Are Yum! Brands' China Problems Really Over?

Yum! is expanding rapidly in many international markets, outpacing McDonald's considerably, but recent problems in China have caused same-store sales in that country to plummet. The trend seemed to reverse in November, but the details may point to bigger problems for the company.

Jan 13, 2014 at 10:21AM

Yum! Brands (NYSE:YUM) has been struggling in China for the past year, with same-store sales declining in the double digits nearly every month. Its KFC business was hit hard after fears of avian flu, along with an investigation into a former food supplier, leading Chinese consumers to avoid the stores.

The situation seems to be improving, with flat same-store sales for KFC China reported for November, but there's still a long way to go before the company regains the trust of consumers. With Yum! battling both local competitors and other Western companies like McDonald's (NYSE:MCD), the incredible growth prospects don't come without challenges.

There may be deeper problems for KFC
While KFC China's same-store sales were flat in November, this result was driven by increased promotional activity. A half-price promotion, which ended on Nov. 10, 2013, boosted sales enough to counteract the 8% decline in same-store sales for the rest of the month. This decline was actually worse than the 7% decline in October, and it points to continued problems going forward.

There are about 4,500 KFC stores in China, and Yum! believes that number could eventually triple. But with local competition on the rise, the company may be too optimistic. The fact that sales collapsed following the end of the promotion in November could mean that the brand is losing its appeal, with only extremely low prices convincing consumers to choose KFC.

It looks like KFC's problems in China will continue into 2014, although the situation is certainly better than it was six months ago.

Pizza Hut could drive growth
There are about 1,000 Pizza Hut locations in China, and Yum! estimates that this number could quadruple over the next decade. Unlike KFC, Pizza Hut has been performing well in China, with same-store sales jumping 7% in November.

Along with dine-in restaurants, Yum! is also focusing on expanding its Pizza Hut delivery business in China. With just 200 delivery units so far, the potential for growth is astounding. In the U.S., market leader Domino's operates nearly 5,000 units, all focusing on delivery. Given China's significantly higher population, Pizza Hut delivery could easily grow into the thousands of units over the next decade.

China could foreshadow problems elsewhere
Translating Western brands for foreign markets is a difficult task, and the problems Yum! is having in China may repeat themselves in other emerging markets. Yum! is rapidly expanding in countries like Thailand, South Africa, and Egypt, surpassing McDonald's in terms of unit count, but it's unclear how big Yum!'s brands can get in these countries. In other words, the saturation point in a country like the U.S., in terms of citizens per restaurant, may be very different than in emerging markets.

Yum! may be running into exactly this problem in China, and it's possible that it will repeat itself in other international markets. The big risk for Yum! is that the brands don't scale successfully in these markets in the same way they have in developed markets.

Is Yum! a good investment?
While Yum! has incredible growth potential, this potential comes with a price. Yum! trades at about 22 times 2012 earnings, with 2013 earnings set to be lower due to the problems in China. Analysts expect earnings to grow to $3.61 per share in 2014, putting the forward P/E ratio at about 20.8. The range of the estimates are extremely wide, however, and this kind of growth requires the problems in China to be completely resolved very soon.

While earnings per share may grow by 20% or more this year as business in China recovers, long-term earnings growth should be closer to 10% per year. This assumes that growth in markets like India goes more smoothly than in China, which is certainly not a guarantee. Yum! isn't unreasonably priced given these growth prospects, but it's not a bargain either.

We can compare Yum! to McDonald's, another restaurant company relying on international growth going forward. McDonald's has been slower to expand in countries like China, with Yum! building twice as many international restaurants over the past five years as McDonald's. But McDonald's has been more consistent, maintaining its industry-leading margins even as the company struggles to grow same-store sales in the United States.

McDonald's trades at 17.2 times expected earnings for 2013, and 16.2 times expected earnings for 2014. While Yum! has the potential to grow faster, McDonald's looks like a better deal from a value perspective, even considering the issues that the company is currently facing. I've been critical of McDonald's on multiple points recently, such as the Mighty Wings debacle and the company's focus on coffee, but McDonald's is still a very solid company.

The bottom line
It doesn't look like Yum!'s problem's in China are completely over, with heavy promotional activity driving results in November 2013. There are bright spots, like Pizza Hut, but the company has some serious work to do in order to turn around KFC China. The growth prospects for the company are enormous, but the stock price seems to be already pricing this in, and McDonald's seems like a better value.

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Fool contributor Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Domino's Pizza and McDonald's. The Motley Fool owns shares of McDonald's. 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.

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