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Mini McDonald's in Shanghai
Mini McDonald's in Shanghai
Li Juan and Cui Dan

BEIJING — McDonald’s is planning to expand franchising in China’s biggest cities, such as Shanghai and Shenzhen, for the first time since its entry into the country.

Since its founding in 1955, McDonald’s has relied on its franchisees to play a major role in the company’s global success. Franchisees account for 80% of the 30,000 McDonald’s restaurants in 120 countries all over the world, and they create more than 70% of the fast food giant’s profits.

Unfortunately, this model has not been successfully replicated in the Chinese market. When McDonald’s first entered China in 1990, it chose to operate its own restaurants, judging that its high operating costs wouldn’t give franchisees much of a profit margin and that China also had few regulations about franchising.

The company began seriously recruiting franchise partners in certain provinces of China in 2010, but McDonald’s franchises account for less than 5% of all its outlets China, and they are mostly located in smaller cities.

Now McDonald’s plans to change the situation. It hopes to double the number of its Chinese restaurants — to more than 4,000 stores — in the next three years. “Developing the franchise business will become an important factor for achieving rapid growth in China for our company in the years to come,” one of its senior executives says.

It is interesting to compare McDonald’s strategy with rival Kentucky Fried Chicken (KFC). “Compared with McDonald’s, KFC is a lot more open in this aspect,” says Kang Jianhua, a researcher who follows hotels and catering at CIConsulting. “Not only has KFC extended its regions allowing franchising, it has also lowered the entry threshold in certain regions so as to boost the retailer’s number of franchisees. Increasing the franchisees is KFC’s important tactic in raising competitiveness.”

From 1990 to 2010, the number of McDonald’s restaurants in China grew at an annual pace of 17% — far lower than in certain other Asian-Pacific markets such as Japan. But by 2013, China had become the company’s third-largest market in the world.

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McDonald's Chinese New Year set meal — Photo: HenryLi

Though McDonald’s restaurants outnumber KFCs globally, the latter has more stores in the Chinese market, with nearly 5,000 outlets. Even Dicos, a local chain offering Western-style food in 2,000 stores, outnumbers the American giant.

Supersize it

“Size advantage plays an important role for chain store operation,” says Li Weihua, a franchising expert and professor at China University of Political Science and Law. “In a competition the value of the number of stores is not to be underestimated.” In Li’s view, McDonald’s is under enormous pressure to be more competitive in China.

Much of this pressure comes from McDonald’s itself. The company’s global income comprises three parts — earnings of its direct sales stores, service fees from franchisees, and the real estate operating income (property rental payments from franchisees). The latter two revenue streams are particularly crucial.

In 2012, as the company’s annual report showed, the franchisees had a $7.4 billion gross profit, more than twice the $3.4 billion of direct sale stores. Meanwhile, of the $8.9 billion of the franchisees’ turnover, $5.8 billion came from rentals.

“People usually think that we sell hamburgers. But in fact we are a real estate dealer,” the fast food empire’s founder Ray Kroc once said. That’s the secret to the company’s long success. Through long-term leasing or by purchasing land and then building, the retailer sublets the stores to the franchisees to help generate profits.

But this profit model didn’t work for McDonald’s in China. Because of China’s restrictions on land purchases and buildings with foreign funds, the food giant owns less than 10% of the properties its stores operate in China. In the United States and Europe, this figure is around 60%.

At the same time, rental costs in China’s first- and second-tier cities are rising sharply. Most McDonald’s stores are located in bustling commercial districts, and most of them have signed a lease for 10 or 20 years. Because many of these stores’ leases are about to expire, McDonald’s will be hit with soaring rental costs.

In Kang Jianhua’s opinion, expanding franchises will reduce pressure on the company in terms of rental costs and create more reveune with franchise fees.

Of course, challenges will follow too. The first question is whether McDonald’s current management and overall operational capability in China are strong enough to support the franchising expansion. After all, the food giant’s development in China hasn’t been all that smooth, and China is still a less-than-ideal legal environment for franchising.

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