Tuesday, May 17, 2005

Hold the fries: McDonalds Adopts a Healthy Lifestyle

On May 11, 2005, McDonald’s CEO Jim Skinner announced 24 consecutive months of improved global sales, and plans to maintain the company’s momentum by offering healthier menu options and improved customer service. After posting its first ever quarterly loss in 2002 amid highly public criticism of its unhealthy food, McDonald’s has turned itself around. Does this signal a new trend in the global fast food industry? Is the big, fat-laden burger a thing of the past for McDonald’s? The answer is a yes … and no.
While competitors have also added healthier options to their menu, many have done the opposite of McDonald’s – adding even bigger, unhealthier options to their product mix. Carl Jr.’s hamburger chain has launched the very successful Monster Thickburger, and Burger King has seen a 20% increase in breakfast sales since introducing the Enormous Omelet breakfast sandwich this year. While hard-core fast food eaters only comprise approximately 18% of the consumer market, they represent 49% of fast food business, and this is good reason to stay in the business of providing unhealthy fast food. CKE Enterprise’s CEO Andy Puzder and Burger King’s CEO Greg Brenneman agree that they are providing what the consumers actually want – traditional fast food in the form of big, tasty and fulfilling sandwiches. Many fast food restaurants agree and are adding more fattening, higher calorie items to the menu.
Obesity and general health concerns are big news for both Americans and Europeans, yet NPD Group tracked consumer eating habits and found that hamburgers and French fries are still the top two items ordered at restaurants. Consumers are estimated to spend over $476 billion eating out in 2005, close to 5% more than in 2004. Much of this will go to hamburgers and fries, not salads.
By 2010 consumers will spend 53% of each food dollar on meals, snacks and beverages prepared away from the home, creating industry sales in excess of $577 billion. The growth stems from the small difference in overall cost between eating out and cooking, the decline in free time, and the growth in disposable income. In response, restaurants are trying to focus on their value propositions and differentiating themselves in the marketplace.
The quick-casual restaurants feature better food quality at higher price points and are already stealing business from fast food chains. Customers are willing to pay higher prices than previously assumed for quality products. Additionally, McDonald’s may have been a bit too close to its core set of customers – French fry fanatics – and lost focus on the health craze and serious obesity issues sweeping the nation. In the long run, obesity threatens the companies’ own customer base. Thus, places like McDonald’s are focusing on product innovation and adjusting menus to meet this new demand, thereby increasing average check paid and improving profitability and operating margins.
McDonald’s new products include premium coffee from Seattle’s Best coffee, fruit and walnut salad, upgraded chicken sandwiches, and deli style sandwiches. However the stores have seen an increase in sales and a CSFB survey indicates that new product news keeps customers coming back into the restaurants – but what they order when they get there is their own decision, and sales have been up across the board. Yet, the success of these new food products is still up for debate. Some of the rollouts have only been on a select basis and while the deli sandwich market could earn 17 billion annually, the cost of entry is high and U.S. test markets show that the sandwiches have cannibalized existing product sales. So what else is driving the 24 months of consecutive same store sales growth? Other operational changes. McDonald’s appears poised to create and capture a new portion of the restaurant pie – creating one stop shopping for both the “burger and fries” and “calorie sensitive” crowds.
In Europe, McDonald’s is moving to a bridge operating platform, remodeling stores, testing value menus in Germany, and offering breakfast foods in the UK. However this market hasn’t escaped the health concerns, especially around the lunch food market for children in the UK, and new menu options are still the main hope for future sales. In the U.S. market, operational changes include a doubling of 24-hour restaurants from 2500 to 5000 within the next year, and another 2000 restaurants being remodeled on top of the 2000 remodeled in 2004. Additionally, the increases in credit card payment capability and gift card purchases have provided stable growth. The theme of “better not bigger” has led to 24 consecutive months of same store sales growth and big plans to return cash to shareholders (there is more than 1.4 billion in cash on McDonald’s balance sheet). This strategy has helped re-focus the firm on expanding its core services instead of growth through new units. McDonald’s is moving from a commoditized burger-oriented business to a more value-added, sandwich-focused business.
The most recent analyst reports are favorable, predicting a growth of $3-8 per share over the course of the next 12-18 months. AG Edwards believes McDonald’s will trade towards the high end of its peer group based on solid fundamentals, global brand power, international infrastructure, and meaningful cash flow generation. The ever-present risks in the food industry include intense competition, volatile food/labor costs, and the impact of overall consumer spending on sales. Indeed, as a CSFB analyst report states, competitors are starting to take notice, and as McDonald’s achieves success it has become more important for other industry peers to differentiate themselves.
The restaurant industry is changing for the better and analysts are hopeful that the changes will reap financial rewards. However their predictions rely solely on customer response and average check paid. Yet other players in McDonald’s value net also significantly affect profit and operating margins.
· The Substitutors – Developing the new food strategy creates a win-win strategy amongst the competition. The former price discounting strategy in the industry was a lose-lose scenario. The S&P Industry Survey finds that the move from price discounting to product innovation has “significantly benefited overall industry profitability.” By changing the values, McDonald’s has begun to change the way the fast food game is played.
· The Suppliers – Food costs are one of the largest input costs for restaurants and can significantly affect profitability. While McDonald’s has traditionally held the bargaining-power over suppliers, with new products that rely on freshness and quality, they need to tread carefully. Additionally, the forward pricing options for traditional foods may not be possible for fruits and vegetables. Still, other external factors remain - unpredictable weather cycles, geographical location, or outbreaks of mad cow or bird flu, can severely impact the availability of new product raw materials, and ultimately add cost to the franchisee and to the end user.
· The Complementors – Franchisees and labor relations are also important to a successful transition to new products. Between 70 and 80 percent of McDonald’s locations are franchised – product consistency is key. Involving franchisees in the decision making process for new products will be valuable. Wages, often at the lowest end of the national pay scale, are generally the largest single expense at restaurants. To deliver this new high quality food product requires dependable, committed employees. Turnover has been low due to the high unemployment rate, but as the economy improves McDonald’s needs to stay on top of labor relations.
McDonald’s new initiatives will run through part of next year but beyond that, there is little on the horizon. There are many operational risks that need to be addressed before this consumer buys into this new revitalization plan. But the opportunity for success is just as possible. If McDonald’s manages to retain the typical burger and fries crowd along with attracting the salad and yogurt crowd, they will have created a recipe for success that may last for the next fifty years.
Questions regarding this blog can be directed to Vicki Ledajaks (vledajak@chicagogsb.edu), Deanna Markley (dmarkley@chicagogsb.edu) or Julia Zupko (Julia.wit@chicagogsb.edu).

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