The emerging Chinese market, with its massive population and fast-growing economy, has attracted restaurateurs from around the world. Recently, the world's largest coffee retailer, Starbucks (Nasdaq: SBUX ) , after enjoying early success in China, decided to more than triple its retail outlets there. Last week, KFC-parent Yum! Brands (NYSE: YUM ) served up an awesome quarter, with China contributing to nearly 60% of its 3Q operating profits.
But high inflation in both commodities and labor poses a major threat to these specialty retailers. Especially Yum!, which has been promoting its low prices to help increase store traffic in China as it looks to grow market share. Let's delve a little deeper.
The "emerging" problem
China's economic growth in the last few years, among other things, has led to high food-price inflation. Food prices in August grew by 13.4% from a year ago, with pork prices jumping a staggering 52.3%, causing major headaches for Yum!'s Pizza Hut chain. The company anticipates food prices this quarter to rise in the mid-teens. Yum! will likely find it difficult to balance its low-price draw with the pressure of rising input costs.
Though China was once a preferred hub for outsourcing one's business, this may not be the case anymore, with the cost of labor steadily rising. This same reality will also impact Yum!, which expects labor costs to inflate by 20% this quarter. These two types of costs rising together may force the company to raise its menu prices even further: It recently raised prices by 2%, though it was trying desperately to avoid this.
A small silver lining
Overall, Yum!'s emphasis on affordable menu items may work in its favor, as this may help increase sales since other food retailers will be forced to raise prices even higher than Yum!. This massive organization can typically purchase at rock-bottom prices, a luxury smaller competitors may not have. The company is hoping that food inflation fades by next year, but still expects labor costs to remain high -- though less than current prices.
Today's higher costs are likely to weigh on Yum!'s margins this quarter, meaning China may not contribute to 60% of its profits in the coming quarter. Its rival, McDonald's (NYSE: MCD ) , saw only 3% of its income come from its Chinese hamburger chains. According to Morgan Stanley analyst John Glass, the burger maker faced inflation in the low single digits in its most recent quarter.
The Foolish takeaway
Yum! expects its sales momentum to carry forward to the last quarter of the year, resulting in high same-store sales. However, rising input costs are likely to weigh on its bottom line. It will be interesting to see how the company tackles the pressure of rising costs as it looks to bridge the gap between its lower prices and higher costs. To keep an eye on this and stay ahead of other prudent investors, click here to add Yum!, or any other stock mentioned above, to your stock Watchlist.