McDonald's China and Its 2,400 Restaurants Will Soon No Longer Belong to McDonald's

All of McDonald's China becomes franchised in one stroke. For the next 20 years the largest franchisee will be a new joint venture of CITIC Limited, CITIC Capital, The Carlyle Group and McDonald's — but the controlling shareholder is CITIC, a company with state-owned roots.

Twenty-six years after entering China, McDonald's will no longer own the 2,400 restaurants it runs in this market.

At noon on January 9, yesterday, McDonald's announced a strategic partnership with CITIC Limited, CITIC Capital and The Carlyle Group to set up a new company. The company, which does not yet have a name, will pay up to US$2.08 billion in cash and newly issued shares for the franchise rights to McDonald's business in mainland China and Hong Kong.

"In other words, all of McDonald's China will be franchised, and the operating rights will belong to the new company," Xu Yingting, vice president of public relations at McDonald's China, told several Chinese media outlets on a conference call afterwards.

In the new China company, McDonald's holds 20%, The Carlyle Group 28%, and the remaining 52% goes to CITIC. That makes CITIC the largest shareholder — and the effective owner of McDonald's China.

On the call, Xu said more than once that "after today's announcement of this partnership, McDonald's China will have no other franchisees." Even the 30% of McDonald's restaurants that are already franchised fall under the new structure, reporting directly to CITIC Group, Carlyle Capital and McDonald's globally.

So CITIC Group becomes the largest franchisee of McDonald's China, and will also be the largest McDonald's franchisee anywhere in the world. Counting the 1,500 restaurants planned for the Chinese market over the next five years, it will control more than 4,000 McDonald's outlets. In substance, McDonald's has sold its China business to CITIC for more than US$1 billion. McDonald's says this is not an outright sale but a 20-year franchise.

By that valuation, the McDonald's China business is worth about a third of Yum China, which has already listed separately and sold off its own franchise rights — roughly the same ratio as the gap in restaurants, more than 7,000 against more than 2,000. Closing that gap is the first job of the new company.

Which makes opening stores the most important thing ahead. Xu put it as hoping "to expand with ambition," aimed at third- and fourth-tier cities, which are "a blank space for McDonald's." McDonald's had in fact announced the sale of its China franchise rights back in March 2016, and through a year of bidding rounds CITIC and Carlyle beat consortiums such as DT Capital–Bain–Wumart and BTG–Sanpower–ChemChina. The reason: "CITIC has excellent government resources, and a property network." McDonald's valued that highly and believed it would work together with its own restaurant experience, helping it into more cities and more locations.

CITIC, for its part, said it would use McDonald's vast store network and customer base to build out its own position in consumer business. Until now, apart from a bank, a publishing house and some commercial property projects, not much of this long-established Chinese institution was familiar to ordinary people. At its founding, CITIC Group received 250 million yuan in cash capital from the state. It is a state-owned enterprise.

The mutual praise, the talk of complementary strengths and the bright forecasts were all to be expected. But the problems facing McDonald's China — winning back young customers, the complexity of China's lower-tier markets, the slowdown across the whole fast-food industry — are not solved by changing the name on the door.

McDonald's says the deal should close by the middle of 2017. Here is what it means for each side.

By Business Model, McDonald's in China Is Finally Becoming Normal

This change of identity in fact makes McDonald's China look more like McDonald's everywhere else.

More than 80% of McDonald's restaurants worldwide are franchised, and in the United States, where the company is based, the figure reaches 90%. McDonald's China, which has always run its own stores, is the outlier. The difference has to do with conditions in the Chinese market, but is not entirely explained by them.

In 1990 McDonald's opened its first restaurant in Shenzhen and formally entered the Chinese market. That restaurant was actually the investment of McDonald's Hong Kong: China's retail sector was not yet fully open to foreign capital, and foreign companies wanting in had to work with Chinese partners, the same route Coca-Cola and others took. So in March 1991 McDonald's teamed up with Beijing Sanyuan Foods Co., Ltd. to set up the joint venture Beijing McDonald's Co., Ltd. Both it and the later Guangdong Sanyuan McDonald's Company ran on a franchise model, with each side holding 50%.

After controls on foreign investment were lifted in 2004, McDonald's China switched to wholly owned operations. Not until 2008 did McDonald's begin opening franchising in China, and it moved very slowly: at the start there were only three franchisees, and the high bar to entry put off many applicants. A McDonald's franchisee needed at least 2 million yuan in liquid assets, though each restaurant was valued differently depending on the city and the site. By 2013 the number of franchisees had grown only to 46, and franchised stores made up just 12% of all McDonald's stores in China.

By comparison KFC, McDonald's biggest rival, started franchising in 2000 and expanded fast. By 2010 it had more than 2,600 stores; McDonald's had about 1,100.

The advantages and drawbacks of running your own stores are both plain. The model let McDonald's, a company that rose on standardized products and service, hold a consistently high standard and put the same burgers and fries in front of Chinese customers, which cut the odds of a food-safety failure (though of course it cannot rule one out).

But owning everything also capped how fast McDonald's could open stores. Same-store sales in China have grown for five straight quarters, yet the future is not comfortable. KFC, Dicos and other rivals have more restaurants and are in more cities, and as we have said repeatedly in our coverage of McDonald's, the company is losing its hold on young people worldwide. To keep growing, McDonald's has to reach more consumers — the market penetration it kept stressing throughout this deal.

Even before the partnership with CITIC and Carlyle, McDonald's had picked up the pace of franchising, lifting the share of franchised stores from 12% in 2013 to 30% today. Still not enough.

And not only in China. McDonald's CEO Steve Easterbrook said in 2015 that by the end of 2018 the company would sell 3,500 restaurants to franchisees, raising the global franchised share from 81% to 90%, mainly through Asian markets. Figures McDonald's published on March 31 last year showed that high-growth markets such as China and South Korea were only 46% franchised.

So McDonald's has also said it would sell its 413 restaurants in Taiwan to franchisees, to cut operating costs, speed up decisions and add restaurants faster. The South Korean franchise rights were, in fact, put up for sale at the same time as China's. Japan looks somewhat like China: McDonald's set up a subsidiary there to manage roughly 3,000 restaurants, two-thirds of them franchised, with franchisees paying a fifth of store sales to McDonald's Japan as franchise fees. Also in 2015, to improve results, McDonald's decided to sell about 15% of the company's shares and bring in outside investors to help run it.

So far, though, the biggest move is in China.

McDonald's in China Goes Asset-Light, and Loses Some of Its Say

The McDonald's China that CITIC now owns will be the company's largest franchisee outside the United States. Even globally, CITIC is already the single biggest McDonald's franchisee by size.

About 90% of McDonald's restaurants in the United States are franchised, and behind those 14,000 stores are roughly 300 franchisees. According to a report by Bloomberg, the largest American franchisee, Century Management, owns just 69 restaurants, and the nine largest average 40 each.

But with this announcement the whole China business becomes franchised. Every store McDonald's now runs itself moves under the new company; existing franchised stores stay as they are but also report to it. That means the franchisee behind all 2,400 McDonald's restaurants in China is CITIC. The at least 1,500 new stores planned for the next five years sit inside the same structure. Over the past four years McDonald's has added 200 to 250 restaurants a year, so CITIC's weight as the largest franchisee will keep rising — inside the McDonald's franchise system it will become a giant that is hard to move.

This is the new abnormality of the new McDonald's China. Beyond the franchise fees paid to McDonald's, the new company's income is split by shareholding. With only 20% of the shares, it is hard to see how much say McDonald's will have left.

On the call, Xu insisted again and again that the present management will stay and that both CITIC and Carlyle accept the McDonald's way of running the business. But when the decision-makers disagree, whoever holds the bigger stake will likely decide. And given how much the Chinese market matters to McDonald's, McDonald's will find it hard to avoid the necessary compromises.

Since word got out last year that the China franchise rights were for sale, consumers have worried about product and service quality and about food safety. The Husi food-safety scandal, which came close to destroying McDonald's here, was itself suspected of having something to do with the loosening of franchise controls. In its press release McDonald's answered that question with "absolutely no compromise," noting that more than 80% of its restaurants worldwide are held and run by local franchisees. But the same point stands: none of those franchisees holds several thousand stores. None of this means that control by CITIC and Carlyle will bring problems with food and service. It does mean more risk for McDonald's.

So as McDonald's drops the weight and travels lighter, its say over this market gets weaker too.

For CITIC, the Deal Makes Sense

If McDonald's had simply sold itself to a private equity fund like Bain or KKR, this would read as ordinary, profit-seeking market behavior. But the controlling shareholder is the state-owned CITIC, and that makes the transaction something else.

McDonald's China made no secret of why it brought CITIC in: because CITIC is "the most capable conglomerate in all of China." "It understands China very well, understands the mainland very well, has excellent government resources, and a very extensive property network." A foreign brand that has spent two decades in the Chinese market does not often describe its controlling shareholder's strengths that way.

CITIC Group grew out of a state trust fund set up in the early years of reform and opening-up. It has since become a diversified conglomerate, but a large share of its business is still in banking, securities, trusts and other finance. That is the base of its main listed arm, CITIC Limited, worth more than HK$330 billion.

Finance includes investment, of course: the group's investment arm, CITIC Capital, manages more than US$7.9 billion in assets. A company that size cares about relatively large deals. On that measure McDonald's, behind only Yum China, counts as the country's second-largest restaurant chain, and its international standing is clearly good enough.

And if CITIC wants growth outside cyclical industries like infrastructure and finance, it does need a stronger way to reach ordinary consumers.

The 2,400 retail restaurants; the 20 million followers of the WeChat official account that Zhang Jiayin, chief executive of McDonald's (China), disclosed last December at the launch of the "Future 2.0" restaurant at the Guanghua branch in Shenzhen; and the more than 20 million members in the Alipay service window — for CITIC these all look like decent ways to reach more data on younger consumers. App ordering, self-service kiosks, delivery and mobile payment — the online-to-offline channels believed to yield more consumer data — will all be available to the future franchisee.

Seen this way, few targets meet CITIC's needs, and McDonald's China is probably one it did not want to miss.

Unlike other financial companies, CITIC can use its government resources and its reading of the macro economy to judge where the country's growth, and its opportunities, are headed. For a McDonald's that wants to open up China as fast as possible, that is worth far more than the billion-odd dollars on the balance sheet.

Then there is CITIC's property. In 2016 a deal between two state-owned giants, CITIC Real Estate and China Overseas, stripped CITIC of its most profitable residential business overnight. But it still holds a batch of mixed-use projects in first- and second-tier cities, along with primary land-development work across the country. Add its partnerships with developers and state firms such as Vanke and China Resources, and while CITIC is not quite in the top tier of commercial property, it is competitive.

Following CITIC, McDonald's could in theory make full use of that "big-data site selection" advantage and skip some of the fights with rivals over street-front shops and anchor positions in mixed-use complexes. Xu even said that CITIC Bank, with 1,300 branches and its own plans for third- and fourth-tier cities, could serve as a "lookout post" for picking sites.

But What Will a Shrinking Market Mean for CITIC?

China's fast-food market passed its fastest-growing years long ago. Data from the research firm Mintel shows that from 2006 to 2011 the compound annual growth rate of Western-style fast food in China reached 19%, with the segment worth 75.1 billion yuan. By 2017 the market will have expanded sharply, to 171 billion yuan, but the expected compound annual growth rate is only 14.3%.

McDonald's is that market in miniature, and it has been hit harder.

The company has never disclosed its China results, but the joint venture with the Shanghai-listed Sanyuan Foods, Beijing McDonald's, offers a clue. In 2011, its best year, the venture earned Sanyuan 108 million yuan in profit; by 2015 that was down to 6.76 million yuan. Strip out the effect of the 2014 Husi incident and the average annual decline still runs to 23%.

Same-store sales at McDonald's China have risen for five straight quarters, helped by digital moves, delivery above all. But as we discussed in an earlier article: McDonald's may not have all that much consumer data to hand CITIC after all.

Delivery is now about 20% of the China business, and it remains a very important strategy. By opening up more to third-party platforms such as Ele.me, Baidu and Meituan, McDonald's has won better sales numbers, but it has also lost chances to touch consumers directly, which could well dull its sense of how the market is shifting.

As first-tier city markets mature and fill up, more and more industries and companies are keen to talk about finding growth in third- and fourth-tier cities.

That is an important move for McDonald's China too, and the challenge there is just as large.

In Chinese fast food, the two brands that have done this reasonably well so far are KFC and Dicos — the first because it opened franchising earlier, the second because it started out in second- and third-tier cities to begin with. Both needed years to build that footprint.

McDonald's, arriving last, faces relatively higher land and operating costs and fiercer competition. And its central problem, the loss of its pull on young people, will certainly not be fixed by opening more stores, however hard the company is now working.

As for the consumers we keep mentioning in this restructuring, and whom the shareholders have set aside for now: they may not care about the deal at all. As long as the McDonald's around the corner still opens 24 hours and still sells them the same Big Mac, Spicy Chicken McWings and soft-serve cone on their phones, who runs the company's China business seems beside the point.

From here on, McDonald's China's strategy will center on decisions made by a China board that includes CITIC Limited, CITIC Capital, Carlyle and senior McDonald's executives from headquarters. "In the past, when McDonald's China talked to headquarters in the U.S., we had to tell them what's popular in China right now. A localized board can skip those steps and speed up decisions," Xu said on the call.

The question is whether it will be a fast-food chain that meets what consumers like and want. The answer may come soon.

Cover image: McDonald's