Haidilao Now Takes In 10 Billion Yuan a Year. What Could Go Wrong for a Hotpot Chain Whose Whole Strategy Is Expansion?

Service is no defense against changing tastes and the turn toward healthier eating

In 1994, Zhang Yong opened a four-table hotpot restaurant called Haidilao in Jianyang, Sichuan. KFC and McDonald's had just begun expanding across China, and every outlet in every city was packed.

With Western fast food booming, the restaurant industry and the press argued over one big question: why has Chinese food never produced a company like KFC or McDonald's?

The usual answer was that Chinese cooking resists standardization. Yum Brands, which had made its money on KFC and Pizza Hut, tried to build a KFC of Chinese food, launching East Dawning in 2004.

Bento-box Chinese fast food never caught on. What the market showed instead was that hotpot — food that tastes good without a chef — is the easiest Chinese business to standardize. Yum bought Little Sheep in 2011.

In the end, the first Chinese restaurant brand to reach 10 billion yuan in annual revenue was Haidilao, where the average diner spends close to 100 yuan. Its revenue is more than double that of the number two. On May 17, Haidilao — 320 restaurants as of the first quarter of 2018 — filed its prospectus with the Hong Kong Stock Exchange, planning to raise money for fast expansion. It will add 180 to 220 restaurants this year.

Haidilao is still climbing, and second-tier cities supply half its revenue

The prospectus shows total revenue of 10.64 billion yuan last year and profit of nearly 1.2 billion yuan. Founder Zhang Yong and his wife, Shu Ping, hold 62.7% of the shares.

Despite the exposé of its kitchen hygiene and the doubts about whether it was still popular, Haidilao kept growing fast: over the past two years, revenue and profit compounded at 35.9% and 70.5% a year.

Last year each table turned over five times a day, more than in 2014, yet same-store sales stayed roughly flat — which means each table spent less. Spending per customer, meanwhile, rose from 94.5 yuan to 97.7 yuan. The only explanation is that more diners now come in ones and twos. Haidilao is no longer only a place you go with a group.

It is not cheap, but second-tier cities have become Haidilao's key market: that is where it has the most restaurants, where it earns the most revenue, and where tables turn fastest. Third-tier and smaller cities are growing quickly too — same-store sales there rose 16.3% in 2017, faster than in first-tier cities.

A new Haidilao restaurant usually breaks even on a monthly basis within one to three months.

In 2015 and 2016, most Haidilao restaurants earned back the cash put into them within 6 to 13 months. Other major Chinese restaurant brands typically need three to six months to reach monthly break-even and 15 to 20 months to recover the cash.

Haidilao is not just twice the size of the second-largest Chinese restaurant company. On annual growth, table turnover, revenue per restaurant and other measures, it also keeps a clear distance from rivals such as Grandma's Home, Xibei Youmian Cun, Huang Ji Huang and Xiabuxiabu.

In hotpot, a standardized business, Haidilao set itself apart with service

Hotpot is the easiest Chinese food business to standardize: it needs no master chef, and both the process and the product — soup base, prepped vegetables, dipping sauces — are simple to make uniform. Other sit-down Chinese categories struggle to list precisely because their products are hard to standardize, which is why capital markets prefer hotpot.

Longhui Catering, whose brands include Hui Ge and Xiao Hui Ge, is reported to be planning a backdoor Hong Kong listing through Daqing Dairy; Xiaoweiyang, whose restaurants are mostly in smaller cities, trades on the NEEQ. Haidilao is not even the first hotpot company to list in Hong Kong: Little Sheep did it in 2008 and Xiabuxiabu in 2014.

Haidilao set itself apart with service from the beginning. Twenty-four years ago, when he opened the place, Zhang Yong could not cook and knew nothing about restaurants, so warm, attentive service was the only way he could hold on to customers. Most diners, he reasoned, cannot tell one spicy hotpot from another; when location, price and surroundings are much the same, service decides where people eat.

In the late 1990s and early 2000s, service in China had not yet shaken off the state-enterprise habit of scowling at the customer. Haidilao carried your bags, handed out snacks and drinks to people waiting for a table, and threw in manicures and shoe shines. That is how it spread from Jianyang to Xi'an and Zhengzhou, reaching Beijing in 2004.

Care that fine was rare even in first-tier city restaurants, and customers spread the word themselves. One example is the 2011 hit thread on the Tianya forum, Haidilao, Unbeatable by Humankind!!!!! All Those Haidilao Stories!! If You've Eaten There, Come Dish.

Haidilao staff have a fair amount of freedom: they decide on their own which dish to comp or which extra to throw in, without asking the manager. The prospectus says restaurants are judged on "customer satisfaction" and "employee effort" rather than store financials, because Zhang Yong believes a restaurant's numbers depend largely on its location.

Early on, there were also many chances to rise inside the company; most of today's store managers and a good number of senior executives started at the bottom of a restaurant. Haidilao also built a school in Jianyang to help educate employees' children, which few in the industry do. Harvard Business Review called Haidilao "a standout in emotional-culture management among Chinese companies."

Behind the attentive service and the word of mouth sits a payroll. According to the prospectus, Haidilao spent 3.1 billion yuan last year on 50,000 employees, 49,000 of them restaurant staff — an average of 61,200 yuan a head, above Xiabuxiabu's 39,000 yuan. Haidilao pays less on average than Quanjude and Tang Palace, where chefs probably pull the average up.

The expansion that followed rested on the supply chain

What people praise Haidilao for is service, but Zhang Yong says: "Our real strength is the supply chain." What is listing this time is the restaurant business; without six affiliated companies running independently — above all the ones handling soup base and ingredients — it might never have reached this size.

Haidilao's affiliates cover almost every link upstream of the table: Yihai International, which processes soup bases and dipping sauces and is already listed in Hong Kong; Shuhai, which handles food storage, logistics and sales; Shuyun Dongfang, which manages restaurant fit-out work; and Honghuotai, which does cloud technology for restaurants. There is also a separate company doing human-resources consulting. The businesses were probably split up because spreading them out spreads the risk in any financial maneuvering.

Haidilao was refining its processes early, preparing for scale. As the prospectus puts it: "The founders recognized that China's restaurant industry lacked specialized service providers for large chains — particularly in ingredient processing, warehousing and logistics, store construction and human resources."

Before 2004, Haidilao did what most hotpot restaurants do: bought its ingredients at the local wet market and had staff mix the soup base by hand every day. Ingredient quality could not be guaranteed, so in 2005 it set up four logistics centers around the country and a soup-base factory in Chengdu.

Yihai International, which makes the soup bases, listed in Hong Kong in 2016. Last year it took in 1.64 billion yuan and earned 260 million yuan — smaller than Haidilao, but with fatter net and gross margins. From 2013 to 2017, related-party sales to Haidilao held steady at about 55% of its revenue. It also sells soup base straight to shoppers in supermarkets such as Walmart and Carrefour, and has recently moved into food processing with self-heating instant hotpot.

Shuhai began operating on its own in 2007. Its biggest "customer" is still Haidilao, which bought 2.6 billion yuan of goods from it last year, but revenue from everyone else has already reached 1 billion yuan. It runs 11 logistics bases, seven food-processing centers, vegetable farms and a lamb-processing plant. Shuhai supplies prepped vegetables and half-cooked items to 7-Eleven stores in Beijing; it also serves restaurant chains such as Dakaishajie, Mala Youhuo and Jindingxuan, and develops dishes for them.

Past a certain size, what restaurant companies really compete on is the supply chain — buying, processing and delivering ingredients. Nearly every step involves food safety, ingredient quality decides whether the food coming out of the kitchen stays consistent, and a good chain also cuts costs, because trading inside your own group is cheaper than buying from outsiders.

Other large restaurant companies have followed Haidilao into the supply chain and into processed and half-cooked food. Xinliangji, incubated by Xin La Dao, is developing standardized dishes such as crayfish and pickled-cabbage fish for chains including Bifengtang and Shanghai Min. Xiabuxiabu and Xibei Youmian Cun are building supply chains of their own. Online-to-offline companies such as Ele.me and Hema are serving restaurant supply chains too, or planning to.

To expand faster, the company that swore it would never list is listing

Like most companies that go public, Haidilao wants to expand and lacks the money.

The prospectus says 60% of the proceeds will go to opening restaurants, 20% to new technology meant to make restaurants run better — site selection, kitchen operations, inventory and supply management — and 15% to repaying loans.

Haidilao plans to add 180 to 220 restaurants in 2018. A new one in China costs about 8 to 10 million yuan to build. With renovations of older restaurants and technology spending on top, capital expenditure this year is expected to reach 2.5 billion yuan. Cash and borrowing will not stretch that far: at the end of the first quarter Haidilao had 518 million yuan on its books and just over 23 million yuan of unused bank credit, leaving an enormous gap.

It needs to open faster to seize the market and the best locations, especially in the first- and second-tier cities where competition is fiercest.

Haidilao once tried to grow faster through delivery, running hotpot to customers' homes before Ele.me and Meituan Waimai existed.

Delivery brought in 210 million yuan in 2017, a rounding error against 10 billion. Its delivery business also grew more than 10% slower than the delivery industry as a whole, and noticeably slower than the company itself: 30.8% against 35.6%.

Delivery will not carry Haidilao. To grow, it still has to open restaurants.

Expanding this fast will strain management

With capital behind it, Haidilao will open at a pace it has never attempted. Adding 180 to 220 restaurants in one year means growing a base of 320 by 60% to 70% — close to doubling. The prospectus names no clear priority: first- and second-tier cities, third-tier and smaller cities, and overseas markets are all mentioned.

Fast expansion invites trouble. The hygiene scandal reported by the Legal Evening News last August — kitchen staff clearing a drain with a serving utensil, brooms, dustpans and rags washed together with the dishes — reflected exactly the management strain of last year's rapid opening.

Haidilao reacted quickly, apologized, shut the restaurants for a cleanup, put cameras in the Beijing kitchens and invited customers to watch. Even so, it is hard to say such problems will not happen again. Each restaurant is staffed by 132 people, so 180 new ones mean hiring at least 23,700 more, and keeping a workforce that large in line with food-safety rules will only get harder.

Expansion is also thinning out the "emotional-culture management" the company built. Zhang Yong knows it.

He says: "We used to run a lot of incentives — model-worker awards and the like — but now we're cutting some. When you're small, you can afford to look after employees who work long hours and have little schooling."

Harder still to control or predict: what people want to eat

Inner Mongolian hotpot, led by Little Sheep, once swept China. That brand's decline owed a great deal to how it was run, but the flavor it made popular has genuinely gone out of fashion.

Tastes change, and when they do, even the most successful companies struggle to hold the line. Coca-Cola, Pepsi and McDonald's, which advertise endlessly, have all had to reformulate and repackage themselves as eating healthier caught on.

In Chinese food, where tastes are scattered, fashion is even harder to read. Haidilao, the largest player, holds just 0.3% of the entire Chinese restaurant market.

Sichuan hotpot is still the biggest category, but other flavors are rising. One we have written about before is Chaoshan beef hotpot, which turned into a hit from late 2015 through 2016 on the strength of fresh, healthy ingredients.

Chaoshan beef hotpot is past its peak, but the freshness it stands for has become the taste Chinese diners now prefer.

Surveys by Meituan and the China Cuisine Association found that in 2017 diners favored "sweet and fresh" or "savory and fresh" flavors, and that numbing-spicy fell from the top of the list for the first time. For a chain built on Sichuan hotpot, that is not a good sign.

In Beijing and Shanghai, meanwhile, lighter and fresher options are multiplying: pork-tripe-and-chicken hotpot, coconut chicken, Japanese sukiyaki. Chains that, like Haidilao, run their own restaurants and aim at the mid-to-high end, charging 100 to 200 yuan a head — Laowang, Yeting Coconut Chicken, Yezi Buyu, part of the Shanjiantang Group — are expanding. They are still small and pose no immediate threat, but they can peel off some of the customers who would otherwise have chosen Haidilao.

Competition among first-tier city restaurants has never been this hard, and Haidilao's own prospectus shows it. Its first-tier restaurants take in more per day than its second-tier ones (152,100 yuan against 147,100 yuan), but among same-store restaurants — the "older" ones open more than 300 days — first-tier revenue (154,400 yuan) is lower than second-tier (156,200 yuan). In second-tier cities, in other words, a Haidilao digs in over time and grows stronger. In first-tier cities that effect barely shows.

As tastes fragment, and following the rule about eggs and baskets, plenty of midsize and large restaurant companies are trying several brands at once. Grandma's Home has launched 16 of them, including Lu Yu, Guo Xiao Er and UNCLE 5; Xiabuxiabu launched Coucou in 2016, a Taiwanese-style hotpot chain charging about 150 yuan a head. Coucou puts a milk-tea counter by the door, and its service slogan — "don't disturb the customer" — tells you which chain it has in mind.

Haidilao's own multi-brand attempts all sit outside the listed company. Through Youdingyou, an affiliate it does not own directly, it sells maocai, single-serving hotpot in a bowl. Youdingyou is controlled by Zhang Shuoyi, Zhang Yong's younger brother; it trades directly with Shuhai, Yihai and Shuyun Dongfang, and Haidilao has advanced money on its behalf.

Youdingyou's results have been consistently poor. It lost more than 3 million yuan in 2015 and again in 2016. It returned to profit in 2017, but on revenue above 109 million yuan the net profit was 220,000 yuan. U Ding Maocai has closed seven restaurants in Beijing, its main market, and keeps only two in Shanghai.

A run of investments and acquisitions followed. In 2017, Youdingyou put money into the fast-food brand Haidao Xiafan and the malatang brand Xu Xiaoshu; neither sum was disclosed. It also bought 25% of Shanghai Yuangu Catering Management, whose brands include Cai Ni Yunnan Cuisine, Yunnan Yuncaini, Dianyouji and Cang'er Xiaozhen, for nearly 10 million yuan.

In the end, the plan Haidilao chose for life after the listing is to open more restaurants, packing a proven formula more tightly into more cities. Which also means it carries more risk when tastes turn.

Charts: Lingwei Wu

Images from Visualhunt, Haidilao, Xiabuxiabu, Laowang and others