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China: A look at strategies from McDonald's, Yum! Brands

Many restaurant companies have turned to international growth to offset results from the struggling domestic economy, but when it comes to the largest prize in foreign expansion — China — it is a two-company race between Yum! Brands Inc. and McDonald’s Corp.

As Yum and McDonald’s host investors this week in China to tour their respective systems of nearly 4,000 and nearly 1,500 restaurants, the analyst community has a mixed view of how well each global brand can achieve their goals and withstand new pressures on the Chinese economy. In general, both companies are expected to hit their unit growth targets, but analysts view Yum as more exposed to any possible slowdown in China resulting from food and labor inflation.

“The overall market appears to be a win-win for both McDonald’s and Yum, as there is very limited competition from local or Western brands,” Jeffrey Bernstein, an analyst with Barclays Capital, wrote in a recent research note. “Currently, sales are very strong for both companies in China, and inflation is the largest challenge, with food inflation reaching double digits and labor inflation expected to remain in the mid- to high teens in coming years.”

Executives from both companies in recent quarterly earnings calls have pointed to opportunities in China centered on expanding dayparts, value, drive-thrus and 24-hour service.

Yum! Brands. Inc
First entered China: 1987
Locations: 3,300-plus of KFC, 650-plus of Pizza Hut
2011 unit growth target in China: 500 openings
Operating profit from China: more than 40 percent of total corporate operating profit

Yum, the first major American restaurant company to settle China, is coming off an 18-percent increase in same-store sales in China for the second quarter of 2011. Analysts Bernstein and John Ivankoe of J.P. Morgan both wrote in research notes that Yum likely would be able to reach its guidance of annual 15-percent operating-profit growth in the China division over the next few years.

For the June 11-ended second quarter, Yum generated $182 million in operating profit from China, 43.4 percent of Yum Brands Inc.’s total $419 million in quarterly operating profit. For the first half of the year, the portion of Yum’s total $820 million operating profit coming from China was $397 million, or 48.4 percent.

Revenues from the China division totaled $1.2 billion in the second quarter, compared with $753 million from Yum Restaurants International and $883 million from Yum’s U.S. system.

Bernstein wrote that the “size of the prize” for Yum is significant in China, home to 1.3 billion people and an informal eating-out market of $300 billion, which is expected to grow 11 percent in 2011. Yum benefits from its “first-mover advantage” over McDonald’s, he added.

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Ivankoe also noted that Yum could use menu price increases to fight inflation that has taken food costs to 34.3 percent of sales and labor cost to 15.1 percent of sales in China.

“Such increases for Yum could be fully offset by 3 percent to 3.5 percent pricing, which we believe is allowable given such high wage inflation,” he wrote.

By comparison, according to Yum’s second-quarter earnings statement, food costs were 30.7 percent of sales in its domestic system, and labor cost was 30.3 percent of sales.

Michael Kelter and Chris Cerrone of Goldman Sachs are more bearish on Yum’s prospects of weathering inflation in China. The analysts expressed concerns that growth in sales in China would correlate to their projected slowdown in China’s gross domestic product in the second half of 2011. Such a slight stumble in China would weaken Yum’s ability to offset prolonged weakness in the United States, they said.

“Yum’s same-store sales in China tie closely to GDP,” Kelter and Cerrone wrote recently. “Given China’s current monetary tightening cycle and historical correlations, we believe Yum’s China same-store sales may decelerate in the back half of the year.”

Goldman’s analysts expect Yum’s margins in China to be squeezed to the tune of 2 percent in food inflation, as well as labor inflation of 0.8 percent this year and 0.5 percent in 2012. They conceded that a tax cut passed by the Chinese government this month might moderate some of the risks to Yum’s sales by increasing discretionary spending among the country’s lower and middle classes.

McDonald’s Corp.
First entered China: 1992
Locations: 1,400-plus
2011 unit growth target in China: between 175 and 200 openings
Operating profit from China: more than 3 percent of total corporate operating profit

McDonald’s increased same-store sales by 14 percent in China in the second quarter, and analysts wrote that the chain would have room for improving margins in China as it accelerates growth.

Following a meeting with McDonald’s China chief executive Kenneth Chan and Tim Fenton, president of the company’s Asia-Pacific, Middle East and Africa division, analyst Sara Senatore of Bernstein Research wrote that the company likely would achieve its goal of being “bigger, better and faster” in China.

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“Menu innovation and reimaging of stores should serve as points of differentiation — and comp drivers — in China just as they do across the globe,” Senatore wrote. “Combined with continued investments in infrastructure and human capital, we believe these initiatives should support continued strong performance in this dynamic market.”

As with its system in the United States, McDonald’s is promoting menu items at several price points in all three dayparts, Senatore wrote, and the chain would look to implement its big domestic sales driver — McCafe beverages — in China soon. McDonald’s also is making big infrastructure investments, such as a Hamburger University in Shanghai, to reach its goal of 2,000 Chinese locations by 2013.

Senatore also noted that McDonald’s is focusing on refranchising and building more drive-thrus — with which locations are increasing same-store sales at twice the rate of units without drive-thrus.

“McDonald’s appears to be taking a typically disciplined and long-term approach to development,” she wrote. “As the company focuses on winning its five core markets … its implementation of refranchising and developmental licenses should allow it to pursue growth farther away.”

Ivankoe identified those core Chinese markets as Shanghai, Beijing, Guangzhou, Shenzhen and Wuhan, where McDonald’s unit penetration is deeper than Yum’s, as is the case in Taipei, Hong Kong and Singapore.

He noted, however, that Yum’s wider reach across China still would be beneficial in a country with more than 220 cities with populations of at least 1 million people.

Contact Mark Brandau at [email protected].
Follow him on Twitter: @Mark_from_NRN

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