McDonald’s Sells Majority Stake in China and Hong Kong Operations

Conglomerate CITIC and Carlyle Group together buy 80% stake for $2.1 billion

m1McDonald’s Corp. (NYSE: MCD), the world’s largest fast food provider, has agreed to sell a controlling stake in its China and Hong Kong business to state-backed conglomerate CITIC Ltd and Carlyle Group LP (NASDAQ: CG) for up to $2.1 billion, as reported by Reuters on January 09th, 2017. The move is part of McDonald’s massive corporate restructuring initiative announced in May 2015, aimed at reorganizing its struggling business. According to CEO Steve Easterbrook, the restructuring effort is set to save the company $300 million annually.

Under the deal, Hong Kong-listed CITIC Ltd will own about 32% of the business, with CITIC Capital, an affiliate company that manages private equity funds and other alternative assets, holding another 20%. CITIC is a large Chinese conglomerate with interests in businesses ranging from energy and manufacturing to real estate. Carlyle will control 28% of the business, while McDonald’s will retain a 20% stake. The deal will be settled in cash and in shares in the new company that will act as the master franchisee for a 20-year period. The deal caps months of negotiations between the fast-food chain, private equity firms including Carlyle and TPG Capital Management L.P., as well as several Chinese suitors. McDonald’s China and Hong Kong business reported about $200 million in earnings before interest, depreciation, and amortization in FY15.

JPMorgan Securities is advising the buyer group, while CITIC Ltd. hired CITIC CLSA Capital Markets as its financial adviser and CITIC Securities as financial adviser in China. McDonald’s hired Morgan Stanley (NYSE: MS) to spearhead the sale.

Local partners to have better market understanding

McDonald’s announced in March 2016 that it was reorganizing operations in the region, looking for strategic partners in China, Hong Kong, and South Korea. The company later decided to keep its South Korea business. McDonald’s currently has more than 2,400 restaurants in Mainland China and roughly 240 in Hong Kong. However, restaurant sales have been struggling after tensions in the South China Sea dented its earnings. Earlier in 2014, McDonald’s China business suffered a blow after a food safety scandal involving one of its meat suppliers.

With the current deal, McDonald’s is counting on its local partners to help speed up growth through menu innovation, usage of digital technology, and new restaurant openings, particularly in smaller cities and consumers with more disposable income as a result of urbanization and income growth. McDonald’s new partners would also bring to the table a better understanding of the Chinese market. The new partnership plans to add 1,500 in China and Hong Kong over the next five years and will also aim to boost sales at existing restaurants.

McDonald’s in midst of refranchising efforts

According to CEO Steve Easterbrook, McDonald’s aim is to drastically reduce the number of stores it owns in favor of franchises. The China deal will enable it to slash its company-owned stores by 1,750. As part of this move, only 10% of McDonald’s stores will be company-owned by 2018. Currently, 80% of its restaurants are franchisee-owned. McDonald’s is also selling about 3,500 of its 36,000 restaurants as part of these plans.

m2McDonald’s believes that its large-owner-focused franchise system enables it to speed up renovations at its restaurants and the implementation of new technology, such as the self-ordering touchscreens, which are being tested in about 250 locations. Also, larger franchisees with deeper pockets would be able to afford interior makeovers, digitally linked cash registers through mobile apps, espresso machines, muffin makers, and other expensive in-store equipment.

McDonald’s follows Yum!’s strategy         

McDonald’s move to hive off a controlling stake in its China operations closely follows a similar move by rival Yum! Brands Inc. (NYSE: YUM), owner of the Pizza Hut, KFC, and Taco Bell fast-food chains, and the largest fast-food chain in China. Back in October 2015, Yum! announced that it planned to hive off its China business from its US operations after giving in to pressure from activist-investor Keith Meister, who was of the view that by separating the Chinese unit, Yum! could be able to better focus on the Asian markets.

As of October 31st, 2016, Yum! Brands separated its China business Yum China Holdings Inc., which included 7,200 stores over 1,100 cities in China and generated over $8 billion in system sales in 2015. Beginning November 01st, 2016, Yum China Holdings started trading on the New York Stock Exchange under the ticker symbol “YUMC.” The new company became a licensee of Yum Brands in Mainland China, with exclusive rights to the KFC, Pizza Hut, and Taco Bell brand names.

More importantly, Yum!’s divestment of its China unit was part of the Company’s plan of gradually reducing exposure in a business with shrinking market share and move from owning restaurants towards pure franchising. In recent years, Yum! has witnessed a steady decline in market share to 24% in 2015 from 39% in 2010, and has been steadily ceding market share to rival McDonald’s.m3

Restaurant upgrades in the offing

Under CEO Steve Easterbrook, McDonald’s is working to change customer perceptions by switching to cage-free eggs and chicken free of certain antibiotics, as well as removing preservatives from menu items including Chicken McNuggets. McDonald’s has also changed its menu to include fresher ingredients and custom-made meals to bring back young customers who have turned to fast casual restaurants that serve gourmet, customizable burgers.

The company is also rolling out self-order kiosks, mobile pay options, an updated interior design, even table service. The changes are already starting to show up at locations in Florida, New York and Southern California, where 500 restaurants have been updated. Restaurants in San Francisco, Boston, Chicago, D.C. and Seattle will be upgraded in early 2017.

While McDonald’s still trails rivals in terms of mobile ordering and finding ways to reach consumers outside its restaurants, its small-scale product tests like using fresh instead of frozen beef at some Texas locations are expected to garner positive results in the coming quarters.

During Q3 FY16, McDonald’s total revenue fell almost 3% to $6.42 billion (1% in constant currencies) from $6.62 billion in the year-ago same period, down for the ninth straight quarter due to the impact of refranchising. To bring in a fresh perspective at its restaurants, McDonald’s has introduced all-day breakfasts, simplified its sprawling menus, and improved service to turn around its business amid intense competition from Burger King Worldwide Inc., the brand owned by Restaurant Brands International Inc. (NYSE: QSR), The Wendy’s Company (NASDAQ: WEN), Subway, Dunkin’ Brands Group Inc. (NASDAQ: DNKN), and nimbler upstart chains. Adding to its woes, McDonald’s is facing intense competition in the burger segment from Shake Shack Inc. (NYSE: SHAK), Sonic Corp. (NASDAQ: SONC), Chik-fil-A Inc., and Whataburger that offer a more appetizing menu. Moreover, its competitors such as Chipotle Mexican Grill Inc. (NYSE: CMG) and Five Guys Burgers and Fries have been fast expanding their operations.

It remains to be seen whether these restructuring efforts will bear fruits in the coming quarters, given that the company is witnessed saturation in most of the developed markets that it operates.

Stock Performance

m4McDonald’s stock stood at $120.25, slipping 0.15%, at the close on Tuesday, January 10th, 2016, having vacillated between an intraday high of $120.85 and a low of $119.73 during the session. The stock’s trading volume was at 3,107,887 for the day. The Company’s market cap was at $101.18 billion as of Tuesday’s close.

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