McDonalds Q4 2005 Earnings Conference Call Transcript (MCD)

| About: McDonald's Corporation (MCD)
This article is now exclusive for PRO subscribers.

McDonald’s (NYSE:MCD)
Q4 2005 Earnings Conference Call
January 24th 2006, 10:30 PM. Executives March 1, 0000 ET


Larry Miller, Prudential

David Palmer, UBS

Joseph Buckley, Bear Stearns

Peter Oakes, Piper Jaffray

Howard Penney, Friedman, Billings, Ramsey and Co

David Kolpak, Victory Capital

John Ivankoe, J.P. Morgan.

Andrew Barish, Banc of America.

Mark Wiltamuth, Morgan Stanley.

Lawrence Miller, Prudential.

John Glass, CIBC.

Jeff Bernstein, Lehman Brothers


Hello and welcome to McDonald’s January 24th 2006 Investor Conference Call. At the request of McDonald’s Corporation this conference is being recorded. Following today’s presentation there will be a question and answer session for investors. At that time investors only may ask question by pressing “*” “1” on their touchtone phone. 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 Vice President and Investor Relations

Thank you. Hello everyone and thanks for joining us today. With me today are Chief Executive Officer, James Skinner; and Chief Financial Officer, Matthew Paull. Also joining us by phone for Q&A is Chief Operating Officer, Michael Robert. Michael is with our owner-operated leadership at a regularly scheduled offsite meeting to discuss the plan to win. Jim will discuss the progress that we have made against our strategies as well as the priorities he laid out during his tenure as CEO, 2005 highlights and 2006 strategies and a discussion of plans for our company-operated restaurant. Matt will highlight some of the ownership changes we plan to make. He will also outline steps we would take to provide more information to investors about the performance of our company-operated restaurant. I will then comment on our current operating results and look ahead to 2006.

Then we have time to take your question. As always this conference call is being webcast live and recorded for replay. The forward-looking statements which appeared in today’s earnings release and 8-K filing also apply to our comments on this call. But the earnings release in our 8-K with supplemental financial information are available on www.investor.McDonald’ as our reconciliation’s of any non-GAAP financial measures mentioned on the call today to the corresponding GAAP measures, and I would now like to turn it over to Jim.

James Skinner, Chief Executive Officer

Thanks Mary Kay and good morning everyone, we appreciate your participation and interest in this call. On this earnings call last year we reported our standard results for 2004, at that time Mike committed that we would build on our success in 2005. We delivered on that commitment, 2005 was a very solid year for McDonald’s. Our performance resulted from an intense focus on our customers, disciplined execution of our plan to win, continued brand strength and system alignment. You remember on that same call I outlined my priorities for my tenure as CEO of this great brand.

Long-term profitable growth for our system and shareholders, talent management; and leadership development to support that growth in balanced, active lifestyles. We have made excellent progress in each of these areas. For the third consequent year we grew sales in profit. Comparable sales increased 4.2% for the quarter and 3.9% for the year. Revenues increase 4.5%in the fourth quarter and reached a record high for the year at more than $20 billion. EPS was $0.48 for the fourth quarter and $2.04 for the full year.

Our cash flow statement is not yet finalized, but I can tell you that we expect to have another very strong year of cash flow performance. This financial success enabled us to enhance shareholder value by recurring a significant amount of cash to shareholders. In 2005 we increased our annual dividend by 22% nearly tripling the payoffs since 2002. Additionally share repurchases were ramped up this year to $1.2 billion. In 2006 and 2007 combined we planned to return another $5 billion to $6 billion to shareholders through dividends and share repurchasing. Bottomline our actions approve our commitment to building long-term value and you can count on this leadership team to continue acting in the best interest of our system and shareholders.

Turning to talent management and leadership development, we’ve focused on having the right people in the right places with the right skills and this continues to payoff for McDonald’s. We have a strong and deep leadership match. We continually cultivate and promote talent and we have a robust succession planning process for all key leadership positions around the world enabling us to act quickly when we need to.

Over the past year we placed new leadership in Europe, Asia Pacific, Canada and here. Thanks to our effective talent management these dynamically leaders did not miss a beat and are driving the results you see today. In the area of balanced lifestyles we are committed to offering many choice and variety, promoting importance, the importance of physical activity and providing nutrition information. This is important to our customers and it is important to us.

Two years of diligent work culminated in 2005 with the announcement that we will now provide nutrition information on our food packaging. This is a first for the quick service restaurant industry. Our new packaging will launch at the February Winter Olympics in Italy and by the end of 2006 it will be in the 20,000, that’s 20,000 restaurants worldwide.

In 2005 we also launched several new menu items around the world including premium chicken sandwiches in the U.S., new salad varieties in Europe, more Happy Meal™ Choice in Asia, new chicken sandwiches in Latin America and much more. In terms of priorities I established as a CEO I believe we made great progress and I am confident we will continue our momentum in all three areas.

In 2006 I intend to focus more of my time on our achievement of our long-term profitable growth. This means keeping our system aligned around our plan to win and its five strategic imperatives: People, Products, Place, Price, and Promotion. They are the fundamental drivers of our success in the foundation for long-term profitable growth, and there is tremendous room to grow market share and profit under each imperative. Our place strategy will target convenience in Asia-Pacific, the Middle East and Africa. This includes extended hours in the appropriate markets, and an aggressive drive-through strategy to capitalize on increased automobile usage.

If you can just take China for example there were more than 2 million new cars on the road in 2004 with 15 % more expected each year. With this increase spending power and mobility comes a faster pace of life and demand for greater convenience.

The McDonald’s drive-through then becomes a perfect dinning option. We opened the first ever drive-through in China last November and now have a total of three in the marketplace. These drive-throughs are outperforming the market average in sales and guest counts and will profit from our first mover advantage by opening 12 more this year.

Our price strategy uses a sustained value platform to bring in more customers. In Europe we are seeing traction and success with programs that combined everyday value with a strong trade-off strategy. In Germany this balanced approach resulted in higher guest counts, comparable sales and margins.

In the United States our products strategy is aimed at increasing our share of the rapidly growing chicken market, a $22 billion business. Consumption of chicken in the United States has increased nearly 40% over the past five years and we are seizing this opportunity. For example, with the launch of our ‘premium’ chicken sandwich line we are selling about 20% more chicken sandwiches at a premium price, which provides a nice balance with our everyday affordability platform, the Dollar Menu. This year we are adding to our chicken line with new spicy chicken premium sandwiches and Asian chicken premium salads. All of these diverse strategies are part of a holistic plan incorporating all five piece of our plan to win that will continue to generate growth and deliver shareholder value.

Now I want to switch gears and talk about our company-operated restaurants. As you know there is a lot of interest in the accountability of McCopco restaurants and many opinions about the balance of company-operated and franchise restaurants. Let me tell you where we stand. First we absolutely believe that every restaurant McCopco or otherwise needs to be accountable for strong financial performance and deliver a great customer experience. In 2006 we intend to create more transparency around that McCopo performance.

Second we are committed to franchising, McDonald’s as you know is a franchising company and we will always be a franchising company. At the same time we believe it is critical to own and operate a certain number of restaurants, restaurants that we hold accountable for delivering strong financial results. We call it “skin in the game”. We firmly believe that owning restaurants is paramount to being a credible franchisor, credible in providing restaurant operations support and coaching in delivering the bottomline as well as the topline and credible in shaking or sharing the risks and rewards.

In short we will continue to own and operate restaurants to better the McDonald’s system and to deliver shareholder value. Having said that it’s reasonable to ask the question, what’s the right balance? This is something we continually manage and we will manage in the future. We believe we have the right balance in the United States, Australia, France and Russia for example just a few markets with strong margins and returns. But as we said before we also believe some of the roughly 8,000 McDonald’s restaurants we currently own would be better certain to answer franchisees. We talked about this at our Analyst Meeting last September. Over the past year we have identified markets where our customers, system and shareholders will benefit from the entrepreneurial spirit of franchisees who can optimize the market’s potential.

But we will seek a better balance in the right way by being thoughtful and thorough. It will not be wholesale transaction that will not serve anybody’s best interest. Additionally we are looking at ownership in certain markets, we have identified about 15 to 20 countries where we will pursue converting ownership to developmental licenses or DL’s as we say. A DL structure enables a local entrepreneur to use their capital, their real estate and their local knowledge to build the brand and optimize sales and profitability over the long-term. In a DL arrangement McDonald’s collects royalty but invests no capital. They currently have 32 DL markets around the world and experience great success with this model. We believe this is the best approach in markets where the pie isn’t big enough to support both McCopco and franchise restaurants.

We are confident these ownership plans will increase value and Matthew Paull will talk about this in detail in a moment. To close I want to go back to where I began by repeating what I said a year ago. We are firmly focused on our customers and restaurants. Our system is aligned and committed to growing the business through our plan to win and we maintain our commitment to financial discipline in delivering shareholder value. As a result I am confident that 2006 will be another strong year for McDonald’s. Thank you. Now I would like to introduce our Chief Financial Officer, Matthew Paull.

Matthew Paull, Chief Financial Officer

Thanks Jim and good morning everyone. In 2005 we delivered against our stated annual target of system wide sales and revenue growth of 3% to 5%, operating income growth of 6%to7% and return on incremental invested capital in the high teens. These targets continue to be appropriate and achievable for a company of our size. Notably over the past three years our comp sales margins and returns have all improved, with enhanced our financial strength and grown cash flow to even higher levels. All of this is a direct result of our focus and alignment on growing the business by being better not just bigger. But there is clearly more that we can do. We will get better as being better through continued efforts under the five P’s and by evolving our ownership mix to best serve our business needs, our customers and our shareholders. As Jim said we are firmly committed to franchising. It is our historic foundation and the best way to grow our business going forward. The alignment we have with our operators, for example contributed to a 150 basis point improvement in franchise margin as a percent of revenues over the past three years.

While we are deeply committed to franchising we do operate a minority of restaurants as McCopco because we believe it makes us a more credible and more effective franchisor. However as Jim just pointed out just a few minutes ago that does not give McCopco a pass on financial performance.

Lets talk about the performance of the 15% of the U.S. restaurant base that we operate as McCopco. Profits as a percentage of sale in our U.S. franchise restaurants trend about a point and half higher than in our company-operated restaurant. We’ve closely examined our mystery shop scores in the U.S. and the differences are minimal. So it is not operations driving the performance difference but there are differences that relate to the motivation and skill sets of an independent entrepreneur and others that are inherent in the way of our businesses are structured.

First and foremost the independent entrepreneur who owns an average of 3 to 4 restaurants is highly motivated to drive sales and profit after all their livelihood depends on it. Franchisees as you all know are in the restaurant everyday, they make quick changes based on immediate needs. They note their competition they note their trading areas are very close to the day-to-day operations and obviously more connected to the local community then any large public company can possibly be. Structurally franchisees as small businessmen and woman have certain cost advantage for example they have a great feel of flexibility in designing their employee benefits while large U.S. based public company are required by law to provide similar benefits for all employees whether working at headquarters or restaurants.

Similarly regarding insurance a large public company with thousands of restaurants is not as nimble as small entrepreneurs who can pick and choose among carriers capturing cost advantages. These three differences explain the vast majority of the small gap between McCopco and franchise stores in the U.S. We earn excellent returns in our U.S. McCopco business. Even after imputing a 13% rent and service fee these returns are well above our costs to capital.

While our U.S franchisees on average perform slightly better than McCopco, none of the barriers to improve performance I just described is removed by substituting a new publicly owned McCopco for our current structure. As you know there has been a good deal of debate surrounding our McCopco restaurants. The idea of McCopco IPO has been raised along with the suggestion that such a step would improve transparency resulting in better performance and increase shareholder value. As you also know, we have rejected the idea of a McCopco IPO because we firmly believe it will not deliver the value already been created by our current strategy, that McDonald’s plan to win. We put that strategy in place in early 2003, since then we’ve recorded 32 consecutive months of positive global comparable sales, our share price has nearly tripled and we’ve returned more than $4.2 billion dollars to shareholders by dividends and share buybacks.

To state the obvious, Mc Donald’s is on a bit of a role; having said this, we certainly know there is resting on pass burrow which is why we continue to evolve our business to make it stronger. But the key work here is Evolve, we do not believe in McCopco IPO is evolutionary nor is it necessary. Are we committed to significantly reducing the number of our company owned restaurants? Certainly, but as Jim said, we intend to do it in the right way and in markets where it makes the most sense to make changes. And IPO has been served up as a panacea, believe me it is not. From our own experience with the McDonald’s Japan IPO in 2001, we know how much distraction and bureaucracy can be created, after all we owned 50% of the largest publicly traded restaurant franchise in the world.

McDonald’s Japan has 4000 restaurants and their public companies status does not protect them from economic volatility, commodity cost increases or competitive pressures in the marketplace. And just as importantly, we know that taking a large portion of our company-owned restaurants public does eliminate the structural differences or create the entrepreneurial spirit that exists with the franchisee. It merely creates an additional layer of complication and ultimately costs. For all these reasons, we concluded that an IPO of any portion of our company-operated restaurants will not improve performance in the McCopco. We believe there are better ways to accomplish this. We recognize opportunities for improvement exist in many markets, as part of our regular business review, we evaluate approaches that best promotes profitability.

Today we have more than 9000 company-operated restaurants globally including 1000 operated by our partner brands Chipotle and Boston market. I want to focus today on our 8000 McDonald’s company-owned restaurants. 2100 of these are in the US with strong margins and return. Another 900 are in Germany, France, Russia and Australia also with strong margins and return. These markets, which comprise about 40% of our company-owned restaurant base strongly contribute to our result and make us a better franchisor. No significant changes are currently planned. In China and Brazil, where we have a combined 1100 company-owned restaurants, franchise was either do not exist or are more or less unenforceable, so again franchising opportunities are not currently available. But we have about 800 company-operated restaurants in the UK, consistent with what we discussed in our Analyst Meeting in September, we will begin refranchising some McCopco in the UK this year.

Currently the UK is 63% company-operated. The goal is to get something less than 50%. We have not yet determined exactly how far below 50% we will get or how long it might take us to get there. But remember we are starting in the UK with a relatively small owner operator base, as the base grows and as we gain experience with the refranchising strategy, the pace should accelerate. Earlier you heard Jim talk about our Developmental License or DL strategy. This is an excellent opportunity to evolve our ownership structure and capture the structural and motivational advantages that I mentioned earlier.

Over the next three years, we planned to convert 15 to 20 additional countries or 1500 restaurants representing about 1.5 billion in sales. These restaurants also represent about $1.6 billion in combined net investments, generate approximately $60 million in net operating losses and account for nearly $100 million in G&A and $50 million of maintenance CapEx annually. Significantly, when we convert this group of restaurants to developmental licensees, the results we currently report from these markets would be replaced overtime with the royalty based solely on the percentage of sales and our capital requirements will be eliminated. The effect of this DL initiative is to put significant number of restaurants in the hands of entrepreneurs who can keep them locally relevant, improve returns overtime, protect their brand and continue their growth without any use of McDonald’s capital. Please keep in mind it takes time to find the right developmental license partner.

In the first three quarters of 2005, we added two countries and 325 restaurants to the list of markets using a developmental license ownership structure. Increasing total DL countries from 30 to 32 or on establishing DLs in these two additional countries began two years ago. Overtime, we expect to significantly reduce the number of company-operated restaurants from the current 27%, putting more restaurants in the hands of small entrepreneurial local businessmen and women. In this process, markets like China who remain primarily company-operated in the near-term while we await the evolution of China’s franchising and property laws and continue to develop a pool of talented franchisees. So those are the highlights of our plans for refranchising and development licensing. Now lets return to McCopco performance.

We believe in accountability, in incentives, type of results and in transparency. Three years ago, as a lot of you know, we reorganized US McCopco to operate as a separate business reporting to one McCopco Vice President in each US division. At that time, Ralph Alvarez led a team to determine which McCopco’s we could run well and which should be refranchised. Since that time, compensation and incentives for all non-store level employees in US McCopco are directly tied to McCopco’s operating income. U.S. McCopco’s store managers earn bonuses again tied directly to the profitability of their individual restaurants. We have seen the benefit of these simple organizational changes and improved McCopco profitability, margins and returns in the US.

Ralph Alvarez who is now President of McDonald’s North America has begun a similar process in Canada. We will look at which of Canada’s 500 McCopco’s restaurants we can run well and which should be franchised. We’ll organize personnel around their revised structure and implement incentives tied directly to the operating income of McCopco in Canada. We will consider similar changes in other countries where appropriate. On a separate but related topic, we believe we will find the way to supplement our disclosures regarding company operated restaurant performance, of course any information provided must be allowed by disclosure guidelines and must not be misleading meaning, there should be a solid foundation for any imputed data we give you. Let me be clear, the way we report McCopco results today is consistent with generally accepted accounting principles and with how the rest of our industry reports results allowing for comparisons across our industry.

Our intent is to provide more information so investors can better understand the results of the company-operated restaurant as if they were operated on a standalone basis. Because these contemplated disclosures could be considered proforma, we will probably provide you the components and let all of you in the investment community do the math. We are targeting disclosures of this additional information in our 10-K, which will be filed in about six weeks. The bottomline is more information, which we welcome. We will let you and our investors to decide how best to value our cash flows.

So to conclude, our objective over the next several years is to lower the number of our company-owned restaurant and provide more information in the process. Rest assured, we will do this in the right way, when and where it make sense, the best sense for our system and our shareholders. Now I would like to turn the call back over to Mary Kay, who will comment on our current operating result and look ahead into ’06.

Mary Kay Shaw Vice President and Investor Relations

Thanks Matt. Overall we delivered a strong quarter of positive result. Our focus on the plan to win and our alignment generated guest count increases and solid comparable sales growth for both the quarter and the year. Fourth quarter franchise margins, as a percentage of revenue continue to be strong, increased nearly 100 basis points to 80.3%. The US business drew much of this improvement.

Consolidated company operated margins although a smaller contributor to overall margin dollars are an indicator of the restaurant level health of the business. Company-operated margin dollars increased 7% in constant currencies for the quarter and more flat as a percent of sales. US company-operated margins as a percent of sales remain strong at 19.1% for the quarter. These margins were positively impacted by an adjustment to our current year estimates of profit sharing and store manager incentive. This was partly offset by higher beef cost, higher labor and higher occupancy cost including utilities. In the US beef was up about 8% in the fourth quarter and 9% for the year, up slightly from last quarter’s expectation, we are expecting cost for beef as well as chicken and cheese to be flat in 2006.

Utility cost, which represent about 3% of sales for the average traditional restaurants rose approximately 9% this year. We are anticipating increases again in 2006 and have plans in place to address utility cost increases and to improve energy efficiency in the restaurant overtime. To continue our US momentum in 2006 we will introduce two new chicken products and re-image approximately 1400 restaurants. We will continue our focus on improving service and providing a great customer experience in the restaurant.

Turning to Europe’s company operative margin for the quarter, strong sales in Germany and Russia were offset by weak performance in UK and higher beef cost across Europe. Beef cost across Europe increased about 6% in the fourth quarter impacting margins by about 30 basis points. For the year European beef prices were about up 14% over the last year. Looking forward we expect beef cost to be up slightly in the first quarter of ‘06 and basically flat for the year, yet to face by the UK are longer-term and will take time to resolve. We have plans in place to drive improvement including refranchising company operated restaurant, wide range in consumer communications to further build trust and enhancing the customer experience through promotions like monopoly and tie ends to the World Cup. In September we successfully launched Toasted Deli sandwiches in the UK. We have opportunities for greater frequency and awareness with our customers and therefore we are planning some advertising rehabs to remind customers in the UK they have more reasons to visit Mc Donald’s as we now offer more variety.

Moving to Asia-Pacific this segment has generated another quarter of positive comparable sales primarily driven by Australia and Japan. Company operated margins declined 30 basis points for the quarter primarily due to negative comp sales in China and weak results in South Korea.

We remain excited about the opportunities in China, a growing market with 1.3 billion people. This tested value of its past year and are confident we are on the right track with the balance of the premium products and value menu. We’ve also added real estate expertise to improve our sight selection process and our global supply chain is working on efficiency initiative to help reduce costs all of which should lead to improved margin. In 2005 we opened about a 100 restaurants in China and we will open approximately 125 in 2006.

Worldwide we will continue our emphasis on the remaining relevant to our customers, strengthening operations and maintaining capital discipline. In ‘06 we’ve planned to reinvest about $1.8 billion, 50% allocated to existing restaurants and 40% for the new restaurants including approximately 800 new McDonald’s restaurants primarily in the US, China, France and Russia.

Jim mentioned our significant share repurchases, on this topic I know many of you have been disappointed as we have been as our share count has not declined despite all the stock repurchases. I would like to explain why this happened.

We began 2005 with the higher share base for several reasons. First we were not in the market buying shares at the end of 2004. In addition, option exercises were much higher in the past two years at a combined 5% of the outstanding share base as the stock prices improved. As a result we did not offset the diluted impact of option exercises on share count, this is expected to taper off every time as have significantly reduced the number of options granted from about 2% of outstanding shares per year to about 0.7% of outstanding shares per year.

We planned to be aggressive with share repurchases this year buying back a $1 billion worth in the first quarter of 2006 and have a portion already completed but we do expect to decrease in share count for 2006.

In closing 2005 has been a good year and we have much to look forward to in 2006. We have additional opportunities for future growth and are confident we have the right plans in place. At this time I’ll open up the call for questions. Please press “*””1” if you have a question and “# “key to remove yourself from the queue. To give more people an opportunity ask questions, please try to limit yourself to one question. We’ll come back to you for follow-up questions as time allows. First question is from Joseph Buckley at Bear Stearns

Questions-and-Answer Session

Q - Joseph Buckley

Thank you. A couple of questions, I’ll combine them into one on the company-operated McCopco information that you shared with us. I’m curious if your study show that pricing is different in the McCopco stores versus franchise stores across the board. And could you walk through again the margin differential I think you indicated that your studies show franchise margins are about 1.5 points better than the company margins. And is that on a fully allocated basis for the rent of royalty. Just fill that out for us as much as you can please?

A - Matthew H. Paull

Joe that would be on a totally allocated basis. What we are saying is, if you give a franchisee in McCopco the same opportunity, in general on average, the franchisee for all the reasons we’ve sighted, will do a point and a half better profitability as a percentage of sale, that’s why we are a franchising company, we recognize that. However, considering that and whatever it is you want to do with rents and services fees we are still earning a terrific return on US McCopco and it’s making a much more effective more credible franchisor. On the issue of pricing overtime our McCopco prices are probably an average 3% or 4% below or franchisees their prices, bear in mind we are required by law to set our prices independently of where our franchise is that their prices and we never ever try to influence their pricing.


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

Q- Jeffery Bernstein

Thanks very much. Just a question on competitive US landscape. I think that most of your competitors have been following the same, their approach is the higher quality helps your leading options, and you seem strength I guess by a lot of these peers. Just wondering if you could talk about, just the strength in the overall QSR segment, what do you think this category momentum is sustainable? Also just wondering if you could see the overall category growing, or is, think quick service taking share from the segments, I wonder if you could size up the promotional environment? That will be great. Thanks.

A- James Skinner

Jeff this is Jim Skinner, I’ll start with the headline and then Mike Roberts may want to contribute from cost side location. First of all we are so excited about our opportunities in the quick service marketplace and the informal leading marketplace, so we’ve continue to grow share. I think that’s important as to whether that share is high growth or whether that share comes from our competitors I can only reflect upon what appears to be a rather stagnant performance in the overall marketplace rather than to quick service but informal eating out marketplace, an opportunity continues to grow. And our focus on the customers and restaurants and our plan to win and our tactic seem to driving share growth for us. Mike, did you want to...

A- Michael Robert

Yeah thanks Jim, Jeff this is Mike. QSR US is planning to grow in the neighborhood of 3-5%, which is robust. You know the 3-year comp for the US, ‘03 at 96, ‘04 at 64 and now at ‘05 a 44 comp for the year. So we continue to grow our market share. The marketplace is growing, but we are growing faster than the market, it is a combination of all of the initiatives we have spoken about from late night to breakfast to chicken to the new food Walnut Salad and of course the Dollar Menu, so progress continues.


Thanks Mike. The next question is from John Glass at CIBC.

Q- John Glass

Thanks. Could you comment a little bit on the European margins, it looks like their year-over-year decline is starting to abate, maybe it sounds like beef got better in the fourth quarter. Is there – could you maybe decompose it by market, is there anything that’s moved significantly? And also I guess as your comments relating to the difference in the McCopco versus franchises, is that global or is that just the US and maybe if it is the US could you talk about, is that difference the same in Europe?

A- Mary Kay

Hi, John this is Mary Kay, I will cover the Europe margin. Beef costs did abate, for the year beef cuts were up 14%, Europe only 6% in the fourth quarter so you know it’s about 20-30 basis points different, so 50 basis points for the year and only about 30 basis points for the quarter. That was really the primary reason, I think UK was the main market that was pulling the margins down without the UK the margins would have been up in a pretty good way. And the UK is beginning to make some progress too, but the biggest challenges for them are labor. So the beef costs has helped the margins there. Matt, do you want to comment on the second part?

A- James Skinner

John, on the second part of your question about, if we did a comparison of McCopco and franchise results, we have not done an exactly similar study in Europe but if we did, we think we’d see a slightly larger gap on average, slightly larger gap. But it is, the general 51 different countries with 51 different stories, I would be quick to point out that that gap would be heavily influenced by what’s going in the UK right now, where we have probably the biggest gap in Europe. We have already indicated that we are going to be doing re-franchising there. And also I want to point out that probably our best performing margin market in all of Europe is Russia, which is entirely company-operated, somewhere near 25%.

A- Michael Robert

And on the pricing relationship, John, I would say that its probably similar in Europe, its important that though that we all use the same pricing tools, I encourage you to use the same pricing tools because the balance between affordability and driving opportunity for customers to experience McDonald’s through prices so very important it has to be balanced against the profitability of the restaurant on each individual item and so, we spend a lot of time learning and using the tools around this but I would say that the pricing relationships probably about the same there as its here.


Thanks, the next question is from Lawrence Miller with Prudential.

Q - Lawrence Miller

Yeah, thank you, hi, nice to hear you guys. And one of the areas that was raised was higher G&A per store and I was wondering if you could explain why that is and if there is any opportunity there to bring that down. And then I was also curious with the company-operated stores with McCopco stores, did they tend to run higher unit volumes and if so did you adjust for that in your announcement and is that mainly because they maybe of better locations they have more expensive real estates so where is that offset?

A - James Skinner

Oh Larry, this is James Skinner, and then Mike might want to comment on McCopco volumes but three years ago, or three and half years ago, when we set out the revitalization of the financial discipline around that revitalization, G&A reduction and discipline around the G&A spend of the organization was a critical piece of that. And but the focus on that G&A reduction was at the center and not on the field because the relationship that we have with our franchises and our company’s restaurants relative to focus on our customers and our restaurants causes us to believe that it is important for us to have the support in the field relative to the day-to-day operations in that moment of truth to front counter drive-through for our customers and the best experience possible. So, we did not reduce the spend relative to the field but we focus more on the reduction here at the center and we do have higher volume because of that in my mind, we have a better customer experience because of that. And we are able to deliver on the plan to win in that expectation.

A - Matthew H. Paull

Lawry this is Matt, I just want to ask you to recall that at our Analyst Day Meeting we made quite a point in this. We recognize that in our first store basis, our G&A spend is higher than the rest of the industry but the way we run the business as Jim was saying is very different than others. There’s much more collaboration and engagement with our operators and probably more provisions of field support than you see with the other brands. We think that the collaboration and engagement process resulted in us making as a system much better decisions because of all the valuable inputs we get from our franchises. Very few other franchise systems operate that way, it is clearly a more expensive way. To operate, if you are just looking at the G&A line but when you look at the average unit volumes, our system drives probably double the average of the competitors. When you look at the store level cash flow, maybe almost the triple the level of the competitors, we think it’s worth it and also we showed everybody at Analysts’ Day on September 21st what the trend has been in G&A. We committed three years ago to reduce G&A as a percentage of system wide sales by about 10 basis points, here we delivered on at least that every year in the last three years and dramatically brought down our G&A’s percentage of sales and the only thing that gotten the way this year was having to expense option.

A - James Skinner

Mike, you do want to comment on the average volumes of the McCopco versus franchisees?

A - Michael Robert

Jim, the only thing I would add is the average sales in the US now are over $2 million, 3.5 years ago they averaged about $1.6 million so significant increase and there is very little difference between an average McCopco annual sale and the average operated sale so they are roughly the same.

A - Matthew H. Paull

And Larry when we sighted that 0.5 difference we did it using adjusting for differences in volumes, but hopefully that answers your question. Thank you.


The next question is from Mark Wiltamuth at Morgan Stanley.

Q – Mark Wiltamuth

Could you please comment on sales trends in chicken in your China market and if you could just talk about how the returns have changed over the last year there in your China unit, if they are getting better or worse?

A - Michael Robert

I would say, the notion here is that obviously we got a full menu there laid up of beef and chicken, we are promoting beef at the moment and doing quite well, I would add, obviously with Avian Influenza there is significant concerns there as you have heard from our competitors but our chicken sales remain strong in China, and chicken and beef and pork are an important part of the Chinese diet and we offer all three. Thank you.

A - Matthew H. Paull

And Mark, this is Matt on the returns issue, as you know we’ve had a negative comp a large part of 2005 in China, the whole industry has and our comps probably aren’t negative as some others, that has driven our returns down slightly, we are still very optimistic, we are not changing our opening plans and returns aren’t just problematic there because the upfront investment to open a restaurant, this maybe a fourth of what it is in the US. So we are still very optimistic and we are proceeding with our opening plan. Thank you.


The next question is from Andrew Barish at Banc of America.

Q – Andrew Barish

The question is in the kind of first quarter European promotional activity, last year you guys were a little bit more aggressive on the couponing the brand books is, is there anything you see out there promotionally that would either be positive or negative to margins in the European business here for the next few months?

A - Matthew H. Paull

This is Matt, Andy. In Germany last year we had heavy couponing in January that we did not run this year, you could expect that to have a small negative effect on sales but probably a small positive effect on margins on a standalone basis for January in Germany. And we did the same thing in Europe, the brand coupon books have been pulled back this year, so the end result of that Andy is less discounting in this first quarter, our goal there as Mike Roberts has said many times, there is a holistic plan around all the things that we know that would drive the business and give our customers a better experience around the 5P’s. That includes everyday affordability, that includes the balance between the affordability menu and premium sandwiches and premium items on the menu and we know what works, it is not just a matter of time and the execution I think relative to those marketplaces, and the consumer expectation being delivered.

A - James Skinner

Jim I’d just add for Andy, its much more of a focus on the premium products which is a tactic that we have now used the around the world very successfully continuing here in the US. We got a big tasty re-hit in France, we got the double QPC in Europe as well, the Pound Saver in the UK, much more activity related to cheese saga, in Germany all four price products that historically have done very well for us not only profitability wise but sales wise. Thank you.


The next question is from John Ivankoe at J.P. Morgan.

Q- John Ivankoe

Actually I wanted to have a lot of clarification actually on the DL strategy, I think there Kay, you threw out some numbers, 1500 restaurants at 1.5 billion sales in 15 to 20 countries, is that all company-operated?

A - Matthew H. Paull

That is for all purposes, it is all company-operated.

Q- John Ivankoe

Okay. And I think the numbers that you said, excluding $60 million pre-tax or net of year?

A - Matthew H. Paull

$60 million is the operating income line of losses.

Q- John Ivankoe

Okay, so it’s the pre-tax, and then $100 million of G&A that- ?

A - Matthew H. Paull

That would be included in that loss.

Q- John Ivankoe

Do you have any sense what that G&A would go to, was it DL market?

A - Matthew H. Paull

That G&A would be cut dramatically, I can’t give you an exact number but it would be well well under half of what it is today.

Q- John Ivankoe

And just one final one, hopefully this counts as one question. I mean do you think you can or just round numbers think you can sell your net investment at least a breakeven or perhaps gain or should we expect losses from that?

A - Matthew H. Paull

John this is a very long and careful process. The first thing is to find the right partners. Somebody who believes in the brand has a long-term view and can make the brand and keep the brand locally relevant. We are not focusing on what the proceeds of selling might be but you have to bear in mind the information I gave you in deciding you know what you think we might be able to raise. We are not going to comment on individual markets or what we expect to raise in proceeds. Thank you.


The next question is from David Kolpak at Victory Capital.

Q- David Kolpak

Hi everybody. Recently several of your competitors have boosted their marketing focus on Dollar Menu in the US and I’m just wondering if you’ve seen any kind of a trend from consumer demand towards more value priced items, recently and are you assuming a slow down in average stated growth in the US in ’06?

A- Michael Robert

Yeah. David I would tell you that Dollar Menu in the US remains an important part of our portfolio. In terms of our advertising spend, it represents in a neighborhood of 10-15% of the total. We have a very robust calendar here with new food news like Spicy Chicken and then the new coffee initiative followed by the Asian salad in the spring. So the combination of everyday little price the Dollar Menu as well as new food news and great promotional activity like monopoly and I’m loving it is plan for the ‘06 calendar. We would tell you that with higher energy cost and what have you related to consumer’s pocket books. The Dollar Menu is a really important of our portfolio and we intend to continue, communicate to our consumers what great value is available at McDonald.

A- James Skinner

And David I just have to say, this is Jim Skinner, I think that the customer relationship with our restaurants, it proves that they understand a good value and everyday affordability, the balance between that and other options they have on the menu and you know if our competitors pay attention to our customers, they understand that formula and it makes sense for them to pursue that.


Our next question from Howard Penney at Friedman, Billings, Ramsey and Co.

Q- Howard Penney

Thanks very much. Can we just walk through the process of how you decided on using the Developmental Licenses as a strategy of refranchising the stores and will this provide you best return versus other potential forms of franchising?

A- James Skinner

Well I can start Howard thanks for your question. We of course have had a number of Development Licenses for a number of years now. And the reason for that is because some I guess we didn’t have the opportunity to own company restaurants, we didn’t have the opportunity to have enough pie in the marketplace for enough growth, the size of the market place for us to make that kind of investment and we didn’t have enough opportunity really to have conventional franchising and therefore we chose the DL route where you’d find a person who has some passion for the brand, they still have to train and develop to be good restaurant tourists, this is important for people to remember. But they also have the willingness to invest the capital, represent the brand and run the business effectively in those marketplaces, but it is a size related issue in terms of the marketplace. And then secondly the size of pie, and of course we make investments and bets in marketplaces and sometimes we go in there as a company operation and find out that we don’t get the same kind of results on an overall basis that we might want to get and then it becomes better for that marketplace to be a Developmental Licenses we talked about the parameters of that earlier.

Q- Howard Penney

Thank you.


The next question is from Peter Oakes at Piper Jaffray

Q- Peter Oakes

Hi good morning. I was actually hoping to follow-up on Howard’s Developmental License questions. You know in the past you’ve utilized joint ventures and obviously outright franchising. Can you articulate a little better on the developmental license program, how much capital is involved, the royalty stream that we might think of versus the alternatives and even the current Unicorn word stands here at the end of the year. Thank you.

A - Matthew H. Paull

Peter, its Matt, to give you some perspective. When we go to developmental license structure, we are focusing a lot on what is the upside potential on the market versus the risk. And if we decide that that doesn’t work to our favor and then having a local developmental license gives us an advantage in the marketplace, we go developmental license route. We’ve made the most expensive use of it in the Mid East. James Skinner actually launched that program probably we have 15 or 20 markets in the Mid East on a developmental license program. And when you look there, none of our capital is at risk, we don’t put any capital into the entity that’s running the restaurant. We get a pure royalty and using the Mid East as an example, we probably collect royalties anywhere from 2% to 7% of sales and the G&A we spend to make sure that the brand is being presented in the right way and the standards are being met might run in 20%, 30% of the royalty that we collect. So that’s the way we think about it, now we are going to be using to developmental license structures in other parts of the world we have already. If we are going to some new parts of the world and we can’t predict exactly what royalty stream we will get. We are going to focus first and foremost on finding the right development licensee and frankly we would expect a lower loyalty to get the right person into the market running that business. Thank you.


The next question is from Joseph Buckley of Bear Stearns.

Q - Joseph Buckley

Hi thank you. Could you talk about, or just update us on the plans to refranchise units in UK, I think you mentioned 50 restaurants for this year, in that you mentioned that the DL deals was done last year, took a couple of years to, you have to finally come to formation, where are you in the pipeline on additional DLs, or would we like to see any this year?

A- James Skinner

Joe, on the UK refranchising, I think we said that in our September Analyst Day meeting around 50, I think there’s a chance we will end up getting more done but we don’t want to say exactly how many. Part of this is trying to determine how quickly and how well our franchises in UK can absorb additional restaurants. The franchisee base there is not as big as in the US and the proportion of restaurants that are McCopco to the number of franchisees we have is not exactly what it want to be. But if see it working, we would move it along more quickly. On the pipeline issue, with respect to the developmental licenses, I want to say a few things, sometimes these things happen quickly and sometimes they take years, I do want to say that we have two officers working just about full time in this project. But remember we’ve got 15 to 20 different countries on our list, we cannot predict whether this will be one a quarter or none for the first six quarters and then we’ll complete eight of them all at once. It’s just not something that we can predict but we wanted to let you know, what things will look like when we’re done. We will not have capital invested in these markets, we will be collecting a royalty and we will be applying a small amount of G&A against that. Thank you.

Operator: The next question is from David Palmer with UBS.

Q - David Palmer

Thank you, this is a great call. I guess one last, I have two last ones if I could just fit in here, on the dividend, perhaps you can give us a thought or two as to what you will be thinking in the coming years about the key factors that we drive decisions on increasing a dividend perhaps faster than your earnings per share growth. And secondly on Coffee, I see the Gourmet coffee chains and Donuts chains are driving about a third in the US industry unit growth and you have the upcoming reformulations and re-launch and possibly you do so more things on Coffee down the road. Nationally you are not weak, you are not doing a co-branding of your coffee and I was wondering what your thoughts was there, why not co-brand and of course I’ve realized that in New England you recently rolled out Newman’s Own Green Mountain coffee, how are coffee and breakfast sales doing up there, is any learning’s to project nationwide? Thanks

A - James Skinner

David, this is James Skinner, I just make a comment on the dividend and then Matt may want to try, Mike I am sure you want to talk about your pet project on Coffee. Thanks Jim. But as you know, we are already committed to $5 billion to $6 billion over the next two years of return to shareholders over dividends and stock repurchase. And we take the dividend decision as you know somewhat later in the year and we will take off under advisement and relative to the ratios of the payoff that gets determined at that particular time relative to the nature of our share repurchase and dividend and return to shareholders. Matt, you want to say something else?

A- Matthew Paull

Sure, David, I want to point out a couple of things. The payouts that will take place in ‘06 and ‘07 will probably end up being 100% of our net income when you think about it the way Jim just described it, dividend and share repurchase combined. When you look at how do you break that between the dividend and share buyback here are the factors that we consider. We absolutely consider how the market values dividend versus share buyback, that is a big factor. We consider flexibility obviously dividend is a quasi long-term commitment, we look at the strength of the business and finally it’s a minor factor but it is a consideration what’s going on with the tax law, treatment of dividends versus share repurchase. And Mike were you going to cover coffee?

A- Michael Robert

Yeah thanks Matt. David as you mentioned premium coffee and specialty coffees are really important part of the American breakfast experience now. We’ll be launching as I said a new premium Roast Coffee in the US and we are beginning to, it’s rolling out as we speak with new cup, new lid and new graphics etc. We’ll start promoting the end of February. The objective obviously is to increase both coffee and breakfast sales. We promoted coffee with McGriddles in April of ’05 and improved our coffee sales and improved our breakfast sales. As you mentioned we have some locally relevant brands that are part of our chest sales, with Green Mountain and Boston and Seattle’s Best in Seattle, they are part of our advertising plans beginning in February here in US as well. And then we have another 50 or so restaurants that have begun its sales on specialty coffees. And we know what an important play specialty coffees are. So a lot of activity related to coffee and we are optimistic about February’s launch here in the US. Thank you.


Thanks. Our next question from Larry Miller at Prudential.

Q- Lawrence Miller

Yeah, my follow-up question was answered but can you just give us a sense Mike what the coffee percent of sales is right now in the US?

A- Michael Robert

Larry, it’s a small percentage overall. Our goal is to increase it, we promoted coffee with McGriddles as I said in April of 05 and my recollection is that’s the first time we ever advertised our coffee in over 10 years. And so we are getting more active here and getting a lot of expertise built up in our many management teams and look for more from us on coffee.


Okay, looks likely we are out of questions. So thanks everyone I’m going to turn it over to Jim for a closing comment.

James Skinner, Chief Executive Officer

In closing let me just say thanks again everybody for your participation today. I want to reinforce our commitment to providing value for our customers, the McDonald’s system and our shareholders. Our strategy of being better not just bigger is paying off. For three consecutive years our plan to win has delivered results and that momentum continues. We will continue to generate growth by executing our proven plan to win and optimizing our ownership and structuring relevant markets around the world. I am confident that 2006 will be another strong year for McDonald’s. Thank you.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: Thank you!