Is sale of China franchise a right move for McDonald's?

Birds fly past a sign of 24-hour McDonald's restaurant at sunrise in Hong Kong, China on November 11, 2015. Photo: Reuters

Getting local strategic investors involved in business development appears to have become a tactic of transnational fast food chains struggling to hold on to their territory in competitive China, as home-grown fast food restaurants are gaining ground. But it does not mean foreign brands have run out of ideas in the country.

McDonald's is one such giant which has had to make adjustments and compromises in China. In a $2.08 billion deal inked recently, the American fast food giant agreed to partner with Chinese state-backed conglomerate CITIC Ltd, CITIC Capital and American private equity firm Carlyle Group to establish a joint venture, which will act as the master franchisee of McDonald's outlets in the Chinese mainland and Hong Kong for the next two decades. The deal allows Chinese investors to own a controlling stake of 52 percent combined in the new company, while Carlyle and McDonald's will have 28 percent and 20 percent respectively.

McDonald's has built a legend in China since its entry into the world's most populous market in 1990, when having a meal at McDonald's was regarded as extravagance.

Coincidently, Yum Brands, the owner of KFC and Pizza Hut and also the archrival of McDonald's, already did a similar thing last year to sell a slice of its China operations for $460 million to Chinese private equity firm Primavera Capital and Ant Financial, the financial arm of the country's e-commerce titan Alibaba Group. The introduction of capital from the China-focused investors was then considered as a significant step in Yum Brands' plans to accelerate the process of localization in China. The local partners' abundant experience in commerce and extensive connections with the Chinese government were needed to enhance its presence in China, said Yum Brands.

At present, Yum China is run independently and trades equities on the New York Stock Exchange, granting the rights to the management on whether to turn the company-owned outlets into franchised ones and what new menus should be developed to appeal to Chinese tastes.

The aims of McDonald's ceding control of its Chinese business is basically the same as Yum Brands: unlock growth potential, free up capital and generate stable returns, as Regina Hui, vice president of communications at McDonald's China, put it, "Our announcement (about the deal) is to accelerate our growth in China."

McDonald's said in a statement emailed to the that the partnership will accelerate its growth in the Chinese mainland and Hong Kong, especially in the third-tier and fourth-tier cities, and that it will focus on opening new stores, innovating menus, developing digital technologies and optimizing delivery experience.

The decision of selling franchise rights in China is based on McDonald's' bet on the growth potential of the middle class, whose disposable incomes are expected to increase as the country is transforming its economy into one driven by consumption. The Oak Brook, Illinois-based company estimated that such a group of people are willing to spend more on dining out and other recreational activities, a key factor it thought could support its growth in China. But the problem is that few middle-class consumers see having dinners at McDonald's restaurants as a symbol of higher social position as they did in the 1990s.

Starting 2016, McDonald's began assessing the ownership structure, targeting Asia including China as a key experimental field where it was planning to reduce the number of company-owned stores for the purposes of cutting operating costs and simplifying the process of policymaking. At the time, McDonald's CEO Steve Easterbrook illustrated the strategy as a way to localize his company's global standards, a goal he said could be achieved by deep cooperation with local partners.

Serving revitalization plan  

The partnership with CITIC Ltd, CITIC Capital and Carlyle is in line with the revitalization plan that McDonald's announced for the Chinese market in the spring of 2016, Hui told the

According to the turnaround plan, McDonald's was planning to open 250 new restaurants in China annually over the next five years, replenished with an auction of its wholly-owned outlets in the country, where there are about 2,600 locations, 1,750 of which are company-owned.

Hui said that the plan will lead to McDonald's achieving a 100 percent franchising ratio in China where its sales recorded positive growth in the past five quarters.

Analysts believe that the approach could make its prices stay competitive in order to survive the intense Chinese market and that entitling local franchisees with 100 percent ownership of the restaurants in China will relieve the burden of the rising capital spending on rent, employment and taxes.

In this aspect, CITIC Ltd and CITIC Capital could be more helpful. The state-owned companies are well connected with the Chinese government and property developers, which could give a strong hand to McDonald's in exploring new locations across the country.

Besides, CITIC Ltd, CITIC Capital and Carlyle have a wide-ranging cooperation framework of mobile technologies that McDonald's needs to better connect its restaurants with consumers. Last year's agreement between Yum Brands and Ant Financial allowed Alipay, a popular mobile payment service operated by the latter, to be used at more KFC and Pizza Hut restaurants across China, a good cooperation that Ant Financial President Eric Jing said will help shorten queues at the cashier.

"The cooperation with CITIC Ltd, CITIC Capital and Carlyle will have a far-reaching impact on China's fast food industry. And it can be predicted that foreign fast food giants will bring in more locally oriented products to meet the Chinese demand," said Zhu Danpeng, a researcher from the China Brand Research Institute.

At the same time, the partnership indicates that the two Chinese investors treat the deal as a desirable investment target at a time when the Chinese government is curbing rapidly growing outbound investment by domestic companies amid the yuan's depreciation expectations.

China's State Council recently circulated a document to set stricter restrictions on outbound investment and merger and acquisition activities. It banned investments of more than $1 billion in the real estate sector by the state-owned companies, investments of more than $1 billion if the deals have nothing to do with the investors' core businesses, ultra-large investments valued at over $10 billion and acquisitions of 10 percent or less of the shares in the overseas listed companies.

'Growth momentum will persist' 

Ceding the franchise right in China to outsiders has triggered speculations that McDonald's is planning to quit the Chinese market after the earlier food safety scandals dented its sales and reputation in the country. What's more, with the rise of domestic players and the Chinese government's tightened industry policies toward foreign companies, McDonald's is finding it harder to navigate in what it is called a "saturated market".

In response, Hui told the that the business in the Chinese mainland and Hong Kong "has been growing with good momentum", but she refused to give specific sales figures, citing that McDonald's is listed in the New York Stock Exchange. "The remaining 20 percent stakes in the new company held by McDonald's shows our confidence in the prospect of the Chinese market," she said, vowing zero tolerance for food safety problems.

The statement of Hui is echoed by a manager of a company-owned McDonald's outlet in Shenyang, the capital city of northeastern China's Liaoning province, which hit the headlines recently for falsifying financial data between 2011 and 2014.

"Both our consumer flows and sales have not seen a decline in recent years even after the food safety scandals," said the manager, who refused to be named. He also insisted that his store was not involved in the food safety scandals.

Another manager at a Beijing-based outlet of a famous Chinese-style fast food chain described McDonald's franchise sale as a "sensible decision", saying that it will contribute to the company's localization in the country.

"I think that its growth momentum will persist for at least 10-20 years, because McDonald's still holds on to its most valuable assets that can generate profits including brand, staff training and (industry) standards and because most domestic fast food restaurants remain inferior to McDonald's in aspects of location selection, management, supply chain and use of mobile technologies," said the manager on condition of anonymity.

The future growth of domestic players would partly decelerate due to a manpower shortage, increasing costs of ingredients and lack of experience in talent management, she revealed.

"Compared with McDonald's, I think that (our chain) has no advantage in pricing. (I guess) our capital spending on materials supply chain is much higher than McDonald's."

However, a market survey conducted by Euromonitor International showed that the market shares of KFC and McDonald's in the Chinese fast food industry have plummeted to around 37 percent (24 percent and 13 percent for these two brands respectively) from a peak of 57 percent (40 percent and 17 percent respectively).

Ripple effect

McDonald's and KFC are not the only foreign fast food brands that collaborate deeply with the Chinese investors.

Media reports said that US fast food chain Burger King had been seeking suitable Chinese investors for an expansion as it thought it will be helpful if Chinese partners were involved. Since entering the Chinese market, Burger King has attached importance to localization, integrating its supply chain, logistics system and management with the Chinese elements. During last year's Christmas Day, Burger King joined hands with, a food delivery app in China, to launch a sales promotion activity for Chinese consumers.

Also, Starbucks could be a pioneer in striking long-term agreements with the Chinese partners. Recently, the US coffee chain extended a 20-year deal with Uni-President, which allows the latter to continue to run its operations in eastern China. The Seattle-based company also has an ambitious expansion plan to increase the total number of its stores in China to 4,500 in 2020 and has started tapping into the country's traditional tea-drinking market with its Teavana brand.

"After 20 years, we will make a comprehensive assessment on whether to extend the deal based on the performance of the franchisee. CITIC and Carlyle are very powerful partners, and what they bet on McDonald's will not be confined to 20 years," said Hui.

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