Carnegie Consulting Strategic Solutions for Business

Improving Customer Satisfaction and Preserving the McDonald’s Brand

Prepared for:

! Table of Contents

Executive Summary ...... 3

Company History...... 3

Internal Rivalry...... 3

Substitutes and Complements ...... 5

Entry ...... 6

Buyer and Supplier Power ...... 7

Strengths, Weaknesses, Opportunities and Threats ...... 9

Financial Outlook...... 13

Strategic Analysis: Improving Store Performance ...... 14

Conclusion...... 17

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -2- Executive Summary

Competition for fast food customers is fierce. For the purposes of this report, we discuss the fast food industry, focusing on the Southern California region. The Southern California region was selected specifically for two reasons: First, Southern California often acts as a bellwether for food trends nationwide. Second, inter-brand competition is especially intense in Southern California because of the variety and high concentration of restaurants. Because of this structure, internal rivalry among fast food establishments has a tremendous effect on restaurant profitability. Similarly, substitute goods are plentiful and growing in popularity, and therefore represent a threat to current and future earnings. Entry does exist; however it is usually limited to the local level, decreasing its power. Both buyer power and supplier power are low in the fast food industry. Our analysis of the fast food industry can be summarized in the following chart:

Summary of Five-Forces Analysis of the Fast Food Market

Force Threat to Profits

Internal Rivalry High Entry Low to Medium Substitutes and Complements Medium Supplier Power Low Buyer Power Low

Improving QSC and offering competitive prices are necessary steps for McDonald’s customer retention and brand reputation. Carnegie Consulting therefore recommends that McDonald’s pare down its menu size in an effort to improve quality, lower labor costs, and reduce wait time. Further, we encourage McDonald’s to consider devolving some menu decision power to local restaurants in an effort to create efficiency gains and maximize profits using local area knowledge. McDonald’s corporate management has taken some important and meaningful steps towards improving QSC at McDonald’s restaurants, but we believe corporate management has not properly evaluated the long-term effect of underperforming restaurants. We therefore urge that stronger action be taken to monitor franchises and enforce McDonald’s QSC standards. Company History

Richard and Maurice McDonald opened the first McDonald’s restaurant in 1948 in Southern California. Ray Kroc, the founder of the McDonald’s Corporation opened his first McDonald’s in Des Plaines, Illinois in 1955. In the 1950s franchising consisted mostly of assigning geographic territories in exchange for fees. Kroc believed that the idea of geographic monopolies with multiple outlets operated by a single owner undermined the control McDonald’s could exert over franchisers. Rather, he assigned only one franchise at a time, thus ensuring consistency in each store’s output. By 1956 there were 12 McDonald’s Restaurants, and by 1960 there were 228.

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -3- Ronald McDonald was created in 1963. A testament to McDonald’s amazing marketing power, Ronald McDonald is now the second most recognizable character in the world (after Santa Clausi). Other famous creations include the Big Mac in 1968, the popular Egg McMuffin in 1973, and the Happy Meal in 1979.

In 1965 McDonald’s stock went public and it was added to the S&P 500 in 1985. Since its initial offering the stock has split 12 times (most recently in 1999). 100 shares in 1965 would have cost $2250, but by now would have grown to 75,000 shares worth $2.8 million. McDonald’s reigns supreme as the largest food-service retailer in the worldii. 1970 marked the first international expansion of McDonald’s (into Costa Rica). Since then 3500 restaurants have been added in Japan and 164 in Africa. Restaurants were opened in Russia and China in 1990. By 2000, McDonald’s was present in 118 countriesiii.

Currently, 80% of McDonald’s restaurants are franchises, with licenses costing around $45,000 per outletiv. In 2000, income from franchising fees totaled to $63.7 million. Beginning in 1956 McDonald’s also began to purchase real estate, which it leases to franchisees. Today McDonald’s owns the land at approximately 40% of its restaurants. This has had the duel effect of increasing both McDonald’s wealth and its control over its franchisees.

Despite its previous rapid growth and innovative product development, today some analysts view the future of McDonald’s with an increasingly skeptical eye. Lately the company has been affected by many adverse developments. A mad cow disease outbreak in Japan dramatically slowed sales in all of Asia. Though the company believes it will recover, significant resources must be expended to reassure customers of McDonald’s beef safety. Also abroad, implacable political and ideological resistance to McDonald’s presence remains strong in many countries, and the resulting bad publicity is a real threat to brand image both domestically and abroad. Domestically, low customer satisfaction ratings have been the focus of management’s efforts, and it is still unknown whether management’s plans will be sufficient to reverse the loss of customers. Labor issues have been plaguing many McDonald’s (and other fast food establishments) as well. A booming economy has made low-cost labor scarce, and this puts upward wage pressure on McDonald franchises. Trends away from unhealthy food are also adversely affecting McDonald’s, although it is unclear whether this represents a permanent shift away from fast food. Further, because many demand characteristics vary by geographic region, McDonald’s has had difficulty directing local marketing campaigns effectively.

Overall, McDonald’s has had a storied history, and has overcome numerous problems equally as vexing as those it encounters today. But today’s problems are real, and they are serious. Carnegie Consulting believes that through the implementation of the plan we present in this report, McDonald’s will be able to recover its market share and delight its customers well into the future. Internal Rivalry

McDonald’s competes in the fast food market. The product in this market is food; either a meal or a snack, individual or family-size. McDonald’s Standard Industrial Classification

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -3- (SIC) number is 5812-10. Competitors are other restaurants selling quick, made-to-order food, including but not limited to burgers, fries, pizza, fried chicken, sandwiches and tacos. National rival food chains can be grouped in the following categories:

a) Burgers: McDonald’s, Burger King, Wendy’s, Jack in the Box, Carl’s Jr. / Hardee’s b) Pizza: Round Table, Domino’s, Little Caesar, Papa John’s, Pizza Hut c) Chicken: Kentucky Fried Chicken, Popeye’s Fried Chicken d) Mexican Food: Taco Bell e) Healthier Alternatives: Quiznos, Subway, f) Regional brands: Baja Fresh, In-N-Out, Del Taco g) Local establishments: Any non-national rival restaurant.

This report which is prepared for corporate McDonald’s will focus on the first five of these categories. Store or regional managers should deal with competition from local establishments.

McDonald’s has 34.7 percent market share in the U.S. hamburger/sandwich chain market, and 43.0 percent in the U.S. fast food hamburger chain market.v Under the first market definition, close rivals are Burger King with 15.8 percent, Taco Bell with 9.6 percent, Wendy’s International with 9.5 percent, and Subway with 5.9 percent.vi We calculate the HH-Index as 1,722 for the hamburger/sandwich chain market.vii This is the “numbers-equivalent” of approximately six firms of equal size. Participants in this market engage in intense product and price competition. Marketing efforts emphasize product and price simultaneously (e.g., “$1.99 flame-broiled Whopper”). Historically, competition has been so fierce that each fast food restaurant is forced to offer at least one hamburger selling for less than $1.

Not surprisingly, there has been no history of cooperative pricing. Raising prices tends just to encourage greater marketing efforts emphasizing low prices at other chains. Prices at corporate chains cannot be adjusted quickly or unobservably – but prices can be adjusted faster in chains with franchise-models. It is difficult for firms to retain brand loyalty because customer switching costs are low. It is not difficult for an unhappy customer to frequent a different restaurant chain. Customer loyalty is weakest in the burger group of the fast-food market because products are relatively undifferentiated. There is the highest degree of product differentiation between the non-healthy and healthy groups.

Because the industry is moderately capital intensive but does require location-specific knowledge, most fast food chains are franchisee operated. Franchising also helps overcome serious agency problems that would exist if McDonalds owned and operated its own retail outlets. The franchisee pays McDonald’s a fee that is usually a percentage of monthly sales revenue; in this way McDonald’s shares risk with franchise owners, since the fee is low if sales are poor and increases when sales grow. In exchange, the franchiser provides raw materials, brand reputation, advertising, training, guidelines and other forms of assistance.

Growth in the industry has been aided by shifting consumer-dining habits. An increasing number of households have either two working adults or a single working head of household, and this means less time to prepare meals. That plus rising incomes means more and more Americans are eating outside the home and on the road.

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -4- Firms in the mature fast food restaurant industry has been diversifying in order to offer a greater variety of choices for customers. In this mature industry, restaurant operators have chosen to grow by acquisition rather than internal development, and this has lead to consolidation. For example, the Hardee’s chain, popular along the East Coast, was acquired by Carl’s Jr. as part of its Eastward expansion. Robust expansion in the industry, accelerated by the popularity of co-branded units in airports, stadiums, entertainment parks, hardware stores, and other locations, has also increased capacity. However, continued growth and store openings have hurt some franchisees that have experienced cannibalization of sales. Substitutes and Complements

Substitutes

Substitutes to the fast food industry include sit-down restaurants, convenience stores, specialty-food retailers and cooking at home.

Major Chains: a) sit-down restaurants: Applebee’s, Olive Garden, TGI Friday’s, Denny’s, Chili’s b) convenience stores: 7-11, AM/PM, Circle K, gas station marts c) specialty-food retailers: Starbuck’s Coffee, Dunkin Donuts

Consumers have many options to choose from when dining. The food products available at convenience stores offer the closest substitute and the most significant threat. Many convenience stores offer sandwiches, burgers and hot dogs at prices often below those of fast food establishments. The fast food customer is generally looking for convenience and value; although convenience stores lack drive-thru service, they do provide inexpensive and quick meals and snacks. Convenience stores cater to the late-night customer and are even more attractive to someone with limited time when they are paired with gas stations.

Specialty-food retailers are relatively good substitutes for the snack portion of the fast food business, but these establishments rarely offer meals. Patrons of espresso shops are generally looking for higher quality and do not mind the higher prices. The good is often more than just a cup of coffee – the purchase price includes atmosphere and a place to socialize with friends.

Sit-down restaurants are not a very close substitute to fast food. Again, the restaurant product bundles service and ambiance with the food product – the fast food consumer usually does not want to spend the time and money necessary for these additional amenities. For customers who choose to dine in the fast food restaurant, however, these sit-down restaurants offer a reasonable product substitute.

Cooking at home is a viable alternative to fast food for consumers who spend a good portion of their time at home. The majority of fast food purchases, however, are made on the go when returning home to make a meal would be inefficient. In general, there has been a growing trend toward eating outside the home; thus, many households lack the food, time, and tools which would make cooking at-home a convenient alternative.

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -5- Complements

Complements to the fast food industry include businesses that are partnered with fast food restaurants. Examples include gas stations, discount retailers, airports, mall retailers and sports stadiums. On a long road-trip, most people would prefer making only one stop for gas and food rather than two. Hence, the appeal of a combination McDonald’s / gas station is strong. Customers at a discount retailer appreciate low prices and they are able to pick up dinner while they run an errand after work. Airports, malls and sports stadiums all produce a collection of captive consumers for the fast food industry. McDonald’s, for example, has locations attached to Chevron gas stations and locations within Wal-Mart stores, Home Depot stores, Disneyland, and in malls and airports. Entry

Barriers to entry to become a national fast food chain are substantial; entrants must spend large amounts on marketing to increase awareness and establish brand recognition. An entrant would have to expend considerable resources to match existing marketing campaigns. However, considering the stiff price competition and low customer loyalty in the industry, advertising expenses are probably less of a barrier to entry in the fast food industry than in many other consumer industries. At the local level, some barriers to entry may exist because fast food restaurants, in particular, depend on having a good location. The main criteria for choosing a location are customer traffic levels and convenienceviii and incumbents may have an advantage if they are already located in a desirable spot. In general, the local barriers to entry in the fast food industry are low, as fast food restaurants have relatively low fixed cost start-up expenses

There are two facets of entry into the quick-serve, fast food market: either entry by existing, national fast food chains into new locations or by smaller, regional and local quick-serve restaurants. The fast food market is an intensely competitive market and entry increases competition, which reduces companies’ margins and restricts growth.

Entry by large chains generally takes one of two forms. One type of entry is geographical entry – that is, the firm may be diversifying geographically. For instance, Carl’s Jr. is located primarily in California and the Southwest. Recently, however, it has been growing and entering new markets, as newly acquired Hardee’s restaurants are outfitted with the Carl’s Jr.’s menu items and its trademark star. Also, there is room for many existing firms to open new locations in markets where they already compete. If McDonald’s is used as a baseline for when one chain has saturated a market, it becomes evident that other large fast food chains can have significant growth in units without cannibalizing existing locations (assuming that fast food customers are loyal to just one type of restaurant).

Chain U.S. Units at End of 2001 McDonald’s 13,099 Subway 12,254 Burger King 8,064 Pizza Hut 7,927 Taco Bell 6,746 Wendy’s 5,455

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -6- KFC 5,364 Dairy Queen 5,058 Domino’s Pizza 4,818 Arby’s 3,153 Sonic Drive-In 2,175 Jack-in-the-Box 1,634 Source: Standard & Poor’s Industry Survey: Restaurants, March 7, 2002.

Large firms can also pursue another type of entry. Since convenience is essential to the fast food industry, many firms are opening new restaurants in areas not traditionally associated with fast food. Fast food can increasingly be found in countless locations outside of the traditional units, from retailers such as Home Depot and Wal-Mart to food courts in shopping malls.ix

The other important type of entry is by smaller, regional or local quick-serve restaurants. These firms make up a significant portion of the restaurant industry as a whole. Including both full service and quick serve restaurants, 43.9% of the entire market or $113.2 billion in annual sales, comes from small chains or independents.x Furthermore, small operators run nearly seven out of every 10 restaurants.xi Though these numbers are for the industry as a whole, it seems reasonable to assume that the small restaurant operator is an influential player in just the quick-serve market. Examples of these types of firms would be a neighborhood deli or a small hole-in-the-wall ethnic restaurant offering low prices and quick service coupled with a relatively plain décor. The barriers to entry that exist for a smaller quick serve restaurant are relatively low. The fixed costs associated with starting up are likely lower for a small independent company than for a large national chain as the investment required to create a uniform dining experience across all units does not exist. Moreover, a smaller firm may enjoy advantages in training and employee loyalty that would reduce their operating costs. As annual labor turnover in the fast food industry as a whole is about 96%, employee training and length of employment are important for quick serve restaurantsxii.

However, even though barriers to entry in local markets are low in the fast food industry, entry by smaller firms is not necessarily as important an issue for large chains as is competition between those firms. This is due to two factors. First, small restaurants are a local problem. The success of local chains or restaurants affects each region independently. Therefore, it is local competition that concerns franchise owners and regional managers. Also, it is more difficult for large firms to compete directly against smaller firms with advertising and price promotions. Thus, Wendy’s is a larger threat to McDonald’s than the local burrito stand. Wendy’s market share in the quick-serve sandwich sector rose to 10.2% in 2000 from 9.6% in 1998. During the same period, McDonald’s share fell to 34.4% from 35.0%.xiii While entry by local restaurants is a concern for large firms, entry and competition with other large firms represents a greater threat to the large firms’ bottom line. Buyer and Supplier Power

Supplier Power

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -7- Supplier power is a measure of the power of suppliers to extract economic rents from the fast food industry. Suppliers to the fast food industry include food suppliers, labor, and equipment suppliers. The most common food inputs to the industry are soda, beef, potatoes, dairy products and vegetables. Many food suppliers have commonly-known brand-names, such as Kraft, Coca-cola, Pepsi, Tyson Foods and Carnation – fast food chains try to gain or enforce a reputation for quality by using popular brand inputs. Once a fast food chain has established a relationship with a brand-name supplier (e.g. McDonald’s always serves Coke), the supplier gains some power because repeat customers expect these products. More importantly, however, the supplier is dependent upon the fast food industry because it comprises a large percentage of its sales. Suppliers’ potential power is also weakened because they want their brand name associated with major fast food chains. This gives corporate McDonald’s tremendous power over its franchisees. Additionally, McDonald’s tremendous size gives it leverage over all their input suppliers.

The meatpacking industry is typical example of McDonald’s power. The fast-food/ meatpacking alliance has led to a consolidation of the meatpacking industry. In 1968, for example, McDonald’s bought from 175 local beef suppliers; today they buy from five.xiv During that same period, a rancher’s share of the retail beef dollar fell from 63 cents to 46 cents.xv Even with substantial concentration of the industry, the beef producers retain low supplier power. This trend may be reversing, however, as beef slaughter in the United States has decreased rapidly. In 1996 7.3 million cows were slaughtered, while this year only 5 million are expected to be slaughteredxvi. Thus, McDonald’s has recently been forced to turn to foreign beef markets to ensure supply. This could be problematic for two reasons: First, it may result in an increase in supplier power. Second, with mad cow disease fears McDonald’s will have to be test its meat and convince customers of its safety.

Food suppliers have some supplier power because of the possible threat of forward integration, carried out already, for example, by PepsiCo’s previous ownership of Pizza Hut and Taco Bell. Although there are no available substitute inputs for food, supplier power is doubtless limited by the large number of potential suppliers and the homogeneity of their products.

Because fast food chains have such vast purchasing power (or conversely because supplier power is so low) they are often able to encourage major changes in how food inputs are produced. When McDonald’s wanted to begin producing chicken nuggets in the 1980’s, Tyson had its contract growers switch to big breasted birds.xvii

Labor and equipment inputs are of secondary importance to the fast food industry. Equipment inputs include food preparation and order-processing equipment (e.g. cash registers, computers). Because these are only purchased every few years and the fast food industry is the major buyer of these products, equipment supplier power is fairly low. The primary labor pool for fast food/restaurant services are non-unionized , part-time people age 16 – 24.xviii Without years of experience and education, these workers do not have many employment alternatives. The restaurant industry is also increasingly using automation to increase productivity and decrease their dependence on labor.

Buyer Power

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -8- Buyer power measures the power of those who buy products from the fast-food industry. Buyers in the fast food industry have little buyer power. Because buyers are individuals and families, the purchasing volume of any individual buyer is very low. Buyers are not concentrated – the fast food market serves the majority of the US population. However, because of many available substitutes to fast food, buyers possess some power. Alternatives such as cooking at home or going to a sit-down restaurant, however, lack the convenience and quickness of fast food – anyone looking for a prepared meal on the go will be a captive consumer for the industry.

Individual franchisees similarly have little buyer power over corporate McDonald’s. McDonald’s calls the shots when drawing up the terms of franchise contracts. Strengths, Weaknesses, Opportunities and Threats

Strengths

Brand Recognition and Customer Base

McDonald’s is one of the world’s most recognized brands. It is the largest restaurant chain in the United States:

Restaurant Name Number of Units Total US Sales McDonald’s Restaurants 12,804 $19.572 billion Subway 12,253 $3.800 billion Burger King 8,326 $8.542 billion Pizza Hut 7,927 $5.000 billion Taco Bell 6,746 $5.100 billion Wendy’s 5,095 $5.757 billion Note: These are the numbers of “McDonald’s” stores. These do not include sub-brands, such as Chipotle Grill. Source: Technomic Information Services “Top 100 Chain Restaurant Companies.” 2000.

It’s continual community rebuilding efforts, such as the Ronald McDonald House, have established it as a philanthropic organization with strong community ties. Additional brand strength is built through the Ronald McDonald characters and menu items such as the Happy Meal and Big Mac. On top of this, McDonald’s benefits from years of successful relationships with its many franchisees, many of who operate several McDonald’s stores.

Franchise System

McDonald’s was the first to capitalize on the franchise system. Nearly 85% of McDonald’s restaurants are franchised, and each restaurant earns a higher per-store income than do any McDonald’s competitorsxix. Thus, investors have an incentive to perform well and open multiple stores, and there always remains an incentive for entrepreneurs to help expand the company’s location base with relatively low risk for McDonald’s Corporation.

International First Mover Advantage

By aggressively pursued international opportunities McDonald’s has secured an early foothold in many countries and has begun building the goodwill and community bonds it

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -9- enjoys domestically. These may become invaluable as competition from other restaurant chains increases.

As previously noted, people in some parts of the world have been resistant to McDonald’s, viewing it as a symbol of American hegemonic culturexx. McDonald’s CEO Jack Greenberg believes that angry allegations should not be taken too seriously. Because McDonald’s works inside regional economies (e.g. with local farmers and marketing agencies), Greenberg believes that anger at McDonald’s is misplaced and not particularly widespread. He states that McDonald’s is “an amalgamation of local businesses owned by local entrepreneurs.”xxi Further, Greenberg believes that McDonald’s strengthens local culture and does not erode it.xxii Thus, misplaced anger at McDonald’s will likely subside in the upcoming years.

Weaknesses

Customer Loyalty and Customer Satisfaction

Fast-food is a fickle industry. Consumer switching costs among fast-food restaurants are practically nothing. Therefore, to retain its business McDonald’s must deliver a quality product to every customer. Fortunately, this weakness is endemic in the industry, and therefore any other faltering restaurant chains similarly risk losing customers to McDonald’s.

Because of low levels of service, however, McDonald’s is at risk of damaging its customer base. Below is the table of customer satisfaction scores for fast-food restaurants:

Restaurant Name Satisfaction Index Score Papa John’s 78 Domino’s Pizza 73 All Others 73 Wendy’s 72 Pizza Hut 71 Little Caesar 70 Taco Bell 66 Burger King 65 Kentucky Fried Chicken 63 McDonald’s 62 Source: American Customer Satisfaction Index, 2002.

When one McDonald’s performs poorly it generates a negative externality on other franchises and on the McDonald’s brand. Therefore, it is important that corporate McDonald’s assure that each restaurant provide the high levels of service.

The franchise system is intended to reduce agency problems, by tying the success of the franchise owner to that of the franchise. In theory, this means that corporate McDonald’s does not need to micromanage each individual franchise owner. However, since individual franchise owners have incentives to shirk on product and service standards without experiencing the externality they impose on all of McDonalds, corporate McDonald’s must institute monitoring systems to detect such shirking and to insure that standards are maintained. (For more on this, see the Strategic Analysis section.)

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -10- Over-Centralization

Nearly 85% of McDonald’s restaurants are franchised. Lately many of these McDonald’s franchise operators have become increasingly unhappy with corporate McDonald’s decisions. These franchise operators claim that McDonald’s is failing to respond to the geographically specific varied needs of local market segments, Last year, for example, an association of 560 Southern California McDonald’s operators wrote an angry letter regarding the company’s policies, stating that, “There is a battle for customers currently raging among competitors and McDonald’s is not keeping pace.xxiii” These franchisees claimed they were being undercut by low prices of rivals and that corporate McDonald’s was not responding appropriately to the difficulties presented in the marketplace. Although the company then instituted a 99-cent Big- Mac deal, the decision came too late to satisfy many operators. This example illustrates the potential dangers of over-centralizing operations. Slowly, McDonald’s is moving decision- making capabilities back to the regional level in an attempt to respond to this concern.

McDonald’s is on the horns of a dilemma. On the one hand, McDonald’s would like to ensure consistency by centralizing decision making. On the other hand, some power must be reside with regional operators so they can compete against local establishments. Carnegie Consulting believes that McDonald’s plans to hire regional managers is a step in the right direction. It may become necessary, however, to further devolve power if the problems faced by franchise owners are not resolved.

Danger of Cannibalized Growth

McDonald’s restaurants generate very high annual sales. The average McDonald’s outlet generates $1.6 million in sales, compared with $1.2 million at Jack in the Box, and $1 million for Carl’s Jr. Nevertheless, same store sales figures for McDonald’s are not growing at a rate comparable to its competitors. Rather, same store sales numbers are lagging. This may be an effect of cannibalized growth. That is, increasing numbers of McDonald’s stores may be eating into the sales of already existing franchises. Further, with the acquisition of other brands, such as Chipotle and Boston Market, McDonald’s is further exposing itself to internal competition. Chipotle, for example, grew restaurants at 181% in 2000, while only growing sales at 116%xxiv.

Opportunities

Cross and New Branding Opportunities

McDonald’s is steadily expanding its brand name and expertise to many new ventures. McDonald’s cafes can be seen in airports. McDonald’s has moved into the fresh-Mex market with an acquired stake in Chiptole Mexican Grill. The recent purchase of Boston Market gives McDonald’s a presence in still another market segment.

Cross-branding opportunities are also now being pursued. McDonald’s can be found in WalMart, Home Depot, Disneyland, and merged along side Chevron gas stations. Delivering McDonald’s food to shoppers is becoming easier and easier for the shopper.

International Opportunities

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -11- International growth remains one of the most exciting opportunities for McDonald’s. Nearly one-third of total sales during the last year came from Europe, and McDonald’s hopes to increase its presence there even more. Aroma Café coffeehouses have opened in the U.K. have been fairly successful as well.

Although sales have slowed in Asia following an outbreak of Mad Cow Disease, marketing campaigns are well underway to dispel any fear regarding McDonald’s beef (which comes from Australia, not Japan where the disease was detected). Following similar scares in Europe it took nearly a year in some markets for full recuperation. Once confidence is restored, a resumption of growth in Asia is to be expected.

Likewise, marketing in Europe has been somewhat hampered recently by the adoption of the Euro currency. Price-based marketing (such as the “Under a Euro Menu”) have not been successful. The company believes that as consumers become more comfortable with the new currency and its value, price-based marketing will once again become very effective.

Menu Alterations

McDonald’s is continually updating and refining its product selection. Recent menu additions include items such as the Parmesan chicken sandwich and the creation of a McValue menu. The McDonald’s menu features more than 20 items priced under $1. The McValue Menu has been particularly successful, according to company executives and local McDonald’s managers. The company has plans to roll out further menu innovations, which will include such products as the Chicken Selects (breaded chicken breast strips) and a Grilled Chicken Flatbread Sandwich. Both of these products should help raise overall store margins. The Parmesan chicken sandwich has also been a successful addition. The average purchase total for a customer ordering this sandwich was around $7, much higher than average.xxv There is always a risk that McDonald’s will add new items too quickly. In order to ensure that the products are adopted fully and served properly, the company has slowed menu additions from four, down to two items a quarter. McDonald’s hopes this will address service issues surrounding the addition of further menu items. For more on menu alterations, see the Strategic Analysis section.

Menu decisions are l made at the corporate level. As discussed previously, this can create difficulties for individual owners. For example, one franchise owner explained that in one his McDonald’s, located where there is a higher ethnic minority concentration, he sold many more Big Macs and far fewer chicken sandwiches. Pricing and menu item selection that might help him capitalize on this fact, however, remain beyond his control, much to his frustration.

Threats

Healthier Alternatives

One possibly serious threat to McDonald’s ongoing dominance in the fast food industry is a trend toward food alternatives healthier than fast food. This may turn out to be a major threat for McDonald’s in the long-run. This trend is easily observable in the Southern California market where healthy alternatives to French fries and burgers are abundant. Rubio’s, Baja

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -12- Grill, Quiznos, and Au Bon Pain all offer menus with substantially healthier fare. Outside of Southern California this trend is still evident. The international growth of Au Bon Pain and Boston Chicken are examples.

Competition From Other Fast Food Restaurants

Competition also exists from other fast food restaurants domestically and internationally. The fast food market is intensely competitive domestically, with McDonald’s, Wendy’s, Burger King, and Carl’s Jr. (among others) fighting for a share of a saturated market. McDonald’s must be especially alert to price competition from these other venders. The value menus that these establishments commonly employ to compete on price with McDonald’s have been countered by the recent unveiling of the McValue Menu. Although not McDonald’s first value menu, this is the company’s first serious attempt to reverse customer losses caused by rivals’ low prices. Rather than lower prices (that is, enter into price competition against other chains), the McValue menu aggregates lower price menu items into one location. Whether this offering will suffice to allay concerns of price competition remains to be seen. Regardless of the McValue Menu’s success, the need for its invention is indicative of increasingly fierce inter-industry competition which presents a definite threat for McDonald’s in the future. Financial Outlook

For the fiscal year ended December 31, 2001 McDonald’s revenues grew 8% to $14.9 billion, net income fell 15% to $1636.6 million and EPS fell 12% to $1.25 in constant currencies. The increase in revenues was driven by restaurant expansion, which was partly offset by reductions in same store sales.xxvi Additionally, McDonald’s recorded a $200 million special charge which was due to streamlining operations by reducing the number of divisions and regions, enabling the company to combine staff functions and improve efficiency. In addition, McDonald’s introduced a variety of initiatives domestically designed to improve customers’ restaurant experience, including accelerated operations training, restaurant simplification, incentives for outstanding restaurant operations and an enhanced national restaurant evaluation system.xxvii A low current ratio of 0.81 combined with a cash-debt coverage ratio of 0.21 may indicate some financial issues; however, these are beyond the scope of this report.

Analysts’ forecasts of 2002 EPS range between $1.45 and $1.53, averaging $1.49. For 2003 the EPS forecasts are even more ambitious ranging between $1.53 and $1.68 with an average of $1.62. As a result of these high EPS estimates, many analysts rate the stock a “Buy.”

ANALYSTS’ OPINIONS # of Ratings % of Total 1 Month Prior 3 Month Prior Buy 7 39 6 5 Buy/Hold 2 11 2 2 Hold 6 33 7 6 Weak Hold 1 6 0 0 Sell 1 6 1 1 No Opinion 1 6 0 0 Total 18 100 16 14

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -13- Even though the stock price has fallen over the last year, many analysts are still enthusiastic about the company. Recently McDonald’s has begun to address what many analysts see as its biggest problem, low scores on quality, service and cleanliness (QSC). A McDonald’s mystery shopper initiative coupled with increased training and a simplification of systems will likely lead to improved QSC scores (See Strategic Analysis section for more.). As a result, most analysts seem optimistic that McDonald’s will improve its performance and recapture its lost market share .

Over the last year, McDonald’s stock has tracked and slightly outperformed the S&P 500, while it has significantly under performed peer companies in the restaurant industry. Strategic Analysis: Improving Store Performance

Customer satisfaction scores must improve if McDonald’s is to compete effectively against other fast food restaurants. However, because McDonald’s competes in a mature industry where price competition is fierce, any initiatives undertaken must also reduce costs. Carnegie Consulting therefore has derived a two-part strategy designed to simultaneously lower costs and provide incentives to improve service.

Menu Reduction and Control

Menu changes create many problems for restaurateurs (See Appendix A for a Sample McDonald’s Menu). Physical changes be made to update menus. Workers must be informed about new items, how they are prepared, and their price. In theory, new menu items should increase customer satisfaction by providing greater variety. However, at McDonalds, the pleasing effect of variety is mitigated by the bad effects increased variety has on prices and on quality of service.

A more extensive menu means that more items must be ordered by managers, complicating their work and increasing the probability that some items will not be available for customers. Further, greater variety means employee actions become less routine, which lowers margins by increasing the amount of labor that is put into each prepared item. Finally, more variety means that additional menu items may not be cooked properly. Having fewer products encourages “learning by doing,” increasing the likelihood that each product will be made properly. By making production more routine, food can be provided by fewer employees, either increasing store margins or allowing for other service issues to be addressed more frequently (e.g. cleaning restrooms). Further, a small menu selection can be assembled more quickly by the person at the cash register, thereby decreasing customer wait time (which would also have a positive impact on customer satisfaction).

In a recent analyst conference call, management acknowledged the service difficulties it creates by introducing so many new products every month. They pledged to slow menu item growth to only 2 items per month. This reduction is a step in the right direction, but it is our recommendation that McDonald’s seriously reconsider reducing the scope of its menu and decentralizing some decision making power about menus.

Across the Board Reductions

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -14- Carnegie Consulting recommends that McDonald’s pare back its offerings in order to achieve the benefits of specialization. Over the years, the scope of McDonald’s menu scope has increased as McDonald’s has striven to grow same store sales. The product proliferation has been overdone. For example, McDonald’s burgers include the Mac Jr., the Cheeseburger, the Double Cheeseburger, the Big Mac, the Big Mac with Cheese, the Big N Tasty and the Quarter Pounder. On top of this plethora of burger offerings, which alone seem sufficient to confuse customers and workers alike, typical offerings also include several chicken sandwiches (fried or grilled, served on a bun or with flat bread), several types of chicken nuggets, fish sandwiches, fries, onion rings, a range of breakfast items (e.g., Egg McMuffin), a salad bar, a number of desserts, and other offerings, such as the new Chicken Fajita Rollup. This is not to mention coffee, milk, and a number of soft drinks. These are only core offerings. New offerings appear and disappear regularly throughout the year. (For example, the McRib sandwich was just removed from the menu after one month.)

McDonald’s should reduce its menu offerings to improve its customer satisfaction. Although any menu reduction will result in some dissatisfaction from customers expecting a certain item the costs of menu simplification will be far outweighed by the benefits. A majority of McDonald’s profits come from very few of its offerings, according to franchise owners to whom we spoke (the company does not disclose exact margin information). Therefore, McDonald’s should focus on its high margin items and its high volume items, eliminating items that have a low margins and low volume.

The short-term impact of a menu reduction on overall sales may be negative. The decision to reduce the menu is, however, in the best long-term interest of the company. This is an easy way to please customers by (1) simplifying the menu and thereby the ordering process (2) making sure each order is made correctly and (3) making sure each order is filled quickly.

Corporate strategy consists of establishing the boundary between what a company will do and what it will not do. McDonald’s has been attempting too much.

An Alternative Approach: Local Menu Decisions

As we have noted before, McDonald’s must balance the desire to have consistent products at each restaurant nationwide against the benefits serving differences in tastes by allowing some local autonomy to franchise operators. Until now, McDonald’s has chosen to centralize menu control for the sake of consistency. Using this approach, a customer knows that every McDonald’s will have the same selection. Additional benefits to uniform menus are that marketing costs are lower and distribution is simplified by delivering uniform products.

Centralized menu control (currently at the regional level) has its benefits, but it also creates many difficulties. Treating every McDonald’s menu identically may have been optimal when the restaurant focused on burgers and fries, but now that the menu is so diverse that requiring identical menus is counterproductive. Further, supply chain management technology is advanced enough so that delivering different products to different stores will not be excessively expensive.

Under this program, corporate McDonalds will delegate some but not all authority to individual franchises for determining the menu. Certain items will be required offerings (a

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -15- price special being heavily marketed, for example). Outside of the set of “core” menu items (the core will be determined by corporate McDonald’s), franchise owners can choose to carry or not carry the remaining McDonalds approved products. By requiring certain items to appear on the menu, marketing campaigns will still be effective. These required items will be the most popular items that already generate the bulk of corporate and franchise sales and profits. This means that consumers traveling from one McDonald’s franchise to another will not notice an appreciable difference in menu as the core menu would be available everywhere. Advertising will also continue to be effective because it will still tout McDonald’s as a great place for value and service. Advertising can also still focus on individual items from the core menu.

If managers and franchise owners can choose which non-core menu items they want to carry, they can enhance their profits. McDonald’s already allows franchisers to select their physical location based on first-hand knowledge of the local environment. The concept here is similar: local franchise owners are more acutely aware than corporate McDonald’s of how their franchise product needs differ from the core menu. Different items appeal to different demographics and different product competition can exist in different markets.

Allowing individual restaurants too much latitude may lead to problems. For example, granting pricing power, which we do not recommend, may lead to inter-McDonald’s price wars. However, the negative effects of letting each McDonald’s decide which items it wants to carry are small and surmountable. Letting each McDonald’s eliminate certain items would mean that labor costs would be lower, prices could be lower, and product quality and customer satisfaction would certainly be higher. Essentially, we believe that allowing each McDonald’s to determine its menu scope would allow for greater profitability and customer satisfaction.

Agency Problems

An agency problem is created whenever incentives are not aligned between an owner and an employee. Individual franchisees have incentives to not offer optimum quality and service in many instances, instead preferring to offer low cost (and therefore lower quality and service) products. For example, imagine a McDonald’s on the side of a freeway in a desolate area. Customers at this McDonald’s are usually travelers, who will eat there once and never again. The owner of this McDonald’s, knowing that the majority of his business is non-repeat business, does not care if the customers are pleased. Rather, the owner can spend less time training his workers or hire fewer workers to clean the restaurant in an effort to maximize profit. Unfortunately, this profit maximization creates an externality for other franchises and for corporate McDonalds by damaging brand reputation.

In order to deal with agency problems from a store-specific level, corporate management has instituted a number of new initiatives. The focus of these initiatives is to improve Quality, Service, and Cleanliness (or QSC, as management refers to it). For example, a mystery shopper program is now in operation and corporate management’s benefits (the inspectors and enforcers of franchise standards) are tied to how well each individual store performs. Similarly, a new 1-800 complaint number will help the corporate offices identify which McDonald’s locations are in need of improvement. Once identified, teams of QSC experts will meet with local store managers to help them improve their performance.

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -16- McDonald’s corporate management has found that higher QSC scores are tied to better financial performance. It is therefore believed that increasing levels of QSC will improve the each restaurant financially, and therefore McDonald’s stores collectively will benefit if QSC improves. The success of these programs will depend on the energy and diligence that corporate McDonald’s brings to monitoring and enforcing its QSC standards. During McDonald’s most recent profit report conference call, financial analysts expressed concerns regarding how management plans to deal with consistently underperforming restaurants. Although special QSC teams will be deployed to underperforming restaurants, McDonald’s has no intention of undertaking more drastic methods for improving performance. This bothered many of the analysts, and for good reason.

Poor franchises impose a serious negative externality on the McDonald’s brand. With a neutral and objective set of evaluative tools (the 1-800 number and the mystery shopper program), the onus is now on corporate McDonald’s to ensure that QSC standards are met. Several steps may be taken by McDonald’s. The new a management training program for in- store managers may help solve problems based on lack of knowledge and experience. In more serious cases, however, revoking the franchise and installing new franchise owners may be necessary. Corporate McDonald’s must vigorously enforce QSC standards to preserve the value and reputation of the McDonald’s brand. Conclusion

Improving QSC and offering competitive prices are necessary steps for McDonald’s customer retention and brand reputation. We therefore suggest that McDonald’s pare down its menu size in an effort to improve quality, lower labor costs, and reduce wait time. Further, we encourage McDonald’s to consider devolving some menu decision power to local restaurants in an effort to create efficiency gains and maximize profits using local area knowledge. McDonald’s corporate management has taken some important and meaningful steps towards improving QSC at McDonald’s restaurants, but we believe corporate management has not properly evaluated the long-term effect of underperforming restaurants. We therefore believe stronger action must be taken to monitor franchises and enforce McDonald’s QSC standards.

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -17- Appendix A – A McDonald’s Menu

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -3- i http://www.mcdonalds.com/corporate/info/history/index.html ii http://www.mcdonalds.com/corporate/info/history/index.html iii McDonalds 2000 Annual Report iv “A Recipe for Riches.” Foreign Policy. May / June, 2001. pg. 33. v Market Share Index – Restaurant Industry, US Business Reporter, http://www.activemedia-guide.com vi Market Share Index – Restaurant Industry, US Business Reporter, http://www.activemedia-guide.com vii Market Share Index – Restaurant Industry, US Business Reporter, http://www.activemedia-guide.com viii Standard & Poor’s Industry Survey: Restaurants, March 7, 2002. ix Standard & Poor’s Industry Survey: Restaurants, March 7, 2002. x Standard & Poor’s Industry Survey: Restaurants, March 7, 2002. xi Standard & Poor’s Industry Survey: Restaurants, March 7, 2002. xii Standard & Poor’s Industry Survey: Restaurants, March 7, 2002. xiii Standard & Poor’s Industry Survey: Restaurants, March 7, 2002. xiv http://progressivefarmer.com/issue/0501/fastfood/default.asp xv http://progressivefarmer.com/issue/0501/fastfood/default.asp xvi “McDonald’s Tests Imported Beef.” Associated Press. April 2, 2002. xvii http://progressivefarmer.com/issue/0501/fastfood/default.asp xviii Restaurant Industry Profile, US Business Reporter, http://www.activemedia-guide.com xix Techmonic Top 100 Chain Restaurant Companies xx “McAtlas Shrugged.” Foreign Policy. May/June 2001. pg.26 xxi “McAtlas Shrugged.” Foreign Policy. May/June 2001. pg.27 xxii “McAtlas Shrugged.” Foreign Policy. May/June 2001. pg.27 xxiii “McDonald’s Looking For a Break.” Ballon, Mark. The Los Angeles Times. December 15, 2001. Part 3, page 1. xxiv Technomic Spreadsheet xxv McDonald’s Q1 Investor Webcast xxvi http://www.mcdonalds.com/corporate/press/financial/2002/01242002/index.html xxvii http://www.mcdonalds.com/corporate/press/financial/2002/01242002/index.html

______Carnegie Consulting 425 N. College Ave. s Claremont, CA 91711 -4-