YUM!’s China Speed Bump of Little Concern

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Yum! Brands (NYSE: YUM), the owner of KFC, Pizza Hut and Taco Bell restaurants, saw its stock rise by 5.2% after it posted strong results for its quarter ending Sept. 8. Revenues increased by 12.6% sequentially and 10% year-on-year to $3.57 billion. Meanwhile, net income has surged 42.3% sequentially and 23% year-on-year to $471 million.

More importantly, Yum Brands was able to improve its net profit margin both sequentially and year-on-year, which now stands at 13.2%. The graph below shows the net profit margin along with the rising trend line with a positive slope.

<img src="/media/images/user_12925/magrins_large.png" />


An increasing concern for Yum Brands has been the reliance on China.  For all intents and purposes KFC is a Chinese brand now not an American one. But the recent trends for major U.S. brands in China have been disturbingly negative.  Recently, leading sports equipment manufacturer Nike (NYSE: NKE)reported a drop in future sales which indicated that powerful brands will not be able to charge premium price from Chinese customers who have become increasingly finicky with their expenditures as the Chinese economy slows down. Like Nike, Yum Brands also earns a large part of its revenues, ~47% in H1 2012, from China where it operates one of the country’s largest restaurant chains.

So far, in the first two quarters of Yum’sfiscal year, it has not been able to book as much revenue2 from China as it did in 2011. In the current quarter, Yum!earned the lowest profit from China in the past four quarters.

Despite the sequential increase in Chinese revenues in the second quarter, profits dropped which dragged the operating margin back to 11%, and looking at the trend over the past 6 quarters it is distinctly negative.  However, this trend should begin to reverse in the coming quarters because the drop in margins was caused by a temporary surge in salaries and ingredients.

I don’t see these declining margins as a deal-breaker for Yum! as an investment, it is likely they’ll never see net margins in China above 20% again, however. It is ahead of McDonald’s (NYSE: MCD) is terms of number of restaurants and is expanding rapidly in the emerging markets, particularly in India and China where around half of its sales occur. Since June, 2012, Yum has opened 394 new restaurants, including 192, or almost 50% of the total new restaurants in China.

Unlike Yum, the much bigger MCD (in terms of revenues and market cap) has not been able to increase its profits on a year-on-year basis. Its most recent earnings release for the quarter ending 30th September saw net income rising by 8% sequentially but falling by 3.5% from the same quarter last year to $1.4 billion. Although MCD earns a much higher net profit margin which, unlike YUM’s margin, has fallen over the year from 21.o% to 20.3%.

The effect of differing trends of profits of MCD and Yum is evident in the performance of their stocks. Overall, since the beginning of the year till the week ending 19th October, Yum has been up an impressive 18.8%, beating the SPDR S&P 500 ETF (NYSEMKT: SPY) which has increased by 14.2% in the same period. On the contrary, MCD has fallen by 11.6%.

<table> <tbody> <tr> <td> </td> <td> <p><strong>MCD</strong></p> </td> <td> <p><strong>YUM</strong></p> </td> </tr> <tr> <td> <p><strong>P/E</strong></p> </td> <td> <p>16.7</p> </td> <td> <p>20.9</p> </td> </tr> <tr> <td> <p><strong>EPS</strong></p> </td> <td> <p>5.31</p> </td> <td> <p>3.4</p> </td> </tr> <tr> <td> <p><strong>Yield</strong></p> </td> <td> <p>3.5%</p> </td> <td> <p>1.9%</p> </td> </tr> <tr> <td> <p><strong>ROA</strong></p> </td> <td> <p>16.5%</p> </td> <td> <p>15.6%</p> </td> </tr> <tr> <td> <p><strong>ROE</strong></p> </td> <td> <p>39.2%</p> </td> <td> <p>73.7%</p> </td> </tr> </tbody> </table>

MCD has a lower P/E but gives a better yield. The return on assets of both the firms is similar but Yum has given almost twice as much return on equity than MCD and therefore despite the higher P/E and lower dividend/yield, YUM’s position in these major emerging markets and willingness to for its brands to re-invent themselves to cater to local tastes gives it a real advantage in the long-run over McDonald’s who is stuck both with a franchise model that has not translated to Asian markets and an unwillingness to truly customize its menu

The company is now planning to open 750 new stores in China this year, as opposed to 700 announced earlier.  Currently it has roughly 4,000 restaurants across China and it has made a new strategy: at least 500 new restaurants each year. By comparison, MCD has around 1,500 stores in China, is aiming to touch 250 new restaurants in the country this year and wishes to reach the 2,000 restaurant count by the end of 2013. Although Yum’s income in China has fallen the rapid expansion of new KFCs will result in higher sales in the future and Yum should continue to grow in this region of the world far faster than McDonald’s. 

PeterPham8 has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's and Nike. Motley Fool newsletter services recommend McDonald's, Nike, 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.

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