Does McDonald’s Need A Local Partner To Grow In China?

Recently, Yum Brands, the owner of KFC and Pizza Hut entered into a deal with Ant Financial (an Alibaba group company) and Primavera Capital (run by a former Goldman Sachs executive) to sell a part of its China operations for $480 million as a part of its efforts to spin off its China unit.  Meanwhile, McDonald’s (NYSE:MCD) is looking to revive its operations in China after its reputation took a beating in the region on the back of an expired meat scandal in 2014. The company is looking at the franchising model to grow in China; however, experts believe that partnering with players who understand the evolving Chinese market better might be the right way forward. While Yum brands has lost significant market share in China, McDonald’s is also facing a declining trend in market share in the region, amidst tough competition from local players.  We believe that, as the Chinese fast food market tilts in the favor of local players, McDonald’s could benefit from a regional partner to grow its business in the region.

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Right Positioning In The Chinese Market

The Chinese fast food market is evolving as an increase in the disposable income of the population is attracting consumers to more upscale western restaurants and local players are increasing their market share in the fast food segment. Chinese chains such as Kung Fu are strong competitors to McDonald’s and experts believe that the company does not have the food or brand position that Chinese consumers want. However, McDonald’s is increasing its focus on “high growth markets” such as China and Russia. (Read Is McDonald’s Dependence On High Growth Markets Increasing?). It plans to add 1,000 more restaurants in China in the next five years which will make it the company’s second largest market, next to the U.S. The company is also trying out initiatives such as a customized menu to attract consumers to its restaurants. On the one hand, McDonald’s is looking to identify strategic partners in the region who will work as its franchisees.  On the other, McDonald’s needs a more localized menu that caters to customer preferences in the region.  And in our view, both factors are critical for growth in China. Indeed, diners in China at the same time for fast food favor not only local players with familiar fare, but upscale western restaurants for a “foreign” meal.  Within this spectrum, McDonald’s needs to find a niche for itself in the region and position itself accordingly. A local player who understands the market better can play a key role in this strategic positioning, which can in turn attract more customers to McDonald’s restaurants in China.

According to our estimates, Annual Customers Per McDonald’s Restaurant is a key metric which can drive the valuation of the company. We expect this number to remain steady at around 640,000 throughout our forecast period.

There can be a nearly 10% upside to our price estimate if this number reaches 700,000 by the end of our forecast period.

China is a difficult market for McDonald’s.  However, it holds strong potential.  Its market share in the region fell from around 15% in 2010 to nearly 14% in 2015, which is not significant when compared to the Yum Brand’s figures of 40% to nearly 24% respectively. In Q2 2016, McDonald’s comparable sales grew by 1.6% in high growth markets, which is an indication of its popularity in these regions. While the franchising model in the region can show positive results, we believe a local partner can help the company to tap the full potential of this high growth market.

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