McDonald’s Corporation’s (MCD) CEO Don Thompson on Q2 2014 Results – Earnings Call Transcript

I also want to share with you how our strategies have evolved, to guide our actions going forward. As we shared with you at our Investor meeting last November and in the last couple of quarterly calls we entered 2014 well aware of the challenges we face for comparable sales and margins amid ongoing broad based challenges and cost pressures throughout our P&L. And we don’t expect any material changes to this operating environment in the second half of the year.

Our financial model is built on growing comparable sales, which in turn drive profitability. So when comparable sales are relatively flat as in second quarter our ability to grow income is significantly impacted. We’ve often said that there is no one silver bullet or single solution for driving sustained growth. In fact the key to our success over time has been that we’ve executed multiple initiatives simultaneously. Enduring success requires an ever stronger foundation. So we’re pushing forward on a multiple fronts as we focus on those areas within our control to enhance our relevance and appeal to consumers.

Earlier this year we evolved our Plan to Win Framework, refocusing our planning and actions on what matters most to our customers; relevant food choices, easier engagement with our brand through digital and greater transparency into the quality of our food and what we stand for as a brand. Serving good food through good people and being a good neighbor in the communities in which we operate is what McDonald’s stands for.

In April we shared our updated global Plan to Win framework with the more than 15,000 franchises, suppliers and company employees at our Biannual Worldwide Convention. Our decentralized system is now moving forward as we run with more than 35,000 restaurants in 119 countries aligned around an evolved global Plan to Win framework and executing in a way that takes into account local consumer needs and local business environments.

As we work to regain business momentum we are pursuing two parallel paths. First, we are strengthening key foundational elements of our business to deliver our better overall customer experience today. And second, we are making progress on comprehensive strategies in pursuit of the sizeable growth opportunities that lie before us. These activities are interrelated and together they position us to drive profitable growth over the long turn.

Let me talk first about the work currently underway for foundational elements of our business today. These include value first. We are evaluating the relationship between pricing and quality perception across our menu board and that’s because value is one of our grand pillars. So we must continue to fortify our position within this key consumer attribute.

Second, operations and service; around the world we are enhancing our operations and service platforms to improve the customer experience and ultimately increase visits. This includes the service reset in the United States and servicing kitchen enhancements in Europe.

Third, marketing. We are taking actions to reestablish our marketing leadership position globally. In some markets, this means adding fresh perspectives by bringing in new leadership or agency partners. In others it means heightening our awareness of how customers use McDonald’s and creating stronger messages to reinforce our place in customers’ lives. And around the world we are also strengthening our creative messages by placing greater emphasis on the quality of our food and again reestablishing the emotional connection that our customers associate with the McDonald’s experience.

The fourth area is simplification. We are streamlining our merchandizing menu board and product offerings and in addition to making it easier for customer to order their favorite products, this will reduce complexity in our restaurants which in turn should enhance accuracy and speed of service.

Getting these foundational element right is critical to maximizing the impact of the additional growth initiatives that we are actively pursuing within the strategic priorities of the Plan to Win framework. Specifically these growth initiatives include menu customization and personalization, digital engagement and brand trust. In the area of menu customization and personalization our initial efforts focus on delivering the best burger experience to our customers. I’ll talk more later about our learning lab we recently established in the United States to help us better understand what matters most to customers in this arena today?

We are also accelerating our digital leverage as we talked about before, leveraging learning from markets like France and Australia we’re now executing some elements of our e-commerce digital strategies. We are also testing various additional elements of our strategy in other markets like the U.S, Sweden and the UK as we refine and execute our global digital vision. And we are taking meaningful action to become even a more respected brand including our work with the World Wildlife Fund and the Alliance for Healthier Generation which was found by the American Heart Association and the Clinton Foundation. These represent just the subset of our broader sustainability efforts.

We are pursuing these initiatives holistically and building on investments we already made to deliver an unparalleled experience to our customers and consumers in general. It’s these combined efforts that give me confidence in the future and our ability to drive enduring profitable growth for our system and our shareholders over the long turn.

Let’s now turn to performance for the quarter. Global comparable sales were relatively flat for the second quarter and comparable guest counts were negative. Operating income was down 1% in constant currencies and earnings per share was $1.40, a 1% increase in constant currencies. Several markets delivered solid results, stronger operating income performance in China, the UK and France was offset by weaker performance in markets including Germany, Japan, the U.S. and Australia. These four markets remain priority areas of focus for us and I’ll talk more later about the actions we’re taking in these markets to reignite momentum.

We’re moving with a sense of urgency but recognize that it will take time to see the results of our actions. Our franchise business model is a clear advantage for us but it also requires alignment around our plans and actions and this takes time. Once allied it takes time to enact changes in the restaurant and time for customers to notice the changes we’ve made and reward us with more visits. Therefore we expect continued volatility across markets for the second half of the year and expect full year 2014 global comparable sales to be relatively similar to year-to-date June performance with July global comparable sales excepted to be negative.

Let’s talk more specifically about performance and the actions we are talking by geography starting with the U.S. In the United States comparable sales for the quarter were down 1.5% and operating income increased 1%. While comparable sales were disappointing the U.S. is making progress in three critical areas, improving service through the operations reset, focusing on menu and strengthening our marketing position. The service reset was designed to place greater emphasis on the critical role of proper staffing, scheduling and positioning in our restaurants across all the day parts.

Over the last six months our operation support staff are making [inaudible] with all franchise and company owned restaurants to recalibrate around service and customer experience standards. Restaurants across the U.S. are now executing as planned and we are beginning to see a reduction in order accuracy complaints.

From a menu standpoint, we are placing greater emphasis on the balance between our core classics and the number of new products that are being introduced into the marketplace and this is to ensure that they can be delivered at the speed and convenience that customers expect from McDonald’s.

We are also continuing to innovate. We recently started a restaurant on the West Coast and created a learning lab to help better understand what matters most to customers when it comes to delivering the absolute best burger experience. It definitely starts with great ingredients like our high quality burger, 100% beef with a pinch of salt and pepper but it’s more than that. It’s about creating an engaging experience which addresses all elements of customer sensory perceptions and leverages the investments that we already made in technology, reimaging our physical plans and digital to create a more personalized memorable experience that our customers will feel good about.

The U.S. is also taking actions to strengthen marketing leadership. We reorganized the marketing department and are reallocating our median mix to place greater emphasis on digital channels. We are also strengthening our creative, to connect more deeply with customers placing an even greater emphasis on the quality of our great food and on the strong emotional connection that our customers already have with our great brand.

Let’s now move to Europe, where comparable sales were down 1% for the quarter and operating income was down 4% in constant currencies. These results reflect solid performance in the UK and France partially offset by weak results in Germany and a slowdown in Russia. The UK’s track record of solid performance continues due in part to its strong customer centric planning process. While second quarter comparable sales were positive they softened compared to recent trends, partially because we are now lapping last year’s successful blended ice rollout.

We continue to grow market share through strong premium promotional activity which is complemented by an ongoing focus on breakfast, extended hours and side-by-side dry fruits. Comparable sales continue to be positive in France and we are gaining market share despite a contracting informal eating out industry. The recent launch of our new premium Chicken Patty in April helped reinforce strong food quality perceptions in the marketplace.

Germany remains the primary area of focus as negative sales and guest count momentum continues. The leadership team is actively working to reset the foundation, focusing its efforts on improving our food quality and value perceptions and regaining consumers trust. These include strengthening our marketing organization in creative and evaluating our affordability platform and ensure that we offer compelling values to customers across the entire menu.

Now let’s shift to Asia Pacific, Middle East and Africa where comparable sales were up 1.1% for the quarter and operating income increased 1% in constant currencies. Strong comparable sales performance in China as well as positive performance in many other markets was somewhat offset by continued weakness in Japan.

In China, comparable sales increased 8.8% for the quarter, partly reflecting the lap of last year’s Avian influenza. Given volatile consumers sentiment in China we’re focused on enhancing our all day value platform to drive traffic and grow market share. At the same time we are building on our strong momentum in breakfast and through brand extensions such as delivery, dessert kiosks and mid-café.

In Australia, affordability remains key to driving traffic with consumer confidence at the lowest levels since 2008. We’re strengthening our value proposition by relaunching our Loose Change menu with compelling value offer and we’re also making it easier for our customers to enjoy the great tasting McCafe beverages that they have grown to love.

Negative momentum Japan persisted amid a highly competitive environment and a contracting informal eating out industry. The leadership team remains focused on regaining customer relevance and loyalty by repositioning the affordability platform to resonate more strongly with customers while working to differentiate the McDonald’s experience through menu innovation and a focus on the family and happy meal business.

Around the world markets continue to adjust their plans to be even more relevant to customers but we have recognized again that it will take time to reignite momentum. Overall 2014 is a year of strengthening the foundational drivers of our business, activities that are critical in enabling and advancing our longer-term strategies. Even during periods of softer performance our business continues to generate significant levels of cash. Our first priority regarding use of cash is to invest in our business to drive future growth and future returns. In addition we’ve established an $18 billion to $20 billion cash return to shareholders target between 2014 and 2015. Year-to-date June, we’ve returned $2.8 billion towards that goal.

I want to close by reemphasizing my confidence in McDonald’s. We continue to move forward as one system guided by the framework of our global Plan to Win and relentlessly focused on the significant opportunities that exist within our strategic global growth priorities to optimize our menu by serving our customers’ favorite food and drink, to modernize the customer experience so that it’s even more memorable, to broaden accessibility so that we deliver unparalleled convenience and to become an even more trusted and respected brand.

We’re moving forward thoughtfully and with a sense of urgency. Our plans and actions build on our core strengths and I am confident that they will ultimately result in additional business from new and existing customers. Thanks again everyone. I’ll now turn it over to Pete.

Peter J. Bensen – SEVP and CFO

Thanks, Don and hello everyone. The McDonald’s system and our financial model are built with the expectation of future sales growth. Yet we know from history that our top line growth overtime is neither consistent nor linear. In addition any growth is a product of the significant base off of which we operate which includes serving approximately 70 million customers every day and generating industry leading average unit volumes in virtually all of the countries in which we operate.

Importantly this large base also provides financial resiliency during periods of softer performance. Though we did not meet our growth targets through the first six months McDonald’s still generated over $4.1 billion of operating income. Our strong financial foundation allows us to remain focused on the significant long term opportunities that we believe McDonald’s is uniquely positioned to seize, which is why we continue our disciplined approach to investing in targeted growth opportunities.

We know that enduring success requires an ever stronger foundation. So we’re pushing forward on multiple fronts guided by our evolved Plan to Win framework and the strategic growth priorities. As Don discussed it takes time to evaluate and align with franchises on the changes needed and then implement them in our restaurants, and time for customers to notice the changes and reward us with increased visits.

I am confident that we’re taking the right steps to strengthen our foundation and position the company for future growth. Our charge over the next 12 to 18 months is to accelerate the changes, effectively communicate the enhancements to our customers and execute at the highest standards in our restaurants.

Now turning to the results, for the six months ended June system wide sales increased 3% in constant currencies primarily due to expansion. Combined operating margin declined 60 basis points to 29.7% over that same period reflecting the softer results. McDonald’s is primarily a franchisor with over 80% of our global restaurants operated by local businessmen and women. As such franchise margins drive overall profitability comprising approximately 70% of restaurant margin dollars.

In second quarter, the franchise margin dollars increased 2% in constant currencies while the margin percent declined 60 basis points to 82.2%. Expansion continued to contribute to the margin dollar growth whereas soft comparable sales, increased rent and depreciation expense and the impact of refranchising pressured the margin percent.

Global company operated margin dollars for the quarter totaled $816 million, a 3 % decline in constant currencies. The margin percent decreased 60 basis points to 17.1 % as relatively flat comparable sales could not offset cost pressures throughout the P&L. Europe’s margin declined which I will discuss in a moment, accounted for the majority of the global margin decline. In the U.S., second quarter company operated margins declined 40 basis points to 18.3% due to higher labor and 3% higher commodity costs. As a result of effective risk management efforts and supplier production efficiencies we are maintaining our full year outlook for the increase in our U.S. grocery basket of 1% to 2%.

In terms of pricing, U.S. is running about 3% at the end of June. This is the midpoint for the full year 2014 projected food away from home inflation of 2.5% to 3.5%. Through June, food away from home inflation stands at 2.2%. So we will be disciplined with future price increases as we move through the second half of the year. In Europe second quarter company operated margins decreased 80 basis points to 18.6%, primarily impacted by higher commodity costs in Russia and Ukraine due to weaker currencies as well as negative performance in Germany. Russia and Ukraine import approximately half of their commodities, most of which are denominated in either Euros or U.S dollars.

For a perspective, Russia and Ukraine accounted for nearly all of Europe second quarter company operated margin decline. Europe’s projected full year commodity cost increase remains at 1% to 2%. Excluding currency, commodity costs were relatively flat in the first half of the year which implies a second half increase of about 2%. Our menu price increases in Europe vary by market with the overall segment averaging about 2% year-over-year.

Turning to Asia Pacific, Middle East and Africa, company-operated margins for the quarter decreased 60 basis points to 13.7% as positive comparable sales were more than offset by higher labor, occupancy and other costs. In addition, new restaurant openings negatively impacted the segment’s margin percent though to a lesser degree than a year ago. The decline in the margin percent was also impacted by the mix of relatively lower margin markets like China contributing a greater share of the overall margin dollars. That being said we are encouraged by the margin percent improvements we are seeing in certain individual markets, including China in this high growth area of the world.

With our current sales outlook and expected currency volatility in some of our company owned markets we expect continued pressure on consolidated company operated margins in the second half, more significant pressure in the U.S due to higher labor expenses, partly as a result of planned minimum wage increases in several states and likely less benefit from pricing.

Second quarter G&A expenses increased 3% in constant currencies primarily due to our biannual worldwide convention in April and higher employee costs partly related to our long term growth initiatives. One of our key competitive advantages is our size and scale and our conventionist integral and maintaining alignment so that we could move together as one system. We have reduced our full year projected constant currency G&A increase from 8% to 4% to 5% primarily due to lower incentive-based compensation as a result of not expecting to meet our growth targets.

Even with softer performance the McDonald’s business model continues to generate significant amounts of cash. Our first priority remains at reinvesting this cash in our business to build future returns and enhance shareholder value. These investments are balanced between opening 1,500 to 1,600 new restaurants and re-imaging over 1,000 existing locations in 2014. We remain committed to this effort and are making steady progress towards these targets. Through June we’ve opened 461 new restaurants globally and relative to reimaging we’ve completed about 90 projects in the U.S, 100 in Europe and 120 in APMEA. Similar to prior year’s new restaurant openings and reimaging projects tend to be more loaded in the back half of the year.

Lastly let me discuss foreign currency translation which positively impacted second quarter EPS by a $0.01. At current exchange rates we expect minimal impact on third quarter EPS with a full year negative impact of $0.04 to $0.05. As usual please take this as directional guidance only because rates will change as we progress through the second half of the year.

In closing I remain confident in the choices we’re making to position McDonald’s for enduring profitable growth. We’re patiently and deliberately making investments to-date to strengthen our foundation and leverage our significant competitive advantages in the $1.2 trillion global and formal eating out category.

Thanks. Now I’ll turn it over to Kathy to begin our Q&A.

Question-and-Answer Session

 

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