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Franchising - the Way to Go in China?

China General Interest

Franchising, despite being almost unheard of in the early 90’s, spread like wildfire in the recent years. The JLJ Group shares some findings of their recent market research on China’s Franchising Industry.

With some 200,000 franchised retail stores representing over 2,600 brands, China is now the largest franchise market in the world. Led by early successes of both foreign and domestic brands such as Nike and LiNing, this industry has been growing at an astonishing rate of 35 to 40 percent over the past few years. Especially in the mid to late 90’s, many businesses across all sectors including F&B, fashion, education fitness and real estate have set up franchised chain stores all across China soils.

Drivers of growth

In a study conducted by The JLJ Group, it was found that this rapid spread of franchise networks can be attributed to the growing middle class in China, the rising acceptance of franchising concept among entrepreneurs as well as overall improvements in China’s regulatory environment.

Many brands have been lured to China by the increasing disposable income and the exploratory attitudes of its growing middle-class. This is one of the key drivers that motivated Subway as well as Papa John’s to expand quickly in China. Their goal was to fight for a slice of the market with other well-established early entrants such as KFC, McDonald’s and Pizza Hut – and franchising seemed a viable option. By leveraging the financial resources of the franchisees, Subway swiftly filled East China and Sichuan with more than sixty outlets while over fifty Papa John’s restaurants satisfies the pizza craves of those in East China.

While demand is spurred by the growing middle class, entrepreneurial spirit of Chinese individuals and companies have helped sustained a constant supply of capital that both foreign and domestic franchisors can tap into. KFC attracts 100 applicants every month, each ready with the RMB 8 million capital required to open a KFC outlet.

The gradual evolution and improvement of China’s regulatory environment also played an important role in advancing the franchise industry. China first enacted its franchise law in 1997. However, the laws did not specify any provisions for foreign companies and many early franchisors were operating in grey areas. Following its accession to the WTO (World Trade Organization), new franchise regulations were released in 2005 and 2007, offering much more flexibility and options for foreign brands, particularly in the area of cross-border franchising.

The thoughts of utilizing the franchisees’ deep pool of capital to penetrate the market faster, as well as having entrepreneurs themselves as motivated managers to run the business have definitely enticed many brands. At the start of 2007, 69% of the companies with existing chain stores in China have adopted the franchise model for business expansion.

However, there are others who are hesitant. KFC and McDonald’s - who have both embraced the franchising model outside China - have only few franchised outlets in China. And Pizza Hut has none. So why are these major players so cautious about taking the franchising plunge?

Finding Reliable Partners

Though there is no lack of Chinese entrepreneurs willing to invest in a franchised store, few are competent to manage one. Many local franchisees do not have a good understanding of the franchising concept and lack modern management practices. For example, a popular Inner-Mongolia hotpot chain Xiao Fei Yang is closing franchised stores that do not meet its quality standards. Wide-Tera, an international player with around 70 fitness gyms in China has also reclaimed many of its franchised gyms. Both brands, painstakingly established over the years, were damaged by the franchisees’ poor product knowledge, inferior equipment or ingredient purchases and lousy service quality.

Providing long-term guidance and training has thus become a critical focus of many franchisors. Burger King – which has big plans to set up as many as 1,000 outlets by 2015 – requires all their franchisees to undergo six months of training, while KFC provides a twenty-week training to bring their franchisees up to speed.

There are so many challenges to overcome that many chain stores prefer to expand through direct ownership stores or Joint Ventures (JVs) with local partners in China. At the same time, the fast-growing market offers potential to yield higher returns through direct ownership of stores. Among those that do franchise, 60% chose to establish master franchisee agreements with reputable companies for different regions. Such organizations are better equipped with management experience and are less likely to sacrifice brand image and quality for short-term gains. Most Papa John’s outlets in Shanghai are run by a master franchise Shanghai RCS Group Co. Ltd and RCS’s sub-franchisees.

Adapting to fit local tastes

International franchisors should also consciously assess the vast differences between China and other countries. Even within China, regional tastes and practical needs may vary considerably. While Sichuan food is very spicy, Southeastern food tends to be bland. Though consistency is an important facet of the franchising concept, innovative product modifications to fit local demands have a strong bearing on the success of franchise chains. KFC local offerings such as spicy chicken burgers and mushroom chicken congee have become key attractions for Chinese consumers. Burger King ran a pilot restaurant in a hidden location to analyze local tastes prior to its official entry and has now developed a loyal following among local teens, white collars and expatriates.

Taste preference apart, China is also very fragmented in terms of spending power. Average incomes in cities such as Chongqing, Qingdao, Xi’an are substantially lower than that in Beijing and Shanghai. This implies that franchisors may need to strategize effectively the launch of products in smaller volumes or at reduced prices. For instance, McDonald’s and KFC have been very successful with using their 1 yuan ice creams to attract crowds into their restaurants.

Last but not least, purchase priorities differ across regions in China. Take Nanjing for example, one may imagine that their higher disposable income as compared to cities such as Qingdao, Chongqing and Xi’an, the Nanjing population should correlate to higher dining expenses. In reality, the Nanjing population spends lesser dining out as compared to the other three cities, but prefer instead to spend on education.

Preventing the Copycats

Another key challenge that slows the take-off of franchising, or for that matter any other foreign business entry in China, is the widespread violation of Intellectual Property (IP). While regulations are in place, enforcement is weak. The responsibility to track down violations often falls on the IP owner. Quan Ju De is one that has fallen prey to cheap copycats exploiting their logo to attract customers. Xiao Fei Yang also witnessed many imitators operating under its brand - some of which are ex-franchisees fired for failing to meet standards.

Though registering trademarks may not guarantee the franchisors recourse on IP violations, failure to do so may lead to dreadful consequences. As China grants trademarks on a “first-to-register” basis, there have been cases of individuals maliciously registering another’s trademark and subsequently demanding payment for the use of it. It is therefore imperative for companies to register all trademarks, brand names (both English and Chinese), domain names and patents before entering the market.

Operating in China

The new franchise regulations passed in 2007 effectively abolished many restrictions and gray areas. For the first time, foreign brands are not required to operate at least two stores within China before they can start to franchise. Currently, they just need to own two successful stores anywhere in the world. Despite welcoming cross-border franchising policies, many franchisors still prefer to establish legal presence in China so as to maintain control and supervision over their franchisees.

Choice of cities for franchise expansion is as important as structuring an effective organization model. With Tier 1 cities becoming increasingly expensive and saturated, many franchisors have explored the option of expanding in Tier 2 cities. Ten cities, including key ones such as Shenzhen, Tianjin, Nanjing, Qingdao, Nanjing, Shenzhen, Xi’an, and Chongqing have been analyzed in JLJ’s study. In some of these cities, the population is already familiar with foreign brands but not spoilt with choices yet. These cities offer excellent opportunities for new franchise entrants.

Franchising in China currently accounts for only 3% of total retail sales, compared to 40% in the US. Undoubtedly, there is room for growth. However, several barriers such as difficulty in finding reliable franchisees as well as the desire to yield higher profits from the booming market have steered some foreign brands to opt for direct-run stores and partnerships instead of franchising. In all cases, significant amount of time, effort, and resources are necessary to sustain the franchise network. Foreign companies should research the market thoroughly and seek professional advice where necessary to facilitate the planning of a successful China expansion strategy.

The JLJ Group is a one-stop service provider assisting foreign companies to enter and grow in China. For more information, please visit www.jljgroup.com or email to consulting@jljgroup.com