Hatching an escape plan

When KFC debuted in China in 1987 it sold 2,200 buckets of fried chicken on its opening day – with the only disappointed customers being those who failed to get through its doors before supplies ran out.

As the China Daily later recalled, the enthusiasm was palpable, with the excited diners viewing their chicken dinners as a sign that they were finally getting ahead in life. “KFC brought the idea of ‘fast food’ to China nine years after China embraced the opening-up and reform policy in 1978, when Chinese curiosity about the West was at a peak,” the newspaper explained.

Yum Brands, which later purchased the KFC restaurant chain, was the major beneficiary of the fast food boom that followed, with Pizza Hut serving as the junior partner in Yum’s portfolio of almost 7,000 restaurants in China today.

But Yum’s fortunes have fizzled out over the last three years, leading to demands from an activist hedge fund in May that its China division should be spun off, so as to generate an estimated $7 billion of shareholder value.

Another set of poor results saw Yum reach the same conclusion this month, and it announced that it would be splitting its China business away from its global operation to create two independent, publicly traded companies. Yum China will have exclusive rights to operate the KFC, Pizza Hut and Taco Bell chains on the Chinese mainland, while Yum Brands will own and manage its products elsewhere in the world.

Why is the spin-off making headlines?

In part, because the ascent of American fast food brands in countries such as China was highly symbolic.

The first KFC – and the subsequent launch of Pizza Hut three years later – were celebrated as landmarks in China’s opening to the West, and as a sign of the new opportunities available to the country’s urban population. In a country with one of the world’s oldest and most sophisticated cuisines, persuading millions to eat fried chicken from cardboard buckets was viewed as a sign that American-led globalisation had taken hold.

It was the same in the Soviet Union in 1990 when thousands of Russians queued in Pushkin Square to get into the first McDonald’s, which threw open its doors with the catchphrase: “If you can’t go to America, come to McDonald’s in Moscow”.

In June this year the mood was similar in Rangoon, when the inaugural KFC opened in Myanmar. Like its Beijing predecessor 25 years earlier, the new outlet also ran out of chicken on its debut day, despite two pieces costing only a little less than the country’s daily minimum wage.

But in Yum’s case it also became more than just another American fast food brand. Its power to adapt made it a poster child for how Western brands could conquer the Chinese consumer market. Its startling success spawned a best-selling business book from one of its executives, and a glowingly positive case study from Harvard Business School.

Four years ago Yum was also the first candidate in our Focus issue on The Magnificent Seven – a review of seven international firms that seemed to have cracked the China market. Here was a multinational that had beaten its rivals by getting to China first and then growing its presence at breakneck speed, in large part by discarding its traditional playbook and building a business shaped in large part by local conditions and local tastes.

Yum seemed to have discovered the secret sauce for its chicken and pizza empire, riding on its kudos as a global brand but also earning local respect for showing Chinese characteristics. New restaurants were opened almost every day and the company’s Chinese earnings even overtook those in its home market in the US.

Now the good times are gone?

We finished our feature on Yum in The Magnificent Seven with a word of warning that it risked getting over-reliant on its China business. And this is pretty much the situation that it faces today. Because it gets most of its sales and profits from China, Yum’s shares trade heavily on what happens there. That was fine when KFC and Pizza Hut were doing so well. But as market conditions have worsened, investors have become fed up with the volatility in the share price.

At the start of October when Yum issued another profit warning – once again citing weakness in China – its shares slumped 19% in one trading session. Not that Yum’s China business is in meltdown – the country still accounts for more than half of the firm’s annual revenues and almost half its operating profit. But the crucial point is that its business has stopped growing, with the $6.9 billion of Chinese revenues last year virtually unchanged on three years before. Absent the earlier supercharged growth – in new restaurants and diners filling them – operating profits have fallen steeply.

As a result some of Yum’s shareholders want the chance to get off the rollercoaster – or at least to choose between whether they invest in the more volatile potential of its China business or its more predictable global franchise.

As Keith Meister, the hedge fund manager championing the break-up of Yum’s businesses, explained to Reuters: “The separation of these two businesses gives shareholders the choice to own a growing annuity-like franchise cashflow stream, as well as the leading restaurant concept in a country with the fastest-growing consumer class.”

And the wider lessons in Yum’s China difficulties?

Because Yum is widely regarded as one of the leading proxies for consumer demand in China, its faltering performance raises inevitable questions about consumer sentiment in general.

The problem with this kind of analysis is that Yum’s experience isn’t necessarily a sign of weaker sentiment across the Chinese economy at large. Some of the slowdown at KFC or Pizza Hut is simply about competition and its customers switching to other restaurants, for instance.

Yum is a less reliable weathervane for Chinese consumer demand these days. Instead it’s worth looking at the surge in Chinese tourists heading on shopping sprees in Korea and Japan (see WiC272), the resilience of Apple’s fortunes (see WiC280) and the boom in ticket sales at the country’s cinemas (see WiC292). All of these say something more positive about Chinese consumer appetites (as do Alibaba’s recent results, see this week’s here).

In fact consumption growth has held steady during China’s downturn and retail sales have done reasonably well, beating most expectations over the summer.

The more convincing narrative for Yum’s difficulties is that China is nearing the end of an era in which going for Western fast food is seen as an aspirational moment, akin to what was witnessed at KFC’s debut in Myanmar this summer.

It is also a sign of the continuing evolution of China’s dining market and fast food’s place in it.

While it’s true that Pizza Hut and KFC first thrived on their novelty value and association with the Western lifestyle, some of Yum’s strongest growth came when it started to make a name for itself as one of the first international brands to localise its menu.

This extended beyond giving its standard food offerings a Chinese flourish (for example, the inclusion of egg tarts). There was also the launch of the East Dawning sub-brand for local cuisine, and the further spicing up of its portfolio with the purchase of the Hong Kong-listed hotpot chain Little Sheep in 2011.

But the fast food market has continued to change substantially, with lower birth rates also meaning fewer young families, the core market for KFC and Pizza Hut.

As American writer Adam Minter pointed out on Bloomberg last week, China is home to the world’s largest population of people over the age of 60 – and that’s a demographic that doesn’t go mad for chicken nuggets.

Even for those who do like internationally-inspired fast food, there is a wider range of options to choose from, including homegrown fried chicken challengers like Hua Lai Shi and Dico’s.

Other trends have made the fast food business more cut-throat, including the rise of smartphone apps like Alibaba’s Meituan (now merging with Tencent’s Dianping, see WiC300). These give consumers easy access to a huge range of meal deals. While KFC and Pizza Hut were pioneers in offering home delivery in China, these new O2O (online-to-offline) apps are transforming the competitive landscape yet again by encouraging thousands of restaurants to take advantage of this cheap and effective marketing channel for food deliveries and special offers.

In fact Yum blamed the “savage battle” between the dining apps for why same-store sales grew only 2% in its most recent quarter, far below forecast.

“We are experiencing what we believe is a short-term but significant impact of online ordering aggregators entering the casual dining space,” complained Pat Grismer, its chief financial officer, in the call following this month’s results.

Aside from the immediate pressures from the dining apps, Yum is wrestling with longer-term changes in demand, as millions more Chinese taste new cuisine on trips abroad or simply want to try something a little more sophisticated at home.

A survey in September from the public relations firm Miller Shandwick picked up on this growing interest in food culture, reporting that 62% of consumers were posting their “food experiences” to social media, with many sharing pictures of their meals on a daily basis (not a trend likely to be helping KFC: you wouldn’t upload a drumstick).

These changes in taste are forcing Yum to rethink how it is going to hold on to the next generation of fast food fans. “The decline in satisfaction is partly due to eating at KFC or Pizza Hut no longer being as fashionable and partially due to the improvement in the overall income of Chinese nationals, who have higher requirements for the quality of their food,” explains TMT Post, a news website headquartered in Beijing. “Customers looking for more creative and more delicious food brands are choosing elsewhere.”

Self-inflicted damage too?

One of the outcomes of the boom years was that Yum made itself into a target for the kind of consumer rights campaigns orchestrated by state media against foreign brands.

The first setback came in 2012 when national broadcaster CCTV reported that KFC suppliers were doping their chickens with antibiotics to speed up their growth cycles. The result: same-store sales dropped by a fifth and operating profit fell by almost half following the reports (see WiC178). Just a few months later, as Yum focused on supply chain issues to reassure consumers that its chicken was safe to eat, a bird flu outbreak hit the country.

Yum continued to spend on marketing efforts to regain customer trust in the following months (see WiC244) but the recovery foundered last summer after graphic reports that one of its meat suppliers was using tainted and out-of-date chicken (see WiC248). Yum dropped the supplier almost immediately but it was too late to avoid more reputational damage.

Since then Yum has been compelled to defend itself against lurid rumours on the Chinese internet, including taking legal action against the owners of WeChat accounts that alleged that it was pioneering techniques to breed chickens with six wings and eight legs.

The awful publicity seems to have had an impact, with research firm Millward Brown finding that fewer than a quarter of a 30,000-person survey considered KFC a desirable brand last year, down from 39% in 2012.

Pressure for a new business model…

Yum’s problems with food safety have also undermined one of the core arguments for how it runs its restaurants in China. While the franchise model has prospered for fast food businesses in developed markets, it has less of a track record in China, primarily due to concerns about unreliable franchisees and a murky food chain.

As a result, Yum has opted to manage its operations there almost entirely in-house. Only 7% of its outlets in China are operated as franchises, versus 91% on a worldwide basis, according to Reuters.

Investors didn’t seem to mind these arrangements when times were good – indeed it meant they scooped up a more substantial share of the profits. But the food safety scandals and surging operating costs have since eroded Yum’s returns. Shareholders have changed their tune on the desirability of the wholly-owned model, baulking too at the company’s professed target of a China business with 20,000 outlets. Hence the rise of activists calling for an ownership set-up closer to the franchising model Yum employs elsewhere in the world.

Of course, the announcement of the spin-off doesn’t mean that the newly configured Yum Brands is exiting China – it will earn an unspecified percentage of Yum China’s sales for the rights to the KFC, Pizza Hut and Taco Bell brands.

But by taking the financial commitments for its China operations off the balance sheet it should boost the share price of the Louisville, Kentucky-based parent in asset leverage terms alone.

Existing investors will also get a one-off boost from the share sale of Yum’s Chinese unit, although the company’s critics gripe that the American firm should have made the break at a time when its stock was riding higher.

The backers of the deal claim that the separation could be good for the new company in China, helping it to regain its lustre by allowing it to focus purely on its local customers. In this reasoning Yum’s brands and menus have got stale, and the parting of the ways with the global business will give it the chance to reignite the localisation ethos that made the brand so popular in the first place.

But that argument about localisation jars with the retirement this summer of Sam Su, Yum China’s veteran boss. Local media seem less impressed by the credentials of Micky Pant, the man likely to be the boss of the new China venture.

Su – who hails from Taiwan – spent more than 20 years in China, launching many of the initiatives that made Yum so successful. And as far as TMT Post is concerned, the absence of experienced China bosses like him will make it much harder for the company to regain its former glories. “Now the father of KFC China has had to retire and the new head is a foreigner who was responsible for its Indian business and has no understanding of China at all,” it chided.

As Neil Sedaka sang in 1962 Breaking Up Is Hard to Do. Will Yum find this to be true too?

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