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McDonald's Japan on the brink

McDonald's Japan President and CEO Sarah Casanova answers questions during a July 29 press conference.

TOKYO -- Ronald McDonald has taken a beating from Japanese consumers.

     McDonald's Holdings Japan has seen same-store sales plummet since it came in late-July to light that a Shanghai supplier was selling the company expired meat for its Chicken McNuggets.

     But dodgy chicken is just the beginning. A close look at what is happening at the chain reveals some deep-rooted problems with the company's management.

     Customers are being overcharged, franchise owners are up in arms and staff facing pay cuts are just as disgruntled. Management appears at a loss on what to do, with new products failing and franchise sales saturated. 

     Is this the end of Japan's love affair with the Big Mac?

Rudderless ship

Tofu Shinjo Nuggets, a Japan-only product from McDonald's, were released to fanfare. Then came the problems.

     "I've been working for McDonald's for more than 30 years and have never seen such a fiasco," said the owner of a McDonald's outlet in Kyoto Prefecture. On Aug. 20, the company said it had overcharged customers on purchases of the nuggets and McWings, a fried chicken product.

     Two days earlier, the company lowered the prices for McWings and the Nuggets -- fried balls of pureed fish meat, tofu and vegetables -- to 120 yen ($1.14) each, about half their listed price. But many shops mistakenly sold them at 150 yen. A total of 2,583, or more than 80% of the 3,135 McDonald's restaurants in Japan, overcharged customers.

     McDonald's Japan headquarters in Tokyo must take part of the blame for the mix-up.

     Three days before the discount campaign started, management decided to lower the price for the snacks to 120 yen. It had originally planned to sell them for 150 yen. After cutting the prices, necessary adjustments to the cash registers, centrally managed by headquarters, were not made in time. The buttons for 120 yen and 150 yen were both left on the machines. To make matters worse, coupons for buying the four-piece Tofu Shinjo Nuggets for 190 yen had also been distributed.

     Outlets nationwide received orders from headquarters to sell the items at 120 yen. But errors were inevitably made among the chain's 160,000-strong workforce. Franchisees slammed management's flip-flopping.

    "When we ask drive-through customers to read out their coupon numbers, we have no time to check the item names and prices," said one franchisee. "We use nearly 100 part-timers. It is impossible to ensure that they all deal with such a complicated matter properly," griped one store manager.

     This overcharging scandal broke out only one month after it was disclosed in late July that Shanghai Husi Food, which produced Chicken McNuggets, had used expired meat. The back-to-back scandals have led to serious distrust of headquarters among workers.

    "Chicken and nuggets are two items that have fallen into disfavor with customers," said the owner of an outlet in Hyogo Prefecture. "They may have tried to dispose of the inventory, but the stores have ended up suffering because of the decision to make them campaign items."

Street stalls safer

Intensifying competition in the restaurant industry and the lack of new hit products have conspired against McDonald's Japan's earnings. Same-store sales have been declining every month compared to the previous year since February.

     Video footage showing the use of expired meat by the Chinese supplier contributed to a 17.4% same-store sales drop in July. The scandal made headlines in Japan on the first Tuesday of the school summer vacation. Many of the chain's restaurants saw sales on the following weekdays plummet more than 20%. But the scale of the problem was not fully apparent until the weekend.

     "Usually, the number of families among our customers increases on holidays, but these customers just disappeared," said a McDonald's worker in Tokyo. "When children try to order chicken products, their parents hastily stop them," said a staff member in Miyagi Prefecture.

     In Kanagawa Prefecture, a festival the weekend after "McNugget-gate" broke showed how serious the situation was. It suffered a sharp drop in customer traffic even though the streets around the outlet were thronging with people. The store's sales fell to around a quarter of the level seen during previous festivals.

     "In short, people have decided that foods sold at street stalls are safer than our products," lamented a veteran worker at the restaurant.

Red ink?

Has the company's sales slump bottomed out? Senior Vice President Takehiko Aoki on Aug. 15 told The Nikkei that the impact of the scandals on the company's earnings was gradually weakening. At around the same time, however, some franchisees said their sales on holidays were still 30% or so lower than before.

     "If the company's sales have declined by 30%, it will start losing money," predicts Seiichiro Samejima, manager and chief analyst for the fast food and other business at Ichiyoshi Research Institute.

     Kyoichiro Shigemura, head of Nomura Securities' small- and mid-cap equity research team, initially forecast McDonald's Japan's operating profit to fall 91% to 1 billion yen in the current fiscal year. But earnings results could be "horrifying, depending on how the situation pans out," he said.

     Management appears incapable of formulating an effective game plan to win back customers. Some frustrated franchisees have started making their own efforts to attract customers.

Casanova fails to charm

A Kanagawa Prefecture store manager has told his staff to bow more deeply than usual to customers who have bought chicken products. This humility-focused tactic reflects criticism about President and CEO Sarah Casanova.

     Immediately after the expired meat scandal hit the headlines in Japan, the president of FamilyMart, a major convenience store that also used the Chinese supplier, apologized to consumers. Casanova was nowhere to be seen.

     She instead chose to offer an apology a week later, at the outset of the press conference to announce the company's half-year results. But Casanova mainly expressed her indignation about the supplier's conduct, casting her company as a victim. She also stressed that the other suppliers for McDonald's are honest and sincere, pointing out that the misconduct was committed only by several malicious workers at one factory in one district.

     Such a strategy did not go down well in Japan, a country where humility and public apologies are at the heart of corporate communications during crises. The Kanagawa store manager sees a further problem: "The company clearly isn't considering consumers. If any store manager took a similar attitude to her, we would receive complaints." He went on refusing to refer to Casanova by her formal title. 

Part-timer exodus

McDonald's Japan appears to be trapped in a downward spiral. Its part-time workers are facing cuts in their work hours and consequently their income.

     At each McDonald's restaurant, sales and customer data are compiled every 30 minutes. The data include the number of customers and sales during the period, the number of sandwich products (mainly hamburgers) sold and per-customer spending. It also calculates the number of workers needed for handling the restaurant's situation. If the data report says "plus 1" that means there is one superfluous worker for the current level of sales.

     "A lot of our crew members work more than one job," said an assistant manager in Tokyo. Many of those with other jobs quit McDonald's. 

     McDonald's requires all crew members, including part-time workers, to receive training before serving customers.  After this initial training, crew members have to keep honing their skills through training programs focused on 10 different themes, including leadership and efficient communication. The materials for these training programs have all been developed by instructors at Hamburger University in the U.S., or McDonald's Center of Training Excellence, as well as outside consultants. These materials are constantly improved.

     "We adapt the materials for Japan to offer a higher level of training," said a senior official who is in charge of training crew. "The training also helps us understand which employees want to climb the ladder."

     There are even part-time managers who supervise operations at larger McDonald's restaurants. The policy of promoting competent part-timers to such management posts boosted the company's earnings during economic hard times.

     "In the past, when sales didn't grow, McDonald's used to try to figure out ways to shift more burgers instead of cutting part-timers' working hours," said Sachiko Kakegawa, president of E&CS Support, who once served as an assistant manager at a large McDonald's restaurant in the Kansai region.

     Now, however, the discretionary power of individual outlets has been curtailed substantially as the company's management has put more importance on "brand integrity" and tightened human resources control. This has led to a deep sense of frustration on the front-line, exacerbated by head office blunders.

     "Headquarters' strategy seems to focus on management theory without knowing what is happening in restaurants," observed Tsutomu Fujiki, who once served as the company's representative director. "It has apparently reached its limit."

Stock shock looms

Investors may be about to pay attention.

     "The company's business model has become ineffective," warned Nomura Securities' Shigemura. "It is still losing customers." Shigemura on Aug. 8 revised down his forecast for the company's stock to 1,400 yen, 46% lower than the 2,601 yen at which it closed Aug. 26. Samejima has also predicted a sharp fall of the stock, down to 1,800 yen in half a year.

     That figure would be lower than the price of 2,380 yen the stock logged when the company posted losses for two straight years and recruited Eiko Harada from Apple Computer Japan. McDonald's Japan's stock was priced at 4,700 yen when it was listed on the Jasdaq market in its 2001 initial public offering.

     That would mean the end of McDonald's Japan's history of independently turning the U.S. hamburger chain's business model into a Japanese success story. Den Fujita, founder of McDonald's Japan, created the nation's top restaurant chain by "Japanizing" the U.S. business model. But amid a changing business environment the company has become a victim of its own success.

Deflated by inflation

Fujita opened the first McDonald's in the upmarket Ginza area of Tokyo in 1971. The outlet was inside the flagship Mitsukoshi department store. Fujita was running a successful business of importing and selling luxury-brand goods when he imported McDonald's to Japan. Asked about the secret of his success, Fujita once said it is "sugarcoating." Fujita told overseas business partners to tweak their luxury goods to meet the tastes and preferences of Japanese consumers.

     During his negotiations with McDonald's founder Ray Kroc, Fujita insisted the Japanese unit should accept advice but not any order from U.S. management. Chigasaki, Kanagawa Prefecture, was the preferred location for the first Japanese McDonald's among U.S. management. Fujita rejected that, saying all important cultural trends start in Ginza and spread across the nation.

     Fujita's decision proved the right one. The store rang up daily sales of 1 million yen, far larger than the 150,000 yen projected by Mitsukoshi. The spectacular success of the first outlet led to explosive expansion of the chain, which grabbed the top spot in the restaurant chain ranking in 1982.

     In a move that astutely positioned the company to benefit from the deflationary trend, Fujita that year lowered the price of the standard hamburger to 130 yen from 210 yen.

     Around the turn of the century, however, McDonald's headquarters moved to standardize the management for higher efficiency. This exposed serious problems in the Japanese-style management at McDonald's Japan.

     There was a decline in the management efficiency at individual restaurants. The number of outlets surged to 3,598 in 10 years from 776 in 1990. The expansion was achieved by increasing the number of stores without full-time managers. This led to product line inconsistencies and damage to brand integrity. Some McDonald's restaurants were also competing with each other for customers.

     After the company's IPO, earnings performance deteriorated. It posted a net loss for two straight years through 2003, setting the stage for Fujita's departure and the recruitment of Harada. He pulled off a sharp improvement in same-store sales from 2004 by introducing two new management approaches to the company.

     One was a "sequence strategy," which calls for taking on challenges one by one, according to their priority. Harada first ordered restaurants to focus on improving quality, services and cleanliness. After they recovered their reputation among customers, Harada started cutting prices to boost customer traffic. Then, he launched new products and raised prices to lift per-customer spending.

     The other was to focus on raising asset efficiency. "Harada's big contribution to management was to make employees aware of the importance of balance sheets as opposed to profit-and-loss statements," said Yuki Tomonari, chairman of Mos Dining, who once served as a senior executive at McDonald's.

     When Harada took the helm, the ratio of restaurants under direct management of the company to franchisees was 7:3. The ratio of franchisees in the U.S. was almost exactly the opposite. U.S. headquarters focused on brand, product management and risk minimization in a bid for stability. Entrusting franchisees to manage stores leads to higher efficiency and lower costs.

Side effects

The ratio of franchise outlets in Japan has since risen to 68%, but this has produced unexpected problems.

     McDonald's sales consist of sales of directly-managed stores plus franchise income. But franchise income includes profits from sales of stores.  Such profits reached as much as 4.3 billion yen one year, driving up the company's bottom line. Some market players speculated back then that the company's operating profit would fall if it were not for store sales.

     Harada on Aug. 23 made a comment on this issue through a public relations official. He stressed that the sales per franchise outlet grew 80% during his tenure as CEO, leading to cash flow growth. But dwindling sales of restaurants will make it increasingly difficult for the company to achieve strong growth in operating profit.

     The sequence strategy also stopped working after an earthquake, tsunami and nuclear meltdowns devastated Japan on March 11, 2011. McDonald's created a buzz by cutting the prices of its staple products at that time. But sales did not return to levels seen before the campaign after they were raised back.

     As a result, the company posted a fall in sales in 2011. It started showing declines in both sales and profits in 2012.  In 2013, McDonald's Japan suffered a 53% drop in operating profit. Harada passed the baton to Casanova, a Canadian native, when his formula for success stopped working. She has decided to remodel stores to attract more families and avoid radical changes in the prices of mainstay products.

Limitations of speed-oriented operations

McDonald's faces formidable challenges in product development in an increasingly competitive market.

      The company's core competence lies in its speedy meal preparation system. Numerous items are created from the same several basic components.

     Upmarket hamburgers were introduced last year to try to win back customers. That backfired as the company found that increasing the number of ingredients causes serious confusion in the highly systematized kitchen.

     Then the expired meat scandal hit.

Worker fears

Crew members are now worried. They fear further cuts in working hours.

     Atsushi Okada, who leads the labor union of McDonald's workers, receives inquires from employees across the chain.

     He advocates cooperation between labor and management for the company's future. His plan is to negotiate with the company without damaging its health, while at the same time calling for the sale of unnecessary assets.

     Staff anxiety about the company's future underscores the enormity of the challenge it faces. Can McDonald's Japan survive its sink-or-swim moment?


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