MCDONALDS CORP 10-K 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2006
Commission File Number 1-5231
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code: (630) 623-3000
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
(Title of class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate market value of common stock held by non-affiliates of the registrant as of June 30, 2006 was $41,185,383,725.
The number of shares outstanding of the registrants common stock as of January 31, 2007 was 1,203,480,015.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of this Form 10-K incorporates information by reference from the registrants 2007 definitive proxy statement which will be filed no later than 120 days after December 31, 2006.
The following trademarks used herein are the property of McDonalds Corporation and its affiliates or the Company: Big Mac, Boston Market, Chicken McNuggets, Chicken Selects, Egg McMuffin, Filet-O-Fish, im lovin it, McDonalds, McFlurry, McGriddles, Quarter Pounder, Ronald McDonald, Sausage McMuffin, Snack Wrap, The Golden Arches Logo and mcdonalds.com.
ITEM 1. BUSINESS
McDonalds Corporation, the registrant, together with its subsidiaries, is referred to herein as the Company.
a. General development of business
During 2006, there have been no significant changes to the Companys corporate structure or material changes in the Companys method of conducting business.
b. Financial information about segments
Segment data for the years ended December 31, 2006, 2005 and 2004 are included in Part II, Item 8, page 40 of this Form 10-K.
c. Narrative description of business
The Company primarily franchises and operates McDonalds restaurants in the food service industry. These restaurants serve a varied, yet limited, value-priced menu (see Products) in more than 100 countries around the world.
The Company also operates Boston Market and has a minority ownership interest in U.K.-based Pret A Manger and prior to October 2006, had an ownership interest in Chipotle Mexican Grill (Chipotle). During 2006, the Company disposed of its investment in Chipotle through sales of shares and ultimately a tax-free exchange of all remaining shares held.
Since McDonalds restaurant business comprises virtually all of the Companys consolidated operating results, this narrative primarily relates to that business, unless otherwise noted.
All restaurants are operated either by the Company, by independent entrepreneurs under the terms of franchise arrangements (franchisees), or by affiliates and developmental licensees operating under license agreements.
The Companys operations are designed to assure consistency and high quality at every McDonalds restaurant. When granting conventional franchises, the Company is selective and generally is not in the practice of franchising to or partnering with investor groups or passive investors.
Under the conventional franchise arrangement, franchisees provide capital by initially investing in the equipment, signs, seating and décor of their restaurant businesses, and by reinvesting in the business over time. The Company generally shares the initial investment by owning or leasing the land and building. Franchisees contribute to the Companys revenue stream through payment of rent and service fees based upon a percent of sales, with specified minimum rent payments, along with initial fees. The conventional franchise arrangement typically lasts 20 years and franchising practices are generally consistent throughout the world. Under our developmental license arrangement, licensees provide ongoing capital for the entire business, including the real estate interest. While the Company generally has no capital invested, we receive a royalty based on a percent of sales and initial fees. A discussion regarding site selection is included in Part I, Item 2, page 5 of this Form 10-K.
The Company, its franchisees/licensees and affiliates purchase food, packaging, equipment and other goods from numerous independent suppliers that have been approved by the Company. The Company has established and strictly enforces high quality standards. The Company has quality assurance labs around the world to ensure that our high standards are consistently met. The quality assurance process not only involves ongoing product reviews, but also on-site inspections of suppliers facilities. Further, a quality assurance board, composed of the Companys technical, safety and supply chain specialists, provides strategic global leadership for all aspects of food quality and safety. In addition, the Company works closely with suppliers to encourage innovation, assure best practices and drive continuous improvement.
Independently owned and operated distribution centers, also approved by the Company, distribute products and supplies to most McDonalds restaurants. In addition, restaurant personnel are trained in the proper storage, handling and preparation of our products and in the delivery of customer service.
McDonalds global brand is well known. Marketing, promotional and public relations activities are designed to promote McDonalds brand image and differentiate the Company from competitors. Marketing and promotional efforts focus on value, food taste, menu choice and the customer experience. The Company believes it is important to give back to the people and communities around the world who are responsible for our success through our efforts in social responsibility.
McDonalds restaurants offer a substantially uniform menu, although there may be geographic variations. In addition, McDonalds tests new products on an ongoing basis.
McDonalds menu includes hamburgers and cheeseburgers, Big Mac, Quarter Pounder with Cheese, Filet-O-Fish, several chicken sandwiches, Chicken McNuggets, Chicken Selects, french fries, premium salads, shakes, McFlurry desserts, sundaes, soft serve cones, pies, cookies, soft drinks, coffee and other beverages. In addition, the restaurants sell a variety of other products during limited-time promotions.
McDonalds restaurants in the U.S. and many international markets offer a full- or limited-breakfast menu. Breakfast offerings may include Egg McMuffin, Sausage McMuffin with Egg, McGriddles, biscuit and bagel sandwiches, hotcakes and muffins.
Boston Market is a home-meal replacement concept serving chicken, meatloaf, sirloin, sandwiches, soups and salads. Pret A Manger is a quick-service food concept that serves prepared and packaged cold sandwiches, soups, salads, coffees and teas, primarily during breakfast and lunch.
The Company owns valuable intellectual property including trademarks, service marks, patents, copyrights, trade secrets and other proprietary information, some of which, including McDonalds, The Golden Arches Logo, Ronald McDonald, Big Mac and other related marks, are of material importance to the Companys business. Depending on the jurisdiction, trademarks generally are valid as long as they are used or registered. Patents are of varying remaining durations.
The Company does not consider its operations to be seasonal to any material degree.
Information about the Companys working capital practices is incorporated herein by reference to Managements discussion and analysis of financial condition and results of operations for the years ended December 31, 2006, 2005 and 2004 in Part II, Item 7, pages 11 through 28, and the Consolidated statement of cash flows for the years ended December 31, 2006, 2005 and 2004 in Part II, Item 8, page 32 of this Form 10-K.
The Companys business is not dependent upon either a single customer or small group of customers.
Company-operated restaurants have no backlog orders.
No material portion of the business is subject to renegotiation of profits or termination of contracts or subcontracts at the election of the U.S. government.
McDonalds restaurants compete with international, national, regional and local retailers of food products. The Company competes on the basis of price, convenience and service and by offering quality food products. The Companys competition in the broadest perspective includes restaurants, quick-service eating establishments, pizza parlors, coffee shops, street vendors, convenience food stores, delicatessens and supermarkets.
In the U.S., there are approximately 550,000 restaurants that generated about $365 billion in annual sales in 2006. McDonalds restaurant business accounts for about 2.5% of those restaurants and 7.4% of the sales. No reasonable estimate can be made of the number of competitors outside the U.S.
The Company operates a research and development facility in the U.S., two facilities in Europe and one facility in Asia. While research and development activities are important to the Companys business, these expenditures are not material. Independent suppliers also conduct research activities that benefit the McDonalds System, which includes franchisees and suppliers as well as the Company, its subsidiaries and joint ventures.
The Company is not aware of any federal, state or local environmental laws or regulations that will materially affect its earnings or competitive position or result in material capital expenditures. However, the Company cannot predict the effect on its operations of possible future environmental legislation or regulations. During 2006, there were no material capital expenditures for environmental control facilities and no such material expenditures are anticipated.
The Companys number of employees worldwide, including Company-operated restaurant employees, was approximately 465,000 as of year end. This includes employees at McDonalds and Boston Markets Company-operated restaurants.
d. Financial information about geographic areas
Financial information about geographic areas is incorporated herein by reference to Managements discussion and analysis of financial condition and results of operations in Part II, Item 7, pages 11 through 28 and Segment and geographic information in Part II, Item 8, page 40 of this Form 10-K.
e. Available information
The Company is subject to the informational requirements of the Securities Exchange Act of 1934 (Exchange Act). The Company therefore files periodic reports, proxy statements and other information with the Securities and Exchange Commission (SEC). Such reports may be obtained by visiting the Public Reference Room of the SEC at 100 F Street, NE, Washington, D.C. 20549, or by calling the SEC at (800) SEC-0330. In addition, the SEC maintains an internet site (www.sec.gov) that contains reports, proxy and information statements and other information.
Financial and other information can also be accessed on the investor section of the Companys website at www.mcdonalds.com. The Company makes available, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after filing such material electronically or otherwise furnishing it to the SEC.
Copies of financial and other information are also available free of charge by calling (630) 623-7428 or by sending a request to McDonalds Corporation Investor Relations Service Center, Department 300, McDonalds Plaza, Oak Brook, Illinois 60523.
Also posted on McDonalds website are the Companys Corporate Governance Principles, the charters of McDonalds Audit Committee, Compensation Committee and Governance Committee, the Companys Standards of Business Conduct, the Code of Ethics for Chief Executive Officer and Senior Financial Officers and the Code of Conduct for the Board of Directors. Copies of these documents are also available free of charge by calling (630) 623-7428 or by sending a request to McDonalds Corporation Investor Relations Service Center, Department 300, McDonalds Plaza, Oak Brook, Illinois 60523.
The Companys Chief Executive Officer, James A. Skinner, certified to the New York Stock Exchange (NYSE) on June 6, 2006, pursuant to Section 303A.12 of the NYSEs listing standards, that he was not aware of any violation by the Company of the NYSEs corporate governance listing standards as of that date.
Information on our website is not incorporated into this Form 10-K or our other securities filings and is not a part of them.
ITEM 1A. RISK FACTORS AND CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This report includes forward-looking statements about our plans and future performance, including those under Outlook for 2007. These statements use such words as may, will, expect, believe and plan. They reflect our expectations and speak only as of the date of this report. We do not undertake to update them. Our expectations (or the underlying assumptions) may change or not be realized, and you should not rely unduly on forward-looking statements.
Our business and execution of our strategic plan, the Plan to Win, are subject to risks. By far the most important of these is our ability to remain relevant to our customers and a brand they trust. Meeting customer expectations is complicated by the risks inherent in our operating environment. The informal eating out segment of the restaurant industry, although largely mature in our major markets, is also highly fragmented and competitive. We have the added challenge of the cultural, economic and regulatory differences that exist among the more than 100 countries where we operate. We also face risk in adapting our business model in particular markets. The decision to own restaurants or to operate under franchise, developmental license or joint venture agreements is driven by many factors whose interrelationship is complex and changing. Our plan to reduce our ownership of restaurants may be difficult to achieve for many reasons, and the change in ownership mix may not affect our results as we now expect. Regulatory and similar initiatives around the world have also become more wide-ranging and prescriptive and affect how we operate, as well as our results. In particular, increasing focus on nutritional content and on the production, processing and preparation of food from field to front counter presents challenges for our Brand and may adversely affect our results.
These risks can have an impact both in the near- and long-term and are reflected in the following considerations and factors that we believe are most likely to affect our performance.
Our ability to remain a relevant and trusted brand and to increase sales depends largely on how well we execute the Plan to Win.
We developed the Plan to Win to address the key drivers of our business and results - people, products, place, price and promotion. The quality of our execution depends mainly on the following:
Our results and financial condition are affected by our ownership mix and whether we can achieve a mix that optimizes margins and returns, while meeting our business needs and customer expectations.
As described in Managements discussion and analysis of financial condition and results of operations, our plans call for a reduction in Company-operated restaurants by re-franchising them or entering into developmental license agreements. Whether and when we can achieve these plans, as well as their success, is uncertain and will be affected by the following:
Our results and financial condition are affected by global and local market conditions, which can adversely affect our sales, margins and net income.
Our results of operations are substantially affected not only by global economic conditions, but also by local operating and economic conditions, which can vary substantially by market. Unfavorable conditions can depress sales in a given market and may prompt promotional or other actions that adversely affect our margins, constrain our operating flexibility or result in charges, restaurant closings or sales of Company-operated restaurants. Whether we can manage this risk effectively depends mainly on the following:
Increasing regulatory complexity will continue to affect our operations and results in material ways.
Our legal and regulatory environment worldwide exposes us to complex compliance, litigation and similar risks that affect our operations and results in material ways. In many of our markets, including the United States and Europe, we are subject to increasing regulation, which has significantly increased our cost of doing business. In developing markets, we face the risks associated with new and untested laws and judicial systems. Among the more important regulatory and litigation risks we face are the following:
The trading volatility and price of our common stock may be affected by many factors.
Many factors affect the volatility and price of our common stock. These factors include some over which we have no control, such as general market conditions and governmental actions or reports about economic activity that may have a market-moving impact, regardless of whether the action or activity directly relates to our business. Actions or reports by U.S. authorities are of special import since the United States is our largest segment and our principal trading market. Trading activity in our common stock (whether in the cash or derivative markets) also affects prices and volatility. In addition to reflecting investor expectations about our prospects, trading activity can include significant purchases by shareholders who may seek to affect our business strategies, as well as both sales and purchases resulting from the ordinary course rebalancing of stock indices in which McDonalds may be included, such as the S&P 500 Index and the Dow Jones Industrial Average. Finally, our stock price can be affected not only by operating actions we take, but also by non-operating initiatives, such as our plans to reduce shares outstanding through repurchases or increases in our dividend rate.
Our results can be adversely affected by disruptions or events, such as the impact of severe weather conditions and natural disasters.
Severe weather conditions (such as hurricanes), terrorist activities, health epidemics or pandemics or the prospect of these events (such as the potential spread of avian flu) can have an adverse impact on consumer spending and confidence levels and in turn the McDonalds System and our results and prospects in the affected markets. Our receipt of proceeds under any insurance we maintain for these purposes may be delayed or the proceeds may be insufficient to offset our losses fully.
ITEM 2. PROPERTIES
The Company owns and leases real estate primarily in connection with its restaurant business. The Company identifies and develops sites that offer convenience to customers and long-term sales and profit potential to the Company. To assess potential, the Company analyzes traffic and walking patterns, census data and other relevant data. The Companys experience and access to advanced technology aid in evaluating this information. The Company generally owns the land and building or secures long-term leases for restaurant sites, which ensures long-term occupancy rights and helps control related costs. Restaurant profitability for both the Company and franchisees is important; therefore, ongoing efforts are made to control average development costs through construction and design efficiencies, standardization and by leveraging the Companys global sourcing network. Additional information about the Companys properties is included in Managements discussion and analysis of financial condition and results of operations in Part II, Item 7, pages 11 through 28 and in Financial statements and supplementary data in Part II, Item 8, pages 29 through 45 of this Form 10-K.
ITEM 3. LEGAL PROCEEDINGS
The Company has pending a number of lawsuits that have been filed from time to time in various jurisdictions. These lawsuits cover a broad variety of allegations spanning the Companys entire business. The following is a brief description of the more significant of these categories of lawsuits. In addition, the Company is subject to various federal, state and local regulations that impact various aspects of its business, as discussed below. While the Company does not believe that any such claims, lawsuits or regulations will have a material adverse effect on its financial condition or results of operations, unfavorable rulings could occur. Were an unfavorable ruling to occur, there exists the possibility of a material adverse impact on net income for the period in which the ruling occurs or for future periods.
On April 2, 2004, a class action lawsuit was filed in the United States District Court for the Northern District of Illinois (Case No. 04C-2422) (Allan Selbst v. McDonalds Corporation, Jack M. Greenberg, Matthew H. Paull and Michael J. Roberts), alleging violation of federal securities laws. Two nearly identical actions were subsequently filed in the same court. On October 19, 2004, the lead plaintiff filed its amended and consolidated class action complaint, alleging, among other things, that the Company and individual defendants misled investors by issuing false and misleading financial reports and earnings projections in a series of press releases and other public statements between December 14, 2001 and January 22, 2003, thereby overstating the Companys current and anticipated earnings. The amended complaint seeks class action certification, unspecified compensatory damages, and attorneys fees and costs. On January 18, 2005, the defendants filed a motion to dismiss the amended complaint. On September 21, 2005, the Court denied this motion. The lead plaintiff then filed its first amended complaint on October 7, 2005. On November 16, 2005, the defendants moved to dismiss the first amended complaint. On May 17, 2006, the court granted the defendants motion to dismiss the amended complaint without prejudice, giving the plaintiffs another chance to state a claim. On June 16, 2006, the plaintiffs filed their second amended complaint. On July 17, 2006, the defendants filed their motion to dismiss the complaint. On December 15, 2006, the Court granted defendants motion to dismiss with prejudice. On January 16, 2007, the plaintiffs filed their notice of appeal from the Courts order of dismissal.
The Company intends to defend its interests vigorously in the plaintiffs appeal.
On July 9, 2004, the following shareholder derivative action was filed in the Circuit Court of Cook County, Illinois, Chancery Division, (Case No. 04CH10921) (Marilyn Clark, Derivatively on Behalf of McDonalds Corporation v. Jack M. Greenberg, Matthew H. Paull, Michael J. Roberts, James A. Skinner, Stanley R. Stein, Gloria Santona, Fred L. Turner, Michael R. Quinlan, Hall Adams, Jr.,
Charles H. Bell, Edward A. Brennan, Robert A. Eckert, Enrique Hernandez, Jr., Jeanne P. Jackson, Donald G. Lubin, Walter E. Massey, Andrew J. McKenna, Cary D. McMillan, John W. Rogers, Jr., Terry L. Savage, Roger W. Stone, and Robert N. Thurston). This suit is purportedly brought on behalf of McDonalds Corporation against several of its current and former directors and officers (collectively Individual Defendants), and the Corporation as a nominal defendant. Clark contains allegations similar to the federal court complaint, with additional allegations that the Individual Defendants participated in or failed to prevent the alleged securities fraud violations described above. Clark alleges that these acts or omissions by the Individual Defendants constitute breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment. Clark seeks judgment in favor of McDonalds Corporation for (1) unspecified damages sustained by the Corporation; (2) injunctive relief restricting the proceeds of Individual Defendants trading activities or other assets to assure the Corporation has an effective remedy; (3) restitution and disgorgement of all profits, benefits and other compensation; and (4) attorneys fees and costs. On May 3, 2006, Individual Defendants filed their motions to dismiss the complaint. On September 29, 2006, the plaintiff filed an amended complaint containing allegations as described above.
On November 15, 2006, the Individual Defendants filed their motion to dismiss the amended complaint. On January 8, 2007, the plaintiff voluntarily dismissed her complaint without prejudice.
On January 30, 2006, the following shareholder derivative action was filed in the Circuit Court of Cook County, Illinois, Chancery Division, (Case No. 06CH01950) (Philip Bufithis and Thomas Bauernfeind v. Hall Adams, Jr., Edward A. Brennan, Robert A. Eckert, Jack M. Greenberg, Enrique Hernandez, Jr., Jeanne P. Jackson, Walter E. Massey, Andrew J. McKenna, Cary D. McMillan, Matthew H. Paull, Michael J. Roberts, John W. Rogers, Jr., James A. Skinner, Anne-Marie Slaughter, and Roger W. Stone). Like Clark, this suit is purportedly brought on behalf of McDonalds Corporation against several of its directors, officers and a former officer (collectively Individual Defendants), and the Corporation as a nominal defendant. Bufithis contains allegations similar to the lawsuits described above, claiming that from 2001 to 2003 the Individual Defendants participated in or acquiesced to improper undisclosed accounting practices, in alleged violation of federal securities law. Bufithis alleges that these acts or omissions by the Individual Defendants constitute breaches of fiduciary duty, and seeks judgment in favor of McDonalds for unspecified damages sustained by the Corporation and unspecified equitable relief, as well as attorneys fees and costs. On May 3, 2006, Individual Defendants filed their motions to dismiss the complaint. On July 13, 2006, the court dismissed the plaintiffs complaint without prejudice pursuant to the parties agreed motion for voluntary dismissal.
On or about February 17, 2003, two minors, by their parents and guardians, filed an Amended Complaint against McDonalds Corporation in the United States District Court for the Southern District of New York (Case No.02 Civ. 7821 (RWS)) (Ashley Pelman, a child under the age of 18 years, by her mother and natural guardian, Roberta Pelman, and Jazlen Bradley, a child under the age of 18 years, by her father and natural guardian, Israel Bradley, v. McDonalds Corporation) seeking class action status on behalf of individuals in New York under the age of 18 (and their parents and/or guardians), who became obese or developed other adverse health conditions allegedly from eating McDonalds products. On September 3, 2003, the Court dismissed all counts of the complaint with prejudice. On January 25, 2005, following an appeal by the plaintiffs, the Second Circuit Court of Appeals Court vacated the District Courts decision to dismiss alleged violations of Section 349 of the New York Consumer Protection Act as set forth in Counts I-III of the amended complaint.
On December 12, 2005, the plaintiffs filed their second amended complaint. In this complaint, the plaintiffs alleged that McDonalds Corporation: (1) engaged in a deceptive advertising campaign to be perceived to be less nutritionally detrimental-than-in-fact; (2) failed adequately to disclose its use of certain additives and ingredients; and (3) failed to provide nutritional information about its products. Plaintiffs seek unspecified compensatory damages; an order directing defendants to label their individual products specifying the fat, salt, sugar, cholesterol and dietary content; an order prohibiting marketing to certain individuals; funding of an educational program to inform children and adults of the dangers of eating certain foods sold by defendants; and attorneys fees and costs.
The Company believes that it has substantial legal and factual defenses to the plaintiffs claims and we intend to defend this lawsuit vigorously.
On May 31, 2005, a public civil action was filed in Brazil by the Federal Attorneys Office for the Federal District against, among others, McDonalds Comércio de Alimentos Ltda, a wholly-owned subsidiary of the Company (McCal), and three of its former employees. The complaint alleges that McCal and its former employees made an improper payment to obtain tax guidance relating to the deductibility of franchisee royalty payments in Brazil. The complaint seeks certain monetary and non-monetary relief. Although the Company does not believe that this action will have a material adverse effect on its financial condition or results, it cannot predict the outcome of this matter.
A substantial number of McDonalds restaurants are franchised to independent entrepreneurs operating under contractual arrangements with the Company. In the course of the franchise relationship, occasional disputes arise between the Company and its franchisees relating to a broad range of subjects including, but not limited to, quality, service and cleanliness issues, contentions regarding grants or terminations of franchises, delinquent payments of rents and fees, and franchisee claims for additional franchises or rewrites of franchises. Additionally, occasional disputes arise between the Company and individuals who claim they should have been granted a McDonalds franchise.
The Company and its affiliates and subsidiaries do not supply, with minor exceptions outside the U.S., food, paper or related items to any McDonalds restaurants. The Company relies upon numerous independent suppliers that are required to meet and maintain the Companys high standards and specifications. On occasion, disputes arise between the Company and its suppliers on a number of issues including, by way of example, compliance with product specifications and the Companys business relationship with suppliers. In addition, disputes occasionally arise on
a number of issues between the Company and individuals or entities who claim that they should be (or should have been) granted the opportunity to supply products or services to the Companys restaurants.
Hundreds of thousands of people are employed by the Company and in restaurants owned and operated by subsidiaries of the Company. In addition, thousands of people from time to time seek employment in such restaurants. In the ordinary course of business, disputes arise regarding hiring, firing, promotion and pay, alleged discrimination and compliance with employment laws.
Restaurants owned by subsidiaries of the Company regularly serve a broad segment of the public. In so doing, disputes arise as to products, service, accidents, advertising, nutritional and other disclosures as well as other matters common to an extensive restaurant business such as that of the Company.
The Company has registered trademarks and service marks, patents and copyrights, some of which are of material importance to the Companys business. From time to time, the Company may become involved in litigation to protect its intellectual property and to defend against the alleged use of third party intellectual property.
Local, state and federal governments have adopted laws and regulations involving various aspects of the restaurant business including, but not limited to, franchising, health, safety, environment, zoning and employment. The Company strives to comply with all applicable existing statutory and administrative rules and cannot predict the effect on its operations from the issuance of additional requirements in the future.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS
The following are the Executive Officers of our Company: (as of the date of this filing)
Ralph Alvarez, 51, is President and Chief Operating Officer, a position to which he was appointed in August 2006. He served as President of McDonalds North America from January 2005 to August 2006 and as President, McDonalds USA, from July 2004 to January 2005. From January 2003 to July 2004, Mr. Alvarez served as the Chief Operations Officer for McDonalds USA. Prior to that time, he served as President, Central Division from October 2001 to January 2003. Except for a brief period in 1999, Mr. Alvarez has been with the Company for 12 years.
Jose Armario, 47, is President, McDonalds Latin America, a position he has held since December 2003. He previously served as Senior Vice President and International Relationship Partner for the northern markets in Latin America from July 2001 through November 2003. Prior to that time, he served as Vice President and International Relationship Partner for the Latin American Group from June 1999 through July 2001. Mr. Armario has been with the Company for 10 years.
Mary Dillon, 45, is Corporate Executive Vice PresidentGlobal Chief Marketing Officer. She has served in that position since joining the Company in October 2005. Prior to joining the Company, she was Division President of Quaker Foods, a division of PepsiCo, from 2004 to October 2005. Prior to that role, Ms. Dillon served as Vice President of Marketing, Quaker Foods from 2002 to 2004. Ms. Dillon has been with the Company for one year.
Timothy J. Fenton, 49, is President, McDonalds Asia/Pacific/Middle East/Africa, a position he has held since January 2005. From May 2003 to January 2005, he served as President, East Division for McDonalds USA. Prior to that time, he served as Senior Vice President, International Relationship Partner from September 1999 through May 2003. Mr. Fenton has been with the Company for 33 years.
Richard Floersch, 49, is Corporate Executive Vice President and Chief Human Resources Officer. Mr. Floersch joined the Company in November 2003. He previously served as Senior Vice President of Human Resources for Kraft Foods from 1998 through 2003. Mr. Floersch has been with the Company for three years.
Denis Hennequin, 48, is President of McDonalds Europe, a position he has held since July 2005. From January 2005 to July 2005, he served as Senior Vice President and International Relationship Partner of McDonalds Europe. From January 2004 to January 2005, he served as Vice President of McDonalds Europe. Prior to that time, he served as President and Managing Director of McDonalds France from December 1996 to January 2004. Mr. Hennequin has been with the Company for 22 years.
Matthew H. Paull, 55, is Corporate Senior Executive Vice President and Chief Financial Officer, a position he has held since July 2004. From July 2001 to July 2004, he served as Corporate Executive Vice President and Chief Financial Officer. Mr. Paull has been with the Company for 13 years.
David M. Pojman, 47, is Corporate Senior Vice PresidentController, a position he has held since March 2002. He served as Vice President and Assistant Corporate Controller from January 2000 to March 2002. Mr. Pojman has been with the Company for 24 years.
Gloria Santona, 56, is Corporate Executive Vice President, General Counsel and Secretary, a position she has held since July 2003. From June 2001 to July 2003, she served as Corporate Senior Vice President, General Counsel and Secretary. Ms. Santona has been with the Company for 29 years.
James A. Skinner, 62, is Vice Chairman and Chief Executive Officer, a post to which he was elected in November 2004, and also has served as a Director since that date. He served as Vice Chairman from January 2003 to November 2004 and as President and Chief Operating Officer of McDonalds Worldwide Restaurant Group from January 2002 to December 2002. Mr. Skinner has been with the Company for 35 years.
Jeffrey P. Stratton, 51, is Corporate Executive Vice PresidentChief Restaurant Officer, a position he has held since January 2005. He previously served as U.S. Executive Vice President, Chief Restaurant Officer from January 2004 to December 2004. Prior to that time, he served as Senior Vice President, Chief Restaurant Officer of McDonalds USA from May 2002 to January 2004 and Senior Vice President from October 2001 to May 2002. Mr. Stratton has been with the Company for 33 years.
Donald Thompson, 43, is President, McDonalds USA, a position he has held since August 2006. He previously served as Executive Vice President and Chief Operations Officer for McDonalds USA from January 2005 through August 2006, as Executive Vice President, Restaurant Solutions Group from May 2004 through January 2005, and President, West Division, from October 2001 through May 2004. Mr. Thompson has been with the Company for 16 years.
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Companys common stock trades under the symbol MCD and is listed on the New York and Chicago stock exchanges in the U.S.
The following table sets forth the common stock price ranges on the New York Stock Exchange composite tape and dividends declared per common share:
The number of shareholders of record and beneficial owners of the Companys common stock as of January 31, 2007 was estimated to be about 983,000.
Given the Companys returns on equity and assets, management believes it is prudent to reinvest in markets with acceptable returns and/or opportunity for long-term growth and use excess cash flow to return cash to shareholders either through share repurchases or dividends. The Company has paid dividends on common stock for 31 consecutive years through 2006 and has increased the dividend amount at least once every year. As in the past, further dividends will be considered after reviewing profit-ability expectations and financing needs, and will be declared at the discretion of the Companys Board of Directors.
The following table presents information related to acquisitions of common stock the Company made during the three months ended December 31, 2006:
The following table summarizes information about our equity compensation plans as of December 31, 2006. All outstanding awards relate to our Common Stock. Shares issued under all of the following plans may be from the Companys treasury, newly issued or both.
Equity compensation plan information
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Description of the business
The Company primarily franchises and operates McDonalds restaurants. In addition, the Company operates and has investments in certain non-McDonalds brands that are not material to the Companys overall results. Of the 31,046 McDonalds restaurants in 118 countries at year-end 2006, 18,685 are operated by franchisees (including 1,091 operated by developmental licensees), 4,195 are operated by affiliates and 8,166 are operated by the Company. Under our conventional franchise arrangement, franchisees provide a portion of the required capital by initially investing in the equipment, signs, seating and décor of their restaurant businesses, and by reinvesting in the business over time. The Company owns the land and building or secures long-term leases for both Company-operated and franchised restaurant sites. This ensures long-term occupancy rights, helps control related costs and improves alignment with franchisees. Under our developmental license arrangement, licensees provide ongoing capital for the entire business, including the real estate interest, while the Company generally has no capital invested.
We view ourselves primarily as a franchisor and continually review our restaurant ownership mix (that is our mix among Company-operated, franchised - conventional or developmental license, and joint venture) to deliver a great customer experience and drive profitability. In most cases, franchising is the best way to achieve both goals. Although direct restaurant operation is more capital-intensive relative to franchising and results in lower operating margins as a percent of revenues, Company-operated restaurants are important to our success in both mature and developing markets. In our Company-operated restaurants, and in collaboration with our franchisees, we further develop and refine operating standards, marketing concepts and product and pricing strategies, so that we introduce Systemwide only those that we believe are most beneficial. In addition, we firmly believe that owning restaurants is paramount to being a credible franchisor. Our Company-operated business also helps to facilitate changes in restaurant ownership as warranted by strategic considerations.
Revenues consist of sales by Company-operated restaurants and fees from restaurants operated by franchisees and affiliates. These fees primarily include rent, service fees and/or royalties that are based on a percent of sales, with specified minimum rent payments. Fees vary by type of site, amount of Company investment and local business conditions. These fees, along with occupancy and operating rights, are stipulated in franchise/license agreements that generally have 20-year terms.
The business is managed as distinct geographic segments: United States; Europe; Asia/Pacific, Middle East and Africa (APMEA); Latin America; and Canada. In addition, throughout this report we present a segment entitled Corporate & Other that includes Corporate activities and non-McDonalds brands (e.g., Boston Market). The U.S. and Europe segments each account for approximately 35% of total revenues. France, Germany and the United Kingdom (U.K.), collectively, account for approximately 60% of Europes revenues; and Australia, China and Japan (a 50%-owned affiliate accounted for under the equity method), collectively, account for nearly 50% of APMEAs revenues. These six markets along with the U.S. and Canada are referred to as major markets throughout this report and comprise approximately 70% of total revenues.
During 2006, the Company disposed of its entire investment in Chipotle Mexican Grill (Chipotle) via public stock offerings and a tax-free exchange for McDonalds common stock. As a result of the complete disposition of Chipotle, the Company has reflected Chipotles results for all years shown as discontinued operations, including gains from the disposition in 2006.
In analyzing business trends, management considers a variety of performance and financial measures including comparable sales growth, Systemwide sales growth, operating margins and returns.
Strategic direction and financial performance
The unique business relationship among the Company, its franchisees and suppliers (collectively referred to as the System) has been key to McDonalds success over the years. This business model enables McDonalds to play an integral role in the communities we serve and consistently deliver relevant restaurant experiences to customers. In addition, our strategic alignment facilitates our ability to implement innovative ideas and profitably grow our business.
The Company is focused on increasing McDonalds relevance to consumers through the execution of multiple initiatives under our Plan to Win in order to be better, not just bigger. This plan is designed to deliver operational excellence and leadership marketing leveraged around five key drivers of exceptional customer experiences - people, products, place, price and promotion. Our long-term financial targets include average annual Systemwide sales and revenue growth of 3% to 5%; average annual operating income growth of 6% to 7%; and annual returns on incremental invested capital in the high teens. These targets exclude the impact of foreign currency translation.
Since implementing our Plan to Win, we improved the taste of many of our menu items and have introduced a variety of new menu choices such as premium salads, premium burgers and additional chicken offerings in many markets worldwide. We appeal to a broad range of customer preferences using a locally relevant three-tier menu strategy featuring premium salad and sandwich selections, classic menu favorites and everyday affordable offerings. We strive for continuous improvement in our training programs and restaurant execution through a comprehensive restaurant operations improvement process to enable and motivate franchisees and restaurant employees to improve the customer experience. In addition, our im lovin it global marketing theme continues to evolve to extend our marketing reach to consumers via print, billboards and digital communications in addition to television advertising.
These efforts have increased our consumer relevance and delivered strong results in each of the last three years with revenue growth, operating income growth and returns on incremental invested capital meeting or exceeding our long-term financial targets. In addition, we demonstrated our commitment to shareholders by returning $8.3 billion to shareholders through dividends paid and shares acquired from 2004 through 2006.
In 2006, the Companys increased relevance contributed to more customers visiting our restaurants, helping drive global comparable sales up 5.7% and extending our consecutive monthly increases to 44 months through December 2006.
The momentum of our U.S. business continued as a result of further strengthening our robust breakfast business and expanding our beverage, salad and chicken offerings, including the successful introductions of Premium Roast Coffee, the Asian Salad and the Snack Wrap. Initiatives such as reimaging restaurants, extending operating hours and providing cashless payment options helped make McDonalds more inviting and convenient for customers.
In Europe, we built momentum using locally relevant menu offerings such as premium burgers and classic menu favorites, as well as value platforms such as Ein Mal Eins in Germany and Pound Saver in the U.K. The markets provided predictable menu choice and variety through popular food promotions, and engaged consumers with innovative marketing. Europes results were driven by strong performance in France, Germany and most other markets as well as significantly improved performance in the U.K. We also made progress improving consumer perceptions in Europe, including the U.K., by aggressively communicating McDonalds food quality, nutrition and employment facts. In addition, to enhance local relevance by having local franchisees operate more restaurants and to improve returns, we reduced our percentage of Company-operated restaurants in the U.K. from 63% at the end of 2005 to 54% at the end of 2006. We are encouraged by our momentum in Europe and confident that our combined initiatives designed to enhance the customers experience will continue to drive growth over the long term.
In APMEA, Systemwide sales and revenue growth were primarily driven by strong comparable sales in Japan and Australia and new restaurant expansion and positive comparable sales in China. Strategic menu pricing in Japan and China contributed to this segments performance. In 2006, we also entered into a strategic alliance with Sinopec, Chinas largest petroleum retailer. This agreement provides us the opportunity to co-develop drive-thru restaurants at existing and new Sinopec locations, positioning us to capitalize on changing consumer lifestyles in China. We believe that the long-term growth potential for our business in China is substantial and we are well-positioned to capture the opportunity.
We continue to focus our management and financial resources on the core McDonalds business as the opportunities for growth remain significant. Accordingly, during 2006, we disposed of our entire investment in Chipotle via public stock offerings and an October tax-free exchange for McDonalds common stock. These transactions provided the Company with $329 million in cash proceeds and facilitated the acquisition of 18.6 million shares of McDonalds stock via the exchange.
In 2006, our strong global performance generated $4.3 billion of cash provided by operations. About $1.7 billion of this cash was reinvested in our business primarily to remodel existing restaurants and build new ones. We increased our annual dividend nearly 50% to $1 per share. We also acquired 98.4 million shares through both shares repurchased and shares accepted in connection with the Chipotle exchange. In addition, we paid down $2.3 billion of debt in 2006 reducing the 2005 increase related to the Homeland Investment Act.
To improve local relevance, profitability and returns, we continually evaluate ownership structures in our markets. The ownership mix in a given market depends on current and potential results, the risks associated with operating in certain countries, and legal and regulatory constraints.
As part of this evaluation, in 2006, we established a target of having less than 30% Company-operated restaurants in each of our major consolidated markets and began working toward this goal, specifically in the U.K. and Canada. For certain markets like China, we believe owning and operating the restaurants is prudent until the legal environment in these countries becomes more conducive to franchising.
In addition to our franchising efforts discussed above, we have identified markets with about 2,300 restaurants collectively, primarily Company-operated restaurants in Latin America and APMEA, that we intend to transition to a developmental license structure. Under a developmental license, a local entrepreneur owns the business, including controlling the real estate, and uses his/her capital and local knowledge to build the Brand and optimize sales and profitability over the long term. Under this arrangement, the Company collects a royalty, which varies by market, based on a percent of sales, but does not invest any capital. During 2006, this royalty averaged about five percent of sales. We have successfully used this structure for more than 15 years, and currently have 36 countries that are solely operated by developmental licensees. In addition to the financial benefits the Company achieves when markets are developmentally licensed
such as reduced capital spending, improved returns and a stable stream of royalties, this strategy allows the local owner to improve relevance and accelerate growth in the market, and allows management to focus most of their time and energy on the markets that have the largest impact on results.
Highlights from the year included:
Outlook for 2007
The McDonalds System is energized by our current momentum. We intend to build on this momentum by further enhancing every element of the Brand experience and strengthening our connection with customers to capture the tremendous opportunities that lie ahead. We will do this by continuing to execute our Plan to Win with a strategic focus on our customers and restaurants, while continuing to exercise disciplined financial management.
We are confident that our Plan to be better, not just bigger, supported by the alignment of our unique system of franchisees and suppliers, will continue to drive enduring profitable growth. Our financial targets, previously discussed, focus management on those opportunities that best optimize shareholder value over the long term.
In 2007, we will continue to leverage our three-tier menu approach featuring premium selections, core menu favorites and everyday affordable offerings to appeal to a broad range of consumers. We will complement this three-tier strategy with permanent and limited time offerings of new products that enhance menu choice, variety and value.
In the U.S., our strategies focus on chicken, breakfast, beverages and convenience. We are introducing Snack Wrap variations and the new Southwest Salad as well as additional breakfast offerings. We will also enhance the drive-thru experience by continuing to optimize the layout of restaurant interiors and exteriors.
In Europe, we will continue to attract customers with a variety of new food offerings, such as Premium Chicken Sandwiches and Snack Wraps, while leveraging the strength of our everyday affordability platforms. Building greater brand trust will remain a priority in Europe with ongoing aggressive communication efforts surrounding our food quality, nutrition and employment image. In addition, we will focus on remodeling restaurants and improving operations to enhance local relevance and upgrade the customer experience.
In APMEA, where a large percentage of the population already eats breakfast away from home, we are introducing or expanding breakfast as well as extending restaurant operating hours. We will also continue to reinforce everyday value offerings and work on optimizing our menu pricing structure to enhance profitability.
We will continue to support consumers desire to make balanced lifestyle choices by educating them about our foods nutritional value and encouraging greater physical activity. We added nutrition labeling to the packaging of many of our branded core menu items in more than 25,000 restaurants worldwide by the end of 2006. We will extend this effort to cover even more restaurants and products in 2007. We will also continue to play a leadership role in addressing childrens well-being as we pursue initiatives designed to positively affect childrens choice and activity. This includes committing a large portion of our childrens marketing budget toward communications that encourage kids to be more active physically and mentally.
We will also work to further enhance the customer experience by refining and executing our restaurant operations improvement process and expanding the use of our new point of sale software (POS), which was in approximately 8,400 restaurants as of year-end 2006. Tests indicate this new POS helps improve order accuracy and drive-thru service speed. In addition, we will continue developing a new flexible operating system that takes a modular plug and play approach to kitchen configuration and restaurant operations. In the future, this system will enable greater menu flexibility based on local market needs while making it easier for crew to satisfy customers.
Due to our expectations for continued strong results, relatively stable capital expenditures over the next few years, and the Companys intent on maintaining current debt-to-capital levels of 35% to 40%, we believe that cash available for dividends and share repurchases will continue to grow. We expect our share repurchase activity will continue to yield reductions in share count in the years ahead given our reduction in equity compensation and fewer stock options outstanding, compared to prior years.
In 2007, we will continue to reduce the percentage of Company-operated restaurants in the U.K. and Canada, and we will continue to pursue the developmental license strategy described earlier.
The previously mentioned 2,300 restaurants identified for potential conversion to developmental licensees represented nearly $3 billion in sales in 2006, but only generated $30 million in operating income after impairment and other charges. To achieve these results, we spent about $180 million in selling, general & administrative expenses and invested more than $100 million in capital expenditures. As appropriate, we may license some of these markets as a group to a single developmental licensee. These 2,300 restaurants are about 75% Company-operated and represent about $3 billion in combined net investment, which includes approximately $800 million in accumulated currency translation losses reflected in shareholders equity on our balance sheet.
Our intent is to complete these transactions by the end of 2008. If we are able to complete these transactions, we do not anticipate recovering either the $800 million in historical currency translation losses or most of the remaining $2.2 billion in net book value in the form of sales proceeds, and therefore, we expect that the loss, in the aggregate, would be significant. We will continue impairment testing for these assets annually and as otherwise required by applicable accounting standards. In particular, our annual impairment testing for these assets is based on the assumption that these markets will continue to be operated under the existing ownership structure until it becomes probable that a transaction will occur within 12 months, and we can reasonably estimate our sales proceeds. The timing and amount of any loss for a particular transaction will depend on individual circumstances. In 2006, we completed the transfer of 121 restaurants in four markets to developmental licensees and recorded pretax losses totaling $36 million related to this strategy.
While the Company does not provide specific guidance on net income per share, the following information is provided to assist in analyzing the Companys results:
nm Not meaningful.
Net income and diluted net income per common share
In 2006, net income and diluted net income per common share were $3.5 billion and $2.83. During 2006, the Company disposed of its entire investment in Chipotle via public stock offerings and a tax-free exchange for McDonalds common stock and as a result, has reflected Chipotles results of operations and transaction gains as discontinued operations. The 2006 results included $671 million of income, or $0.53 per share, related to discontinued operations. Income from continuing operations was $2.9 billion or $2.30 per share, which included impairment and other charges of $134 million ($98 million after tax or $0.07 per share), as well as net incremental tax expense of $0.01 per share primarily related to a one-time impact from a tax law change in Canada.
In 2005, net income and diluted net income per common share were $2.6 billion and $2.04. Income from discontinued operations was $16 million or $0.01 per share, while income from continuing operations was $2.6 billion or $2.03 per share. The 2005 results from continuing operations included a net tax benefit of $73 million or $0.05 per share comprised of $179 million or $0.14 per share tax benefit due to a favorable audit settlement of the Companys 2000-2002 U.S. tax returns and $106 million or $0.09 per share of incremental tax expense resulting from the decision to repatriate certain foreign earnings under the Homeland Investment Act (HIA). In addition, 2005 included impairment and other charges (credits), net of $28 million pretax income ($12 million after tax or $0.01 per share).
In 2004, net income and diluted net income per common share were $2.3 billion and $1.79 and income from continuing operations was also $2.3 billion or $1.79 per share. The 2004 income from continuing operations included pretax operating charges of $151 million ($99 million after tax or $0.08 per share) related to a lease accounting correction and $130 million ($116 million after tax or $0.09 per share) related to impairment charges. Results also included pretax nonoperating income of $49 million ($49 million after tax or $0.04 per share) relating to the sale of the Companys interest in a U.S. real estate partnership that resulted in the utilization of certain previously unrealized capital loss carryforwards.
Refer to the Impairment and other charges (credits), net and Discontinued operations sections for further discussion.
In 2006, diluted weighted-average shares outstanding decreased primarily due to treasury stock acquisitions exceeding stock option exercises in 2005 and 2006. The Company acquired 98.4 million shares, or $3.7 billion through both shares repurchased and shares accepted in connection with the Chipotle exchange, driving a reduction of about 5% of total shares outstanding compared with yearend 2005.
For 2005, diluted weighted-average shares outstanding were relatively flat compared to 2004. Shares outstanding at the beginning of 2005 were higher than the prior year due to stock options exercised exceeding treasury stock purchased during 2004. Treasury stock purchased in 2005 offset this higher balance and the impact of options exercised during the year.
Impact of foreign currency translation on reported results
While changing foreign currencies affect reported results, McDonalds mitigates exposures, where practical, by financing in local currencies, hedging certain foreign-denominated cash flows, and purchasing goods and services in local currencies.
In 2006, foreign currency translation had a positive impact on consolidated revenues, operating income and net income primarily due to the stronger Euro, Canadian Dollar and British Pound. Consolidated revenues were positively impacted by the stronger Brazilian Real. In 2005, revenues were positively impacted by the Brazilian Real and the Canadian Dollar, but operating income and net income were minimally impacted by foreign currency translation. In 2004, foreign currency translation had a positive impact on consolidated revenues, operating income and net income due to the strengthening of several major currencies, primarily the Euro.
In both 2006 and 2005, consolidated revenue growth was driven by positive comparable sales as well as stronger foreign currencies.
In the U.S., the increase in revenues in 2006 was primarily driven by our popular breakfast menu featuring Premium Roast Coffee, new products like our Asian Salad and Snack Wrap, and a wide variety of premium chicken options, as well as continued focus on everyday value and convenience. In 2005, the increase in revenues was driven by multiple initiatives that delivered variety like the introduction of Premium Chicken Sandwiches, convenience such as cashless payment options and extended hours as well as our focus on value.
Europes constant currency increase in revenues in 2006 was primarily due to strong comparable sales in France, Germany and Russia (which is entirely Company-operated). In addition, revenues in 2006 benefited from positive comparable sales in the U.K., which were offset by the impact of the markets Company-operated restaurant closings and sales to franchisees and affiliates throughout the year. In 2005, the increase in revenues was due to strong comparable sales in Russia and positive comparable sales in France and Germany, partly offset by negative comparable sales in the U.K.
In APMEA, the constant currency increase in revenues in 2006 was primarily driven by the consolidation of Malaysia for financial reporting purposes due to an increase in the Companys ownership during the first quarter 2006, expansion and positive comparable sales in China, as well as positive comparable sales in most markets. The increase was partly offset by the 2005 conversion of the Philippines and Turkey (about 325 restaurants) to developmental licensee structures. In 2005, revenues benefited from strong comparable sales in Australia and Taiwan, and were negatively impacted by the Philippines and Turkey as mentioned above. In addition, revenues in 2005 benefited from expansion in China, partly offset by that markets negative comparable sales.
The following tables present Systemwide sales growth rates and the increase in comparable sales for McDonalds restaurants:
Operating margin information and discussions relate to McDonalds restaurants only and exclude non-McDonalds brands.
Franchised margin dollars represent revenues from franchised and affiliated restaurants less the Companys occupancy costs (rent and depreciation) associated with those sites. Franchised margin dollars represented about 65% of the combined operating margins in 2006, 2005 and 2004. Franchised margin dollars increased $357 million or 9% (8% in constant currencies) in 2006 and $246 million or 6% as reported and in constant currencies in 2005. The U.S. and Europe segments accounted for more than 85% of the franchised margin dollars in all three years.
The consolidated franchised margin percent increased in 2006 and 2005 due to strong comparable sales, partly offset by higher rent expense in several markets.
Company-operated margin dollars represent sales by Company-operated restaurants less the operating costs of these restaurants. Company-operated margin dollars increased $398 million or 19% (17% in constant currencies) in 2006 and increased $96 million or 5% (4% in constant currencies) in 2005. The U.S. and Europe segments accounted for more than 70% of the Company-operated margin dollars in all three years.
In the U.S., the Company-operated margin percent increased in 2006 due to positive comparable sales, partly offset by higher labor costs primarily due to a higher average hourly rate, higher commodity costs, including paper, and higher utilities. In 2005, the Company-operated margin percent benefited from positive comparable sales, more than offset by higher commodity, labor and occupancy costs.
Europes Company-operated margin percent increased in 2006 primarily due to strong comparable sales, partly offset by higher labor costs throughout the segment. In addition, initiatives in the U.K. such as the closing of certain underperforming restaurants in the first quarter and the sales of Company-operated restaurants to franchisees and affiliates throughout the year, contributed to the increase. In 2005, the Company-operated margin percent decreased due to higher labor costs and negative comparable sales in the U.K., partly offset by strong performance in Russia. In addition, higher beef costs in 2005 had a negative impact across the segment.
In APMEA, the Company-operated margin percent in 2006 reflected improving results in China and many other markets. In 2005, the Company-operated margin percent was negatively impacted by weak results in South Korea, partly offset by improvements in Hong Kong.
We continually review our restaurant ownership mix with a goal of improving local relevance, profits and returns. In most cases, franchising is the best way to achieve these goals. Although direct
restaurant operation is significantly more capital-intensive relative to franchising and results in lower operating margins as a percent of revenues, Company-operated restaurants are important to our success in both mature and developing markets. In our Company-operated restaurants, we develop and refine operating standards, marketing concepts and product and pricing strategies, so that we introduce Systemwide only those that we believe are most beneficial. In addition, we firmly believe that operating restaurants is paramount to being a credible franchisor.
We report results for Company-operated restaurants based on their sales, less costs directly incurred by that business including occupancy costs. We report the results for franchised restaurants based on franchised revenues, less associated occupancy costs. For this reason and because we manage our business based on geographic segments and not on the basis of our ownership structure, we do not specifically allocate selling, general & administrative expenses and other operating (income) expenses to Company-operated or franchised restaurants. Other operating items that relate to the Company-operated restaurants generally include gains on sales of restaurant businesses and write-offs of equipment and leasehold improvements.
We believe the following information about Company-operated restaurants in our most significant markets will provide an additional perspective on this business. Management responsible for our Company-operated restaurants in these markets analyzes the Company-operated business on this basis to assess its performance. Management of the Company also considers this information when evaluating our restaurant ownership mix, subject to other relevant considerations.
The tables below seek to illustrate the two components of our Company-operated margins. The first of these relates exclusively to restaurant operations, which we refer to below as Restaurant margin. The second relates to the value of our Brand and the real estate interest we retain for which we charge rent and service fees. We refer to this component as Brand/real estate margin. Both Company-operated and franchised restaurants are charged rent and service fees, although rent and service fees for Company-operated restaurants are eliminated in consolidation. Rent and service fees for both restaurant ownership types are based on a percentage of sales, and the actual percentage attributable to rent varies depending on the level of McDonalds investment in the restaurant. Service fees may also vary by market.
As shown below, in disaggregating the components of our Company-operated margins, certain costs with respect to Company-operated restaurants would be reflected in Brand/real estate margin. Those costs consist of rent payable by McDonalds to third parties on leased sites and depreciation for buildings and leasehold improvements and constitute a portion of Occupancy & other operating expenses recorded in the Consolidated statement of income. Restaurant margin would reflect rent and service fees paid, and those fees would be accounted for as income in calculating Brand/real estate margin.
While we believe that the following information provides a perspective in evaluating our Company-operated business, it is not intended as a measure of our operating performance or as an alternative to operating income or operating margins as reported by the Company in accordance with accounting principles generally accepted in the U.S. In particular, as noted above, we do not allocate selling, general & administrative expenses to our Company-operated business. An estimate of costs to support this business was made by the U.S., Canada and our three major markets in Europe. We believe, on average, that a range of $40,000 to $50,000 per restaurant is typical, but the actual costs will vary by restaurant depending on local circumstances and the organizational structure of the market. These costs reflect the indirect services we believe are necessary to provide the appropriate support of the restaurant.
Selling, general & administrative expenses
Consolidated selling, general & administrative expenses increased 8% in 2006 and 12% in 2005 (7% and 11% in constant currencies). In 2006, the increase was due to higher employee-related costs, including performance-based compensation expense. Share-based compensation expense due to the adoption of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment (SFAS No. 123(R)) accounted for a majority of the constant currency increase in 2005.
Selling, general & administrative expenses as a percent of revenues were 10.8% in 2006 compared with 10.9% in 2005 and 10.4% in 2004, and selling, general & administrative expenses as a percent of Systemwide sales were 4.1% in 2006 compared with 4.0% in 2005 and 3.8% in 2004. On a pro forma basis, share-based compensation expense would increase these ratios 1.3 and 0.5 percentage points, respectively, for 2004. Management believes that analyzing selling, general & administrative expenses as a percent of Systemwide sales, as well as revenues, is meaningful because these costs are incurred to support Systemwide restaurants.
Impairment and other charges (credits), net
On a pretax basis, the Company recorded impairment and other charges (credits), net of $134 million in 2006, ($28) million in 2005 and $281 million in 2004 associated with impairment, as well as certain strategic actions in 2006 and a lease accounting correction in 2004. McDonalds management does not include these items when reviewing business performance trends because we do not believe these items are indicative of expected ongoing results.
In 2006, the Company recorded $134 million of pretax impairment charges primarily related to the following items: losses incurred on the transfers of the Companys ownership interest in certain markets to developmental licensees ($36 million); the closing of certain restaurants in the U.K. in conjunction with an overall restaurant portfolio review ($35 million); costs to buy out certain litigating franchisees in Brazil ($29 million); asset write-offs and other charges in APMEA ($18 million); and a loss related to the decision to dispose of supply chain operations in Russia ($13 million).
In 2005, the Company recorded $23 million of pretax impairment charges primarily in South Korea. In addition, the Company recorded $51 million of pretax income, primarily due to the transfer of the Companys ownership interest in Turkey to a developmental licensee and a favorable adjustment to certain liabilities established in prior years due to lower than originally anticipated employee-related and lease termination costs.
In 2004, the Company recorded $130 million of pretax impairment charges primarily in South Korea. In addition, like other companies in the restaurant and retail industries, the Company reviewed its accounting practices and policies with respect to leasing transactions. Following this review and in consultation with its external auditors, the Company corrected an error in the amount of $151 million pretax in its prior practices to conform the lease term used in calculating straight-line rent expense with the term used to amortize improvements on leased property. The result of the correction primarily accelerated the recognition of rent expense under certain leases that include fixed-rent escalations by revising the computation of straight-line rent expense to include these escalations for certain option periods. As the correction related solely to accounting treatment, it did not affect McDonalds historical or future cash flows or the timing of payments under the related leases. Its effect on the Companys net income per share, cash provided by operations and shareholders equity was immaterial. These adjustments primarily impacted the U.S., China and Boston Market. Other markets were less significantly impacted, as many of the leases outside of the U.S. do not contain fixed-rent escalations.
Other operating expense, net
Gains on sales of restaurant businesses include gains from sales of Company-operated restaurants as well as gains from exercises of purchase options by franchisees with business facilities lease arrangements (arrangements where the Company leases the businesses, including equipment, to franchisees who generally have options to purchase the businesses). The Companys purchases and sales of businesses with its franchisees and affiliates are aimed at achieving an optimal ownership mix in each market. Resulting gains or losses are recorded in operating income because the transactions are a recurring part of our business.
Equity in earnings of unconsolidated affiliatesbusinesses in which the Company actively participates but does not controlrepresents McDonalds share of each affiliates results. These results are reported after interest expense and income taxes, except for partnerships in certain markets such as the U.S., which are reported before income taxes. Results in 2006 increased partly due to improved results from our Japanese affiliate. Results in 2005 decreased primarily due to results from our Japanese affiliate, which included a one-time adjustment for restaurant employees back pay.
Asset dispositions and other expense consists of gains or losses on excess property and other asset dispositions, provisions for contingencies and uncollectible receivables, and other miscellaneous expenses. These amounts can vary significantly by year. In 2006, results included a gain of $26 million related to the sale of an office building in Russia and results for 2005 reflected a $24 million charge related to a supply chain arrangement in Europe.
Consolidated operating income in 2006 and 2005 included higher combined operating margin dollars, partly offset by higher selling, general & administrative expenses compared with the prior year.
nm Not meaningful.
When comparing 2005 to 2004, the following discussion of operating income relates to the pro forma increase/(decrease) excluding currency translation in the table above.
In 2006 and 2005, U.S. operating income included higher combined operating margin dollars compared to 2005 and 2004, respectively. In 2004, operating income included charges related to the lease accounting correction of $70 million, impairment charges of $10 million and higher asset dispositions compared to 2005.
In Europe, results for 2006 reflected strong performance in France and a gain on the sale of an office building in Russia, partly offset by impairment and other charges. In addition, 2006 operating results in the U.K. and Germany contributed to the increase in operating income. In 2005, results reflected strong performance in France and Russia, improved performance in Germany and weak results in the U.K. In addition, results in 2005 included a supply chain charge of $24 million.
In APMEA, results for 2006 were driven by strong performance in Australia as well as improved results in China and Japan, partly offset by impairment and other charges. Results for 2005 were positively impacted by strong performance in Australia, partly offset by weak results in Japan, China and South Korea. In addition, lower impairment and other charges in 2005 compared to 2004 benefited the growth rate.
In Latin America, results for 2006 and 2005 reflected continued strong sales performance across most markets. In addition, 2006 results included $31 million of impairment and other charges, primarily due to the buy out of certain litigating franchisees in Brazil. In 2005, results reflected lower asset dispositions and other expense compared to 2004.
Results for 2006 in the Corporate & Other segment reflected higher performance-based compensation, as well as costs related to our biennial worldwide operator convention. Results for 2006 and 2005 included favorable adjustments to certain liabilities established in prior years of $7 million and $26 million, respectively. In 2005, results benefited from lower share-based compensation, certain information technology expenses that are now reflected in the U.S. segment and lower performance-based compensation compared to 2004.
Interest expense for 2006 increased primarily due to higher average debt levels as a result of activity related to HIA, funded by local borrowings, in late 2005 and higher average interest rates. In late fourth quarter 2005, the Company repatriated approximately $3 billion of certain foreign historical earnings under HIA, which had a minimal impact on the average debt levels for 2005. Interest expense for 2005 reflected higher average interest rates and lower average debt levels compared with 2004.
Nonoperating (income) expense, net
Interest income consists primarily of interest earned on short-term cash investments. Translation losses primarily relate to the net gains or losses on certain hedges that reduce the exposure to variability on certain intercompany foreign cash flow streams. Other expense primarily consists of gains or losses on early extinguishment of debt, amortization of deferred debt issuance costs and minority interest.
Interest income increases for 2006 and 2005 were primarily due to higher cash levels.
Provision for income taxes
In 2006, 2005 and 2004, the reported effective income tax rates were 31.0%, 29.6%, and 28.8%, respectively. The 2006 effective tax rate was negatively impacted by a tax law change in Canada. In 2005, the effective tax rate included a benefit of $179 million due to a favorable audit settlement of the Companys 2000-2002 U.S. tax returns, partly offset by approximately $106 million of expense related to the Companys decision to take advantage of the onetime opportunity provided under HIA. The effective income tax rate for 2004 benefited from an international transaction and the utilization of certain previously unrealized capital loss carryforwards.
Consolidated net deferred tax liabilities included tax assets, net of valuation allowance, of $1.1 billion in both 2006 and 2005. Substantially all of the net tax assets arose in the U.S. and other profitable markets.
In first quarter 2006, Chipotle completed an IPO of 6.1 million shares resulting in net proceeds of $121 million to Chipotle and a tax-free gain to McDonalds of $32 million reflecting an increase in the carrying value of the Companys investment as a result of Chipotle selling shares in the public offering. Concurrent with the IPO, McDonalds sold 3.0 million Chipotle shares, resulting in net proceeds to the Company of $61 million and an additional gain of $13 million after tax.
In second quarter 2006, McDonalds sold an additional 4.5 million Chipotle shares, resulting in net proceeds to the Company of $268 million and a gain of $128 million after tax, while still retaining majority ownership. In October 2006, the Company completely separated from Chipotle through a tax-free exchange of its remaining Chipotle shares for McDonalds common stock. McDonalds accepted 18.6 million shares of its common stock in exchange for the 16.5 million shares of Chipotle class B common stock held by McDonalds and recorded a tax-free gain of $480 million in the fourth quarter. As a result of the complete disposition of Chipotle, the Company has reflected Chipotles results of operations through the date of the exchange and transaction gains as discontinued operations for all periods presented.
Effective January 1, 2005, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123(R) (SFAS No. 123(R)) using the modified-prospective transition method. Under this transition method, compensation cost in 2005 includes the portion vesting in the period for (1) all share-based payments granted prior to, but not vested as of January 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of the Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, and (2) all share-based payments granted subsequent to January 1, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Results for prior periods have not been restated. Refer to the Summary of significant accounting policies note to the consolidated financial statements for further discussion of this item.
In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132 (R) (SFAS No. 158). SFAS No. 158 requires the Company to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in the Consolidated balance sheet and to recognize changes in that funded status in the year changes occur through other comprehensive income. The Company adopted the applicable provisions of SFAS No. 158 effective December 31, 2006, as required. This resulted in a net adjustment to other comprehensive income of $89 million, for a limited number of applicable international markets.
In June 2006, the FASB ratified Emerging Issues Task Force (EITF) Issue 06-2, Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, Accounting for Compensated Absences (EITF 06-2). Under EITF 06-2, compensation costs associated with a sabbatical should be accrued over the requisite service period, assuming certain conditions are met. Previously, the Company expensed sabbatical costs as incurred. The Company adopted EITF 06-2 effective January 1, 2007, as required and accordingly, we expect to record a cumulative adjustment to beginning retained earnings of approximately $35 million in the first quarter of 2007. We expect the annual impact to earnings to be insignificant.
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), which is an interpretation of FASB Statement No. 109, Accounting for Income Taxes. FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. The provisions of FIN 48 are effective January 1, 2007, with the cumulative effect of the change in accounting principle recorded as an adjustment to retained earnings. We are currently evaluating the impact of adopting FIN 48 on our financial statements; however, we do not expect the impact to be significant.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS No. 157). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. The Company expects to adopt SFAS No. 157 effective January 1, 2008, as required. We cannot reasonably estimate the impact of adoption at this time.
The Company generates significant cash provided by operations and has substantial credit capacity to fund operating and discretionary spending such as capital expenditures, dividends, share repurchases and debt repayments.
Cash provided by operations totaled $4.3 billion and exceeded capital expenditures by $2.6 billion in 2006, while cash provided by operations totaled $4.3 billion and exceeded capital expenditures by $2.7 billion in 2005. In 2006, cash provided by operations was flat compared to 2005 due to increased operating results, offset by changes in working capital primarily due to higher 2006 income tax payments. In 2005, cash provided by operations increased $433 million compared to 2004 due to strong operating results, primarily in the U.S., and changes in working capital. The changes in working capital in 2005 benefited from lower income tax payments compared with the prior year.
Cash used for investing activities totaled $1.3 billion in 2006, a decrease of $544 million compared to 2005. The increase in capital expenditures was more than offset by the proceeds from the disposition of Chipotle as well as the sales of short-term investments. Cash used for investing activities totaled $1.8 billion in 2005, an increase of $435 million compared with 2004 primarily due to higher capital expenditures and increased purchases of restaurant businesses.
Cash used for financing activities totaled $5.2 billion in 2006 compared to cash provided by financing activities of $362 million in 2005. The 2006 activity was due to higher shares repurchased, higher net debt repayments and an increase in the common stock dividend. In 2005, cash provided by financing activities increased $2.0 billion primarily due to $2.9 billion of local borrowings related to HIA and higher proceeds from employee stock option exercises. The increase was partly offset by higher shares repurchased, higher debt repayments and an increase in the common stock dividend compared to 2004.
As a result of the above activity, the Companys cash and equivalents balance decreased $2.1 billion in 2006 to $2.1 billion, compared to an increase of $2.9 billion in 2005.
In addition to cash and equivalents and cash provided by operations, the Company can meet short-term funding needs through commercial paper borrowings and line of credit agreements.