Key Takeaways:

• Domestic Chinese food and beverage chains are utilizing rapid franchising to overtake global giants
• Mid-tier Western brands are struggling to maintain their footing in China due to a lack of localization and sufficient scale

image credit: Bamboo Works

China's food and beverage sector is experiencing a massive franchising boom, led by homegrown brands expanding at lightning speed. Meanwhile, a number of major foreign chains and their franchisees are simultaneously hitting a rough patch, forcing a broader overhaul of their operations. We believe these two trends are closely connected by a shifting consumer landscape, evolving tastes, and the brutal necessity of scale.

The sheer scale of the domestic franchising boom is staggering. The relatively unknown Mixue has overtaken McDonald's (NYSE:MCD) to become the world's biggest food and beverage chain. Serving bubble tea and soft serve ice cream at very low prices, Mixue recently reached around 45,300 shops globally, beating McDonald's 43,100 stores. And it's not alone. Other Chinese companies in the global top 10 include coffee chain Luckin (OTC:LKNCY) as the world's sixth-largest, and homegrown hamburger chain Wallace at eighth.

These companies have grown at lightning speed, adding franchisees far faster than Western counterparts that took decades to reach their current size. Franchising offers a relatively simple mechanism to grow quickly without tremendous capital expenditures at the corporate level. When paired with China's massive consumer market of 1.4 billion people, the numbers heavily favor enterprising domestic companies with products suitable for national consumption and the operational ability to manage an ever-growing network.

Historically, Western goods — from Volkswagen to Buick, and across fashion and food — were highly sought after as Chinese purchasing power grew. However, geopolitics and the aftermath of the Covid pandemic have shifted consumer preferences toward domestic brands.

Yet, we believe this rapid domestic expansion might be moving too fast. Chinese franchisers often appear less careful than their Western peers in vetting franchisees, researching locations, and providing financial assistance. With many eager entrepreneurs falsely believing that opening a restaurant is an easy path to quick riches, we expect to inevitably see a correction and cleanup in the sector. We've already seen Chinese hotel chains that utilize the franchise model run into severe financial difficulties during Covid. As in the West, rapid franchise growth can lead to bankruptcies if not managed carefully.

Foreign mid-tier chains hit a rough patch

As domestic brands surge, some prominent foreign chains are struggling. Private equity firm FountainVest is reportedly looking to sell its CFB Group for around $500 million. CFB operates the Papa John's (NASDAQ:PZZA) pizza and Dairy Queen ice cream chains in China. This potential sale appears to be part of a broader overhaul among foreign fast-food chains and their operating partners, with Starbucks (NASDAQ:SBUX) and Burger King (NYSE:QSR) also experiencing simultaneous rough patches after roughly two decades of relative success in the country.

The core issue for many of these companies — particularly mid-tier Western brands — is a failure to achieve scale and adapt to changing tastes. Papa John's arrived early in Beijing around two decades ago, yet failed to grow fast enough to compete with aggressive localizers like Pizza Hut, part of Yum China (NYSE:YUMC). Dairy Queen, despite its nostalgic appeal in the U.S. and backing from Warren Buffett, has also struggled to establish a sufficiently strong presence in modern Chinese cities.

Other mid-tier brands like Dunkin Donuts and Popeyes have faced similar difficulties after failing to excite Chinese consumers. Dunkin may perform well in India due to a local preference for sugar, but the identical approach falls flat in China. In contrast, highly successful operators like KFC and Pizza Hut have essentially been managed as Chinese operations for quite a while, meticulously catering to local palates. Ultimately, some U.S. brands entered China merely because it was a boardroom trend — a box to tick for CEOs and chairmen to avoid appearing incompetent. Without the financial resources and operational expertise to heavily localize and rapidly achieve scale, these mid-tier foreign players are finding themselves outpaced by homegrown competitors.

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China Inc by Bamboo Works discusses the latest developments on Chinese companies listed in Hong Kong and the United States to drive informed decision-making for investors and others interested in this dynamic group of companies.

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Benzinga Disclaimer: This article is from an unpaid external contributor. It does not represent Benzinga’s reporting and has not been edited for content or accuracy.