Second Act
For Donatos Pizza, the struggle after parting ways with McDonald’s may finally be over.

By David Farkas

They say hindsight is 20-20. Just ask Donatos Pizza founder and CEO James Grote, who sold his then-rapidly growing chain—lock, stock and barrel—to McDonald’s Corp. in 1999 for about $150 million. Reminded that the burger giant acquired now-red-hot Chipotle Mexican Grill at about the same time in piecemeal fashion, management intact, Grote admits things might have been different had he held on to part of his creation.

“Maybe [McDonald’s] could have taken it slower. They would have tested more stuff out,” recalls the 63-year-old entrepreneur, lamenting the immediate introduction of thick-crust pizza, a product Donatos had never sold. “Our traditional crust was thin.”

It’s also been said there are no second acts in American lives. But Grote and his daughter, COO Jane Grote Abell, aren’t buying it. After reacquiring the regional chain in December 2003 for an undisclosed sum, they have opened a new prototype, introduced new products and stemmed the flow of red ink.

Just how much money Donatos lost over four years isn’t clear. But McDonald’s had invested heavily in equipment, people and research, recalls Abell, who filled several top management slots during that time. Filings show that it wrote off $237 million in 2003, the bulk of which was the loss on the sale to the Grotes, who reportedly paid $50 million for the cash-strapped chain.

“We took over a bunch of liabilities, but we were left in a position that we could handle them,” says Grote, whose family owns 70 percent of the business. Senior management and employees own the remainder.

No Pain, No Gain
Getting profitable was painful. Donatos, which once operated and franchised 197 units, grew and then shrank under McDonald’s wing. In the year prior to the sale, Donatos closed 36 units, including 23 in Atlanta. Since then the chain has shuttered seven underperforming units and refrained from opening new ones until last year. Yet today, the company claims, its balance sheet is healthy. “We’ve moved in a positive direction,” says Abell, citing a $10.5 million “turnaround” in EBITDA since parting with McDonald’s.

Working capital is also available and will be used to finance growth. According to CFO Doug Kourie, this year’s capital projects include five company units; two have already popped up, in Columbus, Ohio, and Orlando, Fla. The company is again following what it calls an “asset portfolio strategy,” meaning it will open the right type of store for the market—versus a previous strategy that led to the opening of 55 large “pizzerias,” which ultimately failed to produce profits.

The game plan doesn’t surprise industry observers. “The founder’s the one with faith in the brand, and when a corporate marriage doesn’t work out, he has the belief and experience to make things happen,” says Dennis Lombardi, executive vice president, foodservice strategies, of WD Partners, Columbus, Ohio-based consultants to chain restaurants.

“We are truly going back to what we know,” Abell declares.

One thing Donatos knows well is how to make dough. It will expand an existing dough-making plant attached to its Columbus headquarters this fall. The plant currently manufactures shells used in franchise and company outlets. The company is now working on a new pre-proofed dough, in test in several units, that will eliminate the need for in-store proofing.

Ohio taxpayers are partially paying for the project, which will cost about $5 million. The Ohio Department of Development, which typically funds high-tech ventures, granted Donatos a $2.9 million low-interest loan earlier this year.

The loan drew criticism recently from the Buckeye Institute, a conservative think tank, which chided state officials in an article that appeared on its Web site. “Calculators everyone,” wrote President David Hansen. “State helps one pizza maker sell more pizza…divided by no growth in the market for pizza…equals…less sales for all the rest of the pizza shops on Main Street.”

There’s some validity to the claim. The market for pizza is mature and crowded, offering few opportunities to create new customers. Worse, the swelling price of gas may dampen spending even for a relatively cheap item like a pizza. Domestic same-store sales at category leaders Domino’s and Pizza Hut are down 3.8 percent and 5 percent, respectively, appearing to reflect the squeeze on consumers. Domino’s CEO David Brandon told analysts domestic same-store sales would grow only 1 to 3 percent in ’06. It was no different at Donatos, where first-quarter comps remained flat or down in company markets (Columbus, Cleveland, Orlando, Indianapolis and Philadelphia), and Abell doesn’t expect them to climb above 2 percent, if at all, for the year.

Yet unlike the big national players, Donatos won’t offer steep discounts to boost traffic. Grote doesn’t want to sell “a commodity product,” thus tarnishing the chain’s emphasis on quality, abundance and consistency. And discounts cut into profits quickly given more costly ingredients. Donatos’ current TV commercials—mostly animation—harp on the theme of “edge to edge” toppings and show mouthwatering product shots. The signature 14-inch pepperoni pizza, for example, is guaranteed to include at least 100 pieces (pieces are weighed, not counted).

Company officials maintain these upscale attributes are what attracted McDonald’s in the first place. Asked to confirm that contention, a spokesperson for the burger giant says only, “We no longer own Donatos.”

Let’s Make a Deal
To be sure, Donatos deals, Abell says, but chiefly to spark trial of new products, like a line of ciabatta-bread sandwiches rolled out earlier this year. Coupons typically offer $2 off a $10 purchase. Dayton franchisee Todd Rogers, who operates 15 units in southwest Ohio, recently bundled a two-liter soft drink with a pizza. “It worked well for us,” he says.

Yet during the tough first quarter, the chain couldn’t resist offering a more substantial discount, selling a second medium-size pizza at half price with the purchase of a large. “We are still in a transition period,” Grote admits. “But we want to get off the Kool-Aid.”

When and if they do, management will be counting on an upscale image—both in decor and service. High-quality products and high standards of service are responsible for average weekly sales of $18,300, among the highest outside Columbus, Rogers says. In Columbus, the company’s best market (it has a 40 percent market share, according to officials), Donatos rings up an average $20,000 a week.

Those sales now come chiefly from “pizzerias,” costly 3,000-square-foot units that were McDonald’s idea. Last December, Donatos changed course, opening a 40-seat, 2,100-square-foot prototype that features a walk-up counter and is something like the units Donatos opened prior to ’99. Dayton-based Design Forum created the dining room, while WD Partners subsidiary SME designed the kitchen. The front of the house, which strongly suggests a fast-casual eatery, features soft colors, trendy lighting and inspirational wall messages like, “Enjoy. Hope. Smile.” An open kitchen allows dine-in customers to glimpse employees making pizza, sandwiches and salads without seeing the full process.

“In the old model, we had real separation,” Chief Concept Officer Tom Krouse recalls. “The room was dull, dark and without energy.” He is referring to the larger units McDonald’s called pizzerias, casual-dining-like eateries with menus and, oddly, telephones at each table from which customers called in orders. Often a worker served as both hostess and order-taker, scampering back to the kitchen after seating a party only to answer their phone call. The system confused customers, as did plastic plates and forks.

Franchisees didn’t open pizzerias, perhaps scared off by the cost, which climbed to as much as $1.6 million, officials say. Abell recalls that during McDonald’s tenure, equipment innovation was prized. “Under the Arches, it became about the patent and innovating on equipment,” she says, remembering chilled racks over the make station that required a compressor. Today, she adds, “We look at an equipment package and buy what we need.”

By contrast, the new prototype, which costs just $450,000 (noncapitalized), may prove attractive. “Investment had gone up with the pizzerias. It was an easy thing to bring back down,” Abell says. Donatos won’t share specific unit-economic information but does say the prototype can make money with weekly sales of $15,500.

Model Behavior
The company arrived at the sum after revising its unit-economics model. “We used to try to drive toward a sales number,” Kourie says. “What we think is prudent is to take a sales number we are pretty sure we can hit in average-town America and ask, ‘How do we make money at that?’”

Franchisees (there hasn’t been a new one since 1998) now seem interested. “We [franchisees] stayed on the sidelines,” Rogers says. “Since the Grotes bought the company back, we’re still on the sidelines but much closer to the playing field.” Rogers, a franchisee since 1993, will remodel two stores this year with elements of the new prototype.

Donatos also intends to remodel several pizzerias. “Some of the units are in planning stages,” Grote says. “A couple of them will go to counter service, and some we will do outside renditions with a pick-up window.” He’s referring to the reddish-orange tower, a striking design element, encasing the pick-up window and emblazoned with “D To Go.”

But the extent to which it will retrofit existing units is yet unclear. Management is currently wrestling with how much the company can afford to be “premium” in areas other than product.

Service recently became an area of focus after telephone surveys showed Donatos didn’t meet customer expectations. “We built the premium restaurant,” Abell says, referring to the prototype. “We have not yet built the service platform we need. We have a lot of work to do.”

To improve, Donatos will test a new POS system in company restaurants in July. It will trim order speed, according to Abell, and employees answering the phone will no longer immediately ask for a phone number because the system automatically brings up customer data. “They can say ‘hello’ first,” she says. The cost: about $15,000 per unit. The company is also planning a call center.

“We were always back-of-the-house managers. But the paradigm is changing. How we answer the phone is most critical, and how we cash you out,” Abell says.

In her spare time, she has been reading about successful service-oriented businesses. “I want to know what Nordstrom does to create the ‘wow’ factor. I don’t think it’s anything we don’t know,” she says. “But how do you transform a back-of-the-house culture to into one that turns around to face the customer?