Yum! Brands has stumbled in China over safety issues, but is moving to restore its growth


Yum! Brand’s Global Cuisine and Tasty Stock


Yum! Brands has stumbled in China over safety issues, but is moving to restore its growth.

With 40,000 restaurants in 125 countries, Yum! Brands (ticker: YUM) has long been a poster child for multinational success. More recently, though, it’s also been known for its trouble in China—including food safety issues and local rivals encroaching. Now, though, investors can look to a promising next course.

The Louisville, Ky.-based company offers three brands Americans know well—KFC, Taco Bell, and Pizza Hut. Yum!, however, gets less than a quarter of its sales and just 31% of its profits at home. Taco Bell generates about two-thirds of that U.S. profit and nearly all of the buzz with clever marketing and new offerings like the Doritos Locos Tacos. Later this month, it tackles breakfast, with new menu items like the taco waffle and breakfast burritos.

As enticing as a waffle taco may sound, the more appealing aspect of Yum! is its expanding presence in the emerging markets, especially China. Yum! generates more than half its sales and 35% of profits in China and now operates nearly 4,600 KFCs and more than 1,200 Pizza Huts there—more than double the store count of its largest rival,McDonald’s (MCD). Now China’s biggest food-service brand, Yum! opened its first KFC in China in 1987, wooing a generation of diners by offering Westernized fast food with a Chinese touch. It put shrimp and beef on the menu alongside fried chicken, and, more recently, added Asian staples like congee. For decades, Yum! had a successful strategy that resonated with China’s burgeoning middle-class as a safe and clean option in a country where food safety has long been a concern.


Yum! Brands CEO David Novak referred to the company’s recent trouble in China as “humbling.”

But that premise was challenged by a state TV report in late 2012 that found excessive antibiotic use among two of Yum’s chicken suppliers. The backlash was strong, and came amid intensifying competition from local and foreign rivals. “It felt different than the run-of-the-mill scandals; it felt like a betrayal since they were always the safe option,” says Elizabeth Friend, senior food-services analyst at Euromonitor. KFC took another hit when an Avian flu outbreak kept people away from chicken entirely.

The stock fell 16% to a recent low of $62 during the first 10 weeks after the crisis hit. Yum’s China sales tumbled—the first time since it began breaking out financials for the country in 2005—and the company ended an 11-year streak of double-digit earnings growth. Chief Executive David Novak declined to comment but acknowledged in a recent call with analysts that 2013 was “humbling.”

As a result, Yum’s stock has not been this cheap since the recession. Its shares have trailed the market significantly, up 13% in the past year versus the S&P’s 23% gain. At $73.79, Yum shares currently trade at 17.9 times 2015 earnings, above the S&P 500’s price/earnings ratio of 14.3, but significantly less than the 50% premium it typically commands, making it attractive for investors who have long coveted the stock. “We’ve seen other companies use crises as an opportunity to take a close look at how they operate. That’s what Yum! is doing now,” says Sara Senatore, restaurant analyst at Bernstein Research.

During its year of self-reflection, Yum! has taken steps to boost its profitability, improve food safety, and recharge its brand—efforts that should help it return to double-digit earnings growth and even command a slightly higher multiple that could push the stock to $85 over the next year, Senatore adds. The stock yields 2%.

Analysts, on average, expect 2014 earnings of $1.67 billion, or $3.62 a share, with sales rising 11% to $14.6 billion, but Wall Street may be underestimating its profit prospects once sales recover. Part of that is due to steps the company has taken to improve productivity that may have gotten short shrift when sales were going gangbusters, such as shifting to more-flexible staffing so that there aren’t idle workers when the restaurant isn’t busy, and eliminating some positions, such as greeters, in bigger cities where customers are now familiar with KFC.

OVER THE PAST THREE years, Yum! has doubled the number of Pizza Hut Casual Dining restaurants in China, which, unlike its U.S. counterpart, is much more upscale. In China, Pizza Hut restaurants feature a full bar and get about two-thirds of their sales from items like wings and fried squid, and just a third from pizza—which typically comes with seafood and other toppings not offered in the U.S. Yum! is also seeing growth in its Pizza Hut Home Service delivery business that features a menu that is more than half Chinese food. Analysts say both Pizza Hut businesses generate fatter margins than KFC, in part because of less competition.

Competition has been a growing concern for U.S. multinationals in China as the market matures and local rivals become more formidable, particularly in the biggest cities. Of the 740 stores Yum! opened in China last year, about half of them were in smaller, often interior provincial cities that are in the earlier stages of urbanization. Here, Yum! has a major edge over other rivals because it owns the distribution, transportation, and logistics network that allows it to get ingredients from farms to its restaurants. Rivals must rely on third-party sources, which means less control and higher costs, since few offer those services in these still-developing cities. “Yum! is the only way you can play that growth,” says analyst Di Zhou of Thornburg International Value fund, which owns the stock.

Combined, these efforts could help Yum’s restaurant margins in China rise from the 14% reported in the fourth quarter to beyond the 18% historical average. If sales recover to a mid-single digit pace, that could translate into earnings in 2015 of $4.65, or about 10% higher than Wall Street estimates, and command a slightly higher valuation, Zhou says.

The Bottom Line

Wall Street is underestimating the earnings growth Yum’s retooling of its menus and operations will produce. The stock could rise 15%, to $85.

Despite concerns about a broad economic slowdown in China, these smaller cities still offer lots of growth, with about 16 million people migrating from the countryside to cities every year. Plus, China’s consumer class is expected to double to 600 million in 2020 from 300 million now. With only four Yum! restaurants per million people in China currently, versus 60 restaurants per million in the U.S., there’s plenty of room for growth.

And then there are the other emerging markets, which currently make up over 15% of Yum’s profits. In total, 82% of Yum’s new-store openings abroad are in emerging markets. The company has been investing heavily in India, where it is trying to introduce more vegetarian-oriented options. It has also pushed into countries like Turkey and Russia. In all, emerging markets make up more than half of profits, but Yum! expects that to climb to two-thirds in three to five years. The company has also reorganized its corporate structure around brands rather than geography, (except for India and China), which should help Pizza Hut and Taco Bell gain better traction in markets that KFC has dominated.

IN THE NEAR TERM, however, a turnaround in China’s sales is critical to confirm that Yum’s reputation hasn’t significantly lost its appeal. The good news is that year-ago comparisons make it a lot easier to generate growth, considering China sales fell 13% last year. But Yum! also noted sequential improvements in January, and the latest bout of Avian flu this year has not hit Yum’s sales notably. A promotion late last year boosted sales, suggesting that diners have not sworn off KFC. But perhaps most encouraging is that Yum! is about to freshen up its KFC brand with a major marketing campaign and yet-to-be announced new menu items in the second quarter—a welcome step as the industry matures with sleeker rivals and increasingly sophisticated palates.

“The recovery has been slower than expected, but is happening,” says Margaret Vitrano, manager of the ClearBridge Large Cap Growth fund. “Yum’s brands have enduring appeal in China, and the company has taken steps to improve profitability, setting it up for a long stretch of outsize growth.”

That sounds pretty appetizing.


About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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