Global Glance: January 17, 2017
A quick look at intriguing international stories
By John Bostwick, Managing Editor, Radius
McDonald’s Deal in China: A Switch to an Asset-Light Strategy
McDonald’s boasts over 36,000 locations in over 100 countries. Perhaps surprisingly, the venerable restaurant giant has made much of its money not from selling food, but from acting as a landlord. The 2015 blog post “McDonald’s Real Estate: How They Really Make Their Money,” published on Wall Street Survivor, explains that the Illinois-based company generates real-estate income both by buying and flipping properties and by “collecting rents on each of its franchised locations.”
Collecting rent payments is a huge part of the company’s business model given that franchisees operate 80 percent of McDonald’s locations. The Wall Street Survivor post quotes Harry Sonneborn, the company’s first CEO, as having said, “we are not technically in the food business. We are in the real estate business. The only reason we sell fifteen-cent hamburgers is because they are the greatest producer of revenue, from which our tenants can pay us our rent.”
Sonneborn left McDonald’s in 1967, but the company still makes a substantial portion of its profits through its properties, so much so that some experts feel the company might benefit from spinning off its property holdings into a real estate investment trust, or REIT. In at least one critical global market, however, McDonald’s is adopting a very different strategy that’s light on assets.
On January 8, the company announced a partnership with the Chinese state-funded conglomerate Citic and the US private equity firm the Carlyle Group. The partnership “will act as the master franchisee responsible for McDonald's businesses in mainland China and Hong Kong for a term of 20 years.” The deal is expected to close in mid-2017 (pending regulatory approvals) and is valued at $2.08 billion. Citic will have a controlling 52 percent stake in the venture, with Carlyle holding 28 percent and McDonald’s retaining 20.
The deal reflects current economic and cultural realities in China. It’s also evidence of McDonald’s willingness to depart from tried-and-true domestic strategies when doing business across borders. A Wall Street Journal article from last October — when McDonald’s was courting bidders for the China deal — explained that the company needed “Chinese partners with knowledge of the country’s real estate and market demographics to know where to put new stores and how to supply them.” This is not the kind of advice McDonald’s has needed when operating in the US.
McDonald’s regards partnering with a local Chinese company as critical in part because the Chinese culinary landscape has changed in the last two decades. The Financial Times explains that when McDonald’s opened its first restaurant in Beijing in 1993, “about 40,000 people queued round the block to place an order.” Now, an analyst quoted in that article observes, “China has grown out of the American fast food craze.”
So the novelty of American fast food is gone in China, at least in its primary urban markets, but diminishing buzz is not the only concern for McDonald’s. Obstacles related to health and politics are also hampering growth. An opinion piece that ran last month in Bloomberg Gadfly notes that “McDonald's blamed ‘temporary protests related to events surrounding the South China Sea’ for denting its sales in the nation last quarter.” The piece adds that the company’s reputation in China has “yet to fully recover from an expired meat repackaging scandal.” A recent New York Times article indicates that McDonald’s is also facing “competition from a boom in quick-service Chinese restaurant chains and a shift toward healthier eating.”
Presumably, McDonald’s new partnership — controlled by the locally-owned Citic — will be better equipped to understand the tastes of local consumers. Citic Chairman and CEO Yichen Zhang is quoted in the January 8 press release as saying, "We will work closely with the existing management team and partners … to respond to local market expectations and continue to expand and improve the business to meet the needs of the Chinese consumer."
Catering to locals isn’t new to McDonald’s. Its UK website proclaims: “We try to adapt our menu to reflect different tastes and local traditions for every country in which we have restaurants.” But with Citic as its controlling partner in China, the company may sooner or later offer food there that’s very different from its US-based menu options.
These kinds of changes mirror how Chinese food in the US reflects the American palate, and not uniformly. Anyone who has tasted Chinese food in, say, San Francisco’s Chinatown and then in Grand Rapids, Michigan , knows that Chinese restaurant owners don’t just adjust their recipes to suit American palates, they adjust them to suit the palates of people in particular US regions.
McDonald’s current strategy in China likewise accounts for regional differences. The bloom may be off the American fast-food rose in cosmopolitan cities like Beijing and Shanghai, but huge growth opportunities remain in so-called tier-three and tier-four cities in China, which the new McDonald’s partnership expressly targeted in its press release. The Wall Street Journal article already mentioned quotes Phyllis Cheung, current CEO of McDonald’s China, as saying, “In the lower-tier cities, we want to accelerate, and a local partner would have more local wisdom and more local resources. … The whole idea of franchising is that you have more flexibility and speed to market — and are more able to answer to consumer needs.”
In China, then, McDonald’s plans to cash in primarily on franchise fees, not on real estate holdings. As the Financial Times article explains, “analysts say ceding control of assets and handing decisions to local management will allow the brands to expand more rapidly and localize more nimbly in a crucial market.” McDonald’s CEO Steve Easterbrook and his fellow executives have made this strategic decision not only due to challenges in China, but, as Bloomberg points out, in the face the company’s “fourth straight year of traffic declines in the US, its largest market.”
The Bloomberg article adds that McDonald’s is also “playing catch-up to Yum China Holdings Inc.,” which owns KFC in China and “has a carte blanche opportunity to pursue growth and add 600 restaurants a year in the country.” An expert quoted in the New York Times article contends that McDonald’s may have the edge on Yum in those tier-three and -four cities in China since Yum has already expanded into many of them, whereas they are relatively uncharted territory for McDonald’s.
There are of course other factors to consider in McDonald’s latest partnership deal. For example, a Wall Street Journal article titled “McDonald’s Aims to Flip China Results by Ceding Control,” reports that negotiations between McDonald’s, Citic and Carlyle took over half a year, in part because of concerns over “how McDonald’s would be able to collect its revenue in light of the Chinese government’s moves to limit capital outflows,” which “are now coming under government scrutiny” if they exceed $5 million. Easterbrook admitted to the Journal that “getting cash out of China will be a ‘top-quality problem’ but declined to go into more detail.” Easterbrook and his fellow execs appear to be happy to trade flat sales and the complexities of buying and maintaining real estate in China for sustained growth and the potential for cash-repatriation dilemmas — at least for now.