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In 1978, Deng Xiaoping opened up China's economy to the free-market. This resulted in GDP growth exploding, averaging 10% annually since 1984. He opened up China's economy to private investment, decollectivized the agricultural sector (the Great Leap Forward, Mao's big collectivization of the agricultural sector led to production declining by 25% and productivity collapsing by 30%, which starved 30 million people to death), and the privatization of state run companies. This obviously was a great idea and resulted in China's poverty rate declining from 51% in 1981 to 13.6% in 2011. Also, the emergence of a middle class with disposable income came about from these reforms. It's the emergence of a middle class, which means more families can afford to eat out, where the story begins.
As you can see, boom times!
Yum! That's delicious
Yum! Brands Inc (NYSE: YUM), the owner of the KFC, Taco Bell, and Pizza Hut restaurants, is betting the house on China. In its latest earnings report, Yum! reported 10% same stores sales growth and saw an 18% increase in new units. They opened up 160 restaurants (in China) in the quarter, and raised their full year guidance for new store openings in China from 600 to 700. In the second quarter of last year they saw 20% same store sales growth, so in the upcoming quarters to come, it will be hard to top that, but management thinks they will see high single digit growth.Combining the new store openings and same stores sales growth, organic system sales growth grew 23%. Margins were hit hard due to high levels of inflation and costs associated with its rapid expansion.
Management is bullish on China for several reasons, and one big point is that in the United States there are 60 restaurants per 1 million people, compared to 4 per 1 million people in China. This shows that Yum! Brands has a lot of room to expand into. Plus David Novak said in the latest conference call "the consuming class is expected to double to over 600 million people by 2020." If Yum! Brands can continue to expand and build out new stores in China, then it should continue to see its bottom line grow, especially if Yum! can maintain a 20% margin in China. Margins were down to 19% last quarter, but this is expected to moderate out at 20%. If Yum! can maintain a higher margin than 20%, expect some strong upside.
Yum! Brands has their eyes on China, so let's break down what to expect from China and its economy going forward. Over the past several months China's GDP growth estimate has been continuously ratcheted down, with BoA's Merrill Lynch estimating that China will grow by 7.7% this year and 7.6% next year. Historically, China has averaged about a 10% GDP growth rate, so this doesn't bode well for multinationals operating in China.
In May, McDonald's Corp (NYSE: MCD) saw a 1.7% same store sales decline, versus an expectation for a 3.2% gain. McDonald's has about 1,500 stores in China right now, and expects to increase its store count to be able to serve all the consumers now entering the middle class. Now, one study by McKinsey that doesn't agree with management's 600 million target thinks that "by 2020, the mainstream Chinese consumer – some 400 million people or 51 percent of the urban population – will have annual disposable incomes between US$16,000 and US$34,000."
Now, this isn't a bad thing for Yum! Brands, as the current size of the middle class in China is 300 million (estimated by several, which includes Helen Wang, author of The Chinese Dream: The Rise of the World's Largest Middle Class and What It Means to You). Even a 33% gain in the size of China's middle class would be huge for Yum! Brands, McDonald's and for Burger King Worldwide Inc (NYSE: BKW), which is planning on opening up another 1,000 stores in China with a joint venture over the next 5-7 years.
Regardless of who is right, with the explosion of middle class Chinese consumers, all consumer based companies should benefit, assuming they keep expanding and make sure to offer a product that is competitively priced. Another company that should benefit from this is Tiffany & Co (NYSE: TIF), which has 18 stores currently in China, and 2 of those were opened this year. Tiffany's products are targeted for the upper class of China, which is also rapidly growing. While China's GDP growth is slowing, it is still growing at a fast clip, and when more and more of China's population becomes a part of the middle class, China's economy will become more like the US (where 71% of United States GDP is consumer spending), which makes it less dependent on exports and foreign investment, thus insuring higher levels of stable growth.
Problems with the Bears
The bear case for companies operating in China, which includes Yum! Brands of course, is that China will have what is known as a "hard landing," which means GDP growth will fall down to 5%. Now, that isn't a bad growth rate, but it is half of its historic average since 1978. This means China would see slower consumer spending growth and less people entering the middle class. While the pessimists are crying out warnings about the hard landing, one doesn't seem to be coming around any time soon. Another part of the bear case for Yum! Brands is that input price inflation will continue to hurt margins like it did last quarter.
Valuation, Estimates and Debt
Yum! Brands has a PE (TTM) of 20.7, slightly less than the industry average of 22.85. Also it has a PEG ratio of 1.53, which is slightly less than the industry average of 1.6. It's expected EPS growth rate for next year is 15%, and 13.5% over the next several years. One problem Yum! Brands has it its debt to equity ratio is 155%, which means it is highly leveraged, even compared to its peers (106% is the industry average). If Yum! can keep hitting its growth targets, then its debt will be easily manageable and its PE looks justified. While a PE of 20.7 isn't cheap, for a company growing at 13-15%, that is a fair price. The median PE estimate for the next fiscal year is 17.6.
American products seem to be selling well all over the world, and as long as foreign consumers keep taking to our products, then multinationals will continue to see higher growth rates. Yum! Brands is well positioned to ride China's consumer spending boom upwards, and with management raising its forecast for new restaurant openings in China to 700 (from 600), it is a company worth looking at. I'm bullish on China's new middle class and on its growth in consumer spending.
callumturcan has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's and Tiffany & Co. Motley Fool newsletter services recommend Burger King Worldwide, McDonald's, and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.