While McDonald's stomps on rivals around the world, its U.S. business has plateaued. Can pizzas and teriyaki burgers save the day?

Beyond Burgers

By Bruce Upbin

WALK INTO ALMOST ANY McDonald's these days and you'll find something new: Instead of getting a sandwich that's been assembled, wrapped and parked under a heat lamp for ten minutes or more, it will be custom-assembled for you in just one minute, the bun toasted in exactly 11 seconds instead of being nuked. Want a real treat? Visit one of the stores in the Sacramento area, where the chain is testing a new gimmick called McChoice. You can order your chicken sandwich, and eventually burgers, too, with one of several new baked-in flavors including pepper-enhanced Santa Fe, barbecue and teriyaki.

McDonald's new Made-For-You marketing is a shameless ripoff of Burger King's Have-It-Your-Way promotion. But McDonald's chief executive, Jack M. Greenberg, doesn't care. Greenberg, 57, a former Ernst & Young accountant who has been chief executive of the firm for a year, is a man who knows how to read numbers.

McDonald's is a powerhouse in foreign markets, which account for half its $36 billion in systemwide sales (includes company-owned and franchised stores) and 56% of its operating profits. Overseas it is gaining huge chunks of business every week, much faster than rival Burger King (see sidebar).

But on McDonald's $18 billion home turf, the numbers Greenberg sees are not so rosy. One day--maybe not next year or in five years, but eventually--the Big Mac will flatline in the U.S. The evidence: In the past four years McDonald's has averaged only 1% annual same-store sales growth, trailing the 4% average for its main burger rivals, Burger King, Wendy's and Jack-in-the-Box.

The main reason is that McDonald's menu is stale. The last successful new product it introduced was Chicken McNuggets, in 1983. Nearly every new menu offering since then, such as the McDLT, the McLean, the Arch Deluxe and McPizza, came and went with only a burp to remember them by.

The competition is doing much better repeat business by parading out elaborate gut busters like Wendy's Bacon Mushroom Melt and Jack-in-the-Box's Bacon Bacon Cheeseburger. Wendy's promotional sandwiches aren't that different from its basic burgers, adding a slice of bacon here, some barbecue sauce there. But that's enough to seem more distinctive than the old Quarter Pounder with Cheese.

Maybe it had to happen. After 44 years as one of America's great growth companies, McDonald's is finally arriving at U.S. market saturation. This year McDonald's will add only 150 new U.S. stores, half of what Wendy's will do and down sharply from the 1,100 it opened four years ago. The mid-1990s binge angered McDonald's 2,800 franchisees, some of whom saw sales decline by as much as 20% from cannibalization.

They were further irked by the operations bosses at Oak Brook, Ill., who had issued an 80-page directive, called "Franchise 2000," that tied a lot of new onerous regulations to mandatory store reviews. Franchisee lawsuits rose, and several of them were letting Wall Street analysts know exactly how badly same-store sales were suffering at the expense of store growth.

Greenberg doesn't need to panic. The company expects to earn a healthful $2 billion this year on $13 billion in store sales and franchise fee revenue. Thanks to strength overseas, earnings should come in at $1.40 a share this year and climb to $1.60 the next.

But some smart investors have been concerned. In 1998 Warren Buffett cut 4.8 million more shares from his McDonald's stake. The reduction left him with 1.8 million shares worth $76 million. As recently as three years ago Buffett owned 60.3 million shares (adjusted for stock splits).

The slow U.S. sales growth and the virtual halt to expansion here explain why Greenberg is so eager to bring in new customers. Thus the Made-For-You pitch, which Greenberg has been rolling out nationally since late 1998, spending $162 million to put the necessary equipment in every one of the chain's 12,600 U.S. restaurants.

Thus three other key deals in the past 20 months: $10 million for a minority interest in Chipotle Mexican Grill, a popular Denver-based chain of 25 Mexican restaurants; an estimated $70 million purchase of Donatos Pizza, a 140-store chain based in Columbus, Ohio; and the estimated $15 million acquisition of Aroma, a stylish coffee-and-sandwich bar in London with 23 outlets.

Wait a minute. McDonald's flogging burritos, pizza and ham sandwiches? Fact is, McDonald's just can't afford to stick to the same old formula. "We don't accept that anymore," Greenberg says. The last thing he wants is to have McDonald's end up like Levi's. Jeans didn't go out of style, but the Levi's brand did, as competitors like Tommy Hilfiger and Diesel appealed more to hip young consumers.

Before anything else, Greenberg, a self-effacing, amiable schmoozer, has had to fix Oak Brook's formerly ugly franchisee relations, which had fallen into disrepair under predecessors Edward Rensi and Michael Quinlan. Both were McDonald's lifers known for their aloofness from the franchise set.

Greenberg threw out the Franchise 2000 rule book and has let the locals have more say in what shows up on the menu. A year ago, for example, Midwest franchisees came up with the idea for the McBrat, bratwurst being something that could do well there even if it could never succeed on the coasts. In the past an item ran nationally or not at all. The McBrat, at $1.99 with sauerkraut and onion, has been a big hit in Wisconsin and Minnesota.

Greenberg has to do more rule-breaking. Burger chains still account for 40% of all fast-food consumed, but diners' tastes are changing. "More consumers are willing to pay slightly higher prices for food that's of higher quality and stronger taste profile. McDonald's is more bland than strong," says John Weiss, a restaurant analyst at Thomas Weisel Partners.

So Greenberg has turned McDonald's into a variety show: a McLobster Roll in New England, a hot-mustard-laden Homestyle Burger in Texas and, for Ohioans, the Brutus Buckeye Burger, a stomachful with three burger patties, three cheddar slices, lettuce, tomato and onion.

What does McDonald's bring to pizza or burritos? Like a Dell Computer or a Wal-Mart, McDonald's realizes that success depends not on a superior product, but on a superior process. Says Greenberg: "Can we build [Donatos or Chipotle] into global brands? Why not? At the very least it creates more growth opportunities for all our people, franchisees, suppliers, you name it."

Founder Ray Kroc's true achievement over all those years was to knit his suppliers, employees and franchisees into the world's most efficient ecosystem for feeding people. Nothing is left to chance in a McDonald's kitchen. The 75-page operations manual Fred L. Turner drafted in 1958 has grown into a 9-pound, 732-page tome. Every hamburger comes out of a stamping machine exactly 1.6 ounces, its thickness measured to the thousandth of an inch.

By the Numbers

After 43 years of mass-produced meals, McDonald's finally lets you have it your way with its "Made-For-You" system.

9,000 of 12,600 U.S. stores are using the new custom-burger system.

30% of people always special order (e.g., hold the pickle).

1% reduction in food spoilage from Made-For-You. Pays for the $25,000 equipment in 3 years.

To cook them, a worker tosses frozen patties onto a grill with a top steel plate that lowers to exactly the burger's height. The plate lifts automatically when the burgers reach an internal temperature of exactly 155 degrees in 38 seconds. Quarter-pounders take 104 seconds to cook. One squeeze of the trigger on a plastic funnel squirts exactly a third of an ounce of ketchup and a teaspoon of mustard onto a bun.

A lot of stores now have the Arch machine, which dumps the right amount of frozen spuds into a fry basket. A human still has to pull the basket from the 335-degree oil for a quick shake after a beep sounds in 30 seconds, then submerge it again for two and a half minutes until another longer beep.

McDonald's, the world's largest owner of retail locations, also has real-estate development down to a science. Unlike all other big fast-food chains, McDonald's owns or controls under a long-term lease the vast majority of its stores and land. Its balance sheet books the land's value at $3.8 billion, but it's probably worth three times that amount. Many of the locations were acquired 20 years ago or more. Not only is that real estate a great inflation hedge, it gives the company total control over both the upkeep of stores and occupancy costs.

Once a parcel of land has been selected, McDonald's enters into its database information about that area's demographics and traffic patterns. Out pops a list of ten other locations that match among the system's 12,600 U.S. stores. The franchisee can then call the owners of those ten stores to see how many drive-through windows they have, whether they have Playplaces, how many staff to hire, and so on.

Running all of these stores are owners and managers still very much required to go to Hamburger University either in Oak Brook or one of four overseas campuses. Training at HU and in the field can last for two years before a prospective franchisee gets a store. Students not only learn the basics of how to make a Big Mac but take classes in subjects such as "Respectful Workplace," "Influence and Negotiation," and "Developing a Coaching Style."

The raw materials network, run with militaristic precision, is independently owned but entirely dedicated to the Golden Arches. Like Wal-Mart, McDonald's has regional centers that automatically dispatch preset loads of frozen patties, napkins, chicken parts and fries to stores twice a week.

Competitors like Burger King and Tricon rely on Holberg Industries' Ameriserve division for their distribution. But they must share Ameriserve with Applebees, Arby's, Chili's, Dairy Queen and 25 others. McDonald's distribution pipe thus needs to carry one-fifth of the items Ameriserve does. That allows McDonald's distributors to turn their inventory over 100 times per year, four times more often than Ameriserve.

Greenberg looks at the system Kroc and Turner built and sees it in terms of excess capacity. If it works for burgers, why try it on some new concepts? "Look, we can sit back and wait for someone else to capture feeding opportunities, or we can do it. We owe it to ourselves to see how we can apply those other concepts globally," says James Cantalupo, McDonald's vice chairman and international chief.

How will the pizza and burrito chains fit in? McDonald's has never acquired another restaurant chain intending to run it. Way back in 1962, the company's first president, Harry Sonneborn, talked Ray Kroc into buying a Chicago burger palace called Hottinger's. It had a bandstand and beer garden, not the smartest attraction, given Lake Michigan's icy winds. Kroc and his coinvestors ate $1.3 million when Hottinger's folded.

Kroc came close to buying Taco Bell, Baskin-Robbins and California pie chain Marie Callendar's in the late 1960s. Instead, he opened Jane Dobbins Pie Shops in 1968, named for his second wife, whom he divorced soon after. That promptly flopped--probably as Kroc lost interest. So did Ramon's, an upscale hamburger place Kroc opened in Chicago and Beverly Hills. Brass railings and potted plants didn't do it.

Recent diversification forays haven't fared much better. In 1995 McDonald's tinkered with a take-home meal restaurant called Hearth Express in Darien, Ill. It served meat loaf and sliced turkey much the way Boston Market was doing nationally. McDonald's quickly learned from that one restaurant what it took Boston Market 1,200 to learn: Food and labor costs involved in elaborately prepared take-out meals make for measly profits.

McDonald's tried for years to sell a McPizza in its own restaurants, without any success. Customers didn't want to wait ten minutes for a pizza when they could get a burger in 60 seconds. In most stores, the pizzas didn't fit through the drive-through windows.

By the Numbers

Now in 117 countries, with a 63% market share of fast-food sales, McDonald's is nearing Coca-Cola in global breadth.

40 million customers served worldwide daily, up from 30 million just 5 years ago.

11,300 new stores will go up outside of the U.S. by 2004, nearly doubling the present level.

30,000 more could follow before Big Mac reaches global saturation.

Becoming a multibrand restaurant operator, like Tricon Global (FORBES, Oct. 11) is an entirely unproven business model for McDonald's. That doesn't mean multibranding can't be done. Remember when Gap was relegated to has-been status in the early 1990s? From 1989 to 1995 Gap watched its same-store sales growth fall from 15% to zero as it plied the same old mid-priced khaki trade.

In 1993 Chief Executive Millard Drexler rolled the dice with Old Navy, since opening 450 big, boisterous stores filled with cheap, almost disposable clothes. Old Navy now grosses $3.5 billion. Gap's overall same-store sales growth climbed to 17% last year.

Greenberg was attracted to Donatos and Chipotle because they are proven winners run by entrepreneurs very much in the mold of Ray Kroc--driven, passionate control freaks.

James Grote started Donatos in 1963 with a single pizza parlor in Columbus, Ohio. He stuck with only one store for the first 11 years because he didn't trust anyone else to make the pizzas the way he did. "I caught one guy using Parmesan instead of provolone, and salami instead of pepperoni!" says the trim, sandy-haired 56-year-old. The errant cook was fired.

Like McDonald's, Grote takes variables out of the cooking process whenever possible. A pump to squirt out the exact amount of tomato sauce. Pizzas are assembled on a digital scale so that every 12-inch pie gets 0.35 pounds of cheese and 0.015 pounds of seasonings.

Big Mac

McDonald's share of fast food has ebbed, but it still rules in burger world.
Numbers are rounded.

Source: Technomic, Inc.

William Rose, formerly McDonald's station chief in Southeast Asia and India, has been dispatched to become the new chief executive for Donatos. His mission is to take it from a 143-store regional player to a 1,000-store national one without losing the wholesome Grote family image.

But if there's any fast-food segment more treacherous than burgers, it's the $23 billion pizza business. Annual growth has been 2% in the past five years, less than half that of fast food in general. Number three chain Little Caesars is in retreat, shutting down 380 stores in July for remodeling. Papa John's, which has opened 850 company-owned or franchised stores in the past two years, may not have the variety of Donatos, but it makes a darn good basic pie. And it has taken Papa John's 14 years to get to 2,000 stores.

Big World

The U.S. is over-Arched. McDonald's is taking nearly all of its $2 billion capital budget overseas.

Sources: McDonald's; Lehman Brothers.

Early money says there is more potential from Chipotle, which sells things like carnitas burritos, a $4.55 dish of heavily seasoned braised pork shoulder served inside warm flour tortillas with black beans, cilantro-lime rice, cheese and salsa. It appeals to exactly the kind of higher-priced, higher-quality crowd that McDonald's has been missing. McDonald's made its investment in the burrito chain nearly two years ago and one can already see the Golden Arches' effect on a concept.

McDonald's has already populated Chipotle with a chief financial officer, chief operations officer, a purchasing chief and several regional managers. The resources are flowing freely. Chipotle will grow to 100 stores by the end of next year, from 17 two years ago. By switching to Perseco, the buyer for McDonald's paper goods worldwide, Chipotle has cut its napkin and packaging costs by 20%. J.R. Simplot, which makes McDonald's french fries, has given the chain a 40% discount on corn kernels.

Chipotle founder Steve Ells, a Birkenstock-wearing 34-year-old gourmet cook, couldn't be happier with his newfound clout. Each Chipotle restaurant makes several batches of guacamole daily. Ells has always wanted the avocados at their absolute peak of ripeness.

As a nobody, he could never persuade his distributors to help him. With McDonald's behind him, he went over the distributors' heads and got a meeting with a big avocado-grower in Oxnard, Calif. Now he gets ripe avocados delivered twice weekly to the three warehouses he shares with McDonald's.

Greenberg isn't saying so, but the odds are that Chipotle will soon become a 100% owned subsidiary, like Donatos. Chipotle is opening 30 new stores this year, averaging $1.3 million in sales; Donatos will open 35, averaging $930,000.

Together these new outfits would account for 30% of McDonald's U.S. sales growth next year on a pro forma basis. That doesn't even include the additional revenue from the 23-store, wholly owned Aroma, which plans to add 50 new cafes in the next 12 months, each grossing $720,000.

In Aroma, Greenberg sees a chance to penetrate a business it has been completely missing. At $5 billion, the U.K.'s cold-sandwich market is almost double the size of the burger segment and growing twice as fast. No fears of cannibalization here: Aroma's largely single, health-conscious and female customer-base has a mere 3% overlap with the Happy Meal crowd.

Since buying Aroma in June, McDonald's has installed as its chief executive David Gerrard, a 35-year-old soft-spoken controller from its U.K. subsidiary. He's ambitious, planning on 150 stores by 2002.

And he's already fine-tuning the menu: London rival Pret A Manger was getting higher marks from lunch crowds, since its sandwiches are made fresh in the stores; Aroma's come from a central commissary. So Gerrard made his $3 roast ham sandwiches bigger and will start baking pastries for the morning crowd to make the stores as appealing to the senses as Pret's.

Will the diversification work? Ever the politician, Greenberg is quick to play down the resources being spent on burritos and pizza. Why spook the franchisee base and Wall Street into thinking that his attention is being diverted from burgers and fries?

But he needs innovations as badly as Gap needed Old Navy. Greenberg has promised earnings increases between 10% and 15% a year over the next three years. Trading at 27 times next year's earnings, the stock doesn't leave much room for stand-pat strategies.