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Breaking down the great wall to franchising in China

Breaking down the great wall to franchising in China

Two little words—“in China”—deleted from a franchising law could make a big difference between profits or perils for American restaurant chains that have yet to open in the world’s fastest-growing economy.

The recent sigh of relief heard in the international franchise offices of restaurant brands eager to tap the Chinese market was in reaction to the elimination of a costly stipulation that threatened to stymie the timing and strategy of such brands as Church’s Chicken, Applebee’s, Ruby Tuesday, Dunkin’ Donuts and others.

But while operators are optimistic that the revised rule lifts a major impediment, they remain cautious about franchising in China. Moreover, many still cannot set a time when they plan to make their debuts there despite years of talking about it.

Chain operators are reacting to a revision to China’s “two-plus-one” rule, which had required franchisors to own and operate their brands’ first two outlets in the nation for one year, profitably, before franchising to local entrepreneurs. Part of a package of laws called the 2005 Franchise Administration Measures enforced by the Chinese government’s Ministry of Commerce, the rule was set to take effect in January.

With the law looming, the International Franchise Association, federal trade officials and other American interests last year mounted intense negotiations with communist Chinese business regulators to remove the provision, arguing that owning company stores, even through subsidiaries as the law allowed, would have been a prohibitively costly investment.

Presumably, that argument made an exception of the fact that China’s largest and fastest-growing restaurant company, Shanghai-based Yum! Restaurants China, a wholly owned arm of Yum! Brands Inc. of Louisville, Ky., had directly opened hundreds of KFC and Pizza Hut outposts in China before it began franchising—just as McDonald’s still is doing there.

Ultimately, the American franchising advocates got what they wanted. Philip Zeidman, an international franchise attorney at DLA Piper in Washington, D.C., who is the IFA’s chief negotiator in China, says the revised franchisors-first rule does not include the phrase “in China,” though it still requires that franchisors own and operate at least two restaurants somewhere for a year before franchising in the nation.

“Assuming there is no change in the law by the Chinese agencies that will be implementing it, there appears to be no effort to restore the reference to ‘in China,’ which appeared in the previous draft,” he says. “So it seems very clear that you do not need to have [franchisor-owned stores in China] in order to franchise.

“This is a tremendous change in terms of liberalization and is the culmination of months and months of discussion with the Chinese government about the difficulties and impediments many franchisors face trying to go to China.”

What also remains from the previous law is the requirement that a franchisor administer a “well-functioning chain” and continuously provide guidance, technical support, business training, marketing assistance and all other needed services to franchisees.

Rick Johnson, an attorney in DLA Piper’s Atlanta office who represented Hooters of America—perhaps the first American restaurant franchisor to come up against the law with the opening of its third unit in China, says the elimination of the franchisor-first provision would substantially reduce costs that brand owners might have faced.

“That was a fairly Draconian law for any company that just wanted to sell franchises,” Johnson says. “Instead of racing to expand the brand through franchising, a franchisor would have had to have boots on the ground.

“It would have been burdensome because of the inherent time delay. You lose a year running a restaurant when it could take that much time just to find a franchisee.”

New franchising frontier

Although political and cultural theories have been suggested, it’s not clear exactly what prompted the Chinese government to draft the franchisors-first rule in 2005, though one might presume that business woes besetting some inexperienced local franchisees could have prompted the enactment of a law requiring brand owners to demonstrate the viability of their concepts before they could be licensed to others.

In an interview with Nation’s Restaurant News in June 2005, Sam Su, president of Yum Restaurants China, discussed the country’s relative lack of familiarity with franchising.

For business people in the world’s most populous nation, “franchising is a vague concept today; it’s really just a contract,” Su said, noting that Yum China then had only 21 franchisees operating a total of 50 restaurants, even though its Chinese system was nearing the 2,000-unit mark. Of those pioneering owner-operators, several were single-unit franchisees, “some of them overseas Chinese who may have worked in Australia or the U.S.” and therefore were “easier to work with,” Su said, adding that the company had only recently begun “doing deals with small, local entrepreneurs.”

Despite the lack of a clear record of success among Chinese franchisees of American brands, a U.S. franchisor’s buyback of a local franchisee’s assets is not necessarily a sign of problems. The recent sale to Louisville, Ky.-based Papa John’s Pizza of a Beijing franchisee’s five outlets, quality control center and initial development rights was unrelated to the two-plus-one rule or stress factors that may have prompted it, says Robb Chase, president of Papa John’s international division.

Color-coded warning system in Beijing signals food safety risk ratings

Legal uncertainties that are keeping some U.S. brands from diving into the lucrative Chinese market may not be the only deterrents to confidence about franchising restaurants in China.

Indeed, consumers and restaurant operators there have been alarmed in recent years by increasing signs that the Chinese government’s food safety systems are antiquated and insufficient to stop recurring instances of contamination, such as a carcinogenic-ingredient scandal that suppressed KFC’s sales throughout China for several months a few years ago.

In a first-ever nationwide survey by the nation’s Ministry of Health, 82 percent of the 4,482 people polled said they worry about food safety and 40 percent had gotten ill eating food away from home.

Food safety and consumer confidence have become such big issues in China’s capital city that the government there recently deployed a public-warning system that is reminiscent of the U.S. Department of Homeland Security’s color-coded terrorism alert system.

The Beijing Municipal Health Bureau established the system to warn the public when restaurants and other food places are linked to outbreaks of foodborne illnesses.

Health authorities in Beijing this year began publicizing the graduated, four-color code, which reflects the severity of an outbreak. The system is designed to stem a rash of serious foodborne illness outbreaks that have exploded throughout the Beijing metropolitan area in recent months. Among the hundreds of outbreaks was an incident last summer in which 87 diners fell ill after eating raw or half-cooked snails contaminated with a parasite.

Under the new warning system, after such a foodborne illness is confirmed a placard is placed outside of establishments to indicate their risk ranking. Blue is a low-level danger. Yellow is elevated. Orange is high. Red denotes the most severe outbreaks, generally in which more than 100 people have gotten ill or more than 10 people have died.

At each level of the outbreak, the color codes also give the public an idea of the corresponding corrective action the government is taking in concert with medical, health and sanitation authorities.

Meanwhile, private enterprise has taken separate precautions, such as Yum! Restaurants China’s establishment of its own food safety labs and crackdowns on suspicious suppliers.— Milford Prewitt

The law “was not a driving factor,” he says. “We didn’t have to purchase them.”

Instead, Papa John’s, which now has five company-owned outposts and 45 franchised branches in China, made the buyback because “we believe the growth potential is enormous and a good investment,” Chase says. “We think operating our own [outlets] will make us a better franchisor for the rest of the country.”

With most forecasts predicting that China’s economy may surpass the U.S. economy to become the world’s dominant engine of economic growth within the next 30 years, most internationally driven restaurant chains and emerging brands admit that they cannot afford a lengthy delay in their brands’ inevitable penetration of the Chinese market, even if the two-plus-one rule had remained intact.

China already boasts a middle-class consumer base of 330 million people, larger than the total U.S. population of 300 million. Many international restaurant developers and real estate experts are fond of quipping that “every location is an A location in China.”

According to the World Bank, China’s real rate of economic growth in 2005 was 9.9 percent, compared with a 3.2-percent growth rate in the United States. Seen another way, according to the International Monetary Fund, the whole world’s economy grew 4.3 percent in 2005, and China alone accounted for one-third of that.

Such powerful economic trends account for the reasons that veteran players in China like KFC—the first American brand to tap the market 20 years ago—and McDonald’s, T.G.I. Friday’s, Starbucks Coffee and even Hooters have made ambitious growth projections.

In the case of KFC—which purportedly opens a store in China every 24 hours—Yum’s predominant ownership position in the market meant that in 2004 the brand owner’s Chinese operations began yielding more operating profit than did the chain’s entire, mostly franchised U.S. system of restaurants.

Other chain operators, such as Cold Stone Creamery and Papa John’s, have shown a determination to develop in China through company stores.

For some, easy does it

But even as the easing of that rule excites franchisors, and the boundless economic prospects of China titillate them as they anticipate mining the market, many restaurant companies that had expressed intentions to expand to China remain cautious.

Like many of his peers who haven’t set a date by which their brands would make Chinese debuts, Zack Kollias, Church’s Chicken’s senior vice president of international operations, says that even before the law had changed, the chain was determined to enter the country only through franchising.

But Kollias, who has overseen site selection and has tailored building designs to fit various international locales, says China remains an imposing market that requires careful thought about partners, the culture and the costs.

He notes that unlike in Europe, where he could pick from among Church’s building format inventory of stand-alones, drive-thrus and kiosks to enter targeted markets, China’s cultural sensitivities would require more careful analyses of facility footprints.

“We’re pleased the law has changed and that there appears to be no restrictions on franchising at the moment, but China is a challenge,” Kollias says. “We’re very optimistic that we will be there because it is such a great opportunity. I guess you could say we are still in our exploratory phase. They still have legal challenges that you don’t see in other parts of the world.”

Ricky Johnson, a spokesman for Ruby Tuesday, which has franchised units around the globe, including Hong Kong but not in mainland China, says his chain has never opened a company-owned branch abroad and depends on the resources of local operators who know foreign markets. The company therefore welcomes China’s rule change.

However, Ruby Tuesday still has no specific timeline for debuting on the Chinese mainland and continues to study the opportunities there, Johnson says.

He says that given the popularity of American food concepts in China and the potential of that market, even if Ruby Tuesday were required to open company stores to get a foothold, that would be worth the investment.

A spokesperson for Applebee’s International, which has yet to open a restaurant in China despite repeated statements of intent by its executives over the past few years, declined to discuss the status of its China expansion strategy.

Applebee’s, the industry’s largest casual-dining brand by unit count with nearly 1,950 restaurants worldwide, has traditionally expanded domestically by selling huge, territorial agreements to well-capitalized master franchisees with heavy industry experience.

Executives of the wholly franchised Dunkin’ Donuts chain, which terminated a four-unit foray to China years ago, are reconsidering a new drive there. A Sarasota, Fla.-based Dunkin’ Donuts franchisee told local media that he was making plans to open a unit in China to coincide with the Summer Olympics in Beijing in 2008.

Canton, Mass.-based franchisor Dunkin’ Brands Inc. says the Jan. 17 debut of a Dunkin’ Donuts outlet in Taipei City, Taiwan, marked an initial step in the chain’s plan to expand into mainland China. Following the Taiwan opening by Mercuries & Associates, which agreed to develop 100 Dunkin’ outlets in Taiwan over the next decade, Dunkin’ Brands says it is talking with potential Asian partners and expects to sign agreements this year to open units in China.

In addition to Dunkin’ Donuts’ usual fare, the initial Taipei outlet offers sweet potato, green apple and pineapple doughnuts and a doughnut with a sweet rice paste called a mochi ring.

A Dunkin’ Brands spokesman would only say that the Florida franchisee’s plans were under review.

Years ago, various news outlets reported that Dunkin’ pulled the plug on an earlier foray into China after suffering weak customer traffic, blamed on Chinese consumers’ lack of appetite for pastry sweets.

Anation of evolving laws

Observers speculate that Chinese officials may have devised the two-plus-one provision because a communist nation that is wholeheartedly embracing capitalism could find itself torn between old-guard, secretive traditions of central control and the temptations of Western-style wealth and systems for generating it.

Zeidman, the International Franchise Association negotiator, said Vietnam is perhaps the only other nation in the world with a rule similar to China’s now-modified two-plus-one provision.

But while many economic pundits compare the state of maturity of China’s commercial and business laws to those of the 19th century American frontier—largely unregulated and rife with bribery and scandal—Zeidman insists that corruption has little to do with the country’s franchising regulations.

Even though the communists have been cracking down on scores of bribe-soliciting government officials, and although a former McDonald’s executive was one of 22 people in China charged in a kick-back scheme involving exclusivity in the awarding of computer contracts, Zeidman says the country’s corruption problems are tangential to the two-plus-one franchising issue. Locally based franchisors that feared competition from slick, Western franchised brands might have had more to do with that legal evolution. And perhaps the government’s aversion to large public gatherings—in the form of franchisee conventions—was another factor, he theorizes.

But Zeidman urges franchisors not to ignore China.

“There are lots and lots of difficulties opening in China, and it is not just legal challenges and issues,” he says. “It takes a lot of thought and a considerable amount of capital.”

However, he says, no company that intends to be a global player can afford to ignore “what is shaping up to be the biggest marketplace in the world.”

Still, cultural and ethnic differences in China can be thorny factors. For those reasons, some brands may just be ill-suited for parts of the Chinese market, says Paul Fetscher, an international restaurant real estate broker who travels to China with some regularity as president of the Long Island, N.Y.-based Great American Brokerage. He notes, for example, that among the Cantonese, a dominant population group, it is considered “barbaric” to lift more than one bite of food to one’s face.

But Fetscher also is bullish in urging franchisors to spare no expense in getting to China, and he is forgiving about its government’s evolving effort to gain a regulatory grip on the emerging franchising industry.

“It makes sense that the Chinese, given all the scam artists and snake oil salesmen that have been going through there in recent years, would want to weed out weak companies or shysters,” he says. “It is the new frontier. But look at what is at stake. You know how many cities there are in America with more than 1 million people? Nine. Know how many cities there are in China with over a million people? Thirty-five. Know how many KFCs you can put in a city with a million people?”

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