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McDONALD'S

Can it regain its golden touch?

The McDonald brothers' first restaurant, founded in 1937 in a parking lot just east 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 most people ate it sitting on an outdoor stool or in their cherished new autos while being 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 some of their romance, indoor restaurants took over. When adults became bored with the 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-largest poultry seller.

The changes were vital, but never radical. McDonald's gave us what we wanted before 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 corporate icons and its most ubiquitous store. The philosophy was neatly summarized by Ray 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 goal seems less assured than ever. Forget for a moment all the recent talk about Burger 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 the famous 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 to American culture--a culture that it, as much as any modern corporation, helped to shape. Not even a still booming international division, responsible for half of sales and 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 new product was the Chicken McNugget, which launched in 1983. In the '90s, the company has careened from tests with pizza and veggie burgers to confusing discount promotions such as last year's Campaign 55. Earnings in 1997 inched up 4%, 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 almost two 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's expansion rate. The result: Domestic sales have climbed only 18% since 1989, while operating profits haven't even kept pace with inflation. They've risen just 2% 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 top consumer brand, from Disney to Marlboro, has prospered.

"MENU TWEAKING." McDonald's has chalked up that dismal record despite the fact that it owns one of the best known brands on the globe. The 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 Golden Arches--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 and Coca-Cola Co. wasn't benefiting. "McDonald's has totally failed to adapt its original concept," says Simon C. Williams, chairman of the Sterling Group, a New 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 the decentralized structure will rekindle the company's entrepreneurial flair. A new cooking 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 domestic division--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, including executives from Burger King, Boston Market, and General Electric Co. "We are not 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 will extend our line, rather than going in more radical, different directions," says Quinlan, 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 have prospered despite wrenching changes in their industries. When GE realized that manufacturing 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 its bottling business and focused instead on becoming a marketing powerhouse. The difference 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 $170 each. Instead, they bring less than $55.

FAMILY VALUES. By contrast, McDonald's core recipe has changed little since 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 to our customers?"' says Adrian J. Slywotzky, a partner at Corporate Decisions Inc., 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 working at 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 a small faction. Negative news accounts are chalked up to misperceptions by reporters. And one persistently critical Wall Street analyst--Damon Brundage, now at J.P. Morgan & Co.--was barred from the company's latest biennial briefing.

And while some companies, such as IBM and AT&T, have brought in outside leaders--albeit reluctantly--to help guide management as the business changed, McDonald's has largely clung to the "McFamily" philosophy of the 1950s and 1960s, which rewards managers who start young and stay for life. Headhunters, noting that virtually no alumni from the McDonald's Oak Brook (Ill.) headquarters can be found running other companies, say it isn't where they look for talent. "They are no longer the beacon of great success they used to be," says a Chicago-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 shareholders could 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 York consultant, 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 still believe in the brand are concerned. Davis Selected Advisers, with $500 million in McDonald's stock, has been a shareholder since 1994 on the strength of the company's international operations, but the big investor believes there needs to be changes in management and in the business. "It means not holding the past sacred," says Chris Davis, a portfolio manager. "There needs to be a sense of urgency."

Even McDonald's formidable international business faces some serious challenges. On the plus side, operating earnings have more than doubled in the past 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 beyond the bustling Londons and Moscows. As it does, margins are dropping--from 20.5% 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 for currency fluctuations. In the fourth quarter, key markets such as Germany and Japan underperformed, largely because of local economic climates and a strong dollar. Overall, says analyst Dean T. Haskell of EVEREN Securities Inc., "the international 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's hugely problematic," Slywotzky says. "If the same set of conditions duplicate themselves abroad, then you have a dead end waiting to happen."

Of course, the strength of the McDonald's brand gives it opportunities to avoid that 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, is that it needs to worry less about market share and more about new profit vehicles.

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. Consumers who 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 in which 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 we have to do some things with our menu," says Greenberg, who believes the new cooking 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 to mean fried food.

KIDS' PLEAS. Take Stephen J. Char, a 31-year-old government scientist in Denver. He has cut his trips to McDonald's in half over the past few years. "A cheeseburger and fries will kill me for the day," he says. He's found tastier options near 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 grape leaves.

Even some regulars say it's not the food that keeps them coming back. Julie Lake is 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 that she 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 visit the Arches.

All the while, McDonald's has concentrated on adding restaurants, angering store owners 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 in the wrong places," says Dick Adams, who heads up a group of concerned franchisees.

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 meals sold at delis, supermarkets, and casual dining restaurants such as Applebee's International 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-restaurant chain based in Anaheim, Calif., has opened a Mexican eatery called Green Burrito 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 decade has seen an array of test products, such as pasta, fried chicken, and fajitas. But customers have been unimpressed, and McDonald's invariably has returned to its core 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 wanted to focus on building more hamburger restaurants. "The brand expectation, at least until 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't necessarily fit people's expectations for the Golden Arches, you have a very difficult 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 is considering new ways to leverage its brand. Chipotle's fresh, inexpensive burrito wraps 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 eventually expand and franchise Chipotle, though they caution that the investment, estimated to 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 and replaced him with Greenberg, who franchisees say is easier to talk to. Five new regional 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 only one has immediate plans to do so. The majority of franchisees still report to the same person. The reorganization, charges EVEREN analyst Haskell, "is an effort to whitewash the public by trying to convince Wall Street things have changed when they really haven't." Says one investor who manages more than $30 million in 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 with underlying problems is its reaction to outside critics. Greenberg has dismissed the Consortium, a San Diego-based group of franchisees unhappy with the company's direction, as "eight people and a guy with a fax machine."

Adams, a former McDonald's owner who runs the Consortium, claims membership of 300 but refuses to release a list, saying franchisees fear reprisals. But other evidence indicates that unhappiness is more widespread than Greenberg's comment suggests. In a 1997 internal survey, only 28% of franchisees said they thought McDonald's was on the right track. The controversial 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: "Ray Kroc once told me, `If you work hard, you get treated fairly.' But these guys don't care 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, chief McDonald's spokesman Charles Ebeling lashed out at reporters. Ebeling dismissed 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 critical stories 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 real domestic operating profits have actually fallen, the head of marketing for McDonald'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," says Senior Vice-President Brad A. Ball, "it would be to correct the misconceptions and 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 they follow in which top executives, including Quinlan, refuse to meet with them. "It's absolutely 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 we think 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 or near-doubling of earnings per share over the next five years--which analysts call feasible, 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, the end of growth in domestic profits, missed international projections, and a decade's worth of failed initiatives. This much is clear: The world's most successful restaurant company is far from achieving its potential--and may be sowing the seeds for further disappointment down the road.

It doesn't have to be that way. Imagine the possibilities: The company uses its powerful 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-quality menu additions. Domestic earnings no longer drag down international growth but add 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 new ways and refusing to be tied to the past. It wouldn't be the first time for McDonald's. After all, consider where the Golden Arches would be now if its first owners had insisted on keeping hot dogs as the centerpiece of the menu.By David Leonhardt in Oak Brook, Ill., with bureau reportsReturn to top


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