Business Week - 3 Mar 03

Prof. Robert B. Laughlin
Department of Physics
Stanford University, Stanford, CA 94305
(Copied 30 Jul 09)

McDonald's Hamburger Hell

The restaurant chain aims to save itself by going back to basics. But the company needs more than a tastier burger to solve its problems

By P. Golgoi and M. Arndt
March 3, 2003

Richard Steinig remembers beaming as if he had won the lottery. There he was, all of 27 when he became a junior partner with a McDonald's Corp. franchisee in 1973, just a year after starting as a $115-a-week manager trainee in Miami. "It was an incredible feeling," says Steinig. His two stores each generated $80,000 in annual sales, and he pocketed more than 15% of that as profit. Not bad at a time when the minimum wage was still under $2 an hour and a McDonald's hamburger and fries set you back less than a dollar, even with a regular Coke.

Fast-forward 30 years. Franchise owner Steinig's four restaurants average annual sales of $1.56 million, but his face is creased with worry. Instead of living the American Dream, Steinig says he's barely scraping by. Sales haven't budged since 1999, but costs keep rising. So when McDonald's began advertising its $1 menu featuring the Big N' Tasty burger, Steinig rebelled. The popular item cost him $1.07 to make--so he sells it for $2.25 unless a customer asks for the $1 promotion price. No wonder profit margins are no more than half of what they were when he started out. "We have become our worst enemy," Steinig says.

Welcome to Hamburger Hell. For decades, McDonald's was a juggernaut. It gave millions of Americans their first jobs while changing the way a nation ate. It rose from a single outlet in a nondescript Chicago suburb to become an American icon. But today, McDonald's is a reeling giant that teeters from one mess to another.

Consider the events of just the past three months: On Dec. 5, after watching McDonald's stock slide 60% in three years, the board ousted Chief Executive Jack M. Greenberg, 60. His tenure was marked by the introduction of 40 new menu items, none of which caught on big, and the purchase of a handful of non-burger chains, none of which were rolled out widely enough to make much difference. Indeed, his critics say that by trying so many different things--and executing them poorly--Greenberg let the burger business deteriorate. Consumer surveys show that service and quality now lag far behind those of rivals.

The company's solution was to bring back retired Vice-Chairman James R. Cantalupo, 59, who had overseen McDonald's successful international expansion in the '80s and '90s. Unfortunately, seven weeks later, the company reported the first quarterly loss in its 47-year history. Then it revealed that January sales at outlets open at least a year skidded 2.4%, after sliding 2.1% in 2002.

Can Cantalupo reverse the long slide at McDonald's? When he and his new team lay out their plan to analysts in early April, they are expected to concentrate on getting the basics of service and quality right, in part by reinstituting a tough "up or out" grading system that will kick out underperforming franchisees. "We have to rebuild the foundation. It's fruitless to add growth if the foundation is weak," says Cantalupo. He gives himself 18 months to do that with help from Australian-bred chief operating officer, Charles Bell, 42, whom Cantalupo has designated his successor, and Mats Lederhausen, a 39-year-old Swede in charge of global strategy.

But the problems at McDonald's go way beyond cleaning up restaurants and freshening the menu. The chain is being squeezed by long-term trends that threaten to leave it marginalized. It faces a rapidly fragmenting market, where America's recent immigrants have made once-exotic foods like sushi and burritos everyday options, and quick meals of all sorts can be found in supermarkets, convenience stores, even vending machines. One of the fastest-growing restaurant categories is the "fast-casual" segment--those places with slightly more expensive menus, such as Cosi, a sandwich shop, or Quizno's, a gourmet sub sandwich chain, where customers find the food healthier and better-tasting. As Lederhausen succinctly puts it: "We are clearly living through the death of the mass market."

If so, it may well mark the end of McDonald's long run as a growth company. Cantalupo seemed to acknowledge as much when he slashed sales growth estimates in the near term to only 2% annually, down from 15%. No one at Oak Brook (Ill.) headquarters blames the strong dollar or mad cow disease anymore for the company's problems--a big change from the Greenberg era. Perhaps most telling is that the chain plans to add only 250 new outlets in the U.S. this year, 40% fewer than in 2002. Sales in Europe rose only 1%, and the chain this year will add only 200 units to the 6,070 it has there--30% fewer new openings than last year. Meanwhile, it is closing 176 of its 2,800 stores in Japan because of the economic doldrums there.

Up until a few years ago, franchisees clamored to jump on board. But last year, in an exodus that was unheard of in Mickey D's heyday, 126 franchisees left the system, with 68, representing 169 restaurants, forced out for poor performance. The others left seeking greener pastures. The company buys back franchises if they cannot be sold, so forcing out a franchisee is not cheap. McDonald's took a pretax charge of $292 million last quarter to close 719 restaurants--200 in 2002 and the rest expected this year.

For their part, investors have already accepted that the growth days are over. Those who remain will happily settle for steady dividends. Last Oct. 22, when McDonald's announced a 1 cents hike in its annual dividend, to 23 1/2 cents, its stock rose 9%, to $18.95--even though the company said third-quarter profits would decline. It was the biggest one-day gain for McDonald's on the New York Stock Exchange in at least two years. Today, though, the stock is near an eight-year low of $13.50, off 48% in the past year. One of the few money managers willing to give McDonald's a chance, Wendell L. Perkins at Johnson Asset Management in Racine, Wis., says: "McDonald's needs to understand that it is a different company from 10 years ago and increase its dividend to return some of that cash flow to shareholders to reflect its mature market position."

The company has the cash to boost shareholder payouts. It recently canceled an expensive stock buyback program. Cantalupo won praise on Wall Street for killing an expensive revamp of the company's technology that would have cost $1 billion. But if increasing the dividend would make Wall Street happy, it would raise problems with its 2,461 franchisees. That would be essentially an admission that McDonald's is giving up on the kind of growth for which they signed up.

Already, franchisees who see the chain as stuck in a rut are jumping ship to faster-growing rivals. Paul Saber, a McDonald's franchisee for 17 years, sold his 14 restaurants back to the company in 2000 when he realized that eating habits were shifting away from McDonald's burgers to fresher, better-tasting food. So he moved to rival Panera Bread Co., a fast-growing national bakery cafe chain. "The McDonald's-type fast food isn't relevant to today's consumer," says Saber, who will open 15 Paneras in San Diego.

In the past, owner-operators were McDonald's evangelists. Prospective franchisees were once so eager to get into the two-year training program that they would wait in line for hours when applications were handed out at the chain's offices around the country. But there aren't any lines today, and many existing franchisees feel alienated. They have seen their margins dip to a paltry 4%, from 15% at the peak. Richard Adams, a former franchisee and a food consultant, claims that as many as 20 franchisees are currently leaving McDonald's every month. Why? "Because it's so hard to survive these days," he says.

One of the biggest sore points for franchisees is the top-down manner in which Greenberg and other past CEOs attempted to fix pricing and menu problems. Many owner-operators still grumble over the $18,000 to $100,000 they had to spend in the late 1990s to install company-mandated "Made for You" kitchen upgrades in each restaurant. The new kitchens were supposed to speed up orders and accommodate new menu items. But in the end, they actually slowed service. Reggie Webb, who operates 11 McDonald's restaurants in Los Angeles, says his sales have dipped by an average of $50,000 at each of his outlets over the past 15 years. "From my perspective, I am working harder than ever and making less than I ever had on an average-store basis," says Webb. He'll have to open his wallet again if McDonald's includes his units in the next 200 restaurants it selects for refurbishing. Franchisees pay 70% of that $150,000 cost.

Franchisees also beef about McDonald's addiction to discounting. When McDonald's cut prices in a 1997 price war, sales fell over the next four months. The lesson should have been obvious. "Pulling hard on the price lever is dangerous. It risks cheapening the brand," says Sam Rovit, a partner at Chicago consultant Bain & Co. Yet Cantalupo is sticking with the $1 menu program introduced last year. "We like to wear out our competitors with our price," he says. Burger King and Wendy's International Inc. admit that the tactic is squeezing their sales. But in the five months since its debut, the $1 menu has done nothing to improve McDonald's results.

As a last resort, McDonald's is getting rid of the weakest franchises. Continuous growth can no longer bail out underperformers, so Cantalupo is enforcing a "tough love" program that Greenberg reinstated last year after the company gave it up in 1990. Owners that flunk the rating and inspection system will get a chance to clean up their act. But if they don't improve, they'll be booted.

The decline in McDonald's once-vaunted service and quality can be traced to its expansion of the 1990s, when headquarters stopped grading franchises for cleanliness, speed, and service. Training declined as restaurants fought for workers in a tight labor market. That led to a falloff in kitchen and counter skills--according to a 2002 survey by Columbus (Ohio) market researcher Global Growth Group, McDonald's came in third in average service time behind Wendy's and sandwich shop Chick-fil-A Inc. Wendy's took an average 127 seconds to place and fill an order, vs. 151 seconds at Chick-fil-A and 163 at McDonald's. That may not seem like much, but Greenberg has said that saving six seconds at a drive-through brings a 1% increase in sales.

Trouble is, it's tough to sell franchisees on a new quality gauge at the same time the company is asking them to do everything from offering cheap burgers to shouldering renovation costs. Franchising works best when a market is expanding and owners can be rewarded for meeting incentives. In the past, franchisees who beat McDonald's national sales average were typically rewarded with the chance to open or buy more stores. The largest franchisees now operate upwards of 50 stores. But with falling sales, those incentives don't cut it. "Any company today has to be very vigilant about their business model and willing to break it, even if it's successful, to make sure they stay on top of the changing trends," says Alan Feldman, CEO of Midas Inc., who was COO for domestic operations at McDonald's until January, 2002. "You can't just go on cloning your business into the future."

By the late 1990s, it was clear that the system was losing traction. New menu items like the low-fat McLean Deluxe and Arch Deluxe burgers, meant to appeal to adults, bombed. Non-burger offerings did no better, often because of poor planning. Consultant Michael Seid, who manages a franchise consulting firm in West Hartford, Conn., points out that McDonald's offered a pizza that didn't fit through the drive-through window and salad shakers that were packed so tightly that dressing couldn't flow through them. By 1998, McDonald's posted its first-ever decline in annual earnings and then-CEO Michael R. Quinlan was out, replaced by Greenberg, a 16-year McDonald's veteran.

Greenberg won points for braking the chain's runaway U.S. expansion. He also broadened its portfolio, acquiring Chipotle Mexican Grill and Boston Market Corp. But he was unable to focus on the new ventures while also improving quality, getting the new kitchens rolled out, and developing new menu items. Says Los Angeles franchisee Webb: "We would have been better off trying fewer things and making them work." Greenberg was unable to reverse skidding sales and profits, and after last year's disastrous fourth quarter, he offered his resignation at the Dec. 5 board meeting. There were no angry words from directors. But there were no objections, either.

Insiders say Cantalupo, who had retired only a year earlier, was the only candidate seriously considered to take over, despite shareholder sentiment for an outsider. The board felt that it needed someone who knew the company and could move quickly. Cantalupo has chosen to work with younger McDonald's executives, whom he feels will bring energy and fresh ideas to the table. Bell, formerly president of McDonald's Europe, became a store manager in his native Australia at 19 and rose through the ranks. There, he launched a coffeehouse concept called McCafe, which is now being introduced around the globe. He later achieved success in France, where he abandoned McDonald's cookie-cutter orange-and-yellow stores for individualized ones that offer local fare like the ham-and-cheese Croque McDo.

The second top executive Cantalupo has recruited is a bona fide outsider--at least by company standards. Lederhausen holds an MBA from the Stockholm School of Economics and worked with Boston Consulting Group Inc. for two years. However, he jokes that he grew up in a french-fry vat because his father introduced McDonald's to Sweden in 1973. Lederhausen is in charge of growth and menu development.

Getting the recipe right will be tougher now that consumers have tasted better burgers. While McDonald's says it may start toasting its buns longer to get the flavor right, rivals go even further. Industry experts point to 160-store In-N-Out, a profitable California burger chain. Its burgers are grilled when ordered--no heat lamps to warm up precooked food. Today, In-N-Out is rated No. 1 by fast-food consumers tracked by consultant Sandelman & Associates Inc. in San Diego. "The burger category has great strength," adds David C. Novak, chairman and CEO of Yum! Brands Inc., parent of KFC and Taco Bell. "That's America's food. People love hamburgers."

McDonald's best hope to recapture that love might be to turn to its most innovative franchisees. Take Irwin Kruger in New York, who recently opened a 17,000-square-foot showcase unit in Times Square with video monitors showing movie trailers, brick walls, theatrical lighting--and strong profits. "We're slated to have sales of over $5 million this year and profits exceeding 10%," says Kruger. Rejuvenated marketing would help, too: McDonald's called its top ad agencies together in February to draw up a plan that would go beyond the ubiquitous Disney movie tie-ins.

It will take nothing short of a marketing miracle, though, to return McDonald's to its youthful vigor. "They are at a critical juncture and what they do today will shape whether they just fade away or recapture some of the magic and greatness again," says Robert S. Goldin, executive vice-president at food consultant Technomic Inc. As McDonald's settles into middle age, Cantalupo and his team may have to settle for stable and reliable.