03-09-19 mcdonald's can it regain its golden touch

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McDONALD'S

Can it regain its golden touch?

The McDonald brothers' first restaurant, founded in 1937 in a parking lot justeast of Pasadena, Calif., didn't serve hamburgers. It had no playground and no

Happy Meals. The most popular item on the menu was the hot dog, and mostpeople ate it sitting on an outdoor stool or in their cherished new autos whilebeing served by teenage carhops.

That model was a smashing success--for about a decade. Then America's tastes

began to change, and the Golden Arches changed with them. As cars lost someof their romance, indoor restaurants took over. When adults became bored withthe menu in the 1960s, a new sandwich called the Big Mac wooed them back.As consumers grew weary of beef, McDonald's introduced bite-size chunks of

chicken in the early '80s and within four years was the nation's second-largestpoultry seller.

The changes were vital, but never radical. McDonald's gave us what we wantedbefore we even knew we wanted it, whether it was movie tie-ins or Egg

McMuffins. Along the way, it built one of the world's best-known corporateicons and its most ubiquitous store. The philosophy was neatly summarized byRay Kroc's brash vow: whatever people ate, McDonald's would be the ones to

sell it.

But now, two years shy of Kroc's benchmark for the far-off future, that goalseems less assured than ever. Forget for a moment all the recent talk aboutBurger King Corp. and Wendy's International Inc. stealing customers from

McDonald's. With a 42% share of the U.S. fast-food burger market,McDonald's still easily outpaces its rivals. Nonetheless, the problems under thefamous Golden Arches are far more serious than a failed Arch Deluxe here or a

french-fry war there. Quite simply, McDonald's has lost some of its relevance toAmerican culture--a culture that it, as much as any modern corporation, helped toshape. Not even a still booming international division, responsible for half of salesand 60% of profits, can mask the troubles.

The company that once seemed a half-step ahead of pop culture today is unable

to construct even an appealing new lunch sandwich. Its last successful newproduct was the Chicken McNugget, which launched in 1983. In the '90s, thecompany has careened from tests with pizza and veggie burgers to confusing

discount promotions such as last year's Campaign 55. Earnings in 1997 inched up4%, to $1.6 billion, on sales of $11.4 billion, up 7%. That's well below

projections McDonald's itself made just a few years ago.

For a company that enjoyed sizzling growth for five decades based on its ability

to read and shape popular trends, the breadth of its problems is astonishing.Since 1987, McDonald's share of fast-food sales in the U.S. has slipped almosttwo percentage points, to 16.2%. The drop has come even as the company has

increased its number of restaurants by 50%, far outpacing the industry'sexpansion rate. The result: Domestic sales have climbed only 18% since 1989,

while operating profits haven't even kept pace with inflation. They've risen just2% a year in that period. That trend has slashed U.S. per-store profits by 20%since 1989--or a huge 40% after inflation. Meanwhile, nearly every other topconsumer brand, from Disney to Marlboro, has prospered.

''MENU TWEAKING.'' McDonald's has chalked up that dismal record

des ite the fact that it owns one of the best known brands on the lobe. The

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company has been unable to harness the strength of its brand to grow beyond its

basic formula of burgers and fries. During a period when Americans have

abandoned their kitchens in droves for food cooked elsewhere, the GoldenArches--easily the world's largest provider of prepared food--has failed to profit.It's as if hundreds of thousands of people started drinking soda for breakfast andCoca-Cola Co. wasn't benefiting. ''McDonald's has totally failed to adapt its

original concept,'' says Simon C. Williams, chairman of the Sterling Group, aNew York-based brand consultancy that works with food companies.

Now, McDonald's is embarking on an effort at reform. Last year, Chief

Executive Michael R. Quinlan shuffled his U.S. management team. He says thedecentralized structure will rekindle the company's entrepreneurial flair. A newcooking system set for 2000 should make it easier to customize sandwiches,improve quality, and expand the menu. Fundamentally, however, tomorrow's

McDonald's won't be much different. ''Do we have to change?'' asks Quinlan.''No, we don't have to change. We have the most successful brand in the world.''

McDonald's, though, is doing some tinkering. The new head of the domesticdivision--Jack M. Greenberg, a pleasant 54-year-old lawyer who has been with

the company 16 years--has brought in a handful of new managers, includingexecutives from Burger King, Boston Market, and General Electric Co. ''We arenot afraid to do things differently,'' Greenberg says. In a first for the burger giant,

McDonald's in February bought a stake in another restaurant, a 14-outlet chain in

Denver called Chipotle Mexican Grill.

But execs emphasized that the heart of the company's menu will remain the same--and that it believes it can squeeze new profits from the U.S. burger business,

even though McDonald's already dominates the crowded segment. ''We willextend our line, rather than going in more radical, different directions,'' saysQuinlan, 53, who started in the company mailroom at age 19. ''I'm a fan of menu

tweaking.''

Compare the McDonald's strategy with that at other companies that haveprospered despite wrenching changes in their industries. When GE realized thatmanufacturing had become less profitable, it moved into financing. When Walt

Disney Co. found it hard to lure more people to its theme parks, it built hotels and

captured more dollars from the tourists already there. And Coca-Cola spun off itsbottling business and focused instead on becoming a marketing powerhouse. Thedifference is profound: If McDonald's had added shareholder value at the same

rate as Coca-Cola over the past ten years, its shares today would be worth $170each. Instead, they bring less than $55.

FAMILY VALUES. By contrast, McDonald's core recipe has changed littlesince the early '80s. ''McDonald's needs to move the question from 'How can we

sell more hamburgers?' to 'What does our brand allow us to consider selling toour customers?''' says Adrian J. Slywotzky, a partner at Corporate DecisionsInc., a consulting firm in Cambridge, Mass.

Such sweeping vision will not come easily. McDonald's is one of the nation's most

insular large companies, with a management team more typical of a private

company than a global powerhouse. The average top executive started workingat the company when Richard Nixon was President. The 15-member board of

directors has sat out the corporate-governance revolution and is more than two-thirds filled with current and former executives, vendors, and service providers(page 76).

As the company's performance has deteriorated, top execs have tended to blame

others. They have publicly blasted dissident franchisees, whom they dismiss as asmall faction. Negative news accounts are chalked up to misperceptions byreporters. And one persistently critical Wall Street analyst--Damon Brundage,

now at J.P. Morgan & Co.--was barred from the company's latest biennialbriefing.

And while some companies, such as IBM and AT&T, have brought in outsideleaders--albeit reluctantly--to help guide management as the business changed,

McDonald's has largely clung to the ''McFamily'' philosophy of the 1950s and1960s, which rewards managers who start young and stay for life. Headhunters,noting that virtually no alumni from the McDonald's Oak Brook (Ill.) headquarterscan be found running other companies, say it isn't where they look for talent.

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''They are no longer the beacon of great success they used to be,'' says aChicago-area recruiter.

Wall Street seems to share that sentiment. Over the past two years, while the

Standard & Poor's 500-stock index grew by 63%, McDonald's shareholderscould have made more money in an insured savings account. Had you invested$100 in the company two years ago, you'd be holding $103 today. Of the

world's 10 most powerful brands, as ranked by Interbrand, a New Yorkconsultant, only beleaguered Eastman Kodak Co. has had a worse run over that

period (table, page 71). Shareholders of Gillette Co., meanwhile, have more than

doubled their money.

''NOT HOLDING THE PAST SACRED.'' Even some investors who stillbelieve in the brand are concerned. Davis Selected Advisers, with $500 million inMcDonald's stock, has been a shareholder since 1994 on the strength of thecompany's international operations, but the big investor believes there needs to be

changes in management and in the business. ''It means not holding the pastsacred,'' says Chris Davis, a portfolio manager. ''There needs to be a sense ofurgency.''

Even McDonald's formidable international business faces some serious

challenges. On the plus side, operating earnings have more than doubled in thepast five years, and some emerging markets will soon see economies of scale.Says James R. Cantalupo, who runs the division: ''We're nowhere near any kind

of penetration that I think is possible.''

But the easy markets have been tapped. Now, McDonald's is expanding beyondthe bustling Londons and Moscows. As it does, margins are dropping--from20.5% in '94 to 19.1% last year in overseas company-owned outlets. In each of

the past two years, McDonald's has badly missed its projection of 18% to 20%international earnings growth, falling short of 10% per year after accounting forcurrency fluctuations. In the fourth quarter, key markets such as Germany and

Japan underperformed, largely because of local economic climates and a strongdollar. Overall, says analyst Dean T. Haskell of EVEREN Securities Inc., ''theinternational story is not quite as good as McDonald's would have you believe.''

And the Arches' domestic woes raise a troubling question for the overseas

operations: If McDonald's cannot respond to changing market forces at home,how will it adapt over time as its most important overseas markets mature? ''It'shugely problematic,'' Slywotzky says. ''If the same set of conditions duplicatethemselves abroad, then you have a dead end waiting to happen.''

Of course, the strength of the McDonald's brand gives it opportunities to avoidthat dead end. Thanks to the movie tie-in trinkets that it gives away, for example,McDonald's is hugely popular with kids. Imagine, says Slywotzky, if it used low-margin burgers to sell a line of high-margin toys--instead of vice-versa.

McDonald's says that's not its core business. But the point, says Slywotzky, isthat it needs to worry less about market share and more about new profitvehicles.

First, though, McDonald's needs to address an even more fundamental problem:the quality of its food. While the burger giant focused on building more stores,consumers have decided they want better food and more variety. Consumerswho eat fast food at least once a month say that both Wendy's and Burger King

offer better-tasting fare, according to a recent BUSINESS WEEK/Harris Poll.And in a soon-to-be-released survey for Restaurants & Institutions magazine inwhich 2,800 consumers graded chains based on the taste of their food,

McDonald's ranked 87th out of 91--just behind Hooters. ''We clearly think wehave to do some things with our menu,'' says Greenberg, who believes the newcooking system will be a turning point.

The fact is, convenience is no longer enough. In the Harris Poll, more than 90%

of consumers listed both taste and quality as ''very important'' factors in their

choice of a restaurant, while location and speed were selected by barely half.Why? With an abundance of choices, consumers no longer choose McDonald's

just because there's one around the corner. And with new entrants offering ethnic

fare, vegetarian menus, and fully stocked salad bars, fast food no longer has tomean fried food.

KIDS' PLEAS. Take Stephen J. Char, a 31-year-old government scientist in

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Denver. He has cut his trips to McDonald's in half over the past few years. ''Acheeseburger and fries will kill me for the day,'' he says. He's found tastier optionsnear his office for about the same price: a taco restaurant, a German deli, and

even Haji Babba's--a food counter at a Texaco station that serves stuffed grapeleaves.

Even some regulars say it's not the food that keeps them coming back. Julie Lakeis the Austin (Tex.) mother of 3-year-old Chloe and 5-year-old Evan. ''After

preschool, when they are whiny and hungry, we go there,'' she says, adding thatshe rarely eats the food herself. That's bad news for McDonald's, which has had

little luck creating dishes that appeal to grown-ups. Last year's Arch Deluxe,though still on the menu, is hardly a blockbuster. As their kids move beyond the

Ronald McDonald years, baby boomers like Lake will need a new reason to visitthe Arches.

All the while, McDonald's has concentrated on adding restaurants, angering storeowners and cutting into margins. It began a major U.S. expansion in the early

'90s, even as business was slowing. ''They built a whole bunch of new stores inthe wrong places,'' says Dick Adams, who heads up a group of concernedfranchisees.

That single-minded focus left a huge opportunity for new competitors eager to

take advantage of changing eating habits. In the same nine years that McDonald's

U.S. profits have stagnated, Starbucks Corp. has become a $1 billion company.Supermarket sales of prepared food have doubled, and the ''casual dining''

segment has emerged. In fact, Americans now spend more on prepared mealssold at delis, supermarkets, and casual dining restaurants such as Applebee'sInternational Inc. than they do at burger chains, according to Technomic Inc., a

market-research firm based in Chicago.

Even among burger chains, McDonald's is no longer the shrewdest innovator.Burger King has nibbled at McDonald's market share with better-tasting burgers.Wendy's has used its new stuffed pitas and spicy chicken sandwich to drive it

toward 21 months of sales gains in existing outlets. Carl's Jr., a 708-restaurantchain based in Anaheim, Calif., has opened a Mexican eatery called GreenBurrito within 120 of its stores. That has helped boost the typically slow dinner

business and led to a $250,000 revenue jump in some stores.

It's not that McDonald's hasn't made a stab at new products. The past decadehas seen an array of test products, such as pasta, fried chicken, and fajitas. Butcustomers have been unimpressed, and McDonald's invariably has returned to itscore menu. It pulled the plug in 1995 on one of its most interesting ideas, a one-

store test of a Boston Market-like chain called Hearth Express, saying it wantedto focus on building more hamburger restaurants. ''The brand expectation, at leastuntil now, hasn't been as broad [as it could be], and that's been an issue for us in

the U.S.,'' Greenberg says. ''When you try to sell something that doesn'tnecessarily fit people's expectations for the Golden Arches, you have a verydifficult time.'' Analysts, however, say that too often the new products just didn't

taste good.

The company's recent stake in Chipotle could be a sign that McDonald's isconsidering new ways to leverage its brand. Chipotle's fresh, inexpensive burritowraps are precisely the type of food that has drawn consumers away from the

Arches in recent years. Executives have said that they would like to eventuallyexpand and franchise Chipotle, though they caution that the investment, estimatedto be less than $15 million, is far too small to have any impact soon.

WHITEWASH? More significant than the Chipotle venture is McDonald's

management reorganization of last summer. Quinlan nudged Edward H. Rensi,who formerly was head of the domestic division, into early retirement andreplaced him with Greenberg, who franchisees say is easier to talk to. Five newregional division chiefs, whose territories divvy up the country, now report to

Greenberg. The idea: create smaller companies within the larger McDonald's that

will recapture its earlier entrepreneurial zeal.

But even the shuffling shows signs of McDonald's discomfort with change. Of the

five new division heads, none has set up shop outside the Chicago area, and onlyone has immediate plans to do so. The majority of franchisees still report to thesame person. The reorganization, charges EVEREN analyst Haskell, ''is an effort

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to whitewash the public by trying to convince Wall Street things have changedwhen they really haven't.'' Says one investor who manages more than $30 millionin McDonald's stock: ''The changes were an improvement, but I don't think it's a

dramatic improvement.''

One of the most troubling signs of McDonald's unwillingness to grapple withunderlying problems is its reaction to outside critics. Greenberg has dismissed the

Consortium, a San Diego-based group of franchisees unhappy with thecompany's direction, as ''eight people and a guy with a fax machine.''

Adams, a former McDonald's owner who runs the Consortium, claimsmembership of 300 but refuses to release a list, saying franchisees fear reprisals.

But other evidence indicates that unhappiness is more widespread thanGreenberg's comment suggests. In a 1997 internal survey, only 28% offranchisees said they thought McDonald's was on the right track. Thecontroversial push to put up more stores remains a flashpoint for many. Says one

former operator who claims new stores helped to put him out of business: ''RayKroc once told me, 'If you work hard, you get treated fairly.' But these guys don'tcare about the operators.''

The media also get blamed for McDonald's bad news. During a guest lecture at

Northwestern University's Medill School of Journalism last year, chiefMcDonald's spokesman Charles Ebeling lashed out at reporters. Ebelingdismissed as ''bullshit'' a story in The Wall Street Journal that prophetically

detailed the problems with Campaign 55, a complicated discount promotion.Then he called Crain's Chicago Business, a respected weekly that had run criticalstories on the company, ''a scandal sheet'' with a ''corrupt'' editor. Ebeling says

the remarks, reported in Rolling Stone magazine, were taken out of context.

''ABSOLUTELY BAFFLING.'' Indeed, after eight years in which realdomestic operating profits have actually fallen, the head of marketing forMcDonald's USA says the biggest problem with the brand is the media's view of

it. ''If there were one thing I would want to change about McDonald's,'' saysSenior Vice-President Brad A. Ball, ''it would be to correct the misconceptionsand perceptions that have become so pervasive in the last few years.''

Wall Street analysts struggling to evaluate the company's prospects say they, too,

have largely been frozen out. They say McDonald's is the only big company theyfollow in which top executives, including Quinlan, refuse to meet with them. ''It'sabsolutely baffling,'' says Howard Penney of Morgan Stanley, Dean Witter,Discover & Co., one of four analysts McDonald's identifies as knowing the most

about the corporation. ''Here we are trying to educate people about what wethink about the company, and the top management guy won't speak to us.''Quinlan says he's in touch with Wall Street.

Through it all, he and other executives maintain that the company remains strong.

Quinlan has cut his projections for future growth but still predicts a doubling ornear-doubling of earnings per share over the next five years--which analysts callfeasible, if optimistic. ''In the U.S., we've made some mistakes,'' Quinlan

acknowledges, but he says: ''Our greatest days lie ahead.''

So what's the problem? Simply put, it's hard to dismiss a lagging stock price, theend of growth in domestic profits, missed international projections, and adecade's worth of failed initiatives. This much is clear: The world's most

successful restaurant company is far from achieving its potential--and may besowing the seeds for further disappointment down the road.

It doesn't have to be that way. Imagine the possibilities: The company uses itspowerful brand to figure out a way to grow in its own backyard. The new kitchen

production system allows executives to think more broadly about high-qualitymenu additions. Domestic earnings no longer drag down international growth butadd to it. And overseas markets, upon saturation, have a model for future growth.

Of course, doing all that requires thinking about the business in fundamentally newways and refusing to be tied to the past. It wouldn't be the first time forMcDonald's. After all, consider where the Golden Arches would be now if itsfirst owners had insisted on keeping hot dogs as the centerpiece of the menu.

By David Leonhardt in Oak Brook, Ill., with bureau reports

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Updated Feb. 26, 1998 by bwwebmasterCopyright 1998, Bloomberg L.P.

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03-09-19 mcdonald's can it regain its golden touch

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