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Fool on Call: Yum! Brands' Wall of China

By Jeremy MacNealy - Updated Apr 5, 2017 at 5:25PM

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The country represents a Godzilla-sized opportunity for this restaurateur.

With roughly 20,000 restaurants operating in the U.S., Yum! Brands (NYSE:YUM) has pretty much tapped all the meaningful growth in the domestic market. Now the most significant growth vehicle for the restaurateur is mainland China. In a prior "Fool on Call," we took a look at this new opportunity, paying particular attention to how its KFC brand has been able to connect with the Chinese culture. China was once again the center of discussion in the latest conference call, offering us additional insight into its development plans there.

"Ginormous" is the one word that comes to mind for me after hearing management comment on the opportunities in China. Read on -- I think you will agree.

KFC is full go in China
China was referred to throughout the call, but no one's remarks better captured the opportunities that that market presents than CEO David Novak's. "Believing is really seeing the power of our Chinese operations and the love our customers have for our brands," he said in his prepared statement.

Most of us do not have the luxury of having a firsthand experience with KFC or Pizza Hut in Shanghai or any of the 420 Chinese cities where Yum!'s restaurants are operating. For the majority of us, numbers will have to do. Let me say this: The numbers are very exciting.

You expect to see high-double-digit revenue growth coming out of this market. So I am sure I was not the only one who yawned a bit when I heard that revenue from the Chinese market increased 26% in local currency terms during the third quarter. What really caught my attention was the unit growth opportunities there.

The company is on track to open up "at least 375 restaurants" in China this year. The bulk of these are KFC openings. By year's end, it will have approximately 2,100 KFCs up and running in 420 cities and counting. KFC's deep penetration into the Chinese market is important, because as far as Western brands go, it and McDonald's (NYSE:MCD) essentially are first movers in the vast majority of these cities. Being a first mover gives the company the opportunity to build significant brand loyalty with new customers.

Pizza Hut and coffee?
Against competitors like Domino's (NYSE:DPZ) and Papa John's (NASDAQ:PZZA), who also have operations in China, Novak called his company's Pizza Hut operation the "undisputed leader in the category." The Pizza Hut brand can be found in more than 60 Chinese cities, with more than 300 casual dining units in operation. It also has more than 40 home delivery services running in six cities.

The rate of growth from this brand is impressive, as it managed to increase the number of locations by 31% in the third quarter. But what was most intriguing was how the company is using this brand in versatile ways to get the most bang for the buck.

Most restaurants look for ways to maximize opportunities in the three major day-parts: breakfast, lunch, and dinner. Chinese custom, however, offers a fourth day-part: tea time. Since Pizza Hut already offers table service in its restaurants, management saw this as a natural opportunity to use its table service during tea time hours. "We are also leveraging our assets with the expansion of tea time, where our table service gives us a strong advantage versus Starbucks (NASDAQ:SBUX), as we serve coffee, tea, fruit drinks and afternoon snacks," commented Novak.

Yum! serves up Chinese food
Yum! is also trying to capture some of the traditional quick-serve market in China with its latest concept, East Dawning. There are only eight East Dawning restaurants in operation -- all of which are in the Shanghai market -- so it is too early to know if this newest brand will gain any significant traction among the Chinese population. Novak said of the concept, "We still have much to do both on the sales and margin fronts, but we are feeling more and more confident each day that East Dawning will be successful."

My gut tells me that East Dawning will face a major uphill battle trying to compete against deeply entrenched, traditional brands in China. But who knows? Perhaps its mix of traditional Chinese delicacies and American-style service will catch on. We need more time to properly gauge this one.

The opportunity is truly staggering
Yum! is facing some challenges in China, mostly in the form of historically high commodity costs. Pork supplies have been tight, which is leading to a run on chicken, pushing both meat prices significantly higher. There's no way to accurately determine when the current price spike will subside, but the reigning sentiment is that the present challenge is "short-term in nature."

Yum! will face any number of short-term challenges in the years ahead as it expands across China, but the long-term trend will remain firmly in its favor: growth. In the third quarter, the company's Chinese division contributed to more than 50% of Yum!'s overall operating growth in the third quarter.

Novak believes that Yum! will one day have more than 20,000 units operating in China. This represents more than eight times its current level of development, meaning a major opportunity for prospective investors. Yum!'s underlying stock has been on a tear since 2000, and by all indications, the company is still in the early stages of its international development opportunities.

If you haven't done so alreadfy, now is the time to take a closer look at Yum! Brands.

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Stocks Mentioned

Yum! Brands, Inc. Stock Quote
Yum! Brands, Inc.
YUM
$114.42 (1.86%) $2.09
McDonald's Corporation Stock Quote
McDonald's Corporation
MCD
$247.90 (1.77%) $4.32
Starbucks Corporation Stock Quote
Starbucks Corporation
SBUX
$78.11 (3.87%) $2.91
Papa John's International, Inc. Stock Quote
Papa John's International, Inc.
PZZA
$83.62 (0.01%) $0.01
Domino's Pizza, Inc. Stock Quote
Domino's Pizza, Inc.
DPZ
$396.54 (-0.40%) $-1.59

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