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McDonald’s challenges KFC’s China dominance

For nearly two decades in China, the KFC logo has enticed the hungry with the promise of juicy, crispy chicken.
/ Source: The Associated Press

For nearly two decades in China, the KFC logo has enticed the hungry with the promise of juicy, crispy chicken.

Now, Yum Brands Inc. — which owns KFC and Pizza Hut as well as Taco Bell in the U.S. — has some competition for the cravings of Chinese diners.

After watching Yum gobble up much of China’s emerging middle class, McDonald’s, which has 800 restaurants in operation in China, is ramping up development in the country.

“The businesses are years apart maturity wise, but we believe Yum’s business can remain the primary driver of corporate profitability and McDonald’s’ business can become a measurable contributor to its own,” said J.P. Morgan analyst John Ivankoe in a note to investors, after he met with both companies’ teams in China last week.

At Yum, the China business helped hasten a recovery after a string of problems in its U.S. business, including an E. coli outbreak at some Taco Bell restaurants on the East Coast and a rat infestation at a KFC/Taco Bell franchise store in New York City.

“It is clearly our number one growth strategy,” said Yum spokesman Jonathan Blum of the chain’s China operation.

Blum said Yum is now opening about one restaurant per day in China and has plans to open 375 new KFC restaurants by the end of 2007.

Along with its standard fried chicken fare, KFC’s 1,940 mainland China locations offers customers several options meant to appeal to Chinese diners, such as a rice porridge dish known as pi dan congee.

The company also has the natural advantage of a strong cultural taste for chicken. Pork and chicken have traditionally been more popular than beef among the Chinese. Raising cattle requires a lot of grazing land that China, which is tight on arable land, needs for farming.

Blum says the company’s success can be at least partly explained by its distribution system, which is much bigger than its competitors and allows it access parts of the country farther away from main city centers.

Friedman, Billings, Ramsey analyst Ashley Woodruff said that investment has paid off.

“Yum’s distribution system in China is second only to the Chinese Army’s, allowing Yum to open stores in provinces and cities McDonald’s may not reach for ten years,” Woodruff said in an analyst note.

Woodruff said Yum has also focused on food safety. Yum visits each distribution center ten times per year unannounced to test for quality controls and does surprise audits of its suppliers.

McDonald’s lacks some of the scale of the Yum operation. But the company plans to open at least 125 new stores per year beginning in 2008. The chain currently has about 800 stores there.

Instead of beating Yum by opening more locations, McDonald’s is looking to two niche areas for growth — drive-thrus and locations open all night.

Deutsche Bank analyst Jason West said the strategy may help McDonald’s make up for lost time.

“We believe McDonald’s has an opportunity to establish a niche as the dominant drive-thru player in the Chinese market,” West said in a note to investors. “While KFC clearly dominates the market for in-line fast food chain restaurants, it is not making an aggressive push into drive-thru.”

McDonald’s made some headway in June last year, when it announced a 20-year agreement with Sinopec, China’s state-owned and largest petroleum retailer, to build drive-thru restaurants at Sinopec gas stations throughout the country.

The company opened its first drive-thru in 2005 and its first Sinopec location in January. Half of the new stores opened in 2008 will have drive-thrus. In comparison, Yum Brands has only opened about 10 drive-thru locations.

Deutsche Bank’s West added McDonald’s drive-thrus have reported sales 15 percent to 20 percent higher than non-drive-thru locations once it paid off start-up costs.

But most analysts still say cutting into Yum’s lead is going to be far from easy.

West said McDonald’s has historically stumbled in the country with management turnover, poor real estate decisions and a lack of “clarity” with its menu offerings.

Morningstar analyst John Owens said even though McDonald’s is ramping up its store development and making a bigger play in the country, Yum may still have a far bigger advantage.

“Yum is actually widening its lead in China,” Owens said. “They’re still putting up new restaurants at a much faster clip than McDonald’s is.”

Rather than playing catch-up by developing more restaurants faster, Owens said McDonald’s can do well by implementing the strategy that fueled its success in the U.S.

“Focus on being better, not on being bigger,” he said.