April 09, 1998

Is Mac Back?
By Jim Surowiecki (TMF Cinder)

Suddenly, everyone's bullish about McDonald's (NYSE: MCD). But if you want to find the most optimistic outlook possible on the fast-food giant, you have to go to Hollywood, where Warner Bros. just hired Robert Ball to head up its marketing efforts. Ball is the man who ran McDonald's marketing operations for the past fifteen years, and while you might think that that means Ball is responsible for the disastrous "Campaign 55," "My McDonald's," and "Did Somebody Say McDonald's" efforts, Warner Bros. apparently thinks differently. If the studio's right, and Ball has done an excellent job of building the value of the McDonald's brand, then it may not be long before the company finds itself back on track.

Certainly Wall Street is convinced that McDonald's future is bright. Investors recently bid the stock up to a new 52-week high, largely as a result of a series of brokerage house upgrades and positive comments by analysts. Given the opportunity to reel off a litany of bad puns, analysts have leaped at the chance. "Investors are starting to say, 'Supersize me,'" a Merrill Lynch analyst noted, while another added, "It appears there is a significant opportunity to become a 'McLeaner' organization." Although no one sees any dramatic improvement in McDonald's short-term earnings outlook, the company's long-term prospects look brighter to the Street than they have for more than a few years.

Given McDonald's reputation for freezing out analysts and shareholders alike, one can be forgiven for wondering if the sudden change of sentiment on the Street is partly the result of McDonald's decision to hold a long conference call with analysts in which it laid out its plans to slash costs and to improve its food-preparation system. After getting almost no attention at all from the company -- a Morgan Stanley analyst once called McDonald's neglect of analysts "absolutely baffling" -- even a mild thaw must have made the analysts feel that they were basking in the sun.

Still, the plans that McDonald's introduced in that conference call do represent a real attempt to solve three of the company's most persistent and pressing problems: high overhead, antagonistic relations with its franchisees, and -- most important -- the quality of its food. For the first time in its history, McDonald's is contemplating layoffs at its corporate headquarters, and at the very least it plans to make significant cuts in its annual $800 million selling, general & administrative (SG&A) budget for U.S. operations. Improvements in this area will, of course, go straight to the bottom line.

Simultaneously, the company announced that it will give franchisees the chance to buy new U.S. restaurants instead of leasing them, which will move McDonald's closer to getting out of the landlord business. Though the least trumpeted of the new moves, this is in many ways the most significant break with the past, and fits well with the company's oft-stated desire to become a more decentralized organization. While it will take away from the company's revenues, it could save McDonald's as much as $200 million in capital spending every year. More importantly, it will improve cash flow for the franchisees, and -- ideally -- give them a greater sense of ownership over their operations. Since McDonald's derives 85% of its U.S. sales from its franchisees, keeping them happy and dedicated is crucial, and at a time when many franchisees are concerned with the company's plans for continued expansion, the buy-instead-of-lease strategy seems like a smart one.

Finally, and of most relevance to consumers, McDonald's is going to introduce a new food-preparation system that is supposed to ensure that you'll never again eat an hour-old hamburger that's been kept warm by heat lamps. The system, which is supposed to be fully installed by the turn of the century (which is no longer that far away), will move McDonald's toward what you might call a just-in-time system, which is of course the best way to make food as well as automobiles. Using computerized projections of customer traffic, the system will help restaurants time their food preparation to match demand, while computer-run bins will let the staff know when food that's been kept warm for too long should be thrown out. It all sounds rather obvious, but if it works, it would be an important change for the company.

The incredible thing, in fact, is that McDonald's has been able to maintain a dominant position in the fast-food burger market even while the quality of its food has slid noticeably. A recent survey of fast-food chains found McDonald's rated 87th out of 91 in terms of taste. And the basic truth of Burger King's claim that its products "just taste better" is so self-evident as to hardly need stating. In that sense, the fact that McDonald's same-store sales have now fallen three years in a row is not surprising. What's surprising is that they haven't fallen further.

In part, McDonald's has been able to keep a large share of the burger market because its brand remains strong, despite the best efforts of its management to weaken it. But McDonald's has also been able to keep that share simply by outbuilding its competitors. The company built 841 U.S. restaurants in 1994, 1,130 in 1995, and 726 in 1996 before slowing last year.

Even so, McDonald's share of the fast-food market as a whole has now dropped to just 16%, while domestic sales have barely risen in the last decade and operating profits have grown more slowly than inflation. As for per-store profits, don't even ask. Adjusted for inflation, they've plummeted 40% since 1989. It's no surprise, then, that franchisees are angry. And the continued decline in same-store sales should give investors pause.

The company's ace in the hole is its plans for international expansion. McDonald's is, depending on whom you listen to, either the first or third most recognizable brand in the world, and at a time when globalization is proceeding more rapidly than ever, McDonald's should be able to leverage that brand strength into a dominance of the international market. At least that's the idea. But average same-store sales last year dropped 15%, and while McDonald's is nowhere near saturating the overseas market -- most countries where it has a presence have only a few McDonald's -- it's not exactly clear that the Golden Arches represent the future of eating either at home or abroad.

There's a good argument to be made, in fact, that McDonald's is relatively distinct from other brand giants like Coca-Cola (NYSE: KO), Gillette (NYSE: G), and Kodak (NYSE: EK), because while it's difficult to imagine a time or a place when people will stop shaving or taking pictures or even drinking sweet beverages, it's not that hard to imagine a time or a place where people will shy away from high-fat meat products and oil-soaked french fries (both of which, I should add, I love). At home, McDonald's is bucking a vague but nonetheless real trend toward healthier eating, while abroad it's constantly contesting different cultural attitudes toward food. Ideally, McDonald's brand will be strong enough to overcome these problems. But in recent years its brand management has been disturbingly unfocused and unimpressive.

None of this is meant to suggest that Kodak, for instance, is in better shape for the future than McDonald's, and all three of the aforementioned companies actually have greater problems with the threat of commoditization than McDonald's does. What it is meant to suggest, though, is that McDonald's might want to look not to these consumer product companies as its model, but rather to Walt Disney (NYSE: DIS), and to concentrate its efforts on leveraging its brand as Disney has done across the globe.

On a pure taste or food-quality basis, after all, McDonald's will probably lose to Burger King, Wendy's (NYSE: WEN), the Tricon (NYSE: YUM) restaurants, and just about everyone else as well. The changes the company is introducing are, to be sure, potentially quite valuable. But in the long run, competing on food alone isn't enough. McDonald's overwhelming strength is its brand name. Of late, it's been difficult to answer the simple question: "What does that brand name represent?" As it goes forward with its sensible plans for restructuring, McDonald's executives should make sure to spend some time answering that question, both in their own minds and in the minds of consumers all over the world.

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