What You Need to Know About Yum Brands in China

Another set of earnings from Yum! Brands (NYSE: YUM  ) , and another setback for its plans to recover KFC sales growth in China. Yum! continues to struggle to recover from adverse publicity due to chicken quality supply issues in China. With the share price now flat on the year, is now the time to be picking up some shares? 

What's going wrong?

There were two main disappointments in the last quarter.  First, KFC's Chinese sales were lower than expected, and the new product launched at KFC in September (a beef burger) failed to generate sales in line with expectations.  Consequently, Yum! no longer expects positive same-store sales in the fourth quarter. Listening to the conference call, it's clear that management feels this is mainly a question of reestablishing credibility in China:

"our overall trust and reliability and safety measures are below what they were the previous year. And we think we really need to get those back at least level."

The question is whether the decline in same-store sales is totally due to the chicken quality/avian flu double whammy, or whether it is a function of hyper-competition in China, or even a macro issue. Indeed, Yum!'s major quick service restaurant (QSR) rival McDonalds (NYSE: MCD  ) has also seen declining same-store sales growth in its Asia-Pacific, Middle East and Africa (APMEA) markets.

source: company presentations

In fact, last quarter's comparable sales were negative in McDonald's big three APMEA markets of China (-6.1%), Australia and Japan. By way of comparison, KFC same-store sales declined 14% in China. Both companies blamed a bout of avian flu in China during the spring, but same-store sales growth has been declining since the end of 2011.  In other words, the trend was in place before KFC's chicken quality issues, and the avian flu issue.

The second disappointment was the $258 million impairment charge taken on Little Sheep (a hot pot restaurant chain acquired in China), and Yum! declared itself 'deeply disappointed' with the results achieved from Little Sheep so far. While the impairment charge is a non-cash item, the ongoing performance at Little Sheep is a concern.

What's going right

There are three good things going for Yum!. First, Yum!'s casual dining outlets are performing relatively better, and Yum! has growth opportunities thanks to innovation. Yum!'s overall US same-store sales were flat, but Taco Bell contributes 60% of US profits and its same-store sales were up 2%. In comparison, Pizza Hut's US number was down 1%. In a confirmation that the quick serve restaurant category is tough globally, KFC's US same-store sales were down 4%. For the immediate future, the good news is that Yum!'s efforts in the US will focus on advertising Wing Street (a chicken wing QSR co-located with Pizza Hut), and developing its breakfast menu at Taco Bell.

Incidentally, many of these trends in the US are confirmed by the National Restaurant Association Restaurant Performance Index (it declined for the third consecutive month to August), or in what QSR suppliers like spice and seasonings company McCormick (NYSE: MKC  ) are saying about the market. In particular, McCormick's QSR-based sales in the US are likely to remain weak, especially because the company is not particularly strong in the breakfast market.

The second positive point is that despite the double-digit decline in Yum!'s China division's same-store sales, restaurant margins only declined 1.9% in the quarter (and by less than 1.5% if you exclude Little Sheep). Hopefully, if and when sales growth turns positive again next year, these underlying productivity improvements should feed into substantial profit improvements for Yum! in China.

Positive indications from sales trends

The third positive indicator may appear esoteric, but bear with me! With regard to third quarter sales trends in China, Yum! said this on the conference call "No real meaningful variances across the city tiers by day part, or any other occasion. Pretty consistent, pretty balanced across the market."

Thinking laterally, different cities will have different levels of competition. Some variance in performance might be expected if the weakness was due to excess competitiveness. In other words, its probably a combination of macro and KFC-specific weakness.

Yum! also stated that the second quarter saw some disparity in performance by city; Shanghai was weaker thanks to its greater concentration of avian flu cases. However, this didn't feed through into the third quarter, which indicates that avian flu fears are receding.

What to do with Yum! Brands?

A bullish case sees a much brighter outlook in 2014. China's sales will turn positive, underlying margin improvements will lead to a massive increase in profitability, and US performance will remain solid on the back of innovation at Taco Bell and Pizza Hut.

On the other hand, the US QSR category remains weak, and so far Yum! has underestimated how long it will take to recover its reputation in China.

In conclusion, a piecemeal approach probably works best here. Investors can monitor three interesting inputs. First, you can look at McDonald's third quarter results (due on Oct. 21, 2013) in order to see if its Chinese sales are turning around. Second, keep an eye out for what McCormick is saying about the QSR environment. Third, Yum! has promised to provide the market with monthly updates on China same-store sales, with the next report due on Nov. 12, 2013.