McDonald’s Sold Its China Business — The Story Explained in Five Questions

(YicaiGlobal) Jan. 11 — Chinese state-owned enterprise CITIC Group Corp. announced this week it had acquired a 20-year franchise for McDonald’s restaurants in both mainland China and Hong Kong at a price of USD2.08 billion, jointly with several other parties. This hunt for buyers had lasted almost a year, with a dozen companies and institutions in a row participating in the bidding.

Noteworthy is that, Yum China Holdings Inc. (NYSE:YUMC), KFC’s parent, announced its separation from Yum! Brands, Inc. (NYSE:YUM) a month ago and its independent NYSE listing. Before listing, Yum China once announced its decision to sell 20 percent of its stake.

These two fast food operators took similar actions. This was no coincidence. We have therefore compiled five questions — possibly the questions uppermost in everyone’s minds — to try to explain this matter.

1. Why did they sell their businesses?

The answer is quite simple. Fast food is not as popular now in China’s market. New brands, convenience stores and food delivery services have displaced it. Also, these two brands’ market shares are falling within the fast food sector itself. Euromonitor International conducted a market survey that showed the market shares of KFC and McDonald’s in China’s fast food industry have dropped 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).

Yum China and McDonald’s adopted different solutions to resolve this dilemma. The former chose to separate from the global structure of Yum! Brands and found an independent company — to whom it sold 20 percent of the new company’s equity — while McDonald’s sold a 20-year franchise in the Chinese market, including 2,200 franchised outlets in current operation.

Both companies reaped massive funding from these deals, a vital source for their next self-investments. The two firms also carry many outlets in need of upgrade, since youngsters prefer comfortable, fashionably-designed restaurants, regardless of menu. They also need to digitize to lure consumers from a now-fragmented market. All these circumstances clamor for massive funding.

Their methods of selling themselves differ in the extreme.

Yum China’s methods indicate its managers will still wield future authority over the firm, whereas McDonald’s will switch to a new boss for its Chinese team. Though whether this new boss will keep the team is as-yet unknown, at least Su Jingshi, Yum China’s former chief executive and senior McDonald’s managers who left office have received requests from the investor team to stay on.

To revert to the question of why they sold their businesses, in the two companies’ own words, “to sell yourself to improve the business” is better than “to sell yourself at the highest premium.”

This is true.

Generally, franchise stores enjoy better business than direct-sales stores because some belong to franchisees willing to lavish more attention and money on running their stores. For instance, they promote their shops with their own resources and better decorate them.

This idea is also applicable to companies.

The sale of Yum China and McDonald’s means that they have transferred their franchise in the Chinese market to local teams, demonstrating localization in such areas as product research and development, and the decision to open outlets. Such localization won KFC a larger market share than McDonald’s.

2. Why did the deals take so long — from the beginning until the end of this year?

Apart from continuous bargaining, no one Chinese company can digest the huge businesses of McDonald’s and Yum China. The large amounts bandied about in the deal spooked ele.me — an online food-booking enterprise with rapid growth — into spontaneously quitting the bidding. More important, although these two companies were anxious to sell their businesses, they also cared about the buyers.

Ant Financial Services Group and Primavera Capital Group are the buyers of Yum China. The former represents the possibility of developing a simple off-line business into an O2O model. The latter indicated that Yum China was looking for a company that better understands investments. After buying into Yum China, Primavera Capital founder Fred Hu (Hu Zuliu) became the firm’s new director. Yum China said, “This indicates we have formed a strong and rigorous corporate governance structure.” To learn the significance of the design of corporate governance structures, the experience this year of China Vanke Co (SHE:000002) is a good example.

McDonald’s has not found a satisfying investor yet, despite multiple offers, because external capital is not only about money, but new relations and competence as well.

The combination of CITIC Group Corp. and Carlyle Group LP (NASDAQ:CG) is quite like the capital combination Yum China took in. As a state-owned enterprise (SOE), CITIC represents ties with the government, which was previously lacking in McDonald’s as aforeign joint-venturebrand. This factor will play a significant role in the hunt for new outlet resources. The key for all chain businesses is location. Carlyle plays a role similar to Fred Hu in Yum China, namely for the global capital needed by McDonald’s, which like Yum is also a US-based company.

3. Why are investors making acquisitions in the sluggish fast food business?

‘Where’s the value?’ is a question confusing many people, including those conducting negotiations with McDonald’s and KFC after the two companies announced their intention to sell at almost the same time. Potential investors are also left wondering which company’s shares offer better value.

Yum complained about bidders’ low valuations, though nobody can accurately determine the shares’ value. Yum director Keith Meister tried to make clear that the offers only matched company revenues, rather than its actual value, indicating investors greater concern over current assets or profitability.

McDonald’s has over 2,000 outlets in China and Yum more than 7,000. After expressing their intent to sell, buyers differed in their interpretations of the reasons for the sale. Some consider how large the fast food market’s potential is in the urbanization of China, while other investors consulted company employees. One former executive suggested the number of outlet stores each company has in prime locations could influence investors.

Investors don’t decide based on the number of restaurants alone. Some noted that acquiring Yum China does not confer on investors the right to control the company, but investing in McDonald’s does. This is an important difference that affects investors’ role within the company and determines their ability to steer its direction.

Two other differences investors noted are leadership and marketing. The former chief executive of Yum China led Yum for around 15 years, whereas McDonald’s changes its head every three to four years. Investors feel McDonald’s has better branding, but Yum is more innovative in products and pricing.

4. Will we still be able to eat ‘authentic’ fast food?

Depending on your definition of authentic, you may never have eaten authentic fast food in China. Products are localized here with flavors altered to match local tastes. Both McDonald’s and KFC ply this practice — like most companies. We need to look at the relationship between the companies’ Chinese and global operations to understand how the sale will affect products.

Once sold, Yum! China will become a franchisee of Yum! and be authorized to operate all company brands and products, but may do so on a different timeline than the rest of the world. Yum! China will also be free to independently develop products for sale in its Chinese stores.

McDonald’s has not disclosed such information, so it is uncertain how its menu will evolve, but it did say that McDonald’s China aims to ‘localize’ its food more, so the Chinese unit will likely be able to customize its menu.

5. McDonald’s China said only a 20-year franchise is sold, so what happens 20 years from now?

To know what will happen in 20 years, look at the cooperation between Starbucks Corp. (NASDAQ:SBUX) and Taiwan-based Uni-President Group Co. After the expiration of their 20-year cooperation, the two companies recently renewed their cooperative agreement — Uni-President develops and operates Starbucks’s businesses in East China.

A brand franchiser cannot easily replace an operator who succeeds in boosting business. Within 20 years, the operator may even change its position within the cooperative relationship through sound business performance.

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