McDonald's hastens development to take bite out of Yum Brands' customer base

Updated: 2007-09-12 05:22

NEW YORK - 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 Chinese mainland 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."

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