McDonald’s Earnings Call Insights: European Outlook and Credit Environment

McDonald’s Corporation (NYSE:MCD) recently reported its first quarter earnings and discussed the following topics in its earnings conference call.

European Outlook

David Palmer – UBS Securities: A two-part question on Europe. You described there is slowing going on in that market; can you just generally describe how your marketing plans are this year, how are you going to adjust this sluggish environment? I recall last summer you were tinkering the value menus particularly in mainland Europe markets. And secondly, as you’re getting closer to the end of this reimaging curve at least on the interiors in Europe, would you consider or are you thinking about refranchising that market further to be maybe more like the U.S.?

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Don Thompson – President and CEO: There are several different points I guess in your question there. First of all, what have we done in Europe? Last year we began to talk about a couple of the markets that we felt we needed to have additional focus on, those markets being France and Germany. We talked about the fact that the Southern division of Europe was really going through tough macro economies and that remains the same today. However, what we have done is in the market of France we have changed and fortified our value offerings. We talked about Casse-Croute this morning. They’ve solidified Petit (indiscernible). They’ve done several things and that’s why we are gaining share in France. If you look at the Southern division, the Southern division as a market, which includes Spain, and Italy, and Portugal, those markets are also gaining share. So, we have been performing. We’re performing well relative to the overall marketplace. However, it is very soft consumer confidence there. Relative to refranchising, what we have continued to do as we always do, is look at our overall Company-operated portfolio and determine whether or not we have opportunities to continue to improve that first or if we have opportunities in terms of leveraging G&A, leveraging scale, improving overall operational efficiency by refranchising. We have one market we continue to look some of that end which is the U.K., but the other markets we feel fairly good about the way that the portfolio is stacked up at this point in time.

Chris Stent – IR: Joe Buckley Bank of America Merrill Lynch.

Joseph Buckley – Bank of America Merrill Lynch: Can you talk about your comments like gaining share in the first quarter, particularly the U.S., what you think the gap between your count number and the QSR sector might have been? And then extend that into April. I guess the April sales commentary is a little bit more surprising given the easier comparison. So could you talk about factors that you think are influencing the April sales number?

Don Thompson – President and CEO: All right, Joe, I think we’ll talk probably a couple of different things. One, it will be from a U.S. perspective and the other is really a global perspective. In the U.S., if you look at our comparisons to the overall competitive set, we’ve outperformed the competition by about 1.4%. That’s the comp gap and that’s overall competitive set. So, we feel again that the things that we have begun to do to bring energy to the marketplace in both food and value, they are solidified, they are in place. Having said that, and we normally don’t talk about weather at all, but we know in the month of April, last quarter – the first quarter of last year, we saw very favorable weather. As a matter of fact, it was the best weather that we had seen in 118 years, the first quarter through March of last year. This year what we’re seeing in the month of – the first quarter was some tougher weather. We also in April, clearly, we’re seeing some differences in weather. So we have to be cognizant of that. We won’t use weather as an excuse because next year we don’t want to use it; we’re going to comping up against it. But the reality of it is we have some seen things in weather that are there. We still feel like from a competitive set, we’re going to perform well and our marketing plans and our food promotions actually are really solid. We have brought better food news and stronger value to the marketplace.

Chris Stent – IR: Keith Siegner, Credit Suisse.

Keith Siegner – Credit Suisse: Just to follow up on that question a little bit, thinking through the headline global April outlook and how some of these issues in China and other parts of Asia might be factoring in. I mean, there’s a big information kind of vacuum right now about what’s actually going on in China with chicken and other countries it might be influencing that. If you could talk a little bit about what might you actually be seeing there and how that plays into the preliminary global April outlook, that’d be very helpful?

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Don Thompson – President and CEO: I’m going to ask Tim Fenton to talk a little bit about China, because as we talk about global; our overall global sales in terms of April. There are some things that have been emerging pieces that we’ve seen that we had not seen before. One of those is avian influenza and I’ll ask Tim kind of to give a little update on that and maybe even talk just a little bit about we’re coming out of one thing which was the chicken industry issues around antibiotics and now we have a different piece which is broader in impact which is avian influenza. And so, that does bear on our global sales as we look forward into April. So, Tim, if you would?

Tim Fenton – COO: Yeah, on China, as we stated, we had a sales decline of 4.6% in the first quarter, going up against a tough first quarter last year as far as high comp. But definitely, we saw a switch out of chicken consumption; for surely, we do have other proteins that we were able to shift people into. But as we were coming out of that and gaining some traction, obviously came the avian influenza which we’ve been there before unfortunately and it not only has had an impact on China, it does have a potential impact on a lot of APMEA, not just China. But again, we continue to move on the different proteins that we have with beef and fish and is of course a breakfast in McCafe. But we’re moving with it; we’re doing what we have, we’re continuing to look at what we do in the restaurants from food safety and for their suppliers, and we’ve been there before and we’ll continue to move forward with our plan.

Chris Stent – IR: Matt DiFrisco, Lazard.

Matthew DiFrisco – Lazard Capital Markets: I guess just touching on some of those food promotions, Don, you were talking about earlier. Relative to prior years, I guess a lot of people have looked at the success of your beverage product. It had multiple years and sustainability and the impressiveness of lapping big comps and putting up big comps on top of that. Are you seeing the same, I guess, in this environment of more food promotional, it seems like there are little bit more of an LTO-ish type environment or a sense that you’re not maybe holding the comp as much? Are you happy with that as far as how long you’re holding the lift from those new introductions such as the Fish Bites and some of the premium chicken warps?

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Don Thompson – President and CEO: Matt, a great question. I think two different parts here. One is the LTO strategy and the other is those things that might become platforms and continue to be part of our core. So, if you look at McWraps, McWraps for us is not a limited time offer promotion. It is one of those things that will be a platform for McDonald’s as we move forward. It’s been that way in Europe and performed well. We feel that the performance at these early stages in the U.S. has met the expectations that we have. And so, we are feeling fairly good about that. I continue to say and I hedge a little bit of comments about we continue to feel great about it because let’s keep in mind, we’re still facing a slow recovery in the United States from an overall economic perspective. And as we look across Europe, we still have high unemployment rates and higher austerity measures. But in the U.S. that is a platform. Something a little different. Fish McBites, that’s a limited time offer. So, we’ll have that come in and go out. When you talk about beverages, we will continue to post in beverage products that remind our customers of the overall beverage lineup. So, when we say blueberry-pomegranate smoothie flavor, we’re also saying that we’re going to remind customers of pineapple mango and strawberry banana. So, we’ll continue to do that and do it more aggressively this year than we did last year….

Chris Stent – IR: Michael Kelter, Goldman Sachs.

Michael Kelter – Goldman Sachs: So, your restaurant level margins now appear to be on pace for their third straight year of declines in all three divisions; in the U.S., in Europe and in Asia. And so, I guess there are two parts to my question on that point. The first is; what are the specific things you’re doing to turn that around, or is it really just waiting for same-store sales to get better? And second, how have the franchisees reacted to declining profit margins at the restaurants?

Peter J. Bensen – EVP and CFO: Michael, it’s Pete. As we’ve always talked that for us margins are much more of a top line gain, so driving comps is critical to driving those margins, and in this environment where you continue to have the cost pressure; so commodities will be up, labor rates are going up, et cetera, and yet you have soft economics, declining to flat eating-out markets, that battle for market share becomes so critical to the long-term health of the business that we’re willing to sacrifice a little bit of margin to maintain that traffic and grow the market share. So, in this environment, that’s how we’re going to continue to go after that. And around the world, we’re generally aligned with our franchisees around that. They understand the importance of driving traffic in this environment and taking market share, because again, if the industry isn’t growing, taking market share means we’re taking guests from other restaurants. And in that environment that is what we have to do to continue to win. Would we love higher margins? Yes. Would they love higher cash flow? Yes. But in this environment, guest count growth and market share growth are critical.

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Chris Stent – IR: John Glass, Morgan Stanley.

John Glass – Morgan Stanley: Pete, as you think about last year and this year to the point that it’s a tougher environment, earnings growth is slower, margins are under pressure, one of the things you have is a balance sheet that’s historically been very strong and the cash flow which you’re using, but can you just reexamine what are the – the likelihood of you using this very low rate environment to increase leverage maybe without even changing your credit metrics; in other words, maybe the rates are just low enough that you’re going to add debt without changing your interest expense? And secondarily, can you talk about maybe just rethinking what the credit metrics you look at and are they appropriate given this environment and maybe you’d like extend those? If you could just maybe help us understand what is the credit metric you look at and you manage to, and then secondarily, if you’re willing to reexamine that?

Credit Environment

Peter J. Bensen – EVP and CFO: John, that’s a great question. One of the things we’ve always talked about is the importance of maintaining our A credit rating, so (I’m not) going to get into the specific measures that underlie that. But as we look at our role as the franchise or that financial strength is critical for us. And you’re aware of our business model; being co-investing with our franchises and part of three-legged stool is a critical piece for us. So, that credit rating is important and we feel the alignment created by maintain that strong credit rating in our financial health is more valuable to shareholders than some kind of one-time leverage events would be. That being said, as you’ve noted each of the last few years, we continue to augment our free cash flow return to shareholders by increasing the debt on our balance sheet, and we will continue to do that again this year, but my guess is that it’ll probably be at a level below what we added last year.

Chris Stent – IR: David Tarantino, Robert W. Baird.

David Tarantino – Robert W. Baird & Co.: Just a follow-up on all the margin commentary and the pressures that you’re seeing. Pete, could you give us an idea of what type of comp would be needed to hold on to either the restaurant margins or at the Company-wide EBIT margin for this year and maybe talk a little bit about how the greater emphasis on value is maybe changing or not changing that equation?

Peter J. Bensen – EVP and CFO: David, we’ve historically said 2% to 3% comp would allow us to hold margin and we’ve kind of said that’s in a normal environment and we’ve defined that as being commodity cost in that 2% to 3% range but also getting half of that growth from average check and half of that growth from guest count. So, when you’re in an environment today where we’re going from more of the – more of the sales growth is coming from guest counts then it is from check growth that puts pressure on that equation and we’re seeing other cost increases in the labor line, additional depreciation et cetera that weren’t in our normal environment kind of calculation which obviously points to a higher than 2% to 3% in this environment to maintain or grow the margins.

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Don Thompson – President and CEO: David, just another point. Keep in mind please too also that the value aspect of our menu is still in the range of 10% to 15%. So, we haven’t seen some huge upsurge relative to the mix of value-based products. The reason that you’ve heard us talk so much about product mix and new food news is because one of things that we are doing around the world is ensuring that we have promotional food and new food that also is accretive to overall cash flow in the restaurants and that also helps us quite a bit and that helps us to move average check. A challenge that we have and we talked about it in our earlier comments is the fact that if inflation is not as high, we don’t have as much pricing power. So, when you think about the overall margin, clearly it’s still demand, which we focus on net demand base, it’s still the average check components. Pricing is a little softer in terms of what we can take, and it’s then the trade-up aspects which is why we focus on the new menu aspects in our core and those larger sandwiches. So, we’re managing all of that and Tim is ensuring that around the world, those things are part of our plans…

Chris Stent – IR: Will Slabaugh, Stephens.

Will Slabaugh – Stephens Inc.: I had a question on the product pipeline, and you mentioned a couple of items you rolled out recently. But wanted to – just more broadly, how you would describe your pipeline now in terms of breadth of products, and then also in the length of the timeline for rolling them out versus last year, and then also maybe versus historically if you would?

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Don Thompson – President and CEO: I will ask Tim to also comment about some of the things that he is seeing and some of the product pipelines around the world. I would tell you today our product pipeline is more robust from a global perspective. And the other aspect of this is we are moving products around the world at a much quicker pace, which is also evidenced in one of the questions earlier about limited-time offers. It may appear that we have more of those only because you’re seeing some of the new food news that’s been coming from different markets around the world. But there’s several products and platforms and product areas that we have felt – we feel like we’re in a pretty strong place with continue to develop. But Tim, maybe some of the things you’re seeing across Europe and now in the U.S.?

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