McDonald’s Corporation (MCD) Q3 2013 Earnings Conference Call October 21, 2013 11:00 AM ET
Don Thompson - President and CEO
Peter Bensen - EVP and CFO
Kathy Martin - VP, IR
Joseph Buckley - Bank of America Merrill Lynch
John Glass - Morgan Stanley
Jeffrey Bernstein - Barclays Capital
David Tarantino - Robert W. Baird
Will Slabaugh - Stephens
Matt DiFrisco - Lazard Capital Markets
Brian Bittner - Oppenheimer
Sara Senatore - Sanford Bernstein
Nicole Miller - Piper Jaffray
Jeff Farmer - Wells Fargo
R.J. Hottovy - Morningstar
Andy Barish - Jefferies
Mitch Speiser - Buckingham Research
Hello and welcome to McDonald’s October 21, 2013 investor conference call. At the request of McDonald’s Corporation, this conference is being recorded. Following today’s presentation, there will be a question-and-answer session for investors. [Operator instructions.]
I would now like to turn the call over to Ms. Kathy Martin, vice president of investor relations for McDonald’s Corporation. Ms. Martin, you may begin.
Thank you, and hello, everybody. With me on the call are President and Chief Executive Officer Don Thompson and Chief Financial Officer Pete Bensen. Today’s conference call is being webcast live and recorded for replay via the phone, webcast, and podcast.
And before I turn it over to Don, I want to remind everyone that the forward-looking statements in our earnings release and 8-K filing also apply to our comments. Both of these documents are available at our website www.investor.mcdonalds.com, as are reconciliations of any non-GAAP financial measures mentioned on today’s call with their corresponding GAAP measures.
And now, I'd like to turn it over to Don.
Good morning everyone, and thank you, Kathy. In July, we talked about three lenses through which we’re framing our performance. We talked about the past, the present, and the future. Today, I want to talk about the present and the future.
We’re focused on the actions that we are taking to drive current performance in an environment that is pressuring growth, and we’ll discuss how those actions will position us to deliver results in the near and the longer terms.
Today, our business continues to grow, as demonstrated by third quarter performance. While global comparable sales of 0.9% were not as high as we’d like, operating income grew 6% in constant currencies and earnings per share was $1.52, a 7% increase in constant currencies.
Even though our comp sales lap eases in the fourth quarter, macroeconomic and competitive conditions are not expected to change dramatically. As a result, we expect October sales to be relatively flat.
Around the world, we are accelerating those initiatives that we believe will have the greatest impact on our customers within our three global growth priorities to optimize our menu, modernize the customer experience, and broaden consumers’ access to our brand. We’re also thoughtfully adapting local market plans to remain relevant and appealing at a time when consumers are uncertain and the industry is stagnant.
We continue to intensify our focus on the most critical tenets of the customer experience: the strength in our performance, menu quality and choice, customer service, affordability, and consumer engagement. I’d like to briefly discuss each one of these.
Regarding menu quality and choice, we must ensure that the true quality of our ingredients and food recipes are better known to all consumers, and that customers have choices across our menu to meet their taste desires and/or nutritional expectations. This includes featuring relevant and appealing new food and beverage news.
Next, customer service. Simply stated, we must exceed our customers’ expectations for fast, accurate, and friendly service at each and every one of our nearly 35,000 restaurants around the world. And furthermore, those restaurants must be clean, well-maintained, and contemporary.
The third point is affordability. We need to offer compelling value options across all price tiers of our menu. And lastly, deepening [unintelligible]. This means creating stronger awareness and excitement around our menu and around our restaurants while further revealing the ways in which we’re a good neighbor in communities around the world.
We know that meeting customers’ expectations in all of these areas is critically important to a great experience at McDonald’s. We’ll talk more about these tenets, including specific examples of actions we’re taking around the world to elevate the McDonald’s experience at next month’s investor meeting on November 14.
So let’s take a look at the business across the globe, starting with the U.S. U.S. comparable sales were up 0.7% for the quarter, and operating income increased 5%. Our current sales performance was driven by a focus on bringing new and familiar taste to customers, exciting promotions, and an ongoing emphasis on affordability across our menu.
We accelerated the timing of our Monopoly promotion in an effort to further increase awareness and encourage trial of recent new product introductions like Quarter Pounder line sandwiches and the new McWraps. Monopoly also reminds customers about our core menu classics. It drives traffic and builds average check while also engaging customers in a fun and familiar game experience that’s only available at McDonald’s.
We also introduced Mighty Wings in the third quarter as a limited time offer. This [bold] (ph) new flavor addition to our U.S. menu originated in China and Hong Kong and has encouraged trade up to increase average check. While overall performance of Monopoly and Mighty Wings met our internal targets, it was not strong enough to offset current guest count trends.
Our promotions and new products are complemented by our consistent value approach to offer affordable variety and choice across the menu. The Dollar Menu remains core to our high-low strategy, with products like the Grilled Onion Cheddar Burger and the popular McChicken continuing to generate strong demand at the $1 price point.
As we celebrate the 10-year anniversary of the Dollar Menu, we’re leveraging the equity we’ve built to ensure we continue to satisfy our customers’ expectations for affordability. The new Dollar Menu and More platform is designed to provide every day predictable value beyond the $1 price point and will be supported with the weight of our national advertising. The sandwich lineup, which ranges from $1 to $2 adds new flavors and tastes to complement our existing favorites and provides additional pricing flexibility for the McDouble.
In addition to the launch of Dollar Menu and More, we’re balancing proven favorites with new tastes that add further excitement and variety to our menu. The return of the popular McRib sandwich and the Southwest Premium McWrap are examples of this flavorful balance that will be seen in restaurants within the United States.
Now let’s turn to Europe, where comparable sales were up 20 basis points for the quarter and operating income grew 8% in constant currencies. These results reflect strong performance in the U.K. and Russia and solid performance in France. Negative trends in Germany continue amidst the highly competitive environment.
The U.K.’s business momentum remained strong, and we continued to grow market share. This growth has been supported by our expanded beverage lineup and an ongoing breakfast focus. This month, we’re launching Mocha in the U.K. and using this opportunity to introduce the McCafe brand across our entire range of espresso-based coffees. Following the successful launch of McCafe iced smoothies and frappes over the summer, this represents a significant step in our journey to become a beverage destination in the U.K.
Russia delivered positive performance in the third quarter despite the lower inflationary environment that continues to limit our ability to take price. Successful food offers such as Tastes of the Season and the Ciabatta Beef Burger helped boost results for the quarter.
France also delivered positive results for the quarter, marking its first positive quarter of comparable sales since the third quarter of 2012. The market continues to grow share in a contracting and [unintelligible] industry. A core menu focus, supported by strong marketing execution and an ongoing emphasis on affordability helped to drive our performance.
The Big Tasty re-hit in September generated strong demand and the Classic Return campaign, which launched in August, proved to be successful drivers of France’s performance during the quarter. Additionally, Petit Plaisirs and Casse Croute continue to do well by providing attractive offers at affordable price points. While we’re pleased with these results, we’re cautious about recent performance, especially given the volatility in France’s economy.
Germany’s performance remains weak, as negative comparable sales and traffic trends continued through the third quarter. Competitive activity remains aggressive, and the decline in IEO category persists as the industry grapples with price-sensitive consumers. Today, affordability and specifically price value is key in Germany. We continue to evolve the balance between our base value and premium offers across the menu to address the near term needs of the marketplace.
Now let’s move over to Asia Pacific, Middle East, and Africa, or APMEA. Comparable sales were down 1.4% for the quarter, and operating income decreased 4% in constant currencies. Performance across our big three markets remains challenging. This reflects tough macroeconomic conditions along with the performance of recent new products and promotions that were unable to overcome our current negative guest count momentum.
Across APMEA, we remain focused on driving performance through consistent price value offers, accelerating growth at key day parts, particularly breakfast and overnight, and by leveraging brand extensions to enhance the service and convenience of the McDonald’s experience.
Australia continues to balance new product news and strong promotional activity to appeal to customers in a highly competitive environment. Looking ahead, Australia is targeting opportunities in chicken and the family business to broaden customer appeal.
Japan’s negative comparable sales and traffic trends persist. We’re committed to making improvements to our value platform in the near term in an effort to appeal to consumers who remain extremely price sensitive in this deflationary environment. At the same time, we’re introducing new products and promotions to create excitement and attract customers into our restaurants.
In China, comparable sales were down 3.2% for the quarter. As a key emerging market, China has significant long term opportunities across all three of our growth priorities. We’re also evolving our value platform to give it a greater reach across day parts and meal occasions. At the same time, we’re using limited time offers and promotions to create energy around new menu news, and we’re leveraging brand extensions like kiosks and McCafes to reach our customers when, where, and how they want the McDonald’s experience the most.
Around the world, we remain focused on our customers. It’s our top priority to deliver an experience that meets their evolving tastes and lifestyles. We recognize the opportunities that exist to profitably grow our business for the immediate and the longer term.
We remain committed to making disciplined investments to fuel future growth and further differentiate Brand McDonald’s. Our efforts to broaden accessibility through new restaurants and to modernize the customer experience by reinvesting in existing restaurants, including reimaging, technology, and convenience initiatives, remains a top priority.
Consistent with our longstanding priorities regarding the use of cash, after investing in our business, we’re committed to returning all free cash flow to shareholders over the long term, first through dividends and then share repurchases. In fact, we recently announced a 5% increase in our quarterly cash dividend to $0.81 per share, bringing the annual dividend to $3.24.
Combined with our share repurchases, we expect our total cash return to shareholders for 2013 to be between $4.5 billion and $5 billion. In times like these, our ability to stay focused on those factors within our control is absolutely critical. As important is our ability to look within, to understand what’s working, what needs to change, and why and we must execute.
Our decentralized local markets have the ability to test their plans and quickly course correct based on customer reactions. This is even more important in this environment because it allows us to identify the right tactics that resonate with consumers and that will drive our performance in the near and longer terms.
Our culture is built on the premise of always putting the customer first, making them feel good about visiting McDonald’s today and into the future. Our ability to deliver on that promise through our actions will enable us to deliver long term value for our system and for our shareholders.
Thanks again, everyone. I’ll now turn it over to Pete.
Thanks, Don, and hello, everyone. Our performance in third quarter speaks to the resiliency of our business model and our ongoing commitment to invest strategically and grow our business over the long term through a balanced approach of adding new units and increasing sales at existing restaurants.
Despite modest comparable sales growth, McDonald’s was able to achieve solid growth in revenues and income. While the growth has not been as high as recent years, we are confident in our ability to deliver significant shareholder value over time.
Through the first nine months, revenues increased 2% and our combined operating margin increased 10 basis points to 31.2%, primarily due to higher franchise margin dollars and lower G&A expenses.
With 81% of our nearly 35,000 restaurants franchised, our profitability is primarily driven by franchise margins. In the third quarter, franchise margins reached about $2 billion, an increase of 4%, or nearly $70 million in constant currencies, with each area of the world contributing to this growth. The franchise margin percentage for the quarter declined 40 basis points to 83% as positive comparable sales were more than offset by higher occupancy costs.
Global company operated margins totaled $919 million for the quarter, and were relatively flat in constant currencies. The margin percent decreased 40 basis points to 18.7% as weaker performance in the U.S. and APMEA offset gains in Europe.
In the U.S., third quarter company operated margins declined 140 basis points to 18.4% due to higher operating and commodity costs. Commodity costs increased about 2.5% in the third quarter, with similar pressure expected in the fourth quarter. We have tightened our full year estimates and now project 2013 commodity costs in the U.S. to be up 1.5% to 2%.
We have taken three price increases year to date, with the most recent increase in September totaling about 1%. This brings our total increase to about 2.6%, which is relatively consistent with a year ago. We are at the midpoint of the projected 2% to 3% full year increase for food away from home inflation. Food at home inflation has been running at about a point lower, so we are keeping a close eye on this measure as well as we consider future price moves.
In Europe, third quarter company operated margins increased 70 basis points to 21.1%, primarily due to the strength of our two largest McOpCo markets, Russia and the U.K. These two markets contribute nearly half of Europe’s company operated margin dollars.
In addition, France, the third-largest market in terms of McOpCo margin dollars, contributed through positive comparable sales and certain labor efficiencies, most of which we don’t expect to realize in the fourth quarter.
Commodities increased about 1% for the quarter. Europe has also lowered its full year projected increase to 1.5% to 2%. Our price increases varied across the 39 European markets. Excluding Russia, most European markets are averaging year over year price increases around 1.5%.
As we consider future price increases, we remain mindful of the economic uncertainty, cautious consumer sentiment, increased taxation, and lower disposable income. Our global strategy and approach to pricing remains unchanged. We continue to balance our goal of driving traffic and market share gains while effectively managing the impact of rising costs and evolving consumer trends.
Turning to Asia Pacific, the Middle East, and Africa, company operated margins for the quarter decreased 160 basis points to 15.3%, primarily due to higher labor costs across the segment as well as new restaurant openings, mainly in China. For a perspective, China represents approximately 30% of APMEA’s company operated margin dollars.
Our G&A expense in the quarter declined 11% or more than $66 million versus a year ago. This was primarily due to lower incentive-based compensation and lapping the sponsorship of the London Olympic and Paralympic Games last summer. For the full year, we now expect G&A to be down 2% to 3% in constant currencies.
Solid, consistent financial performance from our unique business model generates meaningful amounts of cash flow. We strategically reinvest a significant amount of this cash back into our business to drive future growth and returns. Our restaurant development teams are making good progress against their plans for building new restaurants and reimaging existing locations, taking advantage of improved tools and capabilities.
We have trimmed our 2013 capital expenditure estimate to $3 billion. This is a conscious decision to delay a limited number of new openings into 2014 based on current conditions. We feel this is prudent given the short term pressures and our desire to maximize the quality of our new openings.
We continue to generate strong returns at new restaurants in mature markets with emerging markets like China historically achieving our benchmarks within three to four years. In 2013, we expect to open about 1,500 new restaurants, ending the year at over 35,000. New openings by are of the world include over 225 in the U.S., about 300 in Europe, and more than 750 in APMEA. Approximately one-third of our global openings are in development of license or affiliated markets where we do not invest our capital.
We also continue to modernize our existing restaurant base through reimaging more than 1,600 restaurants this year. Globally, about two-thirds of our interiors and over half of our exteriors reflect the current contemporary look.
Let’s now turn to foreign currency translation, which negatively impacted third quarter results by $0.01. At current exchange rates, including the euro at the $1.35/$1.36 level, we expect full year EPS to be negatively impacted by about $0.05 to $0.06, which implies a fourth quarter negative impact of $0.01 to $0.02. Please take this as directional only, given the volatility in exchange rates.
Lastly, I’d like to comment on our expectations for the remainder of this year. On the first quarter call in April, I said that we expected company operated margins to be pressured throughout 2013, though the margin decline should be less pronounced than in the first quarter, as sales comparisons ease in upcoming quarters.
Let me give you an update. Though sales comparisons have eased and will continue to do so, our current sales trends are a stronger predictor of future performance than prior year comparisons. As a result, based on what we know today, we expect fourth quarter global comparable sales performance to be in line with recent quarterly trends and restaurant margin percentage declines, both McOpCo and franchised, to be at a level relatively similar to first quarter declines.
We’re wrapping up our planning cycle over the next few weeks, and we look forward to sharing some of our 2014 outlook with you at our November investor meeting next month.
The McDonald’s system remains focused on building our business to generate enduring, profitable growth for our shareholders, franchisees, and suppliers. Our third quarter results speak to the benefit of our geographic diversification and the many levers we have to generate top and bottom line growth.
We are confident in our ability to successfully navigate this environment while preserving our competitive advantages and positioning the brand to participate fully when consumer spending improves.
Thank you. Now I’ll turn it over to Kathy to begin the Q&A.
Earnings Call Part 2: