Can McDonald's Cook Again? The great American icon ain't what it used to be.
By Grainger David

(FORTUNE Magazine) – Jim Cantalupo wants you to know that McDonald's "gets it." The new chairman and CEO of the largest restaurant chain in the world is sitting back in a leather chair in his Oak Brook, Ill., office, speaking about his plans for the company. He has touched on what he calls improved "relevancy" in the McDonald's menu and why the "new boss at McDonald's is the consumer." But on one final point Cantalupo, who has a raspy voice and a sly smile and looks a bit like Dick Cheney, wants to be very clear. He sits up straight and leans forward. "We get it," he says. "We do. McDonald's has changed before, and we will continue to change with the consumer."

Cantalupo needs to say this.

Consider the following: In January 2003, McDonald's announced its first-ever quarterly loss--$343.8 million--since becoming a public company in 1965. Revenue growth and return on capital, once robust, are in decline. Same-store sales in the U.S., which had been stagnant for about a decade, have been falling for 12 straight months. On the University of Michigan's American Customer Satisfaction Index, McDonald's--the company that once made its living on prompt, friendly service--has ranked at the bottom of the fast-food industry since 1994. It now sits below every single airline as well as the IRS. The company has lost more than $20 billion in market cap in the past year and, at a recent $14 a share, the stock is trading near a ten-year low. And the last time the McDonald's menu saw a real hit was in 1983, with the Chicken McNugget.

What those facts only hint at is something more frightening still for Cantalupo: McDonald's missteps seem to have eroded its position, at least in the U.S., as an American icon. For a number of reasons--from increased fast-food competition to a lack of innovation to poor marketing--McDonald's seems to have lost a sense of itself. "They were the Great American Meal," says Cory Hughes of Loeffler Ketchum Mountjoy, an advertising firm in Charlotte, N.C. "And they have gone from being the Great American Meal to being the leader in fast food. From a brand perspective, that is a really big drop."

Recapturing the McDonald's mission is what Cantalupo--who retired from the company in 2001 after 26 years of service and was rehired to the top spot in December 2002--is determined to do. In his short time back at work, he has shaken up the management structure at headquarters and canned a "distracting" billion-dollar technology project designed to "integrate infrastructure around the world." (His predecessor Jack Greenberg put that in motion in 1999.) To improve service, he is focusing on McDonald's atrophied system for grading the performance of its more than 13,000 U.S. restaurants, and on the menu front he is touting new products like the Grilled Chicken Flatbread and a fresh line of salads with Newman's Own dressing.

The focus is to aggressively improve the quality of McDonald's food and service. While that may not seem like a radical approach for rescuing a beleaguered fast-food chain, it is. Because to get there, Cantalupo has to set his company on a new growth course--one that essentially reverses the way it has traditionally made money. The CEO, for example, is dramatically reducing the number of new store openings worldwide. McDonald's had been opening them at a lightning rate of nearly 1,700 a year over the past decade. And he is currently in the process of closing more than 700 underperforming stores. Cantalupo also insists that the company's once-gospel 10% to 15% growth expectations are now an "unrealistic challenge," as well as a threat to its core values. As the 59-year-old chief puts it, McDonald's is changing its philosophy from "building more stores to get more customers toward getting more customers in our existing stores."

The problem with that strategy, and the thing that makes it both necessary and very risky for McDonald's, is that it is exactly what the company is not good at. Nor is it how the company became, well, McDonald's.

That is the Great Paradox of the Golden Arches. McDonald's is at once two very different companies, making money in two very different ways. First, like most fast-food businesses, McDonald's is a franchiser. It collects a royalty from its franchisees, who are independent business operators. Royalties are about 4% of sales across the industry. Second, unlike almost every other fast-food business, McDonald's also functions as a real estate company, because it owns not only the land but also the buildings in many of its franchised locations worldwide. That allows the company to collect rent (in the U.S.) equivalent to about 10% of sales, on top of the 4% royalty. In fact, you could say that McDonald's is really more of a landlord than a conventional fast-food chain.

This real estate setup is why for a very long time McDonald's chose to chase profits by locating, building, and opening more stores than anyone else in the business imagined possible. It is why Wendy's has some 6,000 stores in the U.S., and McDonald's has more than 13,000--part of their 31,000 stores worldwide, producing some $894 million in net income on 2002 revenues of $15 billion and $41 billion in systemwide sales. (Systemwide sales are total consumer sales; revenue is the portion that franchisees pay the corporation, plus sales from the company-run locations. Franchisees run 85% of McDonald's stores, and the company runs the other 15%. Got it?) As long as the returns from new stores were higher than its building costs, McDonald's profited in ways that none of its competitors could match.

Now that McDonald's ever-expanding real estate machine has run out of steam, however, its shabby in-store problems are becoming screamingly clear. Voila: the Golden Arches Paradox. In the struggle between this iconic company's promise (good food and fast, friendly service) and its profits (which derive from explosive, unbridled expansion), something inevitably had to give. (For how Wal-Mart miraculously conquers that problem, see Jerry Useem's introduction to the FORTUNE 500.)

For Cantalupo, the part that has to give--at least for now--is the company's extraordinary store expansion: McDonald's has to shut down Engine No. 1, he argues, and restart Engine No. 2 (the service and food promise on which the company was founded), all without losing more altitude. It is a risky thing to do.

"McDonald's knows infrastructure," says Janice Meyer, a restaurant analyst at Credit Suisse First Boston, who has been covering the company for more than a decade. "They are excellent at building supply lines, and they are excellent at picking locations--building stores here and overseas profitably. That system is flawless. Once they become penetrated and mature, however, and they have some competition, they are not as good at generating sales gains per store. That is Wendy's territory."

The root of the McDonald's paradox was apparent from the very beginning in the personality of its famous founder, Ray Kroc. Kroc did not invent McDonald's, or the hamburger, or franchising, but he made the company great through his obsession with the unique properties of all three. He was an operations man. From the moment he laid eyes on his first McDonald's, in 1954, he was enchanted by the efficiency of the system. Kroc visited the San Bernardino, Calif., store at lunchtime, and as the crowd gathered, the McDonald brothers' innovative assembly-line production team never missed a beat. Kroc was transfixed: "The tempo of their work picked up," he wrote later in his autobiography, Grinding It Out, "until they were bustling around like ants at a picnic."

Kroc soon took over the McDonald's franchise, and he fell in love with the company and its details. The man was a fanatic. Every pound of ground beef had to make exactly ten burgers, every pound of cheese exactly 32 slices, and every French fry had to be nine-32nds of an inch thick of sufficiently dried No. 1 Idaho russet potatoes that must be dipped once, dried, and then dipped again in oil heated to an exact temperature--as judged by a thermometer-like "potato computer." He was determined that the company would outlast him. The stories about Kroc picking up pickles, and trash, or a mop, are endless. "Work," he wrote later in his autobiography, "is the meat in the hamburger of life."

The problem with the operations-intense system that Kroc perfected, however, was this: It didn't make any money. Despite his passion for performance, Kroc rarely if ever had time for his own company's P&L. Kroc's inability to split his attention between operations and finance was his personal paradox, and it would become the company's. It is why in 1958, McDonald's had 38 restaurants and a net worth of only $24,000. It had lost $7,000 two years before. The company nearly missed payroll and was forced to borrow money from its suppliers.

What saved McDonald's then and what continues to separate it from other fast-food chains today is its real estate strategy. That was devised by Harry Sonneborn, Kroc's chief financial officer, alter ego, and right-hand man. Sonneborn figured out that if McDonald's formed a separate real estate company--Franchise Realty Corp.--it could lease property and stores from local landlords and then turn around and sublease to the franchisee.

Harry Sonneborn couldn't have cared less about hamburgers. He was a finance man, and his solution worked brilliantly: Collecting rent brought McDonald's predictable profits on stronger margins, gave pinched operators comfortable 20-year leases they could not have obtained on their own, and encouraged the kind of new-store growth that would later separate McDonald's from its peers. As long as the new stores stayed in business, McDonald's was in a position to make a good profit--from traditional royalties, plus rent calculated as a percentage of sales, plus a $7,500 security deposit on each new store (which Sonneborn then turned toward acquiring ownership of the leases)--without taking on much risk.

But to get the scheme on its feet, Sonneborn had to borrow money, and to borrow money McDonald's needed to show a higher net worth. Sonneborn hired ex-accountants from the IRS to devise a way to show that future rent payments from franchisees had a present value for the corporation and could be reported as an asset. Accounting principles at the time said nothing on the subject, but it was an aggressive move. According to John F. Love's history, McDonald's: Behind the Arches, Sonneborn's team did it in a footnote titled "Unrealized Increment From Appraisal in Valuation of Assets": The line represented $5.8 million in capitalized leases, quadrupled the company's total assets, and allowed it to report ten times the previous year's net income. "It was the greatest accounting gimmick ever devised," Sonneborn said--a trick so good, he bragged, that it turned McDonald's from a hamburger company into a real estate company.

Sonneborn's scheme allowed McDonald's to finance its explosive growth by becoming easily the most leveraged company in the fast-food race. In the five-year period starting in 1968, store openings mushroomed from 100 to 500 per year. By 1974, McDonald's had 3,000 stores, 2,000 more than second-place Burger King. In 1975, systemwide sales jumped 28% to $2.5 billion, and McDonald's reported a 32% increase in income during what for almost everyone else was a recessionary year.

It was the largest retail expansion boom in the history of the world--yet McDonald's remained the sort of feel-good family-service restaurant that could, in 1971, have its annual report illustrated by Norman Rockwell.

Rockwell might have a hard time depicting McDonald's place in the American cultural landscape today. McDonald's identifies the words "rude," "slow," "inaccurate," and "unprofessional" as the top four customer-service complaints, according to Mark Kalinowski, who covers restaurants at Salomon Smith Barney. Ouch. High employee turnover--at nearly 300% industrywide--is a huge contributor to poor service, especially for the monkey wrench it throws into training. And veteran analysts say that turnover at McDonald's tends to be higher than that of its nearest rivals. At the drive-thru, where McDonald's (and almost every other fast-food company) takes in about 60% of sales, a QSR Magazine study (short for Quick Service Restaurant, as they are known in the industry) shows McDonald's average per-order time to be 35 seconds behind Wendy's. Those seconds matter: McDonald's estimates that six seconds at the drive-thru means a 1% move in sales. For the average McDonald's franchise--with $1.6 million in annual sales--that 35 seconds translates to more than $93,000 a year.

"Speed and quality of service really are the basis of the business," says QSR editor and publisher Greg Sanders. "It's hard to overestimate how important that is."

Since January, Cantalupo's team has been figuring out how to simplify operations. In test markets McDonald's has eliminated items from the menu and reduced by 84 the number of so-called Shelf-Keeping Units in every kitchen. Extra-value meals are shrinking from 13 to eight. Instead of offering, for example, a Double Cheeseburger meal, a Quarter Pounder meal, and a two-Cheeseburger meal--all basically the same thing in different forms--McDonald's plans to tout only the Quarter Pounder. New menu boards will show more pictures and fewer words to keep ordering simple. The number of possible keypad options on registers has been reduced from 400 to 300. Newly automated drink dispensers, French-fry bins, and a hydraulic vegetable-oil-delivery system should save precious time in the kitchen.

More significant, Cantalupo has reenergized McDonald's restaurant-grading system. The company stopped grading its restaurants on a national standard in 1993 in a misguided effort to appease frustrated franchisees. It was a move straight out of Bad Leadership 101: The health of the entire system relies on constant, baby-step improvements in store performance, and while Wendy's operators were competing for "Sparkle" or the even better "Dave's Way" service classifications and a trip to the annual "Sparkle Rally," McDonald's operators were basically left to police themselves.

Now that grading--by "mystery shoppers" and new regional inspection officers--has returned, the company has a much more concrete way to identify, improve, or eliminate its underperforming restaurants. But the proof is still in the execution. McDonald's has claimed to understand its service problem before. For now, the newly calibrated system measures only the exact slope of the uphill battle Cantalupo faces.

The company does claim that overall service ratings have improved by about 2.5% in the past year. And for the month of January 2003, 45% of McDonald's restaurants nationwide hit their expected performance levels. So things are getting better, the company argues. But inconsistency is the killer. In a business where bad visits are remembered far longer than good ones, this service statistic is the most devastating: Of McDonald's 13,000 U.S. restaurants, fewer than 10% have consistently performed up to expected service levels since the beginning of the year.

McDonald's let service slip because it could afford to. Service was simply not as profitable as store growth. The conflict emerged in the late '80s, when McDonald's U.S. business first began to run out of steam, according to CSFB's Janice Meyer. The problems were magnified by fast-food saturation and new, lower-priced competition from places like Taco Bell and Pizza Hut.

Instead of focusing attention at home, however, McDonald's turned--just as it is doing today--to Jim Cantalupo. Cantalupo took over McDonald's International in 1987, and as he began to see major opportunities in Europe and Japan, McDonald's jumped at the chance to grow once again through store expansion.

In retrospect, it was a crucial period in McDonald's undoing, though not through any fault of Cantalupo's. Rather, the company suffered because he did his job so well. Whatever in-store problems existed back home were more than covered up by profits from overseas growth. McDonald's grew from 2,000 restaurants abroad in 1987 to more than 4,700 in 1994, with those stores representing 45% of worldwide operating income. FORTUNE wrote a story headlined "McDonald's Conquers the World" touting "Cantalupo's Theorem"--an equation that figured the largest possible number of McDonald's stores based on world population at somewhere around 42,000. Shortly thereafter, Warren Buffett added the company to his list of holdings at Berkshire Hathaway.

McDonald's was off Buffett's list by 1998. By then, it was clear that McDonald's ownership strategy had a dark side. McDonald's owns 52% of the property in its domestic franchises. Its nearest competitor, Yum Brands (formerly Tricon, which runs Taco Bell, Pizza Hut, and KFC), owns about 8% of the property at its 21,000 domestic stores. Internationally, McDonald's is now in 118 countries and has equity investments in about 90, or 75% of those markets. Yum is in 100 international markets but has equity invested in 15. Wendy's is in 26 international markets, with an equity stake in two.

McDonald's real estate investments magnified the company's financial exposure: When times were good, they were very, very good; when times were bad, they were horrid. And things turned quickly. McDonald's return on capital is a window into this plight. After peaking in 1999 at 17%, it slipped to 13% in 2002 as new stores returned less money. As the number of U.S. stores climbed rapidly from 1994 to 2002, same-store sales stayed put or dropped. Debt, meanwhile, was surging--from $6.2 billion in 1999 to $10 billion last year.

Overseas, the turn was particularly dramatic. The global economy suffered one crisis after another. "This would not have become a problem if everything under the sun had not gone wrong," says John Glass, an analyst at CIBC World Markets. "But it did: mad cow, the Asian financial crisis, the Russian financial crisis, Japan. McDonald's exposed themselves to the risk." That risk has only intensified in recent months as the Golden Arches have become an easy target for anti-American violence.

McDonald's already had enough problems back home. A boom in the U.S. restaurant industry, especially among hamburger chains, was reaching frenzied proportions in the mid-1990s. Several of McDonald's big competitors began looking for a way out of the low-return, high-maintenance business: General Mills unloaded casual-dining company Darden Restaurants (Olive Garden, Red Lobster) in 1995, PepsiCo spun off Tricon in 1997. Diageo would follow, ridding itself of Burger King in 2002.

McDonald's, however, continued to spend money on new stores, many of which were cannibalizing sales from existing ones. Even by 2002, capital expenditures were relatively unchanged at $1.9 billion, on plans to open 1,300 stores worldwide and 300 in the U.S.

While McDonald's still makes most of its profits from rent, the underlying assets themselves aren't exactly liquid. The book value of McDonald's U.S. property is about $4.2 billion, and it has a market value (assuming an average $590,000 per parcel) of $6.9 billion, or roughly $5.50 per share. However, "there's no easy way to monetize all that land," says Mark Kalinowski at Salomon Smith Barney. "They have not found a way to get it reflected in their market cap."

The company has tried all sorts of ideas. It flirted with the idea of setting up a McREIT but that never got off the ground. It has tried to get franchisees to take over property ownership. But the McDonald's operators are small (they own an average of four stores, compared with seven at Wendy's and 16 at Yum) and comfortably dependent. Operators receive about $150 million in annual lending from an off-balance-sheet subsidiary. And operators are feeling the pinch of shrinking sales even more than the folks in Oak Brook. Some stores could close. More are struggling.

Meanwhile, Buffett has invested in Dairy Queen. That company has a much simpler franchising structure: Its operators take nearly 100% real estate responsibility for their restaurants.

Its real estate strategy aside, McDonald's was always supposed to become something more than a burger company. In the 1970s, when a reporter asked Ray Kroc if McDonald's would still be selling hamburgers in 2000, Kroc responded, "I'm not sure what we'll be selling then, but I know we'll be selling more of it than anyone else."

What Kroc meant was that McDonald's was not organized around a particular product but an idea. That idea was crystallized in a 1974 research report Kroc commissioned to assess McDonald's growth potential through 1999, and Kroc reproduced the analysis in his autobiography: "The basis of McDonald's success," the Fourteen Research Co. wrote, "is serving low-priced value-oriented product fast and efficiently in clean and pleasant surroundings."

It is a deceptively simple concept. Today people within the company tout the Krocist notion that McDonald's was built to sell anything when they are plugging new products like salads and the Grilled Chicken Flatbread. But while it is true that McDonald's did update its products and service successfully for a long time--with blockbuster innovations such as the Big Mac ('68), the Drive-Thru ('75), breakfast ('77), Happy Meal ('79), and the Chicken McNugget ('83)--it is also true that recent attempts to evolve the business have been spectacular failures. Do the names Arch Deluxe, McPizza, and McLean Deluxe ring a bell?

You may wonder why McDonald's feels the pressure to innovate at all. Is there something wrong with the basic hamburger as a business model? One wouldn't think so, at first. Harry Balzer, who authors the Annual Report on Eating Patterns in America at the NPD group, says the hamburger remains the No. 1 food ordered in U.S. restaurants, by both men and women. Still, there is something eating into the All-Beef Patty's lead: It's called the sandwich.

Before you snicker, know this: There are now more Subway restaurants than McDonald's in the U.S. Upscale "Fast Casual" sandwich shops like Cosi and Panera Bread are the hottest part of the industry. According to Technomic, the leading food industry research firm, the "other sandwich" category (about $14 billion overall) is growing at a 12.8% clip, compared with 2.8% for the hamburger market.

And that brings us back to the question at hand--whether Jim Cantalupo gets it. He clearly grasps that McDonald's has to stop the current hemorrhaging of its business. And longtime skeptics now say his food and service improvements will help, assuming franchisees don't put up too much of a fight. But the second challenge is more formidable: What to do next? The company needs to find another engine for growth.

One thing that has worked for competitors is diversification. Wendy's has been better at the chicken-and-salads game for a while but, more important, it has diversified as a corporation. Today Wendy's pulls in 40% of its earnings from the Canadian coffee-and-doughnuts chain Tim Hortons, which it acquired in 1995.

McDonald's has developed a decent list of what it calls partner brands: Chipotle (Mexican fast casual), Boston Market (rotisserie chicken), a 30% stake in Pret a Manger (upscale prepared sandwiches), Fazoli's (Italian fast casual), and Donatos Pizzeria. Partner brands make sense to some extent because they lessen the pressure on McDonald's to be all things to all fast-food eaters. But at press time rumors were swirling that the company was putting its stakes in several chains on the block.

Part of the reason, no doubt, is that McDonald's is too big and its partners too small for them to have an impact anywhere close to, say, the 40% Wendy's gets from Tim Hortons. Collectively, McDonald's partner brands represent a little more than 1,000 stores--less than the size of McDonald's Canada. "The trouble is, even if you take a chain with 100 units and grow it to 1,000, you haven't made a dent in a company with 30,000 restaurants," points out David Aaker, author of the book Brand Leadership.

So Cantalupo will have to do a lot of everything: Improve the food, return the service to its Norman Rockwell image, speed the drive-thrus, find new fast-growing partners, and discover some way, perhaps, to unlock the surprising value of the company's real estate. That's a tough mission for any three-month-old CEO to "get." If he pulls it off, Cantalupo will be McDonald's biggest hit since the Chicken McNugget.