McDonald's Needs to Step-up China Expansion (MCD, YUM)

With the US landscape just about full of fast-food outlets, the major players are looking elsewhere for revenue and profits. Not surprisingly, the sweet spot is China, with its 1.3 billion people and booming economy. McDonald’s Corp. (NYSE: MCD) has only about a third as many stores in China as Yum Brands, Inc. (NYSE: YUM), and the company plans to build more Golden Arches in China. But McDonald’s plan does not seem very aggressive, especially given the wide gap it’s needs to close.

Yum opens about five new stores every four days in China. The company already operates 3,200 KFC stores and 500 Pizza Huts in the country. The company’s target is a very aggressive 20,000 stores. It will take the company some years to reach that target at a rate of about 450 new stores a year, but that’s more than enough to keep them well ahead of McDonald’s.

The target that McDonald’s has set for 2011 is to open up to 200 new stores to add to its current total of about 1,135 Chinese outlets. The company’s strategy, as outlined by the CFO in an interview, is to build “mass” in the major cities and then move to the surrounding suburbs and towns and develop drive-thrus.

As more Chinese purchase cars, that strategy appears to be sound. But it could be just a gimmick that will increase sales temporarily until the novelty wears off.

Yum’s approach has been to expand its menu to include traditional Chinese food items as well as buckets of the Colonel’s fried chicken. McDonald’s noted that its same-store sales in January rose 5.2% in its region that includes China partly as a result of “locally-relevant menu items.” At least McDonald’s is trying to make its food more appealing to the local palate.

McDonald’s gets about 35% of its revenue from its US operations, whereas Yum gets about an equal amount of its revenue from China. And Yum is not worried that the Chinese boom will go bust. The company opened a new chain in 2004 and acquired a stake in another chain in 2009.

Both McDonald’s and Yum face margin pressure due to rising wage and food costs, as well as taking a hit from currency exchange rates.

If McDonald’s wants to be number one in China, it needs to build more than 200 new stores a year, and it might want to reconsider the strategy of building out from the hub of major cities. While the company’s strategy may work, it won’t happen quickly, and it depends on Yum making a mistake. That hasn’t happened so far.

Paul Ausick