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Assistant: Mack Agbayani
So I’m here in New York City for some family obligations and I was thinking that this would be the perfect opportunity for some vlogging. What’s a major business trend here we could talk about? What’s something that everyone around the world would find interesting? Hmm.. (FOOD)
(Episode #7: McDonald’s vs Fast Casual Dining)
If you talk about US big business, one of the most well-known is McDonalds, certainly a titan of industry. It’s golden arches have pretty much penetrated every location in the world and its name is virtually synonymous with fast food. But McDonalds seems to be having problems in its home country as it faces the growing threat of what is known as “fast casual dining”. If you’re American, you know what I’m talking about. If you’re not, let me explain.
Back in the 90’s, a man named Steven Ells, graduate of the CIA, (not that one – this one) had a eureka moment. Inspired by a taqueria called Zona Rosa in San Francisco’s Mission District, Ells conceived of a restaurant that would serve high-quality food at an inexpensive price with minimal wait time. He set up this restaurant, which would sell burritos, in Boulder, Colorado, and named it Chipotle. And so was born “fast casual” dining, an amalgamation of fast food and full-service dining. Fast casual dining combines the speed and efficiency of the former, with the quality of food and ambiance of the latter. And it’s gained other adherents. As a result, these fast casual restaurants are increasingly giving established fast-food players a run for their money. Geez, what is it with guys named Steve and business innovation? But, enough talk. Let’s see it for ourselves and check out a Chipotle branch.
So here we are in a Chipotle restaurant. Notice the decor – there’s certainly been some thought put into this.
How it works – you line up and go through an assembly line where you pick the ingredients for your burrito from a limited menu. You can probably surmise that the turnover is very, very quick with this setup, even when compared to your regular fast food setup of cashiers in front and kitchen in the back.
Let’s take a look at this burrito. This thing is huge!!! I can do bicep curls with this thing!
Unfortunately I wasn’t allowed to film on-premise at McDonald’s, but I’m sure you’ve been to a McDonald’s at least once in your life, so you know more or less what it’s like there. I had a quarter-pounder with cheese, and I’m sure you know what that actually looks like.
Okay, so Chipotle serves food with fresh ingredients and a quick turnover. So what? Why is McDonalds, with its over 36,000 stores around the world, so scared of this relatively small chain with an estimated paltry 1,800 stores?
The numbers tell the story. McDonald’s is closing 700 stores this year, and reported an 11% drop in sales and 30% drop in profits for the first quarter of 2015. Same store sales have declined for six straight quarters IN A ROW.
Meanwhile, same store sales at Chipotle have been gaining fast, with an annual gain of 14% in 2014. The general consensus is that McDonalds is losing market share to Chipotle and its fast casual colleagues. To find out why, we have to dig further into Chipotle’s history. As it turns out, McDonalds surprisingly had a key role to play in its success.
McDonalds actually bought into Chipotle in 1998 as part of its strategy to diversify its business. The upside for Ells and team was additional capital, as well as access to McDonalds’ operational knowledge. However, Chipotle’s DNA – its culture, its business model – was fundamentally different from that of McDonald’s, helping lead to McDonald’s divestment of Chipotle in 2006.
In many ways, Chipotle is the exact opposite of McDonald’s. Where McDonald’s operates on franchising and low wages, Chipotle keeps control of all its stores and pays employees above-average wages but lays off mediocre workers. Where McDonald’s serves breakfast and is open 24-hours, Chipotle sticks mainly to burritos and works limited hours. While McDonalds focuses on multiple menu offerings, Chipotle sticks to a limited set of ingredients for its burritos. And last but not least, Chipotle sources ingredients that are perceived to be healthier – such as antibiotic-free meat and, more controversially, GMO-free food, and makes it known.
Chipotle’s strategy has proven to be extremely successful. Not only is it gaining market share, but so far it is getting more profitable. Even though Chipotle pays above industry wages and pays higher for premium ingredients, its operating margins (sales minus cost of materials and operations) have expanded in recent years. and here’s why.
Let’s go back to same store sales. Same store sales continue grow, meaning that each Chipotle branch, on average, has more traffic coming in. That means that the same number of employees are handling a higher number of customers within the same time frame. And here’s where the genius of Chipotle’s business model comes in.
We mentioned the assembly line structure that Chipotle employs. It’s been done before, most notably by Subway. What differentiates Chipotle in this aspect is the limited choices in the menu. When you as a customer go through the assembly line in Chipotle, you make quick decisions of what you want in your burrito based on the limited options available. As a result, traffic moves along quickly and turnover is high. This process is so crucial to Chipotle’s business that management has been known to watch security footage to review worker performance.
This focus on quick, efficient turnover is further amplified by Chipotle’s human resources policies.
The company focuses on promoting managers from within. Furthermore, Chipotle has what it calls a “Restauranteur Program”, where hourly workers are given the chance to become managers and earn over $100K a year, along with a one-time bonus and stock options. These restauranteurs also receive an additional $10K to train another worker to become a general manager. The innovation here is that high-achieving managers stick to training workers rather than leaving to become less effective middle management.
The other reason for Chipotle’s success is slick marketing. Chipotle has marketed itself as as a proponent of creating “food with integrity”. “Food with integrity” means, among other things, using fresh, local ingredients and humanely-raised animals. And Chipotle backs it claims with action. The company is now the largest buyer of humanely-raised and naturally-fed chicken, beef and pork. This image has proven to be popular with consumers, especially in contrast with the negative publicity with regards to health that McDonald’s has received in recent years.
Which is not to say that Chipotle’s burritos are particularly healthy. A single Chipotle burrito can contain more than a thousand calories. Despite this, consumers are more concerned with other food issues, such as the presence high-fructose corn syrup in their food, and, more controversially, whether a food is GMO-free or not, than calorie count, according to a recent Nielsen survey. At the end of the day, perception matters, and Chipotle is perceived as being a healthier alternative to McDonalds.
So slick marketing brings in greater and greater traffic to a Chipotle store, and the quick, efficient assembly line structure means that that traffic is turned over and monetized rapidly. This has created a situation where Chipotle’s sales and profitability have been increasing. What can McDonald’s do to compete?
McDonald’s recently announced a turnaround plan, which included shifting more stores to franchising to improve profitability, as well as initiatives such as simplifying its menu and testing all-day breakfast. These announcements are in addition to previous changes, such as limiting the use of antibiotics in its chicken. However, investors found the plan lacking, and McDonald’s shares actually ended up almost 2% lower afterward. After all, there was no detailed plan to change the perception of low food quality or slow service. Sure, there are new healthy test ingredients, like kale, and yes, there are test branches in Australia that look an awful lot like a Chipotle store, but there are no plans to launch any of these en masse in the US, which accounts for 40% of McDonald’s profit.
And not only is McDonald’s competing with Chipotle, but it also has to deal with other fast-casual restaurants. Shake Shack, which recently went public, provides burgers with higher-quality ingredients, for example. The upstart Blaze Pizza is utilizing the assembly line format and is expanding rapidly.
So far, McDonald’s responses to these threats seem to be limited. This could be due to it’s large size and bureaucracy, making the company slow to adapt to new realities. Will they be able to? Only time will tell.
Before we end, I just want to point out McDonald’s recent ad campaign to reintroduce the Hamburglar. He went from this… to this? I guess they’re trying to play up on people’s nostalgia, like what’s been happening in cinema in recent years? What would the other McDonaldland characters look like? Hmmm….
Ramon Rodrigo Cuenca, CFA
Art and Finance
Assistant: Mack Agbayani