McDonald’s faces test after ceding control of China restaurants

McDonald’s faces test after ceding control of China restaurants

When Beijing’s first McDonald’s outlet opened near Tiananmen Square in 1993, about 40,000 people queued round the block to place an order, a sign of a voracious appetite for fast food that would propel China to become the company’s third-biggest market by outlets, trailing only the US and Japan.

But a quarter of a century later the Golden Arches have lost some of their lustre for Chinese consumers, and amid falling sales McDonald’s on Monday sold control of 2,700 China restaurants to a consortium led by state-run investor Citic. The $2.1bn deal follows KFC-owner Yum Brands’ spin-off of its much larger China operations in October.

McDonald’s faces test after ceding control of China restaurants

McDonald’s faces test after ceding control of China restaurants

While both groups will continue to receive royalties from Chinese sales, analysts say ceding control of assets and handing decisions to local management will allow the brands to expand more rapidly and localise more nimbly in a crucial market.

But both new units will struggle to improve the image of US chains. Where once they were perceived as an exotic, upscale choice for dates, business meetings and even weddings they are now increasingly looked upon as mundane. Sales at both groups were also hit after scandals over expired meat in 2014, while ordering apps have spurred increased competition for deliveries.
When Beijing’s first McDonald’s outlet opened near Tiananmen Square in 1993, about 40,000 people queued round the block to place an order, a sign of a voracious appetite for fast food that would propel China to become the company’s third-biggest market by outlets, trailing only the US and Japan.

“China has grown out of the American fast food craze,” says Junheng Li, founder and president of New York-based equity research group JL Warren Capital.

KFC’s market share fell to 3.6 per cent in 2015 from 6.4 per cent in 2012, according to Euromonitor, with same-store sales declining in absolute terms. McDonald’s does not separate out its China revenues but said like-for-like sales in the country had fallen almost 2 per cent in the third quarter.

China became crucial to both brands, especially for Yum, whose 7,200 KFC and Pizza Hut branches there generated $6.9bn in 2015 — the highest of any region. KFC was seen as a model of overseas management, adapting to local tastes by adding porridge and rice to its menu.

McDonald’s China, in which two Citic affiliates will have a 52 per cent stake, with US private equity firm Carlyle Group taking 28 per cent, is expected to back plans to open 1,500 McDonald’s outlets over the next five years, mostly in smaller cities.

In such locations “the market is still expanding at a fast rate and western outlets are still highly regarded”, says Kamel Mellahi of Warwick Business School, adding that “the franchise model will enable McDonald’s to localise its offerings in China”.

But, says Mr Mellahi, “the franchise brings its own challenges, not least . . . lack of talent and managerial skills in third and fourth cities and, most of all, loss of control”.

Founded in 1979 and best known for investments in property and natural resources, Citic has deep pockets and impeccable political connections but no experience of running restaurants. It was attracted to McDonald’s by the opportunity to gain a foothold in one of corporate America’s most iconic brands, according to people close to the deal.

Under the terms of the 20-year McDonald’s franchise agreement, the new owners are barred from altering management or suppliers for two years, or exiting through a public offering. The FT reported last month that potential buyers including Bain Capital and its Chinese partner had dropped out of the auction over the terms.

McDonald’s will receive higher royalty fees from future China operations than the 3 per cent of sales that Yum gains from its spun-off China unit, which listed on the New York Stock Exchange in October, people close to the deal say.

Yum sold a $460m stake in the China unit to Primavera, a China-focused private equity firm founded by an ex-Goldman Sachs banker, and the finance arm of Chinese internet behemoth Alibaba before the listing. The company said at the time that the proceeds could fund a plan to nearly triple its restaurants in China to 20,000.

“They are both focusing on franchising, which is a more profitable model,” says Jeffrey Towson, a business professor at Peking University. But he likens McDonald’s private equity-style model, which allows for debt-funded expansion, to “Yum China driving a sedan [while] McDonald’s has just upgraded to a Ferrari”.

One challenge both brands face is the rise of mobile apps through which consumers can order food delivery from a wide range of restaurants. Groups such as Ele.ma and Meituan “are doing to the food sector what [online retailers] Alibaba and JD have done to bricks-and-mortar retail”, says Shaun Rein, managing director of Shanghai-based China Market Research Group. “McDonald’s had been known as fast, cheap and convenient. But now Ele.ma has become more fast, cheap and convenient.”

Yum’s China business returned to sales growth in the past year even before the spin-off, as new management cut the number of food offerings and renovated outlets to give them a more upmarket feel. On Monday, it opened the country’s only Taco Bell outlet in Shanghai’s financial district. Decorated in a “California-inspired” style with surfboards hanging from the ceiling, the restaurant sells shrimp and avocado burritos, which the company says are “unique to Taco Bell restaurants in China”.

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