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Local menu, managers are KFC's secret in China

On the edge of Tiananmen Square, across the street from Mao Zedong's tomb, He Yingying munches on a piece of chicken and gazes at the benign-looking figure beaming down at her.

"We love him," she says, bursting into an impish smile.

The 21-year-old student from Beijing's Capital University of Economics and Business isn't referring to Mao, whose iconic official portrait dominates the square. She's talking about the long-dead, white-bearded Kentucky colonel on the logo of the KFC restaurant where she's feasting on her favorite fast food.

In its home market, the United States, KFC is struggling as an also-ran to McDonald's - the world's biggest restaurant company - and feuding with some of its own franchisees over how to halt declining profits.

In China, Colonel Harland Sanders's image is a far more common sight in many cities than that of Mao. That accomplishment is striking in a country where foreign companies often stumble.

The secret to the success of KFC's parent company, Louisville-based Yum Brands, can be traced to its use of local ingredients - both in its management team and on its menus. In the 24 years it has operated in China, Yum has hired Chinese managers to build partnerships with local companies in its expansion drive and used their expertise to offer an array of regional dishes that appeal to domestic tastes.

Local flavors and fare

Today, KFC customers in China can buy a bowl of congee - a rice porridge that can feature pork, pickles, mushrooms and preserved egg - as well as a bucket of its famous fried chicken. In 2010, Yum expected to make 36 percent of an estimated $2 billion operating profit from 3,700 restaurants in China - eclipsing for the first time its total earnings from the 19,000 Taco Bell, Pizza Hut, KFC, Long John Silver's and A&W restaurants it owns in the United States. Yum announced Jan. 18 that it will sell its Long John Silver's and A&W chains in part to focus on China.

In the third quarter, Yum's profit in China soared 23 percent, while its U.S. profit dropped 2 percent. Yum posted $3.56 billion in fourth-quarter revenue, boosted by robust growth overseas.

In a country that Western companies such as Dunkin' Brands and eBay have struggled to penetrate, Yum has opened a new restaurant every 18 hours. It now has a 40 percent market share among fast-food chains, compared with 16 percent for McDonald's, according to Euromonitor International, a market research firm.

Yum, which started with one restaurant in 1987, now operates 3,200 KFCs and 500 Pizza Huts in 650 Chinese cities - stretching from the tropical southern island of Hainan to the North Korean border and the desert oases of the ancient Silk Road. KFC's target: to push that number to 20,000.

"Yum has become the most successful foreign company in China," says James McGregor, author of "One Billion Customers: Lessons From the Front Lines of Doing Business in China."

"They got in early," he says. "They adapted the product. They expanded aggressively, and they gave their Chinese managers real decision-making power."

A huge stake in China

Yum's Chinese success story also has risks. Bearish investors, such as hedge-fund managers Hugh Hendry and Jim Chanos, say that the world's second-biggest economy, which has surged an average of 10 percent a year for more than three decades, could slow to a halt if asset bubbles burst and rising labor and food costs bite businesses.

Within four years, Yum will depend on China for more than half its global revenue and profit margin, according to Warren Liu, a former Yum vice president who is now China chairman of Investindustrial Advisors, a European private-equity firm.

"I worry about too much reliance on a single market, no matter how financially attractive that market is," says Liu, who wrote the unauthorized "KFC in China: Secret Recipe for Success."

McGregor put it this way: "If Yum's China business went south, it would kill the stock."

David Novak, Yum's Louisville-based chairman and chief executive, says that's not going to happen. He cites estimates from Morgan Stanley and Euromonitor that China's economy will triple over the next decade, lifting 200 million more Chinese into the fast-food-consuming class.

"China is the best restaurant opportunity in the 21st century," Novak, 58, says.

Novak has doubled down on China. In 2004, he launched a new chain, East Dawning, which serves only Chinese fast food. In 2009, he acquired a 27 percent stake in Little Sheep Group, a Hong Kong-listed company that operates 480 restaurants specializing in Mongolian hot pot dishes.

Investors are betting that Novak is right. In 2010, Yum shares jumped 40 percent on the New York Stock Exchange, compared with a 23 percent rise in McDonald's shares and a 13 percent increase in the Standard & Poor's 500-stock index. Since Yum Brands was spun off from PepsiCo in 1997, the stock has risen more than sixfold, compared with the 37 percent rise in the S&P 500 to Jan. 25.

"If you want an easy way to get a piece of the China consumer story, Yum is a good stock to buy into," says Shaun Rein, Shanghai-based managing director of China Market Research Group.

Yet Liu Yang, chairman and chief investment officer of the Chinese unit of Atlantis Investment Management, says she wouldn't buy the stock because higher regional minimum wages have pushed up labor costs by as much as 21 percent in major cities and food inflation that hit 9.6 percent in December will increase the price of raw materials.

"Yum used to be a good China consumer play, but they will face a squeeze on their margins," says Liu, who helps manage $4 billion.

Yum executives said at an investor conference in New York in December that the growing importance of the China business could lead to more volatility in the bottom line.

"We want to become less China-dependent," Novak told investors. "I don't know if there's another China, but I think India, Russia - you combine a few of these opportunities, and you'll create another China over time."

Yum's success in China has resulted in large part from its ability to create a menu that combines its traditional finger- lickin' Western fast food with chopstick-lickin' dishes that appeal to Chinese tastes.

Dragon Twister

While McDonald's restaurants in China mostly sell the same U.S.-style burgers, KFC's menu features dishes that would be unrecognizable to its U.S. patrons. Alongside the Colonel's secret-recipe fried chicken, Chinese KFCs offer options such as the Dragon Twister, a chicken wrap in a Peking duck-type sauce, and spicy tofu chicken rice based on the cuisine of Sichuan province, home of China's hottest dishes.

Pizza Huts in China bear even less resemblance to their Western counterparts. While a KFC in the People's Republic still looks like a Western-style fast-food restaurant, Chinese Pizza Huts are marketed as sophisticated venues for the legion of increasingly affluent and status-conscious Chinese. Seated in cushioned booths, customers can choose from a 106-item menu that includes wine and Chinese-influenced dishes, such as scallop croquettes with crushed seaweed and even French-inspired escargot.

Yum's cultural flexibility doesn't end with the localized menu. While fast-food restaurants in the West often host children's birthday parties, KFCs in Urumqi, capital of the Xinjiang region that's home to the Muslim Uyghur people, advertise parties for the families of boys who have just undergone the religious ritual of circumcision.

"KFC is certainly doing better than McDonald's at becoming more Chinese," says Su Yi, 28, a lawyer, as he pauses between spoonfuls of mushroom, bacon and rice at lunch in a packed KFC opposite Beijing's Jishuitan subway station. "I have lunch at KFC twice a week because there's always one close by. And when I'm out on a date and want to impress a girl, I take her to Pizza Hut."

Fast-food culture

China's embrace of Yum brands - and vice versa - is most apparent in the center of Beijing, where Colonel Sanders meets Chairman Mao in Tiananmen Square. On the ground level of the three-story KFC, an elaborate mural of the Great Wall greets diners.

On the second floor, the decor is meant to resemble a hutong - the traditional Beijing neighborhoods that are disappearing to make way for high-rise office and apartment blocks. The third floor doubles as a gallery for local photographers and painters. A plaque at the entrance describes it as an exchange channel between KFC's fast-food culture and Chinese folk culture.

KFC was founded by entrepreneur Harland Sanders, a former farmhand and streetcar conductor, in 1952. His handwritten recipe for the chain's fried-chicken batter remains under lock and key in Louisville. The colonel, an honorary title bestowed by the state of Kentucky, sold out for $2 million in 1964 to private investors who took the company public four years later, though Sanders continued to be the main spokesman for the chain.

In 1986, Kentucky Fried Chicken, as it was then known, was acquired by PepsiCo, which changed the restaurant unit's name to KFC in 1991 as health-conscious Americans began shunning fried food.

In 1997, PepsiCo spun off KFC and its other fast-food businesses into a new company called Tricon Global Restaurants. The company changed its name to Yum Brands in 2002.

KFC's push into Asia faltered at first. In 1973, the company opened 11 restaurants in the British colony of Hong Kong but closed them within two years because it couldn't win over local consumers. A decade later, it returned to Hong Kong and entered Taiwan, where an early joint venture with Japanese partners also ran into trouble.

"KFC's early failure in Hong Kong and Taiwan served as valuable and inexpensive lessons in preparation for its entry into China," Liu says. When KFC arrived in 1987 beside Tiananmen Square, China's population was looking to the West with anticipation, he says

Local management

"The first KFC restaurant opened to the warmest embrace imaginable," Liu writes in his book on KFC. The company had also chosen the right joint-venture partners - Beijing Corp. of Animal Production, Processing, Industry & Commerce and Beijing Travel & Tourism - that were state-owned, providing the guanxi, or connections, that were essential when setting up a business in China.

An even more important decision was to entrust management of the China business to ethnic Chinese from Taiwan, Liu says.

While other foreign companies entering China recruited American or Southeast Asian-born Chinese managers, Yum hired Chinese from Taiwan, who speak the same Mandarin as mainlanders and understand their culture better, he says.

Those employees were key in helping open supply lines to allow Yum to reach Chinese locations out of the reach of rival food companies run by overseas managers. The leader of what Taiwan-born Liu describes in his book as the "Taiwan Gang" is Sam Su, 58, chairman of the China business, who in 2008 was promoted to vice chairman of the main board in Louisville and who earned $6.7 million in 2009 - second only to the $13.1 million earned by CEO Novak.

"Sam is a legend in China business," says McGregor, the former chamber of commerce chairman. Su could not be reached for comment.

Not as hot back home

Yum's performance in China contrasts with its struggles in the United States, where revenue declined in 2008 and 2009.

Even a promotion involving Oprah Winfrey backfired. In May 2009, Winfrey's television show offered free meals with online coupons. The result sparked such a rush that KFC stopped redeeming the coupons two days into the scheduled two-week promotion, prompting consumers to sue Yum. KFC President Roger Eaton was forced to apologize for the fiasco.

After the free-meal giveaway, grilled-chicken sales continued to slide, the dissident franchisees claim. In 2010, some of Yum's franchisees sued the company in an attempt to prevent it from promoting the healthier grilled chicken ahead of the more popular fried product, saying it was damaging the brand. Both the customer and franchisee lawsuits are continuing in the U.S.

It isn't all roses in China, either. Western companies making everything from fast food to autos are being challenged by lower-cost local upstarts. In fast food, Yum is also facing increased competition from Asian chains such as Dicos, a unit of closely held Ting Hsin International Group; Yoshinoya, owned by Tokyo-based Yoshinoya Holdings Co.; and Yonghe King and Hongzhuangyuan, both owned by Manila-based Jollibee Foods, a company that already outsells McDonalds and Yum in the Philippines.

McDonald's is also mounting a belated challenge. It aims to almost double its 1,100 China stores by 2013, its China CEO Kenneth Chan said.

For now, though, China's love affair with Yum brands continues. In the KFC overlooking Mao's tomb, student He Yingying swallows her last morsel of chicken, pronounces it "hao chi," or delicious, and takes another glance at the colonel's portrait.

"Did he really only sell the business for $2 million?" she says incredulously. "He must have regretted it later."

Sanders died in 1980, never imagining that his Southern specialties would one day lure millions of Chinese customers, thanks to KFC's not-so-secret recipe of local business knowledge, Western glamour and spicy regional fare.

A version of this story appears in the March issue of Bloomberg Markets magazine.

- Bloomberg News

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