Yum! Brands Is Recovering in China: Time to Buy?

Source: Yum! Brands.

Yum! Brands (NYSE: YUM  ) reported earnings for the first quarter of 2014 on Tuesday, and the company seems to be making an impressive recovery in China, a key market where Yum! Brands is positioned for growth and materially outperforming competitors such as McDonald´s (NYSE: MCD  ) . Is it the right time to buy Yum! Brands?

Tasting good
Total sales during the first quarter of 2014 increased by 5% versus the same quarter in the prior year to $2.72 billion, below analysts' forecasts of $2.84 billion for the quarter. On the other hand, profit margins were particularly strong during the quarter, as worldwide restaurant margin increased 3.3% to 19.2% and worldwide operating profit increased 22% versus the prior year.

This increase in profitability allowed Yum! Brands to generate a big jump of 24.3% in earnings per share, from $0.70 per share in the first quarter of 2013 to $0.87 per share in the last quarter. That figure was above analysts' expectations of $0.84 per share.

Management also reaffirmed its guidance for an increase of at least 20% in earnings per share during 2014, quite an impressive growth rate for a big company in a mature industry.

Chinese recovery
Sales in developed markets remain lackluster, but the big positive during the quarter was the recovery Yum! Brands is generating in China after the negative impact from controversy regarding poultry suppliers for its KFC restaurants in the country last year.

China division sales increased by a remarkable 17% year over year on the back of 7% unit growth and a 9% increase in same-store sales in the country during the quarter. Restaurant margin increased 6.8% to 23.4%, while operating profit grew by an impressive 80% versus the same quarter in the prior year.

This increase in China profitability had a material positive impact on company-level profit margins, and it was one of the main reasons Yum! Brands reported better-than-expected earnings during the last quarter.

Yum! Brands is focusing on product innovation and an active marketing campaign to reinvigorate sales at KFC in China. The company is promoting 15 new menu items in the country, and it has embarked on an aggressive social media campaign to reverse its image problems.

Yum! Brands' efforts are clearly yielding solid results when it comes to turning around its KFC performance in China: Same-store sales at KFC increased by 11% in China during the first quarter of 2014, and management is encouraged by growth prospects in the medium term.

Emerging-markets powerhouse
Yum! Brands owns a total of 6,332 restaurants in China, including its four concepts: KFC, Pizza Hut, East Dawning, and Little Sheep. KFC accounts for 4,618 of those stores, so the fact that the company is turning things around in its KFC operations in China bodes remarkably well in terms of future returns for investors.

In fact, a strong bet on emerging markets over the past several years has been a crucial differentiating factor for Yum! Brands in the competition against rival McDonald's. The following graph from Yum! Brands' investor conference presentation illustrates how Yum! has clearly surpassed McDonald's in emerging markets over the past decade.

Source: Yum! Brands.

This has important implications for both companies when it comes to financial performance. McDonald's reported a lackluster increase of only 1% in total sales to $1.6 billion in the first quarter of 2014, while earnings per share declined by 4% versus the same quarter in the prior year because of falling profit margins. 

Same-store sales in China were quite strong, with a 6.6% increase in comparable sales during the quarter, but this was not enough to stabilize the declining sales trend McDonald's is experiencing in many emerging markets: Comparable sales in the APMEA region declined by 0.8%, while operating income decreased by a big 10% versus the previous year.  

Both Yum! Brands and McDonald's are generating uninspiring growth rates in developed countries, but Yum! Brands has a much bigger presence in emerging markets, especially China, and that is making a considerable difference when it comes to overall financial performance.

Bottom line
The fast-food industry is notoriously challenging and competitive, and it's difficult for big companies in the industry, such as Yum! Brands or McDonald's, to generate growth in saturated markets. But emerging markets still offer room for growth, and the fact that Yum! Brands is putting its difficulties in China behind it bodes remarkably well for the company in terms of future return prospects.

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Andrés Cardenal

Andres Cardenal, CFA is a tenacious researcher of the best investment opportunities around the world. Andres is an economist and CFA Charterholder living in Buenos Aires, Argentina. Naturally flavored. Follow me on Twitter for more investment ideas:

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9/2/2015 4:07 PM
YUM $80.27 Up +1.17 +1.48%
Yum! Brands CAPS Rating: ****
MCD $96.04 Up +2.57 +2.75%
McDonald's CAPS Rating: ***