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"The growth is over in China for Yum! (NYSE:YUM)." It's one of the favorite debates in the financial realm. The debate was sparked anew by Yum! Brands' recent 2012 year-end reporting and fourth-quarter year-over-year earnings per share (EPS) decline. Suspicion about the sourcing of chicken related to excessive levels of antibiotics led to inspections by the Shanghai FDA. Media attention was heavy and the full impact on KFC China sales will continue into the first quarter of 2013. The end result was no case filed or no fee assessed against Yum! Brands. Recommendations from Shanghai's FDA are being incorporated into Yum! Brands' practices and procedures. But, the damage is definitely done and Yum! Brands must now tackle recovery.

There is no question that Yum! Brands has a stronghold in China. The quick service and casual dining restaurant chain grew sales in China from $1 billion in 2003 to $4 billion in 2009 to over $8 billion in 2012. And, that growth did not come just from footprint expansion as the count of Yum! Brand restaurants quadrupled from around 1000 in 2004 to over 4000 in 2012. The sales growth included expansion of menu options, expansion of hours and expansion into casual dining.

But, why does the China story matter?

  1. China is a success story for Yum! Brands.

  2. China is a proven model for building a brand in a country.

  3. Hindsight is supposedly 20/20. If mistakes were made, it would be irresponsible for Yum! Brands and investors to not learn from them.

  4. China's population model more closely resembles India's.

  5. The growth of China's consumer class more closely resembles the projected growth of India's consumer class.

  6. The China story isn't over by any means.

China's infrastructure is viewed in tiers. There are four Tier 1 cities in China with populations of 10 to 20 million plus. Yum! Brands penetration in Tier 1 cities is modest and, yet, is also at its strongest. The consumer class is expected to double from 300 million currently to over 600 million by 2020. That means the majority of the populace is outside the Tier 1 cities. Less than half of Yum! Brands' units are located in the areas considered Tier 3 and beyond. So, in those tiers, Yum! Brands still has plenty of room to run. While China's GDP growth is 3 points off the high it saw in 2010 at 10.4%, it is still strong at 7.5% when compared globally.

The success in Yum! Brands is primarily based on its KFC brand with over 4000 units. Pizza Hut is on a rapid trajectory as well but on a lesser scale. Ten years ago, there were 65 Pizza Huts in Tier 1 and Tier 2 cities. Currently, there are over eight times more at 537 as well as an additional 203 in Tiers 3 and beyond. Of note, Pizza Hut casual dining and Pizza Hut Home Service are considered two different brands internationally. In the past three years, Pizza Hut has been the biggest success in China and returns in new units are tracking even stronger than KFC units.

Between Pizza Hut and Pizza Hut Home Service, Yum! Brands growth in China is accelerating. In 2012, Yum! Brands opened nearly 900 units in China between KFC, Pizza Hut and Pizza Hut Home Service. In February, 2012, Yum! Brands acquired Little Sheep, a casual-dining hot pot concept, inclusive of 450 restaurants. Future plans and development also include East Dawning, a quick service concept offering authentic Chinese food to Chinese consumers.

China and India aren't Yum! Brand's only opportunities. Yum! Brands has units in over 120 countries in the rest of the world. Economies are developing in the emerging markets of Russia, Africa, Central America and South America, incomes are rising and consumer classes are growing. As a reference point, in 2012, while over 800 units were developed in China, over 950 were developed in the remainder of the international market. In the 10 years since 2002, sales have doubled. Yet, the international market is hardly saturated. Internationally, for every one million people, there are just two Yum! Brands units as compared with domestically, in the United States, where there are 58. That's a particularly intriguing statistic considering 95% of the Earth's population lives outside the United States. Projections for 2013 have Yum! Brands opening another 950 more units. In Africa, Brazil and Russia, the surface hasn't even been scratched. Overall, for the next three years, international profits are expected to increase 30%.

Applying the growth model to India, Yum! Brands is facing its next frontier. By 2030, India is expected to have the largest consumer class. From the onset, Yum! Brands is adopting the concept "Anyone, Any Time," which eliminates the need to later expand into differing geographies and landscapes or the need to expand the menu to cover all times of the day.

In India, Yum! Brands is playing catch-up. Unlike in China, KFC is not the leading quick service restaurant. But, in three years, KFC has doubled in units to 240 and is growing at a faster pace than its competition. The goal is to double units again to 500 in the next three years.

The same is true of Pizza Hut Delivery; it finds itself in the number two spot. (Remember that Pizza Hut as a casual dining concept is a separate entity). Domino's (NYSE:DPZ) is the market leader with more than twice the number of units (508) as Pizza Hut Delivery. Domino's franchise in India, Jubilant Foodworks, is not resting on its laurels. It plans to grow at least 100 units a year until 500 more units are added. Rolled up to include KFC, Pizza Hut, Pizza Hut Delivery and Taco Bell, Yum! Brands is set to execute on plans to triple sales in India in the next three years from $350 million to over $1 billion.

The contest with Domino's won't be focused on just a number of units or just revenues and profits. The breadth of Yum! Brands' international presence cannot be ignored. At present, on an overall basis, Yum! Brands has nearly four times (20,000+) the number of international units as Domino's (5,000+). International annual revenues for Yum! Brands in 2012 are $10.2 billion of which $6.9 billion are from China. Domino's expected international revenues for 2012 are at least $193 million (based on year-to-date results in the third quarter and a fourth quarter assumption of exceeding the third quarter). It is not to be ignored that Domino's international division has posted 75 consecutive quarters of same store sales growth.

Domino's is focusing on winning customers with technology. Yes, Domino's has an app for that. It has embraced the reality that social media is influencing consumers on choosing where to eat. Consumers are embracing the convenience of using smartphones to place orders as well as to track the status. In just one year from 2011 to 2012, digital orders increased 27%. Financially, Domino's is looking for ways to capitalize on traditional advertising spend combined with digital options.

Once the customer is loyal, Domino's intends to customize its customer's experience. Learning about customers will allow Domino's to enhance transactions by recognizing not only the individual but the family unit and by offering helpful information such as ordering suggestions or convenient locations or promotions, all in a secure, safe manner.

In the next 10 years, the pizza market alone is expected to grow by $18 billion internationally. To be fair, Domino's menu includes pizza, pasta, chicken and sandwiches. So, a comparison strictly to Pizza Hut Delivery is actually not weighted fairly. No doubt, India is a key market especially considering it is expected to be home of the largest consumer class by 2030. But, if Yum! Brands Pizza Hut Delivery does not manage to overtake Domino's Jubilant Foodworks in the next three to five years, it still shouldn't warrant a notch in the loss column for Yum! Brands.

Yum! Brands is committed to delivering annual double-digit earnings per share growth. It pays a dividend of $1.34 annually and has grown the dividend an average of 17% the past three years. In fact, the dividend has been increased by double-digits for eight consecutive years. Share repurchases the past three years have averaged $1.1 billion. It has a proven record internationally for opening new units and delivering same store sales growth. Yum! Brands has a genuine knack for tweaking its menus to appeal to local markets. Its brand is strong and it is a world-class operation.

Yum! Brands doesn't have to win India. But, it certainly looks positioned to be a very worthy competitor.

Source: Does Yum Brands Have To Win India?

Additional disclosure: I belong to an investment club that owns shares in YUM.