Dynamic Quad

Yum! Brands in China

Darius HubbardGrace MaDenise OdaroMonica Perez

MGTO 651W Doing Business in China3/23/2009

Contents

Background on Yum! Brands....................................................................................................................................3

Foodservice Industry in China..................................................................................................................................4

Yum! Brands Successes............................................................................................................................................4

Competitive Advantages......................................................................................................................................4

Challenges................................................................................................................................................................5

Recommendations...................................................................................................................................................7

Appendices...............................................................................................................................................................9

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Background on Yum! Brands

Yum! Brands is the world's largest restaurant company with a whopping 36,000 restaurants in over 110 countries and territories – 19,790 of which are in the United States. The company employs more than 1.4 million associates with revenues in excess of $11 billion in 2008, Yum! is ranked #253 on the Fortune 500 List. The company runs a group of diverse fast food eateries under different brands;

A&W Restaurants (Global) Kentucky Fried Chicken (Global)

Pizza Hut (Global)

Taco Bell (Global)

WingStreet (United States and Canada)

Long John Silver's (United States, Puerto Rico, New Zealand, Australia and Singapore)

Angelina's (United States)

Dong Fang Ji Bai 东方既白 (East Dawning) (People's Republic of China)

Ayamas pronounced: uh-yum-ahs (Malaysia)

Four of Yum’s restaurant brands: KFC, Pizza Hut, Taco bell and Long John Silver’s are the global leaders of the chicken, pizza, Mexican-style food and quick-service seafood categories.Yum! Brands was spun off from PepsiCo as Tricon Global Restaurants, Inc. in 1997 with the established goal to be “the best in the world at building great brands and running great restaurants”. The company grew as it acquired Yorkshire Global Restaurants which owned Long John Silver’s and A&W All-American Food chains in 2002 and soon after changed the name of the consolidated company to Yum! Brands. The growth of Yum! Brands in the United States has stifled as the domestic market is at saturation point. Thus, Yum! Brands targets foreign areas for growth in its business. Yum’s international division is the platform for the company’s growth and China is undoubtedly one of the major focuses.The China Division includes mainland China, Thailand and KFC Taiwan and is based in Shanghai. However, mainland China is Yum! Brands focus market for new company restaurant development outside of the United States. In 2008, operating profits for the China Division were $469 million and the company opened more than 500 new restaurants last year in mainland China. Due to its size, unique strength and importance, the division has reported directly to the headquarters, bypassing Yum! International in the reporting line, since the beginning of 2005.

Yum’s strategy is to be the market leader in every major food service category in mainland China. Yum took KFC to China in 1987, the first quick-service restaurant chain. The company was also first to take franchising to China in 1992 and in 2002, it was also the first to open a drive-through in China. KFC continues to be the number one quick-service restaurant brand and the largest and fastest growing restaurant chain in mainland China today, with approximately 2,500 restaurants in 500 cities. Though this number is way below the c.20,000 KFC restaurants in the US, Yum! opens nearly one new KFC

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every day in mainland China and there still exists a lot of depth for penetration. The company’s goal is to reach 20,000 units in the long term.

Again, Yum! made another debut in China with the introduction of Pizza Hut in 1990, the first restaurant chain to introduce pizza and Western-style casual dining to China and in 2001 it became the first pizza delivery restaurant in China. Today Pizza Hut is one of the leading casual dining brand in mainland China with 400 Pizza Hut Casual Dining restaurants in nearly 100 cities and an additional 79 Pizza Hut Home Service delivery units.

Foodservice Industry in China

As recently as the early 1990s, China consumers had very few options in the way of fast food. If consumers wanted quick service restaurant dining, they typically had two options – street side vendors or hotel restaurants. In a little over a decade, the landscape of China’s fast food market has changed dramatically. Chinese consumers now have a plethora of fast food options to choose from. These options include McDonalds, Japan’s Mos Burger and Rongua Chicken. However, with 2500 KFCs and 400 Pizza Huts, Yum Brands has a leading position in China’s Quick Service Restaurant market. Yum restaurants in total make up an astounding 16% of the fast food market. The company’s restaurants outnumber McDonalds 3 to 1 – an amazing statistic given McDonald’s dominant position elsewhere in the world.

Yum! Brands Successes Yum! Brands was first to Market with the first KFC outlet in Beijing in 1987. 1 As such, they have been able to maintain their market leadership in China. KFC’s menu also happened to match local taste preferences. With its chicken-based menu favored by the Chinese palate, KFC has always stayed ahead of McDonald’s, both in terms of store numbers and brand awareness. KFC has also focused on extending its reach into second- and third-tier cities, where it is the top fast-food brand in the minds of local residents2 Yum! Brands has pushed KFC the farthest in tailoring its menu to Chinese tastes, with offerings ranging from pumpkin porridge to Beijing chicken rolls. Earlier this year it even added the traditional Chinese deep-fried twisted dough stick (youtiao) on the breakfast menu. 3

Competitive Advantages

The company owns and operates the entire distribution system for its restaurants in mainland China. This competitive advantage gives the company coverage in every major Chinese province, which has allowed it expand so aggressively, which is critical as the Chinese population grows. Moreover, this gives Yum! an advantage in bringing ideas and products to market as well as the ability to quickly pull unsuccessful items off the menu.

As a market leader, Yum! has invested heavily in innovation and progress. In 2005, Yum! Brands introduced East Dawning, which is their new Asian style fast food in 2005 after perceiving potential for another Asian fast food provider. As of the fourth quarter 2008, there were 17 stores. As a result, this confirms that Yum! holds the leading position in fast food in China. 4

1 Economist Intelligence Unit. “China industry: Here comes a Whopper.” September 15, 2008.2 Economist Intelligence Unit. “China industry: Here comes a Whopper.” September 15, 2008.3 Economist Intelligence Unit. “China industry: Here comes a Whopper.” September 15, 2008.4 Euromonitor International : Country Sector Briefing. “Fast food in China.” October 2008.

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The combination of Asian foods and Western operational methods is expected to be the trend. Even with the general increase of disposable income and fast expansion of Western-style fast food, consumers are less interested in KFC and McDonald’s and Chinese foods remain the main choice. However, advanced Western operational methods, speedy and efficient service, are still necessary for the further development of the industry and East Dawning operated by Yum! may be able to meet that need. 5

Yum! Brands franchises its stores, which has reduced their risk and costs as they aggressively open stores in Tier 2 and Tier cities. Out of the total restaurants operated by the company internationally, 72% are franchisees.6 Yum! Brands is currently reducing the number of company-owned stores. The lower costs and risks involved are increasingly appealing to the company as pressure grows for the company to compete on its primary markets.

Challenges

Economic growth in China has dipped to a seven-year low of 6.8% in Q408, dragging full-year growth for 2008 to 9.0%, which is a sharp decline from the 13.0% in 2007. This is the first time since 2002 that the world's current third largest economy has failed to reach double-digit growth. Analysts predict that recent macroeconomic data shows that economic activity continues to cool and any turnaround for the Chinese economy will not occur until the second half of 2009 at the very earliest. It is much more likely that the economic recovery will not occur until 2010. Expected real GDP growth will most likely slow to around 5.6% in 2009, before recovering to around 6.8% in 2010.7

Price is still too high for some Chinese and it is the most important consideration for consumer. In the United States, fast-food chains often thrive in tough times. Unfortunately, this is not the case in China. Western quick-service food is not the cheapest option for the Chinese consumer and in some target markets like Shanghai, there is simply too much competition for fast food. 8

Additionally, fast casual dining is still negligible in China. Fast casual is defined as the combination of fast food and casual dining, which targets the high-end market with high-quality food and speedy service. However, because price is still the first consideration instead of dining environment for Chinese consumers when choosing fast food, providers will have to be aware of their price with respect to their competitors’ prices. In first tier cities, it has been difficult for fast casual dining to develop because KFC and McDonald’s have such wide coverage. This has been to the advantage of Yum! Brands. For lower-tier markets, it is even harder for the casual dining environment because consumers simply cannot afford the expensive fast food.9 Additionally, Pizza Hut’s image in the China is drastically different than in the U.S. It is seen as a classy, up-scale place for dining, which reinforces that the image of luxury and a splurge for a consumers and families.10

The awareness of health in China is growing. Consumer are starting to take more care in what they choose to eat and consumers are showing more interest in nutritional and dietary considerations, which can be a potentially significant challenge for fast food chains. Some, including Warren Liu, author of

5 Euromonitor International : Country Sector Briefing. “Fast food in China.” October 2008.6 Datamonitor. Company Profile. “Yum! Brands, Inc.” October 20, 2008.7 Business Monitor International. “BMI View: China.” February 11, 2009.8 Los Angeles Times. “China’s appetite for western fast food fades.” February 13, 2009.9 Euromonitor International : Country Sector Briefing. “Fast food in China.” October 2008.10 Datamonitor. “Yum! Brands embarks on expansion drive in China.” May 5, 2008.

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“KFC in China: Secret Recipe for Success." consider this to be the first signs of a long –term trend. 11 To make a bad situation worse, Western fast food, chicken and hamburgers, are attractive, but are not seen as a daily meal by Chinese consumers. Asian fast food is still more popular and dishes that include rice are considered healthier and more balanced in nutritional terms. 12

Politics in China should always be a consideration for a multinational. A few years back there were highly publicized reports about poor working conditions and the backlash in the media has created a shift towards the creation of unions. Wal-Mart was the first case for unions. In 2007, Yum! Brands and McDonald’s had to agree to worker representation after the Chinese press criticized them for not paying minimum wages. It was of no consequence that the charges turned out to be false. If companies oppose the implementation of unions, according to a senior union official who was quoted in the China Daily, those businesses will be blacklisted. Unlike in democratic countries, these companies will not face, but instead they will be subject to endless audits, tax examinations and, as in the cases of McDonald’s and Yum! accusations of employment-law violations.13

The competition in the consumer foodservice industry is intense, with both local and foreign players vying for market share. With Burger King entering the market and planning on opening up to 450 stores over the next five years, Yum! will have to be able to differentiate its product in order to gain a loyal customer base in an industry with low market entry barriers. Moreover, domestic outlets in China are still unable to compete with multinationals in store or non-free-standing locations. In comparison to multinationals, domestic consumer foodservice operators are experts at Chinese-style food, which is generally not as convenient as Western fast food. As a result, consumers would rather choose the convenient Western food in travel locations rather than having a full dinner in a Chinese restaurant. However, in order for non-free-standing locations to share the market, these domestic outlets are trying to develop fast food with convenient packaging, which will only increase the competition in the fast food market. 14

Given the nature of the foodservice business, Yum! Brands, is affected by any fluctuations in the price of beef, chicken, or cheese, all of which are critical ingredients. The company is vulnerable to any increases in food costs due to the economy, weather, food safety and may not be able to pass this additional cost to its customers, primarily because of the existing competition in the market. Also, significant increases in fuels costs could affect profit margins as can an increase in property costs, which will also affect Yum! Brand’s bottom line.15

11 Los Angeles Times. “China’s appetite for western fast food fades.” February 13, 2009.12 Euromonitor International : Country Sector Briefing. “Fast food in China.” October 2008.13 Economist Intelligence Unit. “China business: Membership required.” August 1, 2008.14 Euromonitor International : Country Sector Briefing. “Consumer Foodservice by Location -China.” October 2008.15 Datamonitor. “Yum! Brands embarks on expansion drive in China.” May 5, 2008.

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Recommendations

To address the problem of rising commodity prices

Rising food costs, due to global inflationary pressure, strong demand and lack of supply of commodities, has affected Yum! Brand’s profit margins, where the restaurant’s 4 th quarter 08 profits fell 12% as sales slowed in China16 (See Appendix 1). Thus, we recommend that Yum! Brand should control its input costs very carefully to maximize its profit margins. E.g., it should consider sourcing alternative supplies from other Countries; or to manufacture it’s own products by going up the supply chain and setting up its own factories and farmland. To address the adverse effects caused by tight pork supplies, lower than expected output in chicken and increase in chicken exports that also affected input costs17, we recommend Yum! China division to expand and regularly change the food menu to diversify its supply needs, e.g., include other food categories its KFC menu to avoid over reliance on chicken supply etc.

Fierce Competition

To increase competitiveness, we recommend that Yum! China should continue engage in innovative product differentiation by continue to tailor its menu to Chinese taste and consider commercialization of Chinese cooking techniques, as this is particularly important for its East Dawning brand’s operation in China. Moreover, Yum! China division should engage in continuous segmentation process depending on geographic, demographic, behavioral variables18 and psychographics of consumers19 in different regions of China, and target these niche markets using its different brands and change its marketing mix (4 Ps) to gain market share in smaller cities such as 2nd and 3rd tier cities via expansion.

In order to support the aggressive expansion plans in China, Yum! Brand should continue to invest, expand and upgrade its logistics and distribution network to increase efficiency and cut costs. E.g. it should continue to invest in food safety such as securing clean freezer space; provide further staff training and implement policies on food handling and OH&S issues; to build work-class distribution system and facilities to support the distribution network in order to expand into 2nd and 3rd tier cities and to support its online home delivery service business model. Yum! Brand should also build integrated communication plans and marketing systems to support its diversification strategy20 to ensure that Yum! China has true managerial control over all of its 3,582 stores in China (see Appendix 2 - information on China, US and International restaurant counts for Yum! Brand Inc. in 2008) and that top management is able to track sales, supplies, performance of its stores sand consumer preferences across China and worldwide in order to implement necessary operational changes on a global basis rapidly to gain competitive advantage. Moreover, it should align its HRM system with the organization’s culture and architecture, such as implementation of incentive linked remuneration package, develop strategic recruitment and training plans; talent management plans and performance appraisal systems etc. to build human capital.

16 Dentch C, ‘Yum! Brands Profit Declines as China Sales Slow (Update 2)’ 3 February 2009 <http://www.bloomberg.com/apps/news?pid=20601089&sid=a0VbZo1elK7A#> 17 MacNealy J, ‘Food on Call: Yum! Builds a Chinese Dynasty’ 17 July 2007 <http://www.fool.com/investing/dividends-income/2007/07/17/fool-on-call-yum-builds-a-chinese-dynasty.aspx>18 E.g. the urban affluent, Gen Y, the upper middle class, the lower middle class (see Lane K, St-Maurice I & Dyckerhoff C, 2008, ‘Building Brands in China’, The McKinsey Quarterly) and consumers from different regions, cultures etc19 Marketing Management, 2008, AGSM EMBA20 Ansoff Product Market Growth Matrix

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Build strong brand

To move forward, Yum! China division should leverage its competitive advantage by continue to build strong brand in China by focusing on ‘consumer experience’21 using its multi-branding strategy for different target niche markets in order to increase brand awareness, preference, loyalty and brand equity. In addition to the abovementioned recommendations, we suggest that effective marketing and promotional methods tailored to different consumer segments would assist in brand building given the diversity of Chinese consumers. For example, the company could target the professional/business segment by promotions in business newspapers, news channels and outdoor advertising in business areas. It could target generation Y consumers via TV commercials using advertisements with contents that bond with them similar Nike’s advertisement. It could also target young urban segment by continue to collaborate with QQ.com22, China Basketball Association23 and other large organizations to organize events and online activities; and to continue to sponsor Chinese celebrities and Olympic teams etc. Moreover, Yum! China division could use its wide distribution channel for promotional and marketing purposes. It should continue to expand its online distribution channel and home delivery service to appeal to Generation Y consumers and to expand its Drive-thru distribution channel in retail outlets to capture opportunities given increase in car ownership in China.

Food Safety and quality and social responsibility

Furthermore, given the history of food scares of New York rat infestation issue and the E Coli outbreak at Taco Bell in 2007 in U.S 24, we recommend that Yum! China division should continue to constantly monitor food safety and quality by ensuring proper implementation of food safety policies not just in all stores, but also down the whole supply chain e.g., qualify all supplies base on food safety and quality standards similar to Wal-mart’s ‘sustainability agenda’25; regularly monitor and audit hygiene standards of its suppliers’ factories, its own factories and the whole distribution channel. It could also further participate in environmental protection, animal welfare and further improve its Corporate Governance practices given that these will be factors that differentiate themselves from other competitors, and what Chinese consumers will value in the long term.

Appendices

Appendix 1 - Historic Sales Growth - CHINA DIVISION SYSTEM SALES GROWTH (Local Currency)

(Mainland China, Thailand, KFC Taiwan)   2008 2007 2006 2005 2004

21 Week 4 Course notes, Doing Business in China, HKUST MBA22 QQ.com – chance to win free mobile phone for choosing a song that you would like to hear in KFC stores in China http://kfcmusic.qq.com 23 CBA – Yum! China division’s sponsorship for 3-on-3 basketball tournament in the past 5 years: see http://kfcsports.qq.com/html/news081222 01.html24 Kaminis M, ‘Tasty Chicken, Tepid Price’, 28 June 2007 <http://www.fool.com/investing/general/2007/06/28/tasty-chicken-terrible-price.aspx>25 Where suppliers will be dropped if they failed to comply with the terms and conditions specified in the suppliers agreement: see Winston A, ‘Wal-Mart’s New Sustainability Mandate in China’, Business Week, 28 October 2008

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1st Quarter 28% 19% 14% 26% 17%

2nd Quarter 28% 19% 29% 2% 34%

3rd Quarter 18% 23% 25% 11% 20%

4th Quarter 15% 30% 23% 6% 21%

Full Year 20% 24% 23% 10% 23%

Source: http://www.yum.com/investors/historic_sales.asp

Appendix 2 – Restaurant Counts (2008)

KFC PH TB A&W LJS

East Dawning Total

USA 5,253 7,564 5,588 363 1,022 – 19,790

Mainland China 2,980 585 – – – 17 3,582

International 7,347 5026 245 38 264 – 12,920

36,292

Source: http://www.yum.com/investors/restcounts.asp

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