SHANGHAI (Reuters) - With a possible U.S. recession looming, Colonel Sanders is turning to China to fill the breach, offering a menu of fried dough and preserved egg porridge alongside the chicken that turned KFC into an American icon.
Beset by falling sales at home, Yum! Brands Inc, owner of the Kentucky Fried Chicken and Pizza Hut brands, is mounting an expansion drive in China that could make the country its biggest source of profit within a decade.
But like many foreign firms in China, from mobile phone makers to clothing designers, the U.S. fast food giant has discovered it can't rely on a foreign brand name for growth and must instead adapt to local tastes and lifestyles.
So KFC has given a Chinese twist to its menu by adding dishes similar to the food that tens of millions of Chinese grab from street stalls or hole-in-the-wall restaurants on their way to work every day.
"We felt that we could not just copy a model in a foreign country," Sam Su, the Taiwan-born, U.S.-educated head of Yum's China division, told a forum in Shanghai late last year. "In a market like China, everyone should try to create new models."
The formula is apparently working. Yum's sales in China grew 12 percent in the first quarter compared with 5 percent in other international destinations and 3 percent in the United States.
Yum's KFC was the first foreign fast food company to move into China, opening its first outlet in 1987. Since then, Yum has become China's biggest restaurant chain with some $2 billion of annual sales and over 2,500 KFC and Pizza Hut stores.
That dwarfs the roughly 900 outlets of McDonald's Corp, its nearest rival in China's $28 billion fast food market.
And the drawcard isn't necessarily Colonel Sanders secret recipe of herbs and spices. Chinese customers are often not even interested in fried chicken.
He Qi, a 35-year-old employee at a Shanghai advertising agency, says she visits KFC three or four times a week to eat fish, porridge and egg tarts.
"I avoid touching fried stuff because it's bad for one's health," she says.
Yum intends to increase its lead and plans to add 425 restaurants in China this year. McDonald's has said it aims to open at least 125 stores in the country during 2008.
David Novak, chief executive officer of Yum, has said he envisages eventually having over 20,000 restaurants in China.
"We're in the first inning of a nine-inning ball game in China," Novak told investors in a conference call in February.
So far, investors are welcoming the China strategy. Operating profit at Yum's China division surged 30 percent to $375 million last year, accounting for over a quarter of the firm's total operating profit of $1.36 billion, which rose 8 percent.
Novak has predicted China's contribution could reach 40 percent by 2017, exceeding 30 percent for the United States at that time. Despite sliding U.S. revenues, which dropped 7 percent last year, Yum's shares are up about 29 percent since the start of 2007, while the Dow Jones Industrial Average is flat.
The portly, white-haired figure of Colonel Sanders helped draw Chinese to KFC restaurants in the late 1980s, when China was opening up to the world and customers were eager to experience Western lifestyles for the first time.
But in the last few years, Yum has increasingly designed products and services specifically for local consumers. This strategy has had problems as well as opportunities.
"It's a lot more difficult to standardise Chinese food. It's much easier with hamburgers," said Shaun Rein, managing director of the China Market Research Group, adding that another problem was finding the right managers to run all the outlets.
This year Yum plans a nationwide launch of its breakfast services, now available at about half of KFC stores, and will test 24-hour KFC restaurants and expand home delivery services to target the huge nocturnal populations of China's crowded cities.
It will also add 85 Pizza Hut restaurants and expand the chain's home delivery service.
Yum's China manager, Su, has successfully transformed Pizza Hut, a business that was languishing in China, into an upscale restaurant chain targeting China's 250 million middle-class consumers.
"Pizza Hut is the cheapest of the cheapest restaurants in the United States, but in China, Pizza Hut is seen as a classy, up-scale place for dining," Rein said. "Yum has reinvented the Pizza Hut brand in China ... They know who's spending the money."
Nevertheless there are risks associated with Yum's rapid expansion in China such as over-exposure, analysts say.
"If there are too many KFCs in the street, people would feel sick of it. There may be a backlash; The same store sales will go down. Margins would be hit," Rein added.
Based on Yum's track record so far though, analysts believe it will be able to navigate successfully through the complicated fast food scene in China.
"Yum has the right boss in China," said Lucy Wu, deputy head of China's Chan Store and Franchise Association. "Su is Chinese and knows the Chinese market much better than foreigners. His localization strategy is the secret of success."
Instead of copying the KFC model in the United States, Su, 55, spent the past two decades re-defining fast-food, which is often associated with unhealthy, junk food in the west.
"Yum has localized its menu a lot in China, much more than McDonald's did," said Rein of China Market Research Group. Yum's China business is so successful that Chief Executive Novak is now copying the China model to the United States by introducing healthier products in its U.S. outlets, increasing emphasis on breakfast and evening sales and broader menus that include more desserts and beverages.
"Let's learn from our most successful business. Let's learn from our China Business," Novak told investors at Yum's annual shareholder conference in New York in December.
Su's next goal is to push ahead with a traditional Chinese fast-food chain called East Dawning to head off competition from local players such as Kungfu Catering Management Co and "hotpot" chain Inner Mongolia Little Sheep.
Yum has operated 10 East Dawning branches in Shanghai since 2005, and it plans to test Beijing's market in time for the Olympics. East Dawning, named after a phrase in a Song dynasty poem, serves traditional Chinese dishes such as tomato beef noodles, beef rice and bean curd.
"Yum has a huge first-mover advantage in China," says Wu. "Smaller rivals are not likely to threaten Yum's leadership position in the foreseeable future."
Editing by Andrew Torchia and Megan Goldin