McDonalds and Yum Brands in China
Who Will be the Winner?
We attended investor meetings and store visits for both companies in September 2013 in Shanghai
Yum Brands has outpaced McDonalds in China on almost all metrics, looking at 2008-12 CAGR sales, ops profit, store expansion, margins. This is through first mover advantage and a flexible local team. The food scare for chicken supply and avian flu hurt 2013 results with 1H 2013 sales falling 6.3% YoY. Yum says it “will take some time” for margins (now 18%) to return to 20% and appears to be using this period to experiment with format and menu diversity. McDonalds is focused on a) rolling out its brand name to smaller cities and b) cutting costs. Given the diversity of its current menu and formats, KFC has the higher risk/reward profile.
We attended the back-to-back briefings for Yum Brands China and McDonalds China. We also spent two days on our own visiting Yum and McD stores and competitors in Shanghai.
The chart below shows Yum’s better four year track record in China, with superior 4Y CAGR in sales (Yum’s 24.8% vs McD’s 15.4%), CAGR ops profit growth (21.2% vs 17.8%), ops margin in a difficult year 2H 2013 (13.2% vs 10.6%) and CAGR store expansion (17.4% vs 13.9%). What does the future hold?
McDonald’s Focus on Execution and Operations
McDonald’s China also has been hurt by the food scare and slowing economy. Comp sales and guest counts were down 5.4% and 6.7% 1H 2013, and operating margins dropped to 10.6% from 13.3% in 2012, as operating income plummeted 17.2%. Capex was slashed to $94M 1H 2013 versus $255M FY2012. ROIC is down to 17.9% from 20.4% in 2012 and a high of 21.6% in 2009.
McDonald’s is focusing on establishing the brand in smaller cities, reducing costs through smaller footprint stores in Tier One cities, boosting traditional and online advertising, and closing non-performing outlets. The President of APMEA, Dave Hoffman, said McD culled 600 shops in Japan and is examining a similar process in China. Across APMEA, they plan to reimage 60% of stores, optimize menus and broaden accessibility.
There is little localization or “out of the box” experimentation. Within its formats, McDonalds there are two limited areas of expansion. One is the higher margin formats/products including Dessert Express kiosks (which management calls “ATM Machines”); located in 73% of restaurants, they can account for 10% of sales. The second is tailoring the drive-thru format for the high real estate costs and restricted property in the suburban- urban periphery areas, which account for 25% of sales in these areas. Drive-thru’s in the U.S. average 3500 sq m, while in Asia they are 2,000 sq m., and in high rent areas McDonald’s is reducing that to 800 to 1200 Sq
m. Also, high priority is put on what McDonald’s calls “cost avoidance” — stripping out frills like extra signage used in markets such as Australia. “Do we need to do a full-tier restaurant in a Tier Two market?” asked McDonalds China Head Kenneth Chan. McDonald’s is saving an estimated $152,000 per store with rollout of its stripped down format. Capex savings also will come through a higher rate of franchising, rising from 10% now to a goal of 20-25% in 2015, moving from 170 stores to close to 500. Commodity prices and labor costs are a problem and the company is forecasting continued double digit gains in wages.
Revenue growth for the most part is planned through McDonald’s existing menu and formats. “The goal is to build the base of customers, market share, and raise the average check,” which is $3.30 versus $5.45 in the
U.S. As an example of operational savings, to reduce storefront costs in high rent areas, the company has introduced formats with a kitchen one or two floors above the sales counter, with food delivered to customers via conveyer belt. Another concentration is delivery, a high margin business that are in 34% of restaurants and can account for as much as 15% of SSS. Currently, 75% of stores are in T1-2 cities but they plan to reduce that to 60% within the next five years as they penetrate smaller markets where margins generally are 100 bp higher.
Yum – Seeing What Sticks
Following the chicken scare at the end of 2012, Yum polls showed 60% of consumers reduced visits to KFC. Yum instituted a food supply program called “Operation Thunder” to eliminate smaller suppliers and modernize the food chain. Yum already had the best supply chain in China so it is questionable how much they needed to do apart from a PR campaign. They already have 18 dedicated food supply centers. In addition, Yum also was attacked in a show by national broadcaster CCTV. Ad executives in Beijing said this often is a form of blackmail after a large company (usually multinational) fails to make a big ad buy with CCTV, which is a quasi-monopoly. Currently, too, there are political grounds for the leadership to make foreign multinationals a target at a time when GDP growth is slowing. Conversations with Yum executives over drinks suggest there is not much they need to do to alter the supply chain so we don’t expect much impact on margins.
For growth, Sam Su, China Chairman, said strategy is: More efficient labor management, better pricing strategies, brand positioning, understanding premium versus discount. “There are much more complex decisions than before.”
Our takeaway is 2013 is a year of experimentation for Yum China. This was subtlety confirmed by the lack of detail during the company’s presentation — they don’t yet have the results of the new formats. The company is testing a number of formats and menu items to see which will bear fruit. This includes the low-end “East Dawning,” with a low-end format and a variety of Chinese-style menu items including noodle soups and buns. We visited one storefront in Shanghai’s Nanjing Road that was below ground. It was busy but not packed and the menu had few western items. At this stage, Yum has brands from low to high: East Dawning at the low end, KFC in the middle, Pizza Hut in the upper middle, and the new in-store Pizza Hut offering steak and red wine at the high end.
We visited a shopping mall in a heavily trafficked area in western Shanghai. We counted 25 fast food chains (see list below). Apart from McDonalds and KFC, two are large: Hot Star Large Fried Chicken (432 corner
McDonalds and Yum Brands in China ii
shops in Shanghai) and listed chain Ajisen 661 outlets in China at end 2012. The diversity of offerings was tremendous including something called Madagascar pudding desserts. This is evidence that tastes are still being refined in China which lends support for Yum’s diversified approach to the market. During last year’s Yum Brands meeting in Xian, western China, we spoke to local students who said they preferred another large chain, Country Chicken, as it was cheaper than KFC. Yum management seems most enthusiastic about the high end Pizza Hut in store dining, which makes sense given the sophisticated consumer moving to lower end competitors (confirmed by our survey earlier this year, see attached).
A widely circulated document (no source named) comparing McDonalds with KFC favors the former. It notes that 1) KFC uses milk powder instead of milk in its ice cream; 2) KFC’s fries are darker (a positive) but wilt more quickly than McDonald’s. Also, McDonalds offers 5-10 more fries per pack and uses imported “Shepody” potatos instead of domestic brands; 3) McDonalds uses evaporated milk for its coffee instead of artificial milk powder in a larger container (15 ml versus 10 ml); 4) McDonald’s chicken sauce is 28 grams compared with KFC’s 20 grams; 5) McDonalds uses fruit juice concentrate instead of KFC’s fruit powder; 6) McDonald employees are taught to throw away burgers not sold after an hour.
Conclusion: The Chinese market is far too diversified and too rapidly evolving in tastes for a western firm to rely on brand name and execution alone. KFC appears to have solid execution ability and more creativity in its approach to the local market.
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