The China Turnaround Will Be a Huge Catalyst for Yum!

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The year 2013 has not been kind to Yum! Brands (NYSE: YUM), the parent of KFC, Pizza Hut, and Taco Bell. Its Chinese empire was shaken up first by the chicken scandal that broke out toward the end of last year, and next by the more recent avian flu scare.

The stock has grown by a modest 5% through the year, but the fact that it could still head north despite the consecutive quarters of weak results and bad news from China floating in, underscores the point that investors have not given up hope on the company. And this patience is about to be handsomely rewarded.

The trends in China have already started improving, and Yum! remains a huge potential candidate for leveraging the country’s strong growth over the coming years. Let us explore Yum’s position in the middle kingdom more closely.

Sales are recovering at KFC

KFC’s same-store sales comparisons in the just-reported second quarter may look dismal at the first glance, showing a 26% drop. But, the past three monthly trends warrant a mention. In April, same-store sales were down a whopping 36%. But since then, there has been a sequential improvement of 11 points in May and 12 points in June. These trends reflect that the turnaround in KFC has already started. Yum! expects to get back to positive numbers in the fourth quarter.

In fact, sales picked up right after the reported avian flu cases started receding in May and Chinese media started diverting their attention to other pressing issues of the country. By this time, thanks to Yum’s Operation Thunder, memories of the chicken scandal were also fading.

Yum! is going to huge lengths to win back the confidence of its customers. It is running a big television campaign where it is assuring people of the quality of its food. Even the table mats in KFCs show pictures of chickens making their way to the stores from the slaughterhouses in hygienic conditions.

KFC has started promoting value options for chicken wings, which are very popular in China, and although the company will not talk about it just yet, it is likely to announce more chicken items and step up promotions in the coming months. It is also emphasizing its other protein option, like shrimp and mushrooms.

Pizza Hut is doing well

Yum! is growing the Pizza Hut chain into a solid brand. It is focusing on expanding into lower tier cities. There are already 900 Pizza Huts in 228 cities and more will follow. The returns on new units are impressive, with the company recovering its initial investment in less than three years.

There is also equal focus on improving sales at existing stores through continuous menu innovations. During the second quarter, Pizza Hut witnessed an impressive 7% growth in comparative same-store sales. The chain has recently introduced a Stone Pan Sizzling Steak, which is likely to be a big hit with the Chinese people. Yum! has also launched Pizza Hut home service, which has 171 units in 21 cities.

Until now, the company was mostly known for its KFCs in China. But with more efforts on strengthening the Pizza Hut chain, another solid growth driver is in its first stages of evolution.

Unmatched scale

China has the fastest GDP growth rate as well as the largest population of around 1.3 billion people in the world. So, no wonder the entire world has its eyes set on the country. Bilateral trade between the US and China reached $500 billion in 2012. And it is estimated that the country will generate more opportunities for the industrial community across the globe over the next five years.

Already, around 60,000 US enterprises have invested in China. Among the restaurant chains, Yum! has the largest presence in the country – way ahead of its rivals like McDonald’s (NYSE: MCD) or the coffee house giant, Starbucks (NASDAQ: SBUX). Yum! has around 6,000 restaurants for its various chains. KFC accounts for almost 75% of the company’s total store count. In comparison, McDonald’s has 1,700 units and is eyeing the 2,000 mark. Starbucks, which has 800 stores, is hoping to get to 1,500 by 2015.

Peer comparison

McDonald’s faced lesser impact from the bird flu scare, although same-store sales growth was negative in May.

Presently, the company is trying to woo its Chinese customers with its new “Night is On” campaign. It is offering an evening menu that comprises chicken and beef rice wraps and bowls. It is even having nights of “special dinner experiences,” where the cafés get transformed into night clubs with full karaoke, music, neon lighting, and the works. Meanwhile, more emphasis on value items and breakfast menu continues.

With matured US markets offering limited growth opportunities, the East is the behemoth’s best hope. And Starbucks cannot agree more. Unaffected by the bird flu scares, the coffee chain is witnessing solid sales. The company reported 8% comparative same-store sales growth in China and Asia Pacific business in its last reported quarter.

It has good local partners like Beijing Mei Da for northern China, Uni-President for eastern China, and Maxim's Caterers for southern China, which are of great help in these initial brand-building years of the company.

While McDonald’s and Starbucks are both being very aggressive in the region, it will be some time before they can catch up with Yum!. The latter’s mastery over balanced menu offerings, with both local items as well as staples, scores a huge point.

And Yum! still thinks that its chains are in the early stages of growth. Despite whatever troubles that it has had in China, the company is still on track to add 700 new units in 2013. This would bring the total number of restaurants that it has opened in the last two years to 1,600.

Last word

Yum!’s China rebound is finally taking shape. With KFC sales slowly recovering and Pizza Hut prospering, there is much to look forward to. The company has a huge scale of operations in China and understands the pulse of its customers better than most others. It should see solid momentum going into 2014 and beyond. This would fetch excellent returns for its investors.

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Eshna De has no position in any stocks mentioned. The Motley Fool recommends McDonald's and Starbucks. The Motley Fool owns shares of McDonald's and Starbucks. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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