Is China Fed Up with the Colonel's Chicken?

Hong Kong - Yum! Brands (YUM) has done remarkably well in the battle to win Chinese hearts and bellies, but some investors are now wondering whether the fast-food giant is faltering. Fears that Chinese tastes may be shifting away from Yum's KFC and Pizza Hut chains have hobbled the company's shares. Yum earned $216 million on global sales of $3.36 billion in the fourth quarter, with China revenue up by 8%. Sales at Chinese outlets that have been open for more than a year, though, were off for a third consecutive quarter, dropping 3%. Jitters about what Deutsche Bank (DB) describes as "stubbornly weak sales in China" helped send Yum stock down more than 6% in the two days after the company announced its results on Feb. 3.

Yum Chairman David C. Novak says he's not worried: "If this is a problem, it's a Class A problem." Novak points to the company's many successes in China and blames the same-store sales decline on the lousy global economy.

KFC hit the mainland in 1987, three years ahead of the first Golden Arches. While McDonald's (MCD) tried to convince skeptical Chinese to buy hamburgers, KFC and Pizza Hut spiced up their menus with barbeque squid, egg tarts, and other goodies tailored to local tastes. Today, Yum is China's top restaurant operator, with more than 3,400 outlets, and the country accounts for 36% of total sales, just behind the U.S. "When the consumer rebounds [in China]," Novak says, "we're well placed."

But some analysts think China may be saturated with Western brands, especially in big cities. "There's nothing particularly novel about [foreign products] anymore," says Jason Li, CEO of Yatsen Associates, a Beijing consulting firm. Selina Sia, a researcher at Mirae Asset Securities in Hong Kong, says that while Chinese embraced American fast food a decade ago, that's changing. "It's good for a while," she says, "but then they go back to their own diet."

Yum faces stronger competition from local rivals, too. "Ten, fifteen years ago, if you had air-conditioning with a clean bathroom, you were unique," says Joel Silverstein, president of East West Hospitality, a Hong Kong consulting firm. Now, Chinese chains are cleaning up and expanding, often with help from global investors. U.S. private equity giant Carlyle Group bought into Babela's Kitchen, a Shanghai-based Italian chain. London-based Actis Capital controls Xiabu Xiabu, a hot pot (or Chinese fondue) chain headquartered in Beijing. And Jollibee, the top fast-food player in the Philippines, owns two Chinese chains.

McDonald's, meanwhile, is refocusing in China. It plans to open as many as 175 new mainland restaurants this year, vs. about 140 in 2009. The chain will spruce up some of its dowdier restaurants and offer free Wi-Fi. One thing it won't do is follow Yum's lead and make big changes to the menu to suit local tastes, says McDonald's China boss, Kenneth Chan. While a few additions are possible, he says the Chinese enjoy "Big Macs, our chicken sandwiches, and our French fries."

Yum knows it needs to keep moving. The company is adding more breakfast items at KFC; it's expanding the menu and introducing afternoon tea and coffee at Pizza Hut; it has opened 19 Chinese restaurants called East Dawning; and in October, Yum agreed to pay $40 million for a 7.3% stake in Little Sheep, a chain of hot pot restaurants. This year, Yum expects to open more than 500 outlets in China, says Novak, and it is expanding into smaller cities in the interior. "We'll have three restaurants in a city," he promises, "before McDonald's even gets there."

With Wendy Leung in Shenzhen

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