Thinking Outside the Burger Box

McDonald's is buying into burritos, pizza, and more. But the chains aren't likely to turn things around soon

Times are tough in the burger business, says Benny Scott. He should know, as the owner of five McDonald's restaurants near Dayton. His sales growth, like that of most other U.S. McDonald's Corp. (MCD ) franchisees, has been flat as a cheese slice. It doesn't help that a couple of nearby factories laid off workers recently. But things could start looking up for Scott: Two Chipotle Mexican restaurants he operates--part of a fast-moving chain owned by McDonald's--have posted double-digit increases each month since they opened 16 months ago. Come October, he's opening another. "Dayton can definitely support five Chipotles and maybe a few more," Scott says.

Call it a thin shaft of light for troubled McDonald's. Groping for a way to break free of the saturated U.S. burger business, McDonald's CEO and Chairman Jack M. Greenberg is planning a national ramp-up of the Chipotle chain it bought into four years ago. After two years of virtually flat same-store sales in its U.S. hamburger outlets and a 17% drop in 2001 net income, the Oak Brook (Ill.) chain is adding 70 of the Mexican restaurants in 2002, for a total of 250 in 21 cities, with the bulk in the West and Midwest. Chipotle executives are putting together plans to boost that rate significantly over the next three years, to at least 1,000 restaurants. "We are going to the next level," says Chipotle founder and CEO Steve Ells, who runs the business independently from Denver.

McDonald's is pressing forward on a number of fronts: experimenting with nontraditional store looks in France, attempting to introduce fresher foods in U.S. restaurants. Greenberg clearly thinks investments in entirely new food concepts are one of his most promising expansion alternatives. The burger market is growing at an annual average rate of just 2.7%. Since taking the job in 1998, Greenberg has dabbled in a number of areas, purchasing Boston Market and Donatos Pizzeria and taking a minority stake in the London-based Pret A Manger sandwich shops. In April, McDonald's signed a letter of intent to develop 20 to 30 restaurants with the Fazoli's Italian fast-food chain.

Chipotle is McDonald's first serious foray into "fast-casual" restaurants, which place more emphasis on service for sit-down customers--and which as a group have seen sales growth in the mid-teens in recent years. It's a significant shift for McDonald's, whose executives swore for years that they wouldn't stray from the core fast-food recipe. Still, don't expect burritos, pizza, or roast chicken to turn around McDonald's lagging fortunes immediately. The company is taking a measured approach to moving beyond burgers. As a group, these "partner brands" generated just $977 million in sales and a $66 million operating loss last year. That compares with McDonald's total revenue of $14.9 billion and net income of $1.6 billion.

Even McDonald's expects those brands to add only 1 to 2 percent to its operating income by 2005. And competition is likely to remain fierce anywhere Greenberg turns. Wendy's International Inc., for instance, has its own plans to expand the 169-outlet Baja Fresh Mexican Grill chain it bought in April. "Clearly, the other concepts are dwarfed by the McDonald's chain, and that's not going to change anytime soon," says Timothy M. Ghriskey, a senior partner at Ghriskey Capital Partners LLC in Greenwich, Conn. Shares of McDonald's stock are down about 25%, to $23, since late May.

The truth is, despite lots of tweaking, McDonald's hasn't developed the non-burger brands to the point where it feels comfortable expanding them in a big way. After three years of trying to make it work, McDonald's cut its losses on Aroma Café, a British sandwich and coffee shop, which it sold in March. Pret A Manger, an upscale sandwich shop, has just 12 U.S. stores and is only opening new units in New York City. Certainly no one needs to prove the popularity of pizza, which is a $24 billion U.S. market. Yet McDonald's has chosen Germany's $5 billion market to slowly develop Donatos Pizzerias. And after buying bankrupt Boston Market Corp. in 2000, remodeling its restaurants, and upgrading its home-style menu, McDonald's plans to add only 17 U.S. restaurants this year to the 650-unit chain.

Why the cautious approach? After all, McDonald's is sorely in need of a fix in its home market. Until the second quarter, the chain had posted six consecutive quarters of earnings declines. Same-store sales for its 13,099 U.S. restaurants were down 1.6% in that most recent quarter, vs. a 6.6% rise for Wendy's. Overseas, sales fell in every region except Europe, which was recovering from last year's mad cow disease scare. Nonetheless, officials at the company say they don't want to back any alternative concept until they're sure it can grow enough to make a difference to the bottom line. "For us, if something can't be at least 1,000 restaurants, it's not ever going to be big enough to have a meaningful impact for the McDonald's system," says Russ Smyth, president of McDonald's partner brands.

Chipotle appears to have the best chance of getting there. Restaurants open at least a year have generated average sales of $1.3 million per unit (vs. $1.6 million for McDonald's), have shown 20% average growth for the past four years, and are profitable. In some cities, customers brave long lunch lines to order up burritos and tacos, made to order from fresh ingredients, served with Mexican beer and margaritas. Service is more personal than in a McDonald's, with contemporary decor that includes polished steel tables. And meals cost more: about $8 on average, double a typical fast-food bill.

McDonald's is giving current franchisees first shot at operating Chipotles restaurants. That may quiet grumblings about sales having barely budged despite millions invested by headquarters in such improvements as a costly "Made For You" kitchen. But for many operators, the foray into Mexican food seems like a drop in a deep bucket. Because of the small number of openings planned, "there will be very, very few operators who will be able to fly two flags," says Michael Muntzel, owner of four McDonald's in Little Rock. They're stuck with burgers for now--and with a parent that still hasn't figured out how to break free.

By Julie Forster in Chicago

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