FALLEN ARCHES

By Bill Saporito

McDonald's serves jillions of Happy Meals each year, but not many are being shared around the company's pleasant headquarters in a Chicago suburb these days. "There's no question we've been under more stress than we're used to," says McDonald's USA chairman Jack Greenberg, who runs the company's 12,100 domestic restaurants.

Top management is unhappy because sales in U.S. stores have been flat as a frozen beef patty in the past two years and profit margins are eroding. Some of the 2,750 franchisees are unhappy--some downright testy--because rapid store expansion has cannibalized sales and the company's advertising and promotion, although ubiquitous, have been ineffectual. Most recent case: a deep-discount program called Campaign 55 (the company was founded in 1955), which hasn't been a rousing success.

And the customers? Funny thing: the customers are still reasonably happy--22 million of them show up every day--and they'll gladly take a bargain where they can get one. But McDonald's biggest problem is that customers are, increasingly, just as happy to go elsewhere for their junk-food fix: to Burger King for arguably better burgers, to Wendy's for better variety, to Starbucks and Einstein Bros. for better coffee and bagels in the morning, and to Boston Market or any number of gussied-up supermarkets for dinner. Says Greenberg: "I really believe our restaurants are running better today than we were six years ago; but I think our competition is also running a lot better today than they were six years ago."

McDonald's is still the king of convenience--nobody runs a better fast-food operation than Mickey D--but it has become vulnerable, outflanked on such factors as price and taste. It's having a hard time playing ketchup. Campaign 55 was designed to address pricing, and last year's Arch Deluxe introduction the food issue; neither has gone according to plan.

Take prices. For the past 18 months, the company has been raising some prices selectively, and consumers have begun to stray. "Comp sales," an internal company statistic that tracks performance in existing stores, turned negative for six consecutive quarters through the third quarter of 1996, an unheard-of reversal for a company that lives on growth. Greenberg had to improve McDonald's value equation fast. "The question is, What do you do about that? Lower prices a couple of cents on everything, or go on TV and talk about 55[cent] meals?" He called the media department and got out the price ax.

Campaign 55, which started in April, has a seemingly simple premise: Customers can buy a Big Mac or other designated sandwich for 55[cents] if they also buy any size beverage and fries. "My Size" meal is the tag line. Patrons, the theory goes, love the cheap burgers. Owners pocket profits on the soda and fries. The plan proved less than simple, particularly when details appeared in the Wall Street Journal before franchisees approved it. Fears of an all-out industry price war sent the stock spinning, and some franchisees, already struggling against rising wages, worried openly about the cost. "From a sales point of view, it's not what a lot of operators expected," explains J.M. Owens, who operates eight stores in the Atlanta suburbs. Owens voted against the plan, but he believes that over the long haul, its value message will work.

Customers have had a tough time figuring out whether the deal, which has at least nine permutations, is a good one. A My Size meal generally costs 50[cents] to $1 less than one purchased a la carte, or 10[cents] to 30[cents] less than an Extra Value meal. Got it? Customers seem reluctant to perform this sort of cash-register calculus. Salomon Brothers estimates that same-store sales fell 4% in May. McDonald's is equipping stores with explanatory signs and promising that consumers will catch on. A reported $66 million in advertising may help.

Campaign 55 does not account for taste, which has become a more complicated issue. The older boomers get, the more they worry about food quality. "McDonald's got obsoleted on their food," says Malcolm M. Knapp, a food-industry consultant based in Manhattan. "For a long time, it was good enough to be consistent and clean. Now America wants taste." That was the idea behind the Arch Deluxe, which the company unveiled last year after extensive testing, promoting the product as a burger for grownups. It bombed. Arch Deluxe failed to deliver on the taste front. Says franchisee LuAnn Perez, one of the company's harshest critics: "We were going to make a sign that said, 'It's the food, stupid,' and send it to the board." Janice Meyer, who covers McDonald's at Donaldson Lufkin & Jenrette, notes, "Arch Deluxe was not really a higher-quality product."

Having added hundreds of stores year after year, McDonald's is finding the specter of reaching market saturation very real. Fortunately, overseas sales are robust and last year kicked in 59% of the company's $2.6 billion in operating income. But in the U.S. the $103 billion-a-year fast-food industry is slowing down, and McDonald's, far and away the leader, is feeling the loss of momentum hardest. Its stock has been a notable laggard, returning a paltry 1.2% to investors last year.

The company's systemwide sales in the U.S. (which includes corporate-owned stores, franchises and partnerships) advanced just 3% last year, to $16.4 billion. Even that was only because the company added 726 stores, giving it 12,100 nationwide. But sales in stores open a year declined by a like amount last year.

It's crowded out there. Operators of quick-service restaurants (QSRS, in the industry lingo) have been expanding the number of taco stands, pizza parlors and burger joints 6% to 7% annually. Compare that with the increase in available mouths, 1% annually, and the equation becomes clearer: the only way to grow business is to bite off a piece of the other guy's sales.

That's what the competition has been doing. Pesky outfits such as Wendy's and Carl's Jr. have been nicking pieces from the hide of the Golden Arches. Its share of the $39 billion hamburger market has fallen to 41.9%, from 42.3%, in 1996. Doesn't sound like much, but founder Ray Kroc was famous for noting that a company that isn't growing is dying.

The pressure led to a shake-up last October, when McDonald's CEO and chairman Michael Quinlan brought in Greenberg. He carries an unlikely pedigree--he was an attorney and accountant at Arthur Young who moved over to his client, McDonald's, as chief financial officer in 1982. He spent lots of time building the financial structures needed for the company's overseas development, but has little experience in burger warfare. That's part of his charm. "I don't feel defensive," he says. "I'm the new guy on the job."

The new guy has spent much of his time with the franchisees, "two-thirds listening, one-third talking," which means he's been hearing criticism about too many locations, too many lame commercials, too many promotions--or was that not enough promotions? He is also taking action. The company recently canceled a plan to guarantee service in 55 seconds, an extension of Campaign 55, when franchisees objected.

In a group of 2,750 entrepreneurs (who run 84% of the stores), a couple of hundred figure to be unhappy at any given time. A tougher environment always increases the background noise. But there is also some real shouting going on by a number of dissidents in a group called the consortium, organized by Dick Adams, a former Mac franchisee and executive.

The dissidents are most vocal about a corporate-expansion strategy that they claim has flooded some markets with stores. "I can put up with a Burger King but not with another McDonald's down the road," says Bob Srygley, a consortium member based in Monticello, Ark. Complains LuAnn Perez, whose store on Route 50 in Cameron Park, Calif., is flanked by others: "Business was great until four other McDonald's were built between Sacramento and us." She and her husband are suing the company over the sale of their business.

McDonald's store owners have always paid a steep price for access to burger riches: they can operate no other businesses, they have no exclusive territories, and they generally take orders from headquarters in Oak Brook, Ill. Franchisees own nothing other than a 20-year agreement, renewable at the company's option, to equip and run a restaurant in return for 12.5% off the top in royalty and rent. (The rates can be higher for some sites.) They spend a minimum of 4% of sales for marketing. Last year McDonald's got $1.8 billion from its U.S. franchisees.

When McDonald's was rolling its sesame-seeded success across virgin country, obtaining a franchise was a ticket to a fast-food fortune. Says a winner in Georgia, who insisted on anonymity: "You see a lot of affluence, and you think it's waiting for you when you grab the keys." But as competition stiffened, a set of Golden Arches has become less golden and more arch. The average franchisee owns 3.4 stores, each of which generates about $1.5 million in sales. With profits falling, though, the resale value of a store is half that of three years ago, according to the consortium's Adams.

The expansion push illustrates the company's dilemma: McDonald's needs more stores to dominate trading areas, increasing the chances that a hungry consumer will head for the Arches. But the more stores that go up, the harsher the economics becomes. The company had to develop a program to compensate store owners for encroaching locations. "We've made some mistakes in our desire to create a leadership tradition in particular trading areas," says Greenberg. The company has scaled back its expansion plans. But he is not apologizing: "We have an enormous lead in convenience, and we are not going to cede it."

From a managing standpoint, McDonald's is making a difficult transition. This is a company that is used to crushing the competition. Now, its markets mature, it is finding every sales dollar harder to come by. Greenberg is reportedly planning a restructuring that would embrace this reality and make the corporate side more responsive to the folks who sell the hamburgers. And Campaign 55 is just the first volley in what will be a long war. McDonald's does have some advantages, Greenberg points out, not least of which is one of the most powerful brands in the world. "It's worth remembering that we've got this fabulous thing going," he says. Indeed. He's simply got to get it going a little faster.

--With reporting by Greg Fulton/Atlanta, James L. Graff/Chicago, Nancy Harbert/Albuquerque and Valerie Marchant/New York

With reporting by GREG FULTON/ATLANTA, JAMES L. GRAFF/CHICAGO, NANCY HARBERT/ALBUQUERQUE AND VALERIE MARCHANT/NEW YORK