YUM! BRANDS, PIZZA HUT, AND KFCTeaching NoteOverview

This case describes the evolution of the global fast-food industry and Yum! Brands, Inc.’s development of the Pizza Hut and KFC franchises worldwide. It focuses on international business risk assessment and develops a model of country evaluation that students can use to analyze international business and market entry decisions in a variety of industries, regions, and countries.

Teaching Objectives

1. Develop skills in industry analysis

2. Develop skills in global industry analysis.

3. Develop knowledge of franchising and the costs and benefits of expanding globally using franchises versus company-owned stores.

4. Develop skills in international business risk analysis.

5. Develop skills in country portfolio evaluation and assessment.

Suggestions for Using the Case

This case has been used successfully in undergraduate, MBA, and Executive MBA classes in strategic management, marketing management, and international business. It can be used in undergraduate courses to develop student skills in industry structure analysis, strategy analysis, and international business risk assessment. The teaching note is designed to give students practice in each of these three areas. Instructors may choose to use the case to discuss only one of these three areas during a single class period or to cover all three areas over two class periods. The case can be also used for student presentations and projects, especially for projects on country evaluation and risk assessment.

This note was prepared by Professor Jeffrey Krug as an aid to instructors to accompany the case Yum! Brands, Pizza Hut, and KFC. It is designed to stimulate student discussion, develop student skills in business analysis, and promote creative thinking of alternative approaches to strategy formulation and implementation.

Copyright © 2004 by Jeffrey A. Krug of Appalachian State University, Walker College of Business, Department of Management, Box 32037, Boone, NC 28608. Phone: (828) 262-6236. Email: Krugja@appstate.edu. No part of this case may be copied, reproduced, stored in a retrieval system, or transmitted in any form without the permission of the author.

For MBA and Executive MBA courses in strategic management, the case can be used in the beginning of the semester as a means of presenting a framework for industry structure and

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strategy analysis that the instructor develops throughout the semester. It can also be used in the second-year global & transnational strategy course in the beginning of the semester to introduce international business risk assessment. Alternatively, it can be used at the end of the semester as a review of industry structure, strategy, and international business strategy analysis.

The case is structured around the following themes:

(1) Industry analysis (U.S. fast-food industry),(2) Multi-branding and franchising strategies (Yum! Brands, Inc., Pizza Hut, and KFC),(3) International strategy analysis (Pizza Hut and KFC), and(4) Country risk assessment (Mexico, Brazil, and Latin America).

The case is best understood after a class discussion of environmental analysis and business strategy. It is also helpful if students have been introduced to the concept of corporate strategy. The case has enough information to cover one or two sections of class discussion. If the instructor chooses to cover the case in two sections, one section might be used to conduct an industry analysis. A second section might then be used to analyze Pizza Hut and KFC’s business strategies and discuss international business issues.

An alternative use of the case involves breaking the class into groups of four to five students and assigning one discussion question to each group at least one class period before the case is presented. When students return to class the following session, students can be broken into their groups for ten to fifteen minutes, during which time they formulate a response to their assigned question. The remaining time may then be used for short student presentations. I sometimes ask a representative from each group to give a five to eight minute response to his or her group’s question and interject periodically to make sure that the questions are tied together correctly.

A third use of the case is to ask groups to examine the Latin American market (or more specifically the Mexican and Brazilian markets) and analyze the costs and benefits of expanding further in Mexico versus expanding into other areas of Latin America such as Brazil. This also makes a good individual or group writing assignment. It can also be used for a semester paper.

Teaching Aids

The beginning sections of the case can be used to conduct an in-depth industry analysis (industry characteristics, trends, and driving forces), analyze competitive forces (Porter’s Five Forces Model), and conduct a SWOT analysis for Pizza Hut and KFC. If students haven’t already been exposed to Porter’s work, the instructor might assign the following reading:

Michael E. Porter, "How Competitive Forces Shape Strategy," Harvard Business Review, March-April, 1979, pages 137-145.

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The last portion of the case focuses on international business analysis and country risk assessment. In particular, it discusses environmental risks and opportunities associated with international expansion, particularly in Mexico and Brazil. This section can be used to discuss the risks of doing business in a foreign country, market entry strategies, political and economic risk, and differences in industry structure across countries. The instructor might end the case by asking students which strategy companies like Pizza Hut and KFC should follow in Latin America.

If the instructor plans to discuss the international aspects of strategy, then the following article may be assigned:

Kent D. Miller, "A Framework for Integrated Risk Management in International Business," Journal of International Business Studies, vol. 21, no. 2, 1992, pages 311-331.

Assigned Questions

Industry Analysis1. What are the primary driving forces in the U.S. fast-food industry in 2004?

2. Using Porter's Five-Forces Model, assess the strength of each competitive force in the fast-food industry.

3. Is the U.S. fast-food industry attractive?

4. What are the fast-food industry's key success factors?

Business Strategy Analysis1. Complete a SWOT analysis for Pizza Hut and KFC.

2. In what ways are Pizza Hut and KFC positioned to take advantage of the industry's key success factors?

3. What are Pizza Hut and KFC's competitive advantages?

Franchising Strategy Analysis1. What are the benefits of franchising versus company-owned restaurants for companies

like Pizza Hut, KFC, McDonald's, or Burger King?

International Business Strategy1. Describe Pizza Hut and KFC's investment strategy in Latin America.

2. Using the country and industry risk categories discussed in the case, compare and contrast Mexico and Brazil as alternative investment locations. What risks are associated

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with investment in Mexico? In Brazil? What strategies can be used to minimize these risks?

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INDUSTRY ANALYSIS

1. What are the primary driving forces in the U.S. fast-food industry in 2004?

· Industry sales are flat. The industry growth rate, which has averaged about three percent per year, indicates that the industry has matured. Lower growth rates have intensified competition among fast-food chains. Market share gains are increasingly achieved only by taking customers away from existing competitors rather than by attracting new customers into the industry.

· The industry is consolidating. Significant merger and acquisition activity during the last decade has consolidated many fast-food chains under the same corporate umbrella. Many chains such as Yum! Brands, Inc. are actively engaged in acquisitions as a means of creating purchasing power and greater economies of scale in purchasing, brand management, advertising, and distribution.

· The industry is becoming more global. Most of the top U.S. fast-food chains have implemented foreign growth strategies to expand outside of the mature U.S. market. Foreign markets are less saturated than the U.S. market and offer significant opportunities for chains to grow sales and establish strong, long-term market positions outside of the United States.

· Diversification has become an important growth strategy. Fast-food chains are diversifying outside of their core products and attacking other fast-food chains as a means of increasing growth. For example, McDonald's, Wendy's, Arby's, and Hardee's sell a variety of chicken sandwiches in addition to their core portfolio of hamburgers. McDonald's also sells breakfast burritos, salads, cookies, and ice cream. Pizza Hut and other pizza chains have introduced chicken wings and other non-pizza items to their menus. This has blurred the distinction between competing chains and substitute products – chains that were once classified as substitutes (e.g., McDonald’s and KFC) are now competing chains.

· Many customers are health conscious and want products with lower fat content, lower cholesterol, or fewer carbohydrates. Many hamburger chains have introduced grilled chicken sandwiches, low carbohydrate hamburgers, and salads to appeal to these consumers. The instructor might discuss the wide variety of viewpoints about what constitutes “healthy” food. Americans have historically viewed low-fat, low-protein products (i.e., carbohydrate-rich) products as most healthy. A growing number of Americans, however, have switched to low-carbohydrate, high-protein diets (the Atkins Diet) or more balanced diets (the “Zone”). To take advantage of these trends, KFC has begun advertising its products as “low-carbohydrate” alternatives to other fast-food products such as Burger King’s Whopper, in essence attempting to create the perception that fried chicken is “healthy.”

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· Many consumers are experienced, repeat buyers who are familiar with their favorite chain’s products. Competitors have turned to promotions, price reductions, and other techniques to attract these customers.

· Greater consumer demand for convenience has driven the construction of non-traditional outlets in shopping malls, airports, colleges, fairs, and amusement parks.

· Rising labor costs and a shortage of labor aged 16-24 years has increased pressure to keep other costs down. Many fast-food chains have been forced to pay higher wages and offer benefits to attract employees. Many chains are hiring senior citizens to make up for the low supply of younger workers.

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2. Using Porter’s Five Forces Model, assess the strength of each competitive force in the U.S. fast-food industry.

Substitute Products (Strong Force)

Substitute products include:

· Full service restaurants.· Cafeterias.· Microwavable products purchased at grocery stores and eaten at home.· Family restaurants (Denny's, IHOP, and Cracker Barrel)· Dinner houses (Red Lobster, Chili’s, and Outback Steakhouse)· Grilled buffet chains (Golden Corral, Ryan’s, and Ponderosa).

Substitute products are a strong force because:

· There are a variety of high quality, reasonably priced eating alternatives available.· There are numerous restaurants and other eating alternatives located near most

Pizza Hut and KFC locations.· Customer switching costs are low.

Strong substitute products lower profitability of the industry’s competitors because they provide cheap, high quality, and readily available alternatives to customers. Customers may, for example, choose to take home a cooked chicken purchased from their local supermarket’s deli instead of eating out at KFC.

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Suppliers Competitors

Threat of Entry

Customers

Substitutes

Weak

Strong

Strong

Strong

Weak

Competition (Strong Force)

Pizza Hut’s primary competitors are:

· Other pizza outlets (Domino’s, Papa John’s, Little Caesars, Chuck E. Cheese’s).· Chicken outlets (KFC, Church’s, Chick-fil-A, Popeyes, Bojangles’).· Sandwich chains (McDonald's, Burger King, Wendy’s).

KFC’s primary competitors are:

· Other chicken chains (Church’s, Chick-fil-A, Boston Market, Popeyes, Bojangles’).· Pizza outlets (Pizza Hut, Domino's, Papa John’s, Little Caesars).· Sandwich chains (McDonald's, Burger King, Wendy’s).

An interesting question is whether Pizza Hut, KFC, and McDonald’s are competitors or substitutes. During the 1980s and early 1990s, other fast-food chains (non- “chicken-on-the-bone”) were viewed as substitutes for KFC. Today, McDonald’s sells chicken sandwiches and chicken McNuggets. Pizza Hut sells chicken wings and a variety of pizzas with chicken toppings. This has blurred the distinction between segments (dinner houses versus grilled buffet chains, sandwich chains versus chicken chains, etc.). The instructor may wish to pursue this issue. If a slow-growth market prevents Pizza Hut from growing its pizza sales, then it can attempt to draw customers away from KFC and other chicken chains by offering a variety of chicken products in addition to their traditional pizza menu.

Competition (rivalry) is a strong force (intense) because:

· Industry sales growth is flat.· Competition for market share among existing chains is intense.· There are high first mover advantages (e.g., McDonald's created brand awareness for

its chicken sandwich by introducing its sandwich before KFC).· Low customer switching costs have increased pressure on chains to attract customers

through advertising, new product offerings, and price discounts.

Customers (Strong Force)

Some customers have strong loyalty to particular chains (e.g., McDonald’s, Burger King, Pizza Hut, and KFC). This decreases customer power. Overall, however, customers are increasingly becoming a stronger force because:

· They are knowledgeable, repeat buyers.· They are price and quality sensitive.· They want great convenience and are location sensitive.· Switching costs are low.

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Threat of Entry(High Entry Barriers = Low Threat of Entry = Weak Force)

The threat of new entry is low (weak force) because:

· Many customers have strong loyalty to individual brands such as KFC.· It is extremely difficult to develop brand awareness and image for new brands in a

well-developed industry like fast-food.· High fixed costs reduce the likelihood that new firms will enter the industry.· Economies of scale force new entrants to enter at a cost disadvantage.· Existing fast-food chains are intensely competitive and willing to defend their

positions with discounting and advertising.

Suppliers (Weak Force)

Suppliers are a weak force because:

· Paper and plastic are standardized commodities. This allows KFC to “shop” around for the best price.

· Switching costs are low. KFC can easily switch from one supplier to another.· Threat of backward integration. KFC could integrate backward if needed.· KFC buys in large volumes, giving it the power to negotiate lower prices.

3. Is the U.S. fast-food industry attractive?

· According to Porter's model, it is not. Three of the five forces (substitute products, competitors, and customers) are strong. It is an intensely competitive industry and profit margins are low.

· The industry is mature.

· The segment market share leaders are in the most attractive position because of their ability to leverage assets and lower costs through economies of scale (e.g., McDonald's, Burger King, Wendy's, Applebee’s, Denny's, Pizza Hut, Domino's Pizza, and KFC).

· It is certainly an unattractive industry for new entrants, which must overcome high fixed costs of entry, economies of scale disadvantages, strong brand recognition among existing chains, and the risk of strong retaliation by existing competitors.

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4. What are the fast-food industry's key success factors?

· Product quality and consistency. Q

· Service. S

· Cleanliness. C

· Perceived Value. V

· Location.

· Global brand awareness.

Restaurant companies use the acronym Q S C V to refer to the industry’s key success factors. Because of intensified competition in the mature and increasingly saturated U.S. market, many companies have also begun to view location and global brand awareness as important key success factors.

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BUSINESS STRATEGY ANALYSIS

1. Complete a SWOT analysis for Pizza Hut and KFC.

Strengths (For both brands)

· Strong brand awareness.· Strong brand loyalty.· Market share leader.· Proprietary recipes and

technology.· Marketing expertise.· Brand management.· International expertise.

Weaknesses (For both brands)

· Many restaurants are aged.· Many restaurants are small or

takeout only (KFC).· Reputation for poor service and

cleanliness.· Independent franchises make it

difficult to develop product and operating consistencies (Especially KFC).

Opportunities (For both brands)

· International expansion.· Co-branding (KFC, Pizza Hut,

Taco Bell, A&W, and Long John Silver’s).

· Development of lunch day-part by promoting lunch and snacks.

· Expansion of all-you-can-eat buffets (Especially KFC).

· Promotion of roasted chicken and chicken sandwiches (KFC).

· Promotion of low-carbohydrate/low fat pizzas (Pizza Hut).

· Promotion of ethnic foods in ethnic neighborhoods.

· Construction of restaurants in non-traditional locations such as colleges and airports.

· Expansion of home delivery.

Threats (For both brands)

· Poor service and cleanliness in many restaurants.

· Expansion of chains promoting non-fried chicken (Chick-fil-A, Boston Market, and Pollo Loco).

· Expansion of non-traditional pizza chains (Chuck E. Cheese’s, Round Table Pizza).

· McDonald’s quickly becoming market leader in key international markets such as Brazil.

· McDonald’s is threatening to replace KFC as the market leader in Mexico.

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2. In what ways are Pizza Hut and KFC positioned to take advantage of the industry's key success factors?

· High product quality and consistency.

· Strong brand name and customer loyalty.

· KFC customers love the product despite the fact that it is fried.

· Pizza Hut customers are strongly loyal to the Pizza Hut brand despite alternatives like Papa John’s and Little Caesars.

· Pizza Hut and KFC's leading market shares in the pizza and chicken segments strengthen consumer awareness, give both brands a location advantage, and create economies of scale in marketing and distribution.

· Opportunities for Yum! Brands, Inc. to benefit from technology, management, and market sharing among its five restaurant chains (KFC, Pizza Hut, Taco Bell, A&W, and Long John Silver’s).

· Opportunities for Yum! Brands, Inc. to lower costs by sharing distribution of food products and supplies among its five brands (KFC, Pizza Hut, Taco Bell, A&W, and Long John Silver’s).

· Both Pizza Hut and KFC have strong expertise and experience doing business outside of the United States. Few chains other than McDonald’s can match their international experience.

· Both Pizza Hut and KFC have strong market shares and brand image in Japan, Asia, Australia, Canada, Mexico, and the Caribbean.

3. What are Pizza Hut and KFC's primary competitive advantages?

· Product taste (quality and consistency). Quality

Service?

Cleanliness?

· Brand loyalty. Value

· Consumer awareness. Value

· Location. Location

(Pizza Hut and KFC’s early entry into the fast-food industry enabled both chains to expand into small towns across the United States when there was little competition. This effectively deterred entry by other pizza and chicken chains in smaller markets).

· Global Presence. Globalization

(Pizza Hut and KFC’s early expansion abroad also made them two of the largest global fast-food companies and gave them strong global brand awareness).

NOTE that Pizza Hut and KFC have competitive advantages that match the industry’s key success factors in all but two areas: service and cleanliness. These two factors continue to be an obstacle for both brands. It is especially a problem for KFC because of its large, independent franchises.

Franchising Strategy

What are the benefits of franchising versus company-owned restaurants for companies like Pizza Hut, KFC, or McDonald's?

Franchising

· Franchisees are motivated because the business is theirs. The only obligation is to pay royalties (a small percentage of sales) to the parent company.

· Franchisees often have greater knowledge of the local language, culture, legal and political systems, financial markets, and marketing characteristics.

· Franchisees incur most of the startup costs. Therefore, the company can expand more quickly than through company-owned restaurants.

· Franchisees provide a steady royalty stream to the company well into the future.

Company-owned restaurants

· The company has greater control over product quality, service, and restaurant cleanliness than in franchised restaurants.

· Franchise royalty fees are fixed. Company restaurant profits are unlimited. Company restaurants, therefore, have the potential to contribute more to profits than franchisee fees if the restaurant is managed properly.

· They protect the company from financial problems created by mismanaged franchises.

· The company can lower restaurant level costs by coordinating purchasing, recruiting, training, advertising, and distribution across a large restaurant base.

International Strategy

1. Describe Pizza Hut and KFC's historical investment strategies in Latin America.

KFC· Expanded initially into Mexico and Puerto Rico through company-owned restaurants

during the 1960s and 1970s.

· Expanded throughout the Caribbean using franchised restaurants during the 1970s and 1980s (KFC’s strategy was to place a KFC franchise on every island in the Caribbean and to manage them through KFC's Latin American headquarters in Ft. Lauderdale).

· Established subsidiaries in Venezuela and Brazil, two of South America's largest consumer markets. By expanding into these countries using company-owned restaurants, KFC hoped to leverage its expertise and spread costs across a large number of restaurants. Limited resources, however, caused KFC to close all of its restaurants and shut down its subsidiaries in Venezuela and Brazil by 2000. KFC now operates a limited number of franchised restaurants in these countries

· Expanded into other regions of South America using franchises. Franchises enabled KFC to expand rapidly with little commitment of capital and using highly motivated, local businesspeople.

Pizza Hut· Like KFC, Pizza Hut expanded first into Mexico in the late 1970s and 1980s. Mexico’s

close proximity to the United States made it a natural location for Pizza Hut to expand first until it accumulated greater international experience.

· KFC’s strategy is consistent with “Internationalization Theory.” It expanded further and further away from its headquarters base as it gained greater international experience. In other words, it was willing to invest in markets further from home (greater risk) only as it accumulated greater international experience.

· Pizza Hut’s Latin American strategy has been very different. It identified the largest markets and expanded there first. Brazil, Costa Rica, and Chile are Pizza Hut’s next largest markets. Brazil’s large population, for example, was a major motivation to invest resources there, even though its greater geographical distance made communications and quality control more difficult. KFC was late to expand into Brazil and has had more difficulty establishing brand awareness there.

· Pizza Hut’s strategy has been to establish a greater number of restaurants in a smaller number of countries. KFC’s strategy has been to establish restaurants in every country and island in the region possible.

2. Using the country and industry risk categories discussed in the case, compare and contrast Mexico and Brazil as alternative investment locations. What risks are associated with

investment in Mexico? In Brazil? What strategies can be used to minimize these risks?

The instructor might consider one of the following four assignments:

a) In-class discussion : Use the framework on the next page as a basis for in-class discussion of the case.

b) Written assignment : Distribute a copy of the following framework to students. Ask them to prepare a written analysis based on the framework (either as an individual or group assignment). Collect the assignment at the beginning of the following class and discuss the framework using the tables on the following three pages.

c) Oral student presentations : Distribute a copy of the framework to students. Ask groups to prepare an oral presentation for the following class. Use the tables on the next three pages to monitor students’ presentations.

d) Group papers : Distribute a copy of the framework to students as a basis for a group paper to be handed in at the end of the semester. Use the tables on the following three pages to grade the papers.

Comments prior to discussing assignment:

Exhibit 7 in the case shows that Latin America is not a homogeneous market; rather, it is a collection of distinct markets that share commonalities (e.g., they are close geographically, Spanish is spoken in most countries with the notable exception of Brazil, where Portuguese is spoken, and Catholicism is the predominant religion).

Population characteristics, however, differ dramatically between countries. Mexico’s population, for example, is primarily composed of indigenous people and people of mixed indigenous-Spanish descent. Brazil, in contrast, is dominated by European descendents and people of mixed European-African blood. Argentina is dominated primarily by European descendents and has almost no indigenous people.

The point is that Latin Americans are not the same. Companies interested in selling their product or service in Latin America should view each market as having distinct characteristics.

Framework for Country Analysis

Environmental Risks

Political Risk• War, revolution.• Change in government.• Price controls.• Tariffs, trade restrictions.• Appropriation of assets.• Government regulations.• Restrictions on repatriation of profits.

Economic Risks• Inflation, interest rates.• Foreign exchange movements.• Balance of trade.• Social unrest, riots, terrorism.• Social concerns.

Natural Risks• Rainfall, hurricanes.• Earthquakes, volcanic activity.

Industry Risks

Supplier Risk• Quality.• Shifts in supply.• Changes in supplier power.

Competitive Risk• Rivalry among competitors.• New market entrants.• New product innovations.

Product Market Risk• Consumer tastes.• Availability of substitute products.• Scarcity of complementary goods.

Note: If the instructor is interested in the theoretical development of these risk categories, it is useful to review Kent D. Miller’s article entitled "A Framework for Integrated Risk Management in International Business," in the Journal of International Business Studies, vol. 21, no. 2, 1992, pages 311-331.

Environmental Uncertainties in Mexico and Brazil

Environmental Uncertainties Mexico Brazil Strategies

Political Risk• War, revolution. Political Risk Insurance• Change in government. HIGH Political Risk Insurance• Price controls. HIGH Political Risk Insurance• Tariffs, trade restrictions. HIGH• Appropriation of assets. Joint Venture with Local Firm• Government regulations. HIGH Joint Venture with Local Firm• Restrictions on repatriation of profits. HIGH Joint Venture with Local Firm

Economic Risks• Inflation, interest rates. HIGH HIGH• Foreign exchange movements. HIGH HIGH Foreign Exchange Contracts• Balance of trade. HIGH Agreement to Export• Social unrest, riots, terrorism. HIGH Don’t Invest or Withdraw• Social concerns. HIGH Don’t Invest or Withdraw

Natural Risks• Rainfall, hurricanes. HIGH Evaluate Investment Locations• Earthquakes, volcanic activity. HIGH Evaluate Investment

Locations

The risk of tariffs, trade restrictions, and other government regulations are significantly lower in Mexico. The North American Free Trade Agreement, which went into effect in 1994, created a free trade area that eliminated tariffs and other trade restrictions on goods traded between Canada, the United States, and Mexico. Trade among these three countries has increased significantly since the agreement was signed. Moreover, Mexico has become significantly more dependent on the United States both politically and economically since 1994. In 2003, 83 percent of its exports went to, and 68 percent of imports came from, the United States (U.S. Department of Commerce, 2004). The strong dependence on the United States for trade and investment has improved both political and economic relations between the two countries and reduced the possibility of future restrictions on trade and investment.

Mexico borders the United States, thereby lowering transportation costs . U.S. companies can assemble products in Mexico and import them into the United States (by truck or rail) at low cost. Closer geographic proximity also makes it easier and less expensive for businesses to monitor their investments and communicate with their offices in Mexico.

The risk of government regulations on trade and investment is far greater in Brazil . Brazil is much less dependent on the United States for trade. Only about 25 percent of Brazil’s total trade is with the United States. Brazil has a much more diversified set of

trading partners in Latin America and Europe than does Mexico. As a result, Brazil has much greater flexibility to enact legislation that protects its businesses from foreign competition.

The Brazilian government has generally opposed a Free Trade Area of the Americas, which would eliminate tariffs on trade among member countries in North and South America. Brazil has played a leadership role in developing MERCOSUR, a free trade area that has eliminated most tariffs on trade between Brazil, Argentina, Uruguay, and Paraguay. Brazil has shown a preference for developing MERCOSUR further – as the lead country – instead of participating in a larger free trade area that would be dominated by the United States.

The imposition of tariffs and other barriers on Brazilian exports to the United States continues to strain U.S.-Brazilian relations. The Brazilian government has also shown displeasure with tariffs on Brazilian goods brought into the United States, such as Brazilian sugar cane, tobacco, orange juice concentrate, soybean oil, women’s leather footwear, and semi-finished steel. The U.S. government imposes tariffs of between 10 and 350 percent on these imports, making Brazilian products significantly less competitive in the U.S. market. Many Brazilians resent these U.S. restrictions, which are a topic of discussion in many Brazilian homes. The creation of a Free Trade Area of the Americas would eliminate these tariffs, thereby improving the competitiveness of Brazilian firms. Many Brazilians, however, do not want tariffs on U.S. goods imported into Brazil to be eliminated. It is widely believed that smaller Brazilian firms could not effectively compete with larger, more global U.S. firms. As a result, there is still a degree of support for regulations that protect the competitiveness of Brazilian firms.

HOWEVER, the risk of social unrest is much greater in Mexico . Despite the success of NAFTA, many farmers and unskilled workers in Mexico continue to oppose trade with the United States. Violent demonstrations and riots, which have resulted in smashed windows at U.S. businesses such as McDonald’s, and the risk of rioting by rebel groups in the Southern part of Mexico, are on-going concerns. Anti-American feelings tend to run much stronger in Mexico than in Brazil, largely because U.S. presence in Mexico is much greater. Mexico is more dependent on the United States than Brazil and U.S. businesses are more developed, especially in highly visible industries such as fast-food and soft drinks. This raises the risk to American businesses operating in Mexico.

FURTHER, the risk of natural disasters is much greater in Mexico . In the 13th century, the Aztecs (Mexica or Tenochca) immigrated from northern and northwest Mexico to settle on a series of small islands in Lake Texcoco. In 1325, the town of Tenochtitlan (Mexico City) was founded. The Aztecs were defeated in the early 16th century by Cortes and the lake was eventually filled in for development. Today, many buildings in Mexico City are in danger of collapsing as they settle into the soft soil.

Earthquakes, volcanic activity, torrential rainfall, flooding, and mudslides are all common natural events that threaten Mexico City and other parts of Mexico. In 1985, an earthquake in Mexico City killed close to 10,000 people and destroyed 100,000 homes. In 1999, southeastern Mexico was deluged with torrential rainfall and mudslides that drove more than 150,000 people from their homes. In 2000, the Popocatepetal volcano erupted, driving more than 30,000 residents in 18 villages from their homes. These natural weather patterns and activities threaten businesses as well as private homes.

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Industry Uncertainties Mexico Brazil Strategies

Supplier Risk• Quality. HIGH Use Multinational Supplier• Shifts in supply. HIGH Use Multinational Supplier• Changes in supplier power. Use Multiple Suppliers

Competitive Risk• Rivalry among competitors. HIGH Strong, Localized Strategy• New market entrants. HIGH First-Mover Strategy• New product innovations. Joint Venture with Local Firm

Product Market Risk• Consumer tastes. HIGH Don’t Invest OR• Availability of substitute products. HIGH Use Joint Venture Partner OR• Scarcity of complementary goods. Take Long-Term View and

Forgo Short-Term Profits

Competition is much more intense in Mexico . Mexico’s fast-food market is highly developed. A variety of U.S. chains have already established strong restaurant bases in Mexico. Mexican consumers generally like U.S. fast-food. They accept the fast-food concept. The acceptance of the fast-food concept has encouraged the entry of a large number of U.S. fast-food chains. Competition is intense and profit margins are thin.

Competition is much less intense in Brazil . Many students will point to Brazil’s large

population and growing economy. Brazil is Latin America’s largest economy and it plays a leadership role in Latin America through it role in MERCUSOR and its extensive foreign investment. There are few fast-food chains other than McDonald’s with restaurants in Brazil. Many students will argue that Brazil is a more attractive, and

generally underdeveloped, location for investment compared to Mexico.

What most students don’t appreciate, however, is that Brazilians generally don’t accept the U.S. fast-food concept. Brazilians don’t like to eat with their hands – even pizza is eaten with a knife and fork. Food courts in shopping malls include a variety of high quality, sit-down restaurants with table service, in addition to a small number of fast-food chains. KFC and Burger King withdrew from Brazil at the end of the 1990s because of poor acceptance. These chains are only now developing new strategies for penetrating the Brazilian market.

EPILOGUE

Following the economic recession of the mid-1980s, Mexico's economy improved in 1989 and 1990. PepsiCo’s financial officers, however, still viewed Mexico as a risky area for investment and recommended that new restaurant construction be slowed until greater stability could be established. PepsiCo’s marketing executives, however, viewed continued restaurant construction as an important strategy for maintaining market share. This problem was particularly important for KFC, which had the leading market share in Mexico. Mexico was also Pizza Hut’s leading Latin American market. After heated debate, PepsiCo decided to allow Pizza Hut and KFC to continue to build restaurants in Mexico. This decision, though risky, was based on PepsiCo’s culture of encourage risk taking and rewarding performance. Managers should be allowed to take risks and if performance declined, they would be held accountable.

Despite the decision to continue building restaurants in Mexico, PepsiCo took several actions to minimize the financial risk of doing business there. It required that Pizza Hut and KFC to use a return-on-investment cut-off of 21 percent to justify new restaurant projects. PepsiCo normally required a 15 percent return for non-U.S. based restaurants. This made it more difficult to justify new restaurant construction. In addition, PepsiCo decided that future restaurant investments would be funded through cash flows generated by Frito Lay's operations in Mexico. This minimized foreign exchange losses that would otherwise have been incurred if Pizza Hut and KFC had converted new investment dollars into pesos at the current exchange rate and invested them in Mexico. During the period 1990-1993, this policy was extremely important because Mexican government controls on the peso/dollar exchange rate resulted in a grossly overvalued peso against the dollar.

In 1994, the peso devaluated against the dollar by 71 percent. In 1995, it devalued by 44 percent. The peso devaluation resulted in an economic recession characterized by high interest rates, high inflation, low real growth in the gross domestic product, lower disposable income, and lower consumer spending. In retrospect, the rationale behind the opposition to further expansion in Mexico by PepsiCo’s financial personnel seemed warranted. However, McDonald's decision to expand despite Mexico's economic problems highlighted the market share dilemma of the company’s marketing executives. The foreign exchange crisis heightened concerns over the profitability of existing and future investments in Mexico.

The most critical constraint on Pizza Hut and KFC was financial resources. Between 1986 and 1997, Pizza Hut and KFC had access to large PepsiCo cash flows. Expansion

decisions could, therefore, be made on the basis of long-term market share objectives. When PepsiCo divested its restaurants in 1997, it required the new company to make a one-time payment of $4.5 billion. A large portion of this payment was made through debt. The combination of high debt brought about by the spinoff and the fact that PepsiCo cash flows were no longer available to fund restaurant expansion significantly constrained the new company’s ability to expand internationally. Future decisions on where and when to invest were critical and had to be made with these cash flow limitations in mind.

By 2004, Yum! Brands, Inc. had refocused its strategy on seven highly profitable markets outside of the United States: Japan, China, Canada, Great Britain, Australia, Korea, and Mexico. Malaysia, Thailand, South Africa, and Indonesia were also high growth markets. In general, Asia represented the most profitable region for investment because of Asia’s wide acceptance of the fast-food concept. KFC was much stronger in Asia because chicken was a staple food. Pizza Hut was more successful in Europe where pizza was more highly accepted. Europeans outside of Great Britain generally hadn’t yet accepted the KFC brand. In Latin America, Puerto Rico and the Caribbean islands were strong KFC footholds. KFC, however, was not widely accepted in Brazil, primarily because the fast-food concept was not entirely accepted by many Brazilians and Brazilians did not eat with their hands. Pizza Hut was more widely accepted in Brazil. Pizza could be adapted to Brazilian consumer desires, for example pizza with white sauce. Brazilians could also eat pizza with a knife and fork. Therefore, Pizza Hut encountered fewer cultural barriers in Brazil compared to KFC. Poor consumer awareness and poor operating capabilities made expansion in South America more difficult for both Pizza Hut and KFC. Yum! Brands, however, was committed to strengthening its brands South America. However, it planned to grow by selectively identifying high potential markets and slowly building its brand awareness there.