Golden Arches Galore

It's been a lousy year for McDonald's Corp. U.S. comparable sales have been sagging, Mad Cow disease in Britain was a distraction overseas and, on top of everything else, the company's heavily promoted Arch Deluxe drew disappointing reviews from critics. In a stock market that loves growth companies, McDonald's shares are performing as if they belonged to a mediocre public utility. Recent price: 465 US, slightly down for the year.

The bad news has not, however, dampened spirits at the company's Oak Brook, Ill. headquarters. McDonald's is in the midst of its biggest expansion spurt since the days of Ray Kroc. By the end of this year McDonald's will have added at least 2,500 new stores, increasing its total store count to over 20,000. That is four times the number of stores McDonald's opened just four years ago. Two-thirds of the new stores will be outside the U.S.

Aren't there too many McDonald's already? McDonald's doesn't think so. The company figures it is a long way from saturating the fast-food market-not just in developing countries, where people are now acquiring a taste for Western-style fast food, but even in mature markets like the U.S. At a time when other fast-food chains from Taco Bell to Checkers, Hardee's and Roy Rogers are hurting, McDonald's sees a rare chance to invest heavily in the future, even if it means suffering a little short-term margin pressure.

McDonald's top management accelerated its expansion plan early this year after it began to understand a startling statistical phenomenon. Call it Greenberg's law, after newly appointed McDonald's U.S.A. chairman Jack Greenberg: The more stores McDonald's puts in a city, the greater the overall number of transactions per capita in that market. Put another way, Greenberg's law holds that the number of per capita transactions varies proportionately with penetration in a market. Acorollary: If McDonald's doesn't put in the new restaurants, its competitors will.

Here's how Greenberg describes this phenomenon: "Where you have two stores per 100,000 people you might have 16 transactions per capita per year. When you go to three stores, to stay even, you would hope to get to 24 transactions per capita, and when you go to four stores, in order to say you're not causing any saturation or decline, you'd expect 32 transactions. But guess what happened? We went to four stores [per 100,000 population] in some markets and ended up with 33 transactions."

Based on these results, McDonald's shifted its focus to market share instead of just individual store sales and profits. "Until a few years ago we never measured market share, we never talked about transactions per capita," says Greenberg, who until recently was McDonald's chief financial officer and vice chairman. "Now we talk about it all the time."

Will this strategy play in Peoria? It already has. In 1981 McDonald's had ten stores in Peoria, a city of 113,000 in downstate Illinois, and a market share of 40%, double that of Hardee's, which had five stores. But over the next ten years McDonald's decided not to expand in Peoria. By 1991 the positions had roughly reversed. Hardee's, which had more than tripled its stores, to 18, held 40% of the market, while McDonald's, with 11 stores, had declined to 28% of the market.

McDonald's decided to fight back. Between 1991 and 1995, it boosted its Peoria store count from 11 to 29, while Hardee's slipped from 18 to 17. McDonald's now is back on top with over 50% of the market. Thanks to Greenberg's law, average volume per restaurant in Peoria has increased by 50%, and cash flow and profits per restaurant are also up.

"I can't tell you every market is going to be Peoria, and we're still learning as we're talking-frankly, this interview is a little premature," cautions Greenberg, as he fingers a large Coke at McDonald's lush headquarters campus in the western Chicago suburb of Oak Brook. "But we have some real-life experience that says the way to approach a market is not 'Where should I put the next store?' but 'Where should I put the next five stores?' "

Rarely are McDonald's new stores like its old ones. Drive-thru windows now account for 55% of McDonald's U.S. sales. That means the new outlets don't need nearly as many seats inside. Which leaves more real estate for other things, like indoor playgrounds to attract families, or gas stations. McDonald's has joint ventures with Chevron and Amoco to codevelop properties and share real estate costs. It also has a ten-year exclusive marketing deal with Disney, aimed at promoting each other's brands starting next year.

McDonald's is testing the idea of sticking smaller, limited-menu versions of its restaurants in new settings, like busy airports, stores and military bases. There are already McDonald's in 800 Wal-Mart stores. Last month Greenberg opened a McDonald's Express unit in a 1,200-square- foot space in an office building in Lansing, Mich. The store cost just $100,000 to build and is forecast to gross $575,000 in its first year.

There are risks involved here. Some of McDonald's franchisees, who as a group own 85% of the chain's outlets, are not convinced that Greenberg's law will hold up. Even if it does hold up, they worry about how long an adjustment period will be required before new stores translate into more business for them.

Consider franchisee Wayne Kilburn. In 1980 he and his wife, Mary Jane, took over the sole McDonald's in Ridgecrest, Calif, a high- desert town of 26,000 about an hour west of Death Valley. Kilburn turned the restaurant into a huge profit machine. Then McDonald's came up with a market share plan for Ridgecrest. In September 1995 it put a company-owned restaurant inside the new Wal- Mart in town. Late last year McDonald's built another outlet inside the China Lake Naval Weapons Center. A third new company-owned store went up right outside the naval base.

"Basically, they killed me," says Kilburn. He claims his volume has dropped by 30%. Kilburn, who doubts that Greenberg's law will eventually click in and restore his volume to its prior peaks, wants out and is now negotiating to sell his franchise back to the corporation. The two parties will probably end up reaching a deal.

McDonald's is so hungry for real estate it is now buying huge collections of stores from weak competitors, something it never did before. A few months ago McDonald's agreed to buy 184 company-owned Roy Rogers outlets, maybe 100 of which will eventually convert to McDonald's restaurants. "Here was an opportunity that was maybe once in a lifetime," Greenberg smiles.

Overseas, earlier this year McDonald's bought Burghy's, an 80-store chain in Italy that dominated the Italian fast-food market. "We have been struggling in Italy forever," says Greenberg. Same story in New Zealand, where McDonald's just picked off 17 restaurants from the 30-store Georgie Pie chain.

Expansion isn't everything. You still have to give people reasons to go to all those McDonald's. That means improving the menu with things like the new line of deluxe sandwiches, offering better promotions (which is what the Disney alliance does), making sure the bathrooms are clean and-above all-offering perceived value for money.

Anton Brenner, an analyst at UBS Securities, thinks McDonald's is on the right track. "There's a shakeout in the industry that's underway, and a lot of market share is going to change hands here," says Brenner. "McDonald's has targeted this period for major expansion." Brenner says the stock, currently selling at 20 times this year's likely earnings, isn't a screaming bargain. But he thinks earnings per share could grow 14% a year over the next five years-more if the company can turn around comparable- store sales. He rates the company a long-term buy.

Jack Greenberg won't get into the earnings-forecasting game, but he leaves no doubt that a new strategy now guides the company in everything it does.

"If you don't grow market share, you are going to lose the game, largely because so much of our business is impulse-driven in the U.S.," Greenberg says. "In the U.S. context, if we had thought this way 20 years ago, you might see a lot more McDonald's and a lot fewer Burger Kings today. But we were in a different mind-set then."