More and more families with two working parents—as well as ever-busier lives and a booming economy—are driving rapid growth in the quick-service restaurant industry. Last year, for example, growth in overall revenues for these purveyors of burgers, chicken, pizza, and other $4-a-shot meals outpaced both the broader retail category and the S&P 500.¹

Yet intense competition, escalating marketing costs, and labor shortages have kept those increasing revenues from dropping to the bottom line. In fact, in the United States, the industry’s market capitalization has grown a good deal more slowly than that of retailers and of the S&P 500 as a whole (Exhibit 1). This unfortunate trend of growth without profits is typified by the Boston Chicken chain, which from 1993 to 1997 opened 1,200 units and built system sales of $1.2 billion, only to file for Chapter 11 last year.

Making money in the restaurant business around the world has always been tough. Now it is tougher than ever. Until recently, the global competition, though intense, involved a small and fairly stable set of players: McDonald’s and Burger King, Kentucky Fried Chicken (KFC), Pizza Hut, and a few other major chains. Today, the competitive field is broader and fiercer. European and US quick-service restaurants must compete not only with growing restaurant brands—such as Carl’s Jr., in the United States, and Pret a Manger, which is expanding from its London base into Paris and the United States—but also with big supermarkets carrying prepared entrées and salads. Meanwhile, such competitors as Boston Chicken (which serves roast chicken and a large variety of side dishes) and Au Bon Pain (sandwiches on fresh, store-baked breads) are constantly introducing innovative products.

Competition for employees is equally fierce. Finding, training, and keeping them has always been a challenge in this low-wage, high-turnover, labor-intensive industry. With employment opportunities abundant even for low-skilled people, however, order takers and french-fry fryers are being wooed away before they have a chance to take off their "trainee" pins. Higher employee turnover means a decline in standards of service (which erodes the brand) and lower productivity (which erodes profits). Add to this the worldwide decline in the number of people in the 17-to-25 age bracket and the increasing complexity of work rules (for instance, the European working-time directive) in some regions, and you have a truly daunting challenge. In fact, finding workers has become so difficult that in some parts of the United States, McDonald’s runs major advertising campaigns to attract them.

Despite all this, the prospects of the quick-service food industry need not be gloomy. Continued revenue growth and the strength of the social trends driving it show that the industry still has great economic potential.² The question is how companies can build their brands and profits in this new environment. It will be essential to combine three approaches: the constant rejuvenation of physical formats and product offerings, a practice known in the retail world as "concept renewal"; the development of a new frontline labor equation; and consolidation.

Concept renewal

For any retailer today, one essential part of the strategic mix is concept renewal, which means not only executing the current concept differently or more effectively but also repositioning it to address shifts in the needs of customers.³ Typically, renewing concepts either increases a retailer’s penetration of the current base or extends it into related segments. By introducing playgrounds, for example, McDonald’s encouraged families to come more often and to stay longer and purchase additional beverages and desserts.

Other devices include changed decor, architecture, and menus (such as the introduction by McDonald’s of breakfasts or its more recent addition of Indian-style meals in the United Kingdom). Since renewal can involve big changes at physical locations, a retailer might find that certain stores don’t work under the renewed concept. Renewers must realize too that they don’t have the freedom enjoyed by those who develop a concept from nothing; instead, they must somehow transform an existing brand, customer group, asset base, and frontline sales force, mostly leveraging current sites to avoid the very high cost of exit.

Renewing concepts must become an essential part of the business because the average restaurant concept of the 1980s and ’90s has a five-year life cycle from launch to peak earnings to stagnation. As the competitive pace quickens and life cycles shrink even further, concept renewal will evolve from a helpful tool into an indispensable part of the brand-building arsenal. Although many operators have experience upgrading their restaurants, advertising is still their weapon of choice for repositioning themselves against competitors: most chains, for instance, spend twice as much on advertising as on renewal efforts. We, however, believe that concept renewal, developed with a sharp eye on the consumer and the competition and managed rigorously, can be an excellent tool for keeping old brands fresh. Combined with appropriate advertising, this approach can quickly deliver traffic and sales improvements of 20 percent or more, with commensurate gains in profits. To date, however, renewals have disappointed food-service operators. Fewer than half of the $50,000-plus refurbishments and renewals undertaken by five of the companies we examined created positive returns for investors.

Although not many restaurant companies have tried renewals, other retailers have. Radio Shack, the specialty electronics retailer, has shown that concepts can be renewed repeatedly and successfully even within franchise structures: by abandoning sales of computers and systematically and cost-effectively remaking itself into a center for basic electronics, accessories, and service, Radio Shack delivered $200 million in annual profits when many computer chains were losing millions. One of the valuable lessons quick-service restaurants can learn from the experience of other retailers is that concept-renewal investments have to be viewed and managed as systematic marketing efforts, not simply as piecemeal refurbishments to buildings or as part of real-estate programs. Operators must ruthlessly exclude nonessential back-of-house items—by not ordering new models of old equipment prematurely, for example—since they can increase the cost of a renewal by as much as 45 percent over what would be needed to buy the front-of-house elements that customers notice.

Unfortunately, restaurant managers and franchisees, who typically are operators first and marketers second, will probably resist that kind of ruthlessness. One chain found that in the United States, a large number of restaurant managers had supplemented a core appearance upgrade—including menu boards, seating, and service stations—with many ad hoc changes in the employees’ area and in the kitchen. The cost of these additions changed the return on the total investment from positive to negative. In Europe, by contrast, overinvestment in front-of-house elements seems to be stealing resources from critical cooking-platform investments. Either way, the lesson is clear: managers must firmly limit spending to items that will deliver returns. Setting explicit spending targets for renewal teams and working with development partners to keep costs at manageable levels can help companies achieve the results they desire.

To succeed, renewals must also focus narrowly on stores that have the highest potential, though not necessarily the highest current sales volumes. Despite the smaller sales bases of lower-volume stores, the sales and profit impact of renewals can actually be higher in them than in their popular flagship counterparts. In fact, several chains actually found that remodeling the latter had no impact at all, because their physical facilities simply couldn’t handle more customers.

Changing the labor equation

The customer’s experience is an essential part of what makes a restaurant brand, and frontline employees define a major part of that experience. Yet with unemployment hovering in the United States near 4.5 percent—a 20-year low—and food service ranking as one of the least attractive industries for frontline jobs, getting and keeping employees has frustrated many operators.

Some restaurateurs have begun to crack the problem, however. By cutting annual turnover from highs of 250 percent down to levels between 80 and 100 percent, they have shown that dramatically improving retention rates is easier and more profitable than conventional wisdom assumes.⁴ The economic effects of higher retention rates are considerable. Low-turnover restaurants have operating margins that are more than 2 percentage points higher than those of comparable restaurants with higher turnover. Their food and labor costs are lower because their managers can put more effort into managing and less into recruiting and because their employees are more productive. Their average sales are 3 percentage points higher because their managers have more time to focus on marketing, and their front-of-house employees are much likelier to deliver error-free orders quickly and even to greet regular customers. This adds up to real money for individual restaurants and to almost $1 billion of potential profit for the industry (Exhibit 2).

Furthermore, restaurateurs who have invested in efforts to deal with this problem have shown that retention rates can rise dramatically, not in the two to three years conventional industry wisdom assumes but within six months—comparable to the time needed to show results from other front-of-house investments. One company that recently acquired a number of ailing shops that were compelled to absorb new operating practices managed to cut turnover by as much as 40 percent over that period.

Nonetheless, much value remains to be captured. Holding on to employees is a hard issue to address, so food-service operators have tended to undermanage it. Despite its economic impact, more than 80 percent of the companies we studied had no way of measuring retention rates at the unit level. For this among other reasons, they can vary by 150 percent at stores that pay the same wages. This variation also stems from the fact that certain operators recruit employees more creatively and have stronger customer service organizations than their rivals do.

Some operators, for example, are finding innovative ways to broaden their target labor pools, such as offering language classes or free transportation from high-density but distant neighborhoods. Others are learning which parts of the labor pool are best suited to their concepts by using simple psychological tests or targeting specific demographic groups: US and European retailers are experimenting, for instance, with hiring older employees to compensate for the shrinkage of the 17- to 25-year-old cohort. Still other operators seek to attract the best entry-level employees by offering such perquisites as moving and hook-up subsidies at local apartment complexes.

Such creative recruiting tactics should be reinforced by value propositions for selecting, compensating, training, and developing crews and managers, as well as better systems support. One well-known chain that had originally looked for restaurant managers mainly through newspapers altered its hiring strategy by targeting business schools, whose MBAs were offered a value proposition stressing a clear career path from restaurant manager to higher levels of management. Other companies use creative scheduling to help employees balance their jobs with outside responsibilities and adapt to work rules. Our research, moreover, shows that the more consistently an organization delivers services to its customers, the more employees want to stay with it. So the best operators also focus their staffing and mentoring systems on service rather than just efficiency, show a greater willingness to dismiss the bottom 20 percent of performers, and establish store- or team-based service and productivity targets.

On the systems side, the best operators pursue less obvious opportunities to improve the environment and brand delivery of their restaurants—such as pulling food preparation out of their restaurants. The Taco Bell system, which combined a brand-new cooking platform with the delivery of preportioned, ready-to-heat food to restaurants, helped simplify many basic food-preparation activities, not only promoting a more consistent product but also giving managers additional time to concentrate on service.

Consolidate for control

To make both the renewal of concepts and labor changes work, restaurateurs must overcome tremendous difficulties—low economies of scale and the extreme fragmentation of most franchise networks—to execute consistently.

Partly because diners want variety and partly because of the pervasiveness of franchising, the food service industry is less concentrated than any other retail sector. Although there has been some consolidation of late in the United States, and more extensive consolidation in Europe, we believe that the process is only beginning. In the United States in particular, food-service today resembles the grocery and department store categories of ten years ago in its dispersion. Not surprisingly, most food-service players are small, with low market-to-book ratios, making them attractive targets for takeovers (Exhibit 3).

As in the grocery and department store industries, aggressive consolidators will probably step in. Several companies have begun to capture these opportunities. CKE Restaurants, which buys and repairs troubled brands, already behaves like a consolidator. Before CKE acquired Hardee’s and started improving its operations and network, its sales had fallen by 9 percent year after year; just two years after the acquisition, sales are expected to increase by 2 percent. CKE also consolidated the Rally’s and Checkers drive-through burger concepts and improved their performance. These moves have given CKE the funds and experience to pursue additional troubled quick-service restaurant targets.

In Europe, the future is less clear. Consolidation is certainly taking place, perhaps more quickly than it is on the other side of the Atlantic; Autogrille (Italy), for instance, has purchased Frantour (France), Stillhorner Raststätten (Germany), and Wienerwald (Austria), and McDonald’s has acquired Burghy (Italy) and Aroma Cafes (the United Kingdom). But the pace may slow as large real-estate premiums, high goodwill on brands, and other forces make it harder to find good deals. For large-restaurant operators that find the right ones, economies of skill and scale can mean a 2 to 3 percentage point performance advantage over smaller operators, to say nothing of greater strategic flexibility.

Given the industry’s razor-thin margins, even a garbage contract covering more can affect the bottom line thanks to economies of scale. Big operations also have lower financing costs and more efficient advertising, as well as the cross-unit efficiencies to reduce waste and cut food costs, for a net saving as high as 2 to 3 percent of total expenditures on food. Sharing operational best practices and marketing know-how with smaller or more fragmented entities after they have been acquired can compound these benefits, for top-line improvements of up to 25 percent.

Three kinds of consolidation will help aggressive brand builders capture value. The first involves consolidating franchisees and restructuring their network operations. Franchise networks do have some advantages, but the brand management of individual operators often suffers from a lack of store-to-store consistency and from resistance to change originating at headquarters. For many operators past the go-go growth phase, very fractured franchisee networks are no longer the most efficient way to structure operations. Our research shows that franchisees with ten units perform better than those with five units, which perform better than one-

off sites. In other words, many scale economies accrue quickly. Some large franchisees are realizing this fact and buying up small ones. Even without changing the ratio of company-owned to franchised stores, many chains could restructure a portion of their large and small franchisees.

In some areas, these dynamics are fueling the development of a group of master franchisees that may even manage portfolios of brands; indeed, the second kind of consolidation involves concentrating and restructuring them. Sites that are marginal for one brand, for example, might deliver big wins for another, and operators that arm themselves with broad portfolios can capture these opportunities across the board and improve their overall exposure and positioning. Pasqua Coffee’s recent acquisition by Starbucks, for example, will immediately improve its presence in downtown office markets.

Combining brands—putting two or more restaurants together under a single roof—offers a third source of value. Besides the operational improvements that can come from physically bringing together two similar concepts, such as Rally’s and Checkers, the location of complementary brands in the same places can increase overall unit volumes. If concepts draw traffic at different times of day, placing them close to each other can yield a 40 percent increase in revenues and a commensurate improvement in profits over the original site.

But this strategy isn’t simply about locating brands in the same places; many restaurants have done so and experienced only cannibalization. The success stories, by contrast, typically include designs that capture kitchen and supply chain efficiencies. And though the example of Starbucks and Barnes & Noble shows that brands don’t have to be consolidated to locate their operations in the same places, for many concepts, including Rally’s and Checkers, this approach is more manageable if both are food concepts.

With such forces at play, we expect a new generation of powerful leaders to emerge. Although several companies are already succeeding in one of the three dimensions of change—concept renewal, labor improvements, or consolidation—none has yet mastered all three. The company that does so will shape the industry through a powerful combination of consumer appeal and operational strength. Others risk seeing five more years of continued growth without profitability.