an operational perspective? Thanks.

A – Matthew Paull

Yes. One example certainly is that the Cashless is helping speed service. Mike taught me this. The Cashless transaction takes maybe four seconds to ring up, making change with cash takes on average 15 or 16 seconds. As that piece of our business grows, our service will speed up, that’s one example.

A - Michael Roberts

John, I think you know in our plan to win we have measures against every one of the things we’ve spoken about: quality, service, cleanliness and value. In Latin America, Europe and AMPA(?) we are making a lot of progress. North America is making progress as well, not as much as we’d like on fast and friendly, but a lot of progress there. The program internally is called shift into overdrive. It’s a program whereby leadership from around the region can visit each and every restaurant and discuss all of these attributes with our management and with out crew, and work to help them do a better job with hiring and with retention, and with training. I would tell you there’s no secret here, it’s just every day effort around the world in terms of improving our customers’ experience.

Mary Kay Shaw

Next question, we have a repeat question from David Palmer at UBS.

Q – David Palmer, UBS Warburg

Hi. Just a follow up on that Mike, I was just reviewing that article from QSR, a magazine where they have their Drive Thru survey and it looks like McDonalds, among others, continues to go the wrong way on Drive Thru speed and I think McDonalds continues to have some struggles here on Drive Thru accuracy. Could you maybe address that, it seems to be an ongoing issue, but meanwhile your sales are telling, obviously, another story about consumer satisfaction. How should we interpret this stuff?

A - Michael Roberts

First of all, David, what’s really important is that our Drive Thru business as a comp is growing. We’re doing the right things. We’re attracting guests to our restaurant. In terms of speed, you know, this is something that, with our customer order display, with our new POS system, we’re making it easier for our crew people to take orders. A significant percentage now of orders in Drive Thru are using Cashless, as Matt said this is about a four second transaction. That really helps our crew people execute in the Drive Thru. We’ve got a lot of initiatives that we’re working on related to accuracy in terms of positioning of equipment and having all of the right product at the presenter’s booth, which is important. I would just tell you that, you know, related to our mystery shops, we continue to make progress there. All of our teams are incentivized to improve where we are today. We’re making progress here. I’d like every order to be fast and accurate and friendly, and that’s what our areas of the world share as well, as with our operate leadership around the world it’s a major focus for 2006.

Mary Kay Shaw

Thank you. Our next question is from Larry Miller at Prudential.

Q – Larry Miller, Prudential Equity Group

Thank you very much. I think in some of the recent sales releases, you’ve talked about improved coffee results. I was just wondering, are you seeing therefore incremental sales and incremental margin? Or is it a swapping from other beverages like soda and juice? I also have one other question if you could let me do that?

A - Michael Roberts

Larry, our coffee business since we launched is up significantly, double digits in fact. Our breakfast comp is up in Q1 as well. What we learned here is that, you know, we have some breakfast rejecters if you will, who didn’t think our coffee was as good as it could be. Now that they know it’s better they’re coming to McDonalds, so coffee combined with our breakfast sandwiches is leading our breakfast comp. The opportunity here I think is enormous. Related to other plays with coffee, we’ve got a very competitive price point at about a dollar for the 12-ounce cup, with the new packaging and the new lid and a robust cup of coffee, I think we’ve got a pretty compelling offer for our guests.

A – Matthew Paull

The breakfast business is really nicely positioned for us. It’s very large, we get very good value scores for our customers and it producers a very attractive margin for us.

Mary Kay Shaw

The next question is from Joe Buckley at Bear Stearns.

Q - Joe Buckley, Bear Stearns

Thank you. I want to go back to my first question, I phrased it badly. What I was asking is how the US operating income was up so much, 17%. You know, given the margin dollar increases of maybe 11-12% and it sounds like higher SG&A? Then, as a second question that I’d like to ask, how far back has China come? Do you think your business there is back to a normalized level, or – put some parameters around the improvement that you’re seeing?

A – Matthew Paull

Joe, this is Matt. We’re probably going to have to have you talk to IR one on one about the US question, because I’m afraid – it’s not you, it’s probably me, I just don’t understand your question. On China, we’ve not come back as far as we’d like to, you know, our margins are improving, our comp was positive, we love what we see from the Drive Thrus, we love what we see in terms of future opportunity, we’re growing into the economies of scale that we enjoy in a lot of other markets; we’re not all the way there yet. We are very positive, you’re going to see a lot of movement in building Drive Thrus in China from us. We think we can do it better than anybody. So China’s going to be a big investment and a big opportunity for us. Having said all of that, I have to remind everybody that we can build a restaurant in China with about one fourth of the CAPEX it takes to build a restaurant in the US. Once in a while, you know, we’re not perfect, if we make a real estate mistake in China, you can get out of a lease at no penalty at 95% of the locations we have by giving three months’ notice. So we don’t expect to make mistakes, but we can afford to be a little bit more aggressive than we’ve been in the past.

A - Mary Kay Shaw

I can add on to the G&A question, Joe, this is Mary Kay – you know, we don’t give you the G&A by segment for the quarter, but keep in mind one of the things Matt talked about that drove the increase was the Olympic cost in Europe, so that was a big part of the increase and corporate was higher. So US G&A was more in line as what you would expect, so that’s probably why operating income looks that way that it does. Thank you. The next question is from Steven Kron at Goldman.

Q – Steven Kron, Goldman Sachs

Great, thanks. Just a follow up on the UK and the refranchising that you’ve done so far and that you plan on doing on a go forward basis. Are these refranchised stores going to existing franchisees or new franchisees, and I guess given the negative comp pressure that you have there and other cost pressures, are you giving any kind of concessions to that rent and royalty which I think, on average from the 10-K, was around 17% in the European region?

A - Michael Roberts

Steve, the bulk of these restaurants will be franchised to existing owner-operators, and our leadership there, Peter Beresford and Steven Easterbrook and I and Denis Hennequin, our President in Europe, we’ve all discussed this. The operators there are very excited about growth. We haven’t opened many new stores there, or many new restaurants in the last couple or three years, and on a case by case basis we’re looking at pre-debt cash flow and sales and the opportunity in front of us to make it right for those operators to be able to compete in that market place effectively. We’re going to look at those P&Ls on an individual operator to operator basis, but the bulk of those restaurants will go to existing owner-operators.

A – Matthew Paull

Steve, I’m pretty sure that we covered this on the January call, but if we didn’t I’ll say it here. You know, we look pretty carefully at the differences in P&Ls between us running a restaurant and an operator running a restaurant in different parts of the world, and we described in great detail what those difference look like in the US. We commented back then that the part of the world where we saw the greatest difference was in the UK, where our operators seemed to do a much better job of running the restaurants than we could. They did a better job of making the restaurant more locally relevant. I think in the area of concessions, I think it’s much less likely to be necessary there because our operators simply run better stores there than we’re capable of running.

Mary Kay Shaw

Thank you. It looks like we are out of questions, so thanks everyone, and I’ll turn it over to Mike for a couple of closing comments.

Michael Roberts

Thank you again, everyone, we appreciate your interest in McDonalds. In closing we’re pleased with the quality of our Q1 earnings and through our intense focus on building relationships with our customers and through the execution of our locally relevant plan to win. We intend to build on the momentum we’re currently enjoying. Thanks so much.

Mary Kay Shaw

Thank you.

Operator

This concludes today’s conference call, you may now disconnect.

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Source: McDonalds Corporation Q1 2006 Earnings Conference Call Transcript (MCD)
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