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Yum Brand (YUM) has been recently cleared by Shanghai Municipal Food Safety Committee after being accused of getting dubious quality mutton from a wholesale food supplier. While it has been cleared in the mutton scandal, the negative publicity, as well as the threat coming from the deadly avian flu, has created problems for Yum in China. The company gets more than half (51%) of its annual revenues from the country where it commands a 39% market share in the $14 billion fast food industry. Yum has recorded impressive growth in emerging markets but now it is facing significant challenges in China.

Last year, China Central Television reported that Yum! Brands and McDonald's (MCD) may have sold chicken that were fed antibiotics and growth hormones. Liuhe Group Co. and Yingtai Food Group did not properly inspect the chicken they bought and supplied to their customers, including KFC and McDonald's. Both companies are now working with suppliers to ensure food safety. Yum stopped buying from Liuhe in August 2012, to tighten food safety and overturn the drop in business in its top market. The company has also issued an apology on its blog.

Earnings and growth

Earlier in April, Yum released its quarterly results in which its restaurant revenue fell 7.6% to $2.53 billion while its net income dropped by 26.4% to $337 million from the same quarter last year. Sales have been down mainly due to the food safety concerns and the fear of the bird flu outbreak in China. Although Chinese food authorities have not fined Yum the negative publicity has caused a slump in sales which has so far not recovered. On other hand its rival McDonald's saw its revenue rise 0.9% to $6.60 billion but its net income remained flat, with just 0.2% growth year over year to $1.27 billion.

In China Yum's system and same store sales fell by 8% and 20% respectively. Naturally, KFC faced the brunt of the avian flu impact as its sales in China fell 24% while Pizza Hut declined by 2%. Yum Restaurant International (YRI) division recorded an increase in system as well as same store sales. The division represents the company's operations in several relatively smaller markets, as opposed to China, India and the U.S. YRI's growth in terms of number of outlets in the emerging markets was 7% while in the developed world, it was just 1%. YRI opened 147 new units in 44 countries, 88% of this development occurred in emerging markets. As a result, YRI same store sales grew by 4% in emerging markets but dropped by 1% in the developed world. India showed strong growth in system sales of 16% but that came on the back of opening 26% more outlets. Same store sales in the country actually dropped by 3%. In the U.S., same store sales rose 1% of with Taco Bell's solid 6% growth offsetting a 1% contraction for both Pizza Hut and KFC.

Yum Sales and Outlet Growth

DIVISION

SYSTEM SALES GROWTH

SAME STORE SALES GROWTH

NEW UNIT GROWTH

CHINA

-9%

-20%

18%

YRI

4%

1%

7%

INDIA

16%

-3%

26%

On other hand McDonald's, which put up relatively better earnings numbers, recorded declines in same store sales in most of its regions -- the U.S, Europe and Asia/Pacific, Middle East & Africa fell 1.2%, 1.1% and 3.3% respectively.

Boost to margins

According to a recent WSJ report, fast food chains are looking to boost earnings through longer operating hours. Doing this minimizes fixed costs from rent hopefully lowering it as a percentage of total operating costs. The plan looks good on paper but it remains to be seen whether the three big operators in this industry, McDonalds, Yum and Dunkin Brands (DNKN), will be able to deliver.

About 45% of McDonald's outlets in the U.S. are now serving customers around the clock, an increase from 30% eight years ago. Dunkin' Donuts 24-hour restaurant count has doubled over the past decade and now accounts for a third of all American outlets. Yum's Taco Bell introduced its breakfast menu just last year, adding 1-3 hours to its operating window. Of the three, Yum gaining access to breakfast through Taco Bell has the best chance of materially affecting the top and bottom line. Drive through breakfast in the U.S. is a big revenue generator, much more so than serving drunks at 4a.m.

Real Issue

Yum's top management, including CEO David Novak, have been working hard to gain back the trust of the Chinese consumers reminding them that deep fried chicken "is perfectly safe" from bird flu. But food scares are a primal thing and not easily dismissed through marketing. A salmonella scare from the Clinton Administration still weighs on people and their eating raw eggs. These effects are going to be dramatic, which is evident by the 29% plunge in April sales year over year.

For the current year, the company is expecting a "mid-single-digit" fall in adjusted profits. However, I believe that the bigger problem in its Chinese operations right now is that the company has become too traditional. With local menus dominating its product offerings, Yum's flagship restaurant KFC, is not keeping pace with the Chinese consumers who want more sophisticated products.

In the coming quarters, due to struggling sales and intense competition from local as well as international rivals (such as McDonald's) Yum will have to focus its attention towards improving its food offerings for the Chinese consumers. Fortunately it has built an envious local supply chain that will allow it to respond to changing tastes. The business is currently focused on rebuilding its reputation and is also considering non-traditional food items into its Chinese menu.

What began as the great Chinese success story for how a U.S. multinational took over China has turned into a bit of a horror movie in the past year. Yum has its work cut out for it and trading at a multiple of 23 with just a 1.9% yield is asking a lot from value investors. If there is a weekly and monthly close above the recent highs near $74 per share then there may be a resumption of the uptrend, but for now Yum like it is range bound. A correction in the general market will likely take the stock back down near $60.

Source: Yum's China Scares Put Growth On Hold