At the end of a yearslong growth streak, the fast-food giant hopes its risky introduction of specialty coffee will wake up dozing sales
By Mike Hughlett
February 24, 2008
"We are in lunch," Nick Karavites declares at 10:30 a.m. as workers at one of his family's Chicago McDonald's outlets scurry to make the daily transition from breakfast. It happens fast, with machinelike efficiency. Eggs give way to beef patties, which after 38 seconds on the grill are on their way to becoming Big Macs.
Oak Brook-based McDonald's Corp. is facing its own crucial transition. At the end of one of the most successful five-year streaks in its history, with the specter of a sales-sapping recession looming, the burger giant is trying to give itself a second identity: coffee giant.
Adding fancy coffees and other specialty drinks is a bold move intended to make McDonald's a beverage destination and a rival to Starbucks and other coffee chains. It's a key strategy aimed at luring more customers for snacks between meals. It also is one of McDonald's riskiest product launches ever.
Franchisees such as Karavites must invest tens of thousands of dollars in their restaurants to add a special beverage section to the kitchen, and managers and counter help will have to get used to a new vocabulary -- "Do you want a caramel cappuccino with that?" -- along with a new, more complex rhythm during the breakfast and lunch rushes.
It's a tall order and comes at a time when McDonald's has shown a hint of weakness. The company's same-store U.S. sales didn't grow in December for the first time in five years, and McDonald's chief executive recently noted that a sputtering economy could put a damper on sales growth.
The franchisee system is squarely behind the coffee rollout, but some worry about the financial commitment as they fret about rising food and labor costs. The coffee initiative "could not have come at a worse time for most operators," one franchisee told a McDonald's surveyor.
But the time had to come.
Every company needs to boost its growth rate, and McDonald's has done just about everything right in the past few years to bring in more customers. But what do you do to generate more sales once you've freshened all the stores, kept them open longer, emphasized the fast-growing breakfast market, found ways to turn simple ingredients such as chicken and lettuce into a hit new category such as the snack wrap, and even fended off tremendous criticism about McDonald's dietary qualities?
At some point you have gamble on something bigger.
For Karavites, the coffee offensive won't be the first time he and his family have invested big time in a big McDonald's initiative. They've spent millions of dollars redesigning their 12 Chicago area restaurants. It's something McDonald's has been pushing the past few years, sort of an architectural counterpart to the broadening of its menu.
At Karavites' outlet at Fullerton and Central Avenues, orange fiberglass furnishings have given way to furniture that looks as if it came from Ikea. The blaring red tile floor has been transformed with earth tones. The lighting is softer, the basement rec-room florescent buzz gone. "We literally almost tore this store down," Karavites said.
Franchisees such as Karavites are at the heart of McDonald's system: They own and operate about 85 percent of the company's U.S. outlets. Nick's dad and mom, Angelo and Janet, opened their first McDonald's outlet in 1978.
Nick started flipping burgers when he was in high school and continued working at the family business while attending Loyola University Chicago. He earned a degree in philosophy and political science. But Karavites also took summer classes in Oak Brook at McDonald's Hamburger University, requisite training for all store owners.
While his parents are still very active in the business, Nick, 35, tends to focus most on day-to-day operations. Lately, he's been spending a lot of time on the big beverage plan.
McDonald's usually has a steady pipeline of new products ready to be introduced. For instance, the company has high hopes for a new chicken-biscuit sandwich on tap for later this year. Like most new items, it will require minimal changes to restaurant's operation.
The beverage offensive, which also includes smoothies, frappes and bottled drinks, is a very different story. It entails an investment of up to $100,000 per restaurant, including $25,000 for equipment and up to $75,000 for remodeling.
Essentially, operators must add a special "beverage cell" to one end of their counters near the drive-through window. The cell will house coffee and smoothie equipment and will be staffed by one worker. It will be highly automated, so McDonald's won't offer the coffee customization level of Starbucks.
But McDonald's should be able to offer quicker service and more value because its specialty coffee drinks cost about 25 percent less than Starbucks, according to Steve West, an analyst with Stifel Nicolaus.
At Karavites' Fullerton Avenue store, the beverage addition will mean reconstructing the front counter and knocking out a couple of 3-foot-wide walls, a common adjustment that franchisees must make. He's riffling through blueprints now and expects to start construction at his stores this summer, like many Chicago-area McDonald's franchisees.
McDonald's, as it does with store redesign and other expensive projects, will financially aid franchisees, offering to pay for up to 40 percent of the beverage build-out. And McDonald's has said franchisees should gain a big pay-off from their investments: an additional $125,000 in annual sales per store.
Still, there's apprehension among some franchisees about the scope and risk of the project -- at least that's what restaurant analyst Mark Kalinowski, who has long followed McDonald's, has found in his surveys of franchisees.
Kalinowski's surveys, while unscientific, have had a good track record predicting sales swings at McDonald's U.S. restaurants. In his most recent survey, done in December, one franchisee called the beverage offensive "a crapshoot."
Restaurant owners are faced with food costs rising at a pace not seen in years, while labor costs are being ratcheted up by minimum-wage increases. Some franchisees in Kalinowksi's most recent survey worried about increasing competition in the "value" end of their business -- the land of $1 double cheeseburgers -- where profit margins are already thin.
But the National Leadership Council, an association representing McDonald's U.S. franchisees, is solidly behind the coffee initiative and has worked with McDonald's to implement it. Karavites is among those franchisees excited about the concept.
Unlike most new products, he said, specialty coffee doesn't involve a trade-off: Customers won't buy it instead of some other McDonald's item, which often happens when a new burger is launched. "Coffee will be huge," Karavites said. Many analysts say it indeed has potential.
First, specialty coffee -- despite the fact that Starbucks outlets seem to be everywhere -- is still a fast-growing business, they say. Plus, the beverage play should lure more customers into McDonald's between meal times. But there are risks, and the weakening economy is one.
Last month, while McDonald's posted another strong quarter and beat Wall Street's profit expectations, it surprised investors by saying its U.S. same-store sales were flat in December compared with the same time a year earlier. That was the first time they didn't grow since 2003.
McDonald's blamed the weather, but also the weakening U.S. economy. U.S. sales growth resumed in January, but at a rather anemic rate of 1.9 percent. Meanwhile, McDonald's Chief Executive James Skinner cautioned Wall Street that if weak economic conditions continue, the firm's U.S. sales growth rate could be shaved by 1 to 2 percentage points.
Many other restaurant companies are also feeling pain from a slowing economy. Starbucks has seen its stock sink by almost 50 percent over the past year, at least partly because of a slowdown in consumer spending. "High-priced coffee might be seen as more of a luxury item and may be more of a difficult sell in an economic downturn," Kalinowski said.
But the bigger issue facing McDonald's specialty coffee rollout is "execution," he said. McDonald's must implement the plan without mucking up its fabled efficiency -- and thus slowing down customer service.
"McDonald's is about seconds, about minimizing the amount of time," Karavites said. When specialty coffee is launched, "I want to make sure it doesn't take you five minutes to get a Big Mac instead of one minute."
Karavites is the "quality service and cleanliness" chairman for the regional McDonald's franchisee association, and as such he's traveled to Kansas City -- a test market for specialty coffee -- to see the concept in action. He's also spent time at McDonald's regional innovation center, learning to make the drinks himself.
Karavites believes the beverage offensive can be done without slowing service, which is what McDonald's says has been the case in test markets. Average service time per customer remains at 90 seconds or less, the company says.
West, the Stifel Nicholas analyst, said he's extensively monitored Kansas City-area restaurants testing specialty coffees and hasn't seen any customer service breakdowns. McDonald's seems to have developed a coffee system that works, he said. "I wouldn't bet against McDonald's right now."