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.

Yum! Brands' Challenges Are Bigger Than You Think

It’s been a frustrating year for Yum! Brands’ (NYSE: YUM) investors, as the fast-food giant has faced some significant challenges in China. The country is at the forefront of Yum!'s efforts to shift toward becoming the emerging-market fast food company du jour. Will the company's problems prove temporary, or are there underlying macro-economic reasons for the weakness in the Chinese fast food sector?

Finger-licking buying opportunity?

The investment thesis behind buying Yum! is that its difficulties in China will be swiftly resolved, and the company’s sales and margins will come back strongly in the second half of the year.  If you buy this argument then you must look into the causes of its problems.

Yum!'s issues in China started with a scare over the quality of its chicken supply, and then moved on to consumers being reluctant to eat poultry due to an outbreak of avian flu. The positive case sees these problems as being short term in nature, and the current valuation as being attractive relative to its long term prospects.

A quick look at its trailing P/E ratio:

YUM PE Ratio TTM data by YCharts. 

Superficially, the above suggests the stock is currently expensive. In addition, if you assume it hits its estimate of “mid-single-digit percentage decline” for 2013, then the stock is priced at roughly 23 times forward earnings as I write.

However,  Yum! forecasts its Chinese sales growth to turn positive in the fourth quarter, with 2014 turning into a year of stellar growth because comparables will be a lot easier. If Yum! hits analysts’ estimates of $3.79 in EPS for 2014, then the stock would be trading on a forward valuation of 18.8x earnings.  This makes it look historically cheap, so should you pile in?

KFC disappoints in China 

In its latest results, Yum! reported that its same-store sales for KFC in China were down 20% for the second quarter in a row. However, in its recent conference call, Yum!’s management outlined – in no uncertain terms – that its EPS forecasts were dependent on Chinese sales coming back swiftly for its KFC operations. It also served up a few indicators as to why it feels confident:

• KFC same-store sales in China were down 13% in June, compared to 26% for the second quarter, indicating that the worst may be over.

• KFC made low-teens sequential improvements in same-store sales in China from April to May, and then May to June.

• Yum!’s second major restaurant chain, Pizza Hut, recorded 7% same-store sales growth in China for the quarter, suggesting that KFC’s problems are company-specific, not due to a weakening Chinese consumer market.

• Overall emerging-market-same store sales grew 5% in the quarter 

In order to demonstrate the importance of China to Yum!, here is a chart comparing its quarterly operating profit and the percentage of Yum!'s total operating profit that comes from the country:

Source: Yum! Brands financial statements.

In summary, all of these points suggest that Yum! can turn around performance in its key profit center. But what is the rest of its industry saying?

A twist in the tale

Unfortunately, Yum! isn’t alone in seeing weaker results in China. In fact, its biggest rival, McDonald’s (NYSE: MCD), also started to see its same-store sales growth slowing at the end of 2011. The main difference appears to be that Yum!’s performance notably deteriorated after the chicken supply scare had its effect. However, the downtrend was already in place by then, and it should be noted that McDonald’s Asia-Pacific Middle East Africa (APMEA) sales haven’t been strong this year, either. All the data in the chart is sourced from company accounts.

It’s all very well for Pizza Hut to be generating growth in China, but KFC makes up more than  74% of Yum!’s restaurants in the country.

Moreover, Burger King (NYSE: BKW) also reported some disappointing numbers in its first-quarter results to the end of March. For example, its global comparable same store sales growth fell 1.4%. In addition, its results in Asia-Pacific (APAC) weren’t much better with a paltry 2.7% systemwide comparable sales growth recorded in the region. Furthermore, Burger King argued that the rise in APAC was due to positive performances in Korea and Australia, thanks to a combination of value promotions and programs.

In summary, neither Burger King nor McDonald’s are reporting anything particularly positive on the global sales environment, let alone for the Far East.

The bottom line

Yum!’s peers are seeing difficult conditions in China, so this looks like it is more than a company-specific issue. Yum! is a compelling proposition, but cautious investors will want to take a pass. The company probably will engineer a recovery in China, but it may not be of the magnitude needed to take the stock materially higher.

McCormick's Evaluation is Looking a bit Rich

There is a lot to like about the long-term prospects for spice and seasoning company McCormick (NYSE: MKC)Consumers are demanding ever more flavor in their cooking, and food companies are being forced to innovate by using flavorings in order to compete in difficult end markets. With these positive trends in place, the company is doing well. But what of its near-term prospects? Moreover, is the stock good value right now?

McCormick delivers mixed results

It was an underwhelming set of second-quarter (Q2) results for McCormick, as reported sales rose a paltry 2%. Its top line growth has been slowing in recent quarters as it laps some difficult comparables. In addition, Yum! Brands (NYSE: YUM), is one of its major clients and it's having some well documented difficulties in China with its KFC stores. First it was a scare over its chicken suppliers, and now it has to deal with fears over bird flu. The issue is hurting Yum!, and McCormick's industrial sales are being hit because it supplies spices and seasonings to KFC.

I’ve broken out the progression of McCormick's divisional sales growth below.

The problems in the industrial division aren’t just about quick-service restaurants in China, because McCormick's industrial sales in the Americas declined 1%. McCormick cited strength in its snack seasonings and food flavorings, but it wasn’t enough to offset declines in demand from quick service restaurants in the Americas. The eating out category has faced some weaker growth and, the areas that are growing within it are not favoring McCormick.

All of which is not to be too negative on the stock because it’s the consumer side that makes the majority of profits. And it is still doing quite well.

A breakout of Q2 operating income here.

Consumer segment sales grew 5% in constant currency. Within developed markets, McCormick is benefiting from a increased willingness among consumers to eat at home and, to utilize more flavors in their cooking. The latter trend is also being driven by an increasingly ethnically diverse population in many developed countries.

Within emerging markets, McCormick is seeing good results via a mix of organic and acquisition-led growth. For example, in India its acquisition of spice company Kohinoor is giving McCormick long-term opportunities in an important growth market. India makes up less that 5% of sales, so there is plenty of scale for this figure to increase in future years. Similarly, the WAPC acquisition in China is believed to bring its Chinese sales up to 7% of the company total.

Two concerns

The first relates to the disappointing performance within China and the Americas on the industrial side. The hope with Yum! is that it will be able to recover from its company specific issues but I think there might be some macro factors at play here too. Yum! Brands' same-store sales in China were getting weaker even before the media scare stories and bird flu worries hit.

It was a similar story with McDonald’s (NYSE: MCD).

The outlook for the quick service restaurant sector is important to McCormick, since much of its industrial demand goes to this industry. The signs are that it is not just a Yum! issue. McDonalds’s could be facing a tough year this year, and Yum! investors need to take note.

McDonald’s management was very clear on its last earnings call that it intends to retain and even grow market share. This as a sign that it will be willing to sacrifice margins and cash flow in order to secure long term positioning. McDonald's and Yum! are likely to increase competitive efforts in North America in order to try and make up weakness elsewhere. McCormick investors will be hoping that Yum! wins out.

The second concern is that even though the consumer division is doing well, its growth is still slowing. The company announced it was increasing incremental marketing on its consumer brands to $15 million but, it did not raise revenue expectations. The weakness on the industrial side is increasing the pressure on the consumer side.Is this marketing increase a sign that it is having to work harder to hit its numbers?

The bottom line

I don’t want to appear too negative here, because this company has plenty of good long-term drivers, and its acquisition strategy makes perfect sense. However, if you are going to add this stock to your portfolio, you will need to assess it on a risk/reward basis. This is a stock that trades at 22 times its November 2013 earnings, which looks pricey when compared to International Flavors & Fragrances' forward PE of nearly 18, and German rival Symrise at 20 estimated 2013 earnings.

McCormick is hardly cheap, and its underlying growth is slowing while its end-market customers (on the industrial side) are facing some difficult market conditions. This stock is worth monitoring for a long-term buy, but an entry point might only come should it miss estimates this year.

McDonald's Facing Challenges

The market gets what the market wants and, for the first quarter of 2013, the market has wanted relatively (as compared to treasuries) high yield ‘defensives.’ I use inverted commas because when looking at a stock like McDonald’s (NYSE: MCD) I’m not convinced it is as attractive as the market thinks it is. Furthermore, if you buy a stock because it is fashionable then you better be prepared for any disappointment should fashion change.

McDonald’s Disappoints

It’s been a tough year for the fast food sector, and McDonald’s delivered another quarter of disappointing same store sales growth. Moreover, it described the informal eating out industry as being flat or declining in many parts of the world. So where did it all go wrong? Wasn’t this supposed to be the great defensive stock that proved itself so well in the last recession?

My take on this is that the 2008-09 recession certainly resulted in a significant amount of global unemployment and income insecurity, which fed through into consumers trading down and adjusting their behavior by dining out in cheaper outlets. Such conditions played perfectly into the hands of companies like McDonald’s and Yum! Brands (NYSE: YUM). In addition they had growth opportunities in expansion into China.

Fast forward into 2012 and the trading down has run its course and suddenly comparables are getting a lot harder. The easy growth has gone and the challenges are building. Sales growth from China is slowing, and McDonald’s is having problems adjusting its menu to deal with the slowdown in Europe. I discussed some of these issues at the start of the year.

 A look at its global comparable sales growth for the last few years.

Spot the slowdown?

Market Share Gains

While recognizing that the US market is tough, McDonald’s spent a lot of time trying to convince investors that it was gaining market share in the US. The idea is that the key to its long term growth would be the retention of market share and not necessarily margin or cash flow growth. It’s hard not to think that this is going to have an effect on Yum and Burger King (NYSE: BKW) in the US.

But this isn’t just about the US. The optics in China are becoming cloudy thanks to a combination of the chicken supply problem at Yum’s subsidiary, KFC, and a later outbreak of Avian flu. All of which has caused issues for the rest of the fast food outlets in China. While this is causing some to believe that there is an inbuilt opportunity to bounce back in the second half of 2013, I’m not so sure. If you look at the chart above, McDonald’s APMEA growth was slowing well before these issues kicked in. Indeed, it was a similar story with Yum, so this isn’t just a story of some temporary weakness.

So even while China’s performance is uncertain, there is no let up in investment with McDonald’s planning to open hundreds of restaurants in China in 2013. Similarly Burger King wants to open 1,000 stores in China within the next seven years, and the country is the focal point of Yum’s growth plans. Obviously these companies wont adjust their long term strategic plans based on some temporary weakness, but might it prove a longer term issue?

As for Europe, despite previous efforts to take action in France and Germany conditions remain weak in Europe, and macro challenges in Southern Europe mean that growth will be hard to come by. Only the UK and Russia are performing in a manner that McDonald’s can be happy with.

Where Next for McDonald’s?

I think this is going to be a tough year for the company. Commodity costs are only forecast to go up 1.5-2.5%, but the real driver of earnings growth will be sales growth. Given that the stated strategy is to preserve or gain market share, it is hard to see any significant margin expansion this year. There is a lot of uncertainty with China, Europe remains in difficulty, and the US is becoming increasingly competitive. In conclusion it is hard to make the case that McDonald’s is the kind of defensive play that investors should be chasing, and if the market loses its fixation with yield then it might not be so well supported.

Is McDonalds a Low Price Offering?

McDonald's But Not as You Know it!

McDonald’s $MCD is a fantastic business that is firing on all cylinders. The recent results sailed ahead of estimates and the company is clearly grabbing market share from Yum Brands $YUM and other competition. However, is all of this fully priced in?

As a potential investment McDonald’s has a strong appeal due to a number of factors which I’ve listed below

• From a macro-economic perspective it offers a play on austerity in developed markets as unemployment remains high and McDonalds offers a value meal proposition
• Within Emerging Markets, McDonald’s has a ‘Western aspiration’ brand that benefits from rising disposable incomes and urbanization
• McDonald’s has successful repositioned itself away from fast food junkies and leveraged its brand into launching newer healthier alternatives
• Customers are-thus far-tolerating price increases but price pressures are increasing

Around a decade ago, McDonald’s made a master stroke in taking a strategic stake in Prêt-A-Manger (in order to ‘learn’ how to service a different market) which has partly been behind the successful re-branding. Back then, it would almost have appeared inconceivable that McDonalds would be discussing the kind of product offerings and innovations that peppered the recent conference call. For example, beverage sales were up 29% and McCafe has seen far better than expected growth in sales per store. Premium chicken sandwiches, smoothies, oatmeal breakfasts and wraps are now alongside the traditional burgers, fries and milkshakes in the product mix.

Not only has McDonald’s successfully rebranding but they have managed to diversify and tailor the product offering to differing regions. Delving deeper into the Q2 numbers for regional sales reveals how this plays out

Region	Q2 Comp Sales Increase	Q2 Op Inc Increase
Global	5.6%	11%
Europe	5.2 %	10%
USA	4.5%	6%
APMEA	5.9%	19%

Clearly, the US is the laggard in terms of both metrics, however, it is the most developed region for the company and it has been grabbing market share from Yum as its rival focuses on Emerging Market growth. Moreover, Europe is actually the biggest market for the company and these results represent strong execution.

Commodity Costs Coming

On a less positive side, commodity costs are on the increase and although customers absorbed them well, margins fell in all three regions for McDonald’s. This is an obvious concern-not least for the demographics of a typical customer- but also for future margin expansion. No one likes to be a business with challenged margins. However, I think that with slower growth, going forward, within emerging markets, we could see a moderation in things like beef prices, which could help out McDonald’s margins.

In this report, the company saw cost increases of around 4-5% generally but that figure could come down going into next year. In addition, I think that the value proposition of McDonald’s means that demand should still grow even if the Asian economies start to slow.

International expansion

Turning to expansion plans for this year, here is a break down of where new store openings will be

Region	New Restaurants for 2011
Global	1115
Europe	225
USA	150
APMEA	650
Latin America	90

APMEA is how the company bundles Asia Pacific with the Middle East. Within the APMEA numbers, new stores for China are 200 and 100 and 30 for Japan and South Korea respectively. It is a misnomer to suggest that only Yum are expanding in emerging markets!

McDonald’s Stock Evaluation

Frankly, I think it is fairly priced and would struggle to see much upside from here. I know most commentators are saying this, but that doesn’t mean I should force myself into thinking something different for the sake of novelty!  The opportunity for margin expansion does exist via lower food prices and the growth strategy looks assured but at a current price of $88.56 the stock trades on 17.3x forward estimates. This drops to 15.8x for 2012 but should investors pay this evaluation for two years out earnings, given that earnings growth ($5.6 from $5.12) is likely to be less than double digits?

I think the answer has to be negative. The yield at 2.9% is decent and it’s a decent stock to tuck away long term, but this evaluation doesn’t look cheap enough to me. I will monitor and hope for a dip.