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China: The impenetrable business behemoth?

China: The impenetrable business behemoth?

Some of the world’s largest franchisors have extensive footprints in this vast region, but you need a very specific skill set to compete with domestic giants, regulatory hurdles, and cultural nuances.

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Words by Kieran McLoone, deputy editor for Global Franchise

China’s potential for franchisors is huge. This should come as no surprise – as far back as 2003, Goldman Sachs predicted that China would be the world’s largest economy before 2050. But as the years have gone by and more brands have tried to penetrate its sometimes tough exterior, the country’s rich opportunity has become increasingly evident.

The latest stats to come out of the China Chain Store & Franchise Association support this, with estimates that the country has around 257,000 franchise stores, generating revenues of over $800bn. The industry as a whole is also projected to be growing at a rate of 17 per cent.

And all the biggest players have some kind of presence; KFC has over 7,000 locations, McDonald’s has more than 3,500, and even hospitality franchisors like Wyndham have around 1,600 sites.

But take a breath – all that glitters is not gold. While these statistics alone may have you packing your bags for Beijing, there are still many things that investors need to know about China before embarking on a potentially risky expansion. After all, as Joel Silverstein, CEO of consultancy East West Hospitality Group, puts it: “If you’re really small fry, then it’s better to probably just forget it.”

China’s unique regulations

The first things that incoming franchisors need to know are the ‘2+1 Rule’, and China’s status as a ‘first to file’ region.

The 2+1 Rule is easy to understand, but crucial nonetheless. Essentially, this stipulates that an organization must operate at least two corporate-owned outlets for more than one year in any part of the world. While many global brands will be able to meet this requirement with ease, franchises that have operated a franchise-only model or are still in their early years would need to hold off before embarking on Chinese development.

“China’s economy is largely returning to its pre-pandemic level”

The ‘first to file’ nature of China could also be troublesome for franchisors that don’t keep a close eye on copyrights and trademarks. “China is what’s known as a ‘first to file’ country, so whoever registers a trademark first, even if they have no interest in that brand, can hold on to it,” explains Gordon Drakes, partner and co-head of franchising and commercial at international consultancy, Fieldfisher.

“Historically, that has meant you’ll get bad faith registrants who hold trademarks and say that brands either have to litigate against them or buy it off of them. More often than not, it’s easier for brands to just buy it off of them. This situation is improving, and over the last 10 years the Chinese IP courts have toughened up on local bad faith registrants. But it’s still an important point to note.”

Getting money out of China can also be a challenge for the unprepared. “You have to get bank approvals for when a franchisee sends money – like royalties or service fees – back to a foreign franchisor,” says Drakes. “You need to be conscious of that; especially in areas like education that are so sensitive and regulated. After all, if you can’t get money out, what’s the point in making a deal in the first place?”

One final regulatory essential is that franchisors must register with the Ministry of Commerce (MOFCOM) in China, with over 6,500 franchisors officially registered as of December 2020.

The effect of the coronavirus

It’s impossible to ignore the coronavirus pandemic when detailing China, considering the global virus is reported to have originated from the country. That being said, while China suffered as a result of shutdowns like everybody else, it seems to be bouncing back.

The average store investment for a franchise in China is $100,000

“Due to the pandemic, China’s GDP grew by only 2.3 per cent last year,” says Zoey Zhang, associate, editorial and research at Dezan Shira & Associates, a direct investment firm based in Hong Kong. “But taking a closer look at the fourth quarter of 2020, its GDP grew by 6.5 per cent compared with the same period last year, indicating that China’s economy is largely returning to its pre-pandemic level.

“According to the China Chain Store & Franchise Association, since the first quarter of 2020, the top 100 franchising enterprises in China have lowered their annual growth targets and development plans for this year,” continues Zhang. “About 30 per cent of them have lowered their annual growth rates from about 10 per cent to about three per cent. Around 30 per cent said their goal in 2020 was to just to ‘survive’.”

How will China’s economy bounce back? A largely digital F&B landscape will help, but it seems the resilience of its consumers is lending itself to this hopeful resurgence.

China has a population of over 1.44 billion people, but relatively low spending power at just under $12,000 per capita

“The F&B market has come back much faster than it has in the West,” says Joel Silverstein. “The next six months in China are going to be a consumer boom. They have what they call ‘revenge spending’, where they’ve been cooped up and haven’t spent money.”

‘What’ and ‘where’ of Chinese franchising

Now we know the fundamentals of bringing your brand into China. The next step is knowing what works in the country, and where franchisors should target as their first port of call. Beijing may be the obvious choice, but markets outside of the capital are proving increasingly appealing to franchises wanting to avoid the fiercest competitive hub.

“Beijing is definitely not the only option for international franchisors, although the capital city is indeed the most popular destination,” says Zhang. “By the end of 2020, more than 1,100 franchisors had chosen to register in Beijing, but that proportion was no more than 17 per cent of the total of over 6,500 registered franchisors in China. And the percentage of franchisors registered in Beijing has actually declined over the past two years – down from 21 per cent in early 2019 – suggesting that franchisors are also exploring other regions.”

Around 35% of McDonald’s locations in China are franchised

As may be expected, the F&B industry accounts for the bulk of China’s total franchisors. This has been the case since KFC first entered the market in 1987, though don’t expect the Colonel’s traditional offering if you step into a Shanghai store. “If you look at the KFC menu, it’s mostly a Chinese menu,” explains Joel Silverstein. “They’re heavily weighted toward Chinese-style food. The western food that goes into China is a little like the Panda Express-version of Chinese food. Meaning, it’s not pure western food; it’s Chinafied, just like Panda Express is Americanized Chinese food.”

Menu adaptations aren’t the only thing that brands need to consider. China’s restaurant landscape is almost entirely digitized, and brands have fully embraced digital payment structures when handling transactions.

“China’s way ahead of the West in digitization,” continues Silverstein. “China has had aggressive digitization of their economy way before others, and the reason for that is that the Chinese government has a value-added tax (VAT), and too many people were skirting that by not including all of their revenue into their point-of-service.

“To get around all that, the government was fully supportive of cashless payments. With that, there’s nowhere to hide. They can get their 10 per cent VAT. So, if you enter the Chinese market and you do not have a good digital payments structure, then you’re so far behind the eight ball. You cannot do business in China with credit cards. You’re going to have to integrate with the local software that’s there.”

“Beijing is definitely not the only option for international franchisors, although the capital city is indeed the most popular destination”

Certain industries, such as accommodation and education, are surprisingly underrepresented in China. We’ve already touched on why this may be the case for the latter, but when it comes to hotels, it seems a general mistrust is limiting the sector’s growth.

“With concerns around management risks, international hotel brands have been less open to franchising in the Chinese market,” says Zhang. “Most international hotel groups are cautious about franchising their high-end brands, specifically.”

THREE TYPES OF BRAND THAT COULD STRUGGLE IN CHINA

Alex DePase, founder and CEO of Global Franchise Exchange, outlines three areas that franchisors need to be mindful of before considering China as their next global endeavor:

1. Brands that don’t fit consumer habits

“Take Edible Arrangements as an example. 10 years ago, Chinese people didn’t send flowers as a gift. When we brought the brand to China in 2011, it was very challenging to promote fruit arrangements as a gift option to the majority of people, because the product did not fit local customer’s shopping habits.”

2. Brands with competitors already in China

“Take Five Guys and In-N-Out Burger as examples. KFC, McDonald’s, and Burger King have already opened thousands of stores with established brand awareness, management teams, low-cost supply chain systems, and premium locations in all the main cities.”

3. Brands in ‘stereotyped’ industries

“Take Kumon as an example. Kumon is a good afterschool math training franchise for K-12 kids in Japan, the U.S., and a lot of international countries. However, it is very hard for the brand to develop in China because Chinese parents will firmly believe that local brands with local math teachers and curriculum will be better than Kumon. This is due to the stereotype that the Chinese are better at math than others.”

THE CURIOUS CASE OF STARBUCKS IN CHINA

China is Starbucks’ fastest-growing market outside of the U.S., with estimates that the coffee chain opens a new location every 15 hours. Its Chinese stores are also 40 per cent larger than elsewhere in the world, and the largest Starbucks unit is located in Shanghai; serving some 7,000 customers every day.

Initially, the Chinese Starbucks franchise portfolio was managed by three unique entities: a Taiwanese group called President in the East, the Hong Kong-based Maxim’s Group in the South, and the former head of McDonald’s Taiwan for the Beijing market.

In 2017, when each market became large enough, Starbucks bought them out and took full ownership of its Chinese portfolio for around $1.3bn. Quite a fee, but for more than 4,800 stores in 200 cities across mainland China, who could argue with that?

SHOULD YOU FRANCHISE IN CHINA?

Let’s summarize. China’s economy is coming back strong, and its structural reforms over the previous decade have led to a consumption-driven ecosystem that’s held up by a dominant trend toward upper-middle and affluent classes. In fact, in the first three-quarters of 2018, consumption expenditure accounted for 78 per cent of the country’s total economic growth.

This is great news for franchisors that can provide a premium service, but establishing yourself to be able to provide that service in the first place can be tricky. Strong domestic and international competitors aside, finding the right kind of master franchisee can be challenging, and protecting your IP is something that has to be taken into account long before that.

The previous sentiment that U.S. brands were superior is quickly fading, too. “‘Made in U.S.A.’ is still conceptually superior to ‘made in China’,” says Alex DePase, “though the gap is getting smaller with the rise of local franchise brands and well-trained talents from international franchisors.”

What it all comes down to is ‘glocalization’: the idea of introducing your brand with considerations to both global and local trends. “KFC’s stores number McDonald’s two-to-one not because it has better products or a better team, but strategically KFC is more localized in product design and innovation,” says DePase.

Extrapolate this out to the wider franchise industry, and you’ve got a great rule of thumb for Chinese expansion. Local considerations are crucial but don’t lose sight of your brand’s unique identity. And because every organization may not be large enough to completely buy-out all of its sites like Starbucks, finding the perfect local partner, or entering into a joint-venture agreement with strong in-country organizations, could be the way to go.

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