Japan's fast food funk: McDonald's Japan slips into the red for the first time in 30 years. Blame deflation--and fashion.

"[yen] 59 ISN'T A REAL price. [yen] 59 doesn't buy you anything in Japan. You show me a place that can sell something for [yen] 59, and I'll show you a place that's going to end up bust."

This is the grim conclusion of Tomoki Harada, the 48-year-old owner of a run-down ramen shop in the Hongo district of Tokyo. Two doors down from his restaurant is the globally renowned, gleaming red and yellow branding of McDonald's. Underneath it is a blaring poster: "Hamburger [yen] 59."

At face value, this is a great offer: a bite of that world-famous taste for a price that no other establishment can possibly match. But scratch the surface a little and the advertisements read like a desperate cry for help.

There are many levels on which the cracks in McDonald's Japan are starting to show, but the most obvious starting place is the raw financial numbers. At an official revision to its figures in December 2002, the group was forced to announce net losses of [yen] 2.3 billion ($20 million) for the full year--the first drop into the red since 1973. Of even more concern to the shareholders was news that the company would be closing 176 branches of its 3,600-strong network of outlets across Japan.

None of these horrors were supposed to befall a business plan that had only ever delivered growth. When shares in McDonald's Japan were floated in 2001, investors saw gold in the golden arches. Den Fujita, the entrepreneur who brought Ronald McDonald to Japan and the father of the McTeriyaki Burger, spent that year predicting great things for his company. At the top of his list was the impressive forecast that he would have 10,000 restaurants up and running by 2010.

This March, however, Fujita suddenly announced that he would be retiring as chairman and chief executive. In a short statement the company made every effort to deny any link between the loss and the departure--after all, the charismatic patriarch would be turning 77 just a week later.

But the market, the analysts and the general public remained skeptical. The move certainly seemed to take the rest of the board by surprise, and at the very least it could be taken as hugely symbolic.

Fujita was the first to successfully take McDonald's out of America, the first to convert an entire people to a new way of eating, the first to show that the basic menu could be molded to local tastes and the first to take a McDonald's subsidiary public. As the McDonald's empire spread east and west from its headquarters in Oak Brook, Illinois, McDonald's Japan was the perfect proxy for its expansion.

But now that Japan has started to change its mind about McDonald's, the fellows back in Illinois are feeling a cold chill about the global business.

Last month, Fujita was forced to face another sign that the magic has gone. After years of resilience, Japanese branches of McDonald's have now become targets of domestic protests. A group of animal rights activists and other demonstrators descended on a large branch In Shibuya to denounce the way the fast food chain handles meat. The pursuit of cheaper and cheaper prices has, they say, forced McDonald's and others to cut major corners. It is a charge that fits particularly well with the spate of food scares that has dogged Japan.

McDonald's Japan has blamed a lot of its woes on issues beyond its immediate control. The worldwide BSE problem, local scandals over meat labeling and a variety of other scares have periodically dented consumer confidence in beef. But "the problem," says protestor Sachiko Azuma, "is that people don't understand the link between the economics of the business and the food scares. So the diners soon come back."

Accordingly, the analysts and economists believe there is a far more fundamental reason that McDonald's bas run into trouble, and it centers on those [yen] 59 burgers. Rather than an astute player of Japan's precipitous deflationary curve, they say, McDonald's is emerging as its first major victim.

As shares in McDonald's Japan continue their relentless decline, several key figures stand out. Foremost among these are statistics released last September showing customer numbers smashing through monthly record highs. The problem is that those customers have only walked under the golden arches because the food is so cheap. The margins, therefore, have been driven cripplingly low. High turnover and financial losses are a doom-laden combination anywhere in the world, but particularly in Japan where the cost of expansion has been so great.

Apart from the [yen] 59 burger, the rest of the menu is being offered at knock-down prices, too. As Michiharu Sato, a Tokyo history student, explains: "Lotteria, KFC, Mos Burger and the other chains have all got their cheap deals, but a Big Mac set for [yen] 450 is still the best value around. The economic climate has turned us all into bargain-hunters, and so we know where to go to fill up."

As the price war rages between the fast food outlets, McDonald's has used its size mad economy of scale to push the boundaries farther than good business sense would allow. At one stage late last year, McDonald's storefronts became a live-action portrait of Japan's deflation. Postings announcing dramatic new price-cuts were hastily plastered in place before the customers' very eyes. As one Nomura analyst observed: "We sat there wondering whether Fujita had a monkey In there making his decisions for him." When, briefly, the price of a burger rose from the [yen] 59 mark, optimists hailed the end of deflation.

It was a terrible false dawn.

By declaring a price war, McDonald's has taken the entire Japanese restaurant industry into the combat zone. Deflation has forced prices in every sector of food retail to plunge, and that spells dire news for the Big Mac. However great the company's ability to market hamburgers, its principal selling point has always been value. "So why on earth should I go to McDonald's to eat, when I can spend just a little bit more and have a lovely plate of fresh sushi in a nice restaurant?" says Takashi Iwata, a retired plumber from Machida.

It is a question that the analysts, and, it would seem, McDonald's itself are unable to answer. Deflation has started to write the ultimate symbol of globalization out of the script in one of its most critical markets. Once McDonald's loses a significant price advantage, it has little to offer a market now moving on rapidly from burgers and fries.

As the group has tried elsewhere in the world, McDonald's Japan took the step late last year of attempting to broaden the menu, foisting McChoice in an effort to appeal to a wider cross section of diners. But few investors hold out much hope. Far more interesting, they say, is the tacit admission in the August 2002 opening in Hibiya of Japan's first Pret A Manger--a UK-based sandwich chain offering a healthy alternative to deep-fried fare. McDonald's became a majority holder in the company two years ago, and the market suspicion has always been that it would turn to Pret when the global going got tough for burgers.

But in the final analysis, McDonald's problems in Japan and potentially the rest of the world may be rooted in something even more destructive than deflation: fashion. Fujita is probably all too aware that his departure coincides with McDonald's creeping loss of "cool." Starbucks, Excelsior and the other coffee chains provide ubiquitous alternatives for young Japanese to meet and kill a few hours. And they currently have the edge in terms of chic.

"It used to be McDonald's every evening after school, hut not now," says 18-year-old Ken Ogawa. "We used to drink coffee, or maybe eat something, but the main thing was knowing that everyone would be there. McDonald's just isn't somewhere we want to meet any more."

Shinjuku Snapshot

A slow day at the fast food empire suggests the snooze-set has settled in.

In Japan, as with everywhere else around the world, McDonald's has paraded itself as a family restaurant that is also cool for kids. But does the reality match the vision? The Japan that McDonald's broke into back in 1971 was a very different place from its 2003 counterpart. The burger chain has always been a master at moving with the times, but a snapshot taken today suggests that the times may now be speeding out of sight. Tight economic conditions mixed with old-fashioned shifts in trend are clearly taking their toll, as a Friday afternoon in one McDonald's branch in Shinjuku shows.

1:30pm

The lunchtime rush starts to thin out, leaving four single men, of whom three appear to be in their mid-fifties. Tray debris suggests that all three of the older men chose the Big Mac Set, and all have been nursing their coffees for some time. None are in suits. The fourth man, in his early twenties, studies a thick PC magazine and sips a coke--the only item on his tray.

Two pairs of women, all in business dress, chat noisily and prod at their McSalad shakers. One has ventured a [yen] 59 hamburger. At 1:45 all start looking at their watches and head back to the office.

A lone woman in her early thirties concentrates on the screen of her mobile phone, which intermittently beeps as messages arrive. She has taken a single bite out of her McApple Pie.

2:00pm

The three older men remain. One has started reading a book; the others check the racing pages of their newspapers.

The younger woman has left, but her spot by the window has now been taken by a lone woman in her late 40s. She tucks into a Double Cheeseburger Set and has bought an extra burger, which she also quickly polishes off. Her mobile phone rings, and she bellows into it for five minutes and then settles down with a magazine.

3:30pm

The PC enthusiast finally leaves but passes by the counter on the way out. He has won another Coke in the latest scratch-card promotion, which he claims and takes out with him. The book-reading man also leaves, but does not bother clearing his tray.

Three women dressed as gothic spectres amble in. One of them brushes magazine-woman with her chains, waking her up and eliciting a grunt.

The Goths buy two coffees between them, spread their shopping on the tables and talk about nose-rings.

The flow of take-away customers rises steadily. Most are buying the cheapest burger and eating it as they walk towards Shinjuku station.

4:00pm

Goths leave and a group of four high-school students (three girls and a boy) approach the counter. One has started ordering when another receives a mobile call. They all decide to leave, but the first one takes his food to a table, promising to catch up with the others. He crams chicken nuggets into his mouth as he talks on the phone.

The two remaining older men groan and get to their feet. Magazine woman continues to snooze.