Yum! Brands Inc. (NYSE:YUM) generates its revenues by licensing Taco Bell, KFC, and Pizza Hut restaurants around the globe. Since the company generates more than half of its revenues from China we are going to see the future outlook in the Chinese market and how it impacts the future profitability of the company. The following discussion will also incorporate the impact on the top and bottom lines of the company as a result of its effort to expand its operations into the emerging markets.
The geographical distribution of the company's revenues indicates that Yum generates about 52% of its revenues from its Chinese division with the remaining 48% distributed between the international (YRI), US and Indian division. The Indian division encompasses India, Bangladesh, Mauritius, Nepal and Sri Lanka. The graph detailing the geographic distribution of the total revenues of the company is shown below:
Source: Third Quarter Report, 2013
Challenges Faced in China
China is a major contributor to the company's revenues. However, demand for Western fast food is declining in China as consumers are becoming increasingly health conscious. This led to the declining profit margins of the restaurant industry in China through 2013. To add to the declining demand problem, fast food chains like KFC and Pizza Hut have earned the notoriety of supplying unsafe foods. According to the Sina Weibo poll conducted last year through a blogging website followed by about 400 million Chinese people, 85% responders marked chicken sandwiches made by KFC and McDonald's as unsafe. Seventy-five percent of responders to the poll indicated that they would refrain from eating fast food due to the same reason. The avian flu scare and the concerns regarding the company's unhealthy poultry suppliers further jolted the profit margins of the company.
The improving financial situation of Chinese consumers is causing a change in their perception about Western fast foods. Previously, eating out in a Western restaurant used to be a status symbol for a typical Chinese consumer but that changed as the personal income for Chinese consumers began increasing.
Competition in the Chinese region is also increasing with McDonald's (NYSE:MCD) promising to open one restaurant everyday up until 2015. Yum plans to grow its restaurant count in the Chinese region to fight the rising competition. Of its 36,846 stores spread around the globe the company presently operates 5,726 stores in China.. Of its projected 1,850 new store openings internationally the company plans to open another 700 stores in China to combat McDonald's expansion plans.
To fight its food quality issues the company is heavily marketing its ability to meet high quality standards. Yum's ability to meet the minimum quality standards of the country was also verified by the Department of Agriculture in North China. However, the company is still struggling to change consumer's perceptions about the quality of its food and it seems unlikely that it will change any time soon.
To capitalize the growing demand in the emerging markets the company plans to open 150 new stores in India. The Indian fast food market is growing rapidly and is expected to double over three years with an average growth rate of 17% per year up until 2016. Indian consumers are gradually turning to fast foods as an alternative food choice. Statistics regarding middle income consumers indicate that spending per household is expected to grow at a CAGR of 65% over the next three years and the growth rate is expected to be even higher in smaller cities compared to big cities. Penetrating the market at an early stage will definitely have a positive impact on the revenues and profit margins of the company.
The company suffered declining margins in 2013 mainly because of the issues it had to face in the Chinese region. Since China is a major contributor to the revenue base of the company Yum's profit margins declined by double digits over the past three quarters of 2013. The company regained composure in the Chinese market towards the end of 2013 indicated by a 1% same store sales growth during the month of November and a 2% increase in December. However, it seems unlikely that the company will be able to bring its profitability to the same level as before in the face of increasing competition and declining demand for Western food in China.
Looking at the emerging markets the company is penetrating the Indian market to capitalize on its double digit growth in the upcoming years. The restaurant industry in India is in a high growth phase so I believe that Yum needs to shift its focus from China to India if it wants to recover its profitability. However, the company is still heavily investing in China as indicated by the number of new stores it plans to open in that region. In my opinion, the company should invest that amount in India instead.
The future outlook of the company appears positive in the long term since the company is now expanding to high growth emerging markets. Therefore, the company's profit margin will show a positive trend through to 2016. Moreover, the company has fought aggressively in the face of the challenges in China and is beginning to redeem its lost profits as determined by the rising same store sales during the last two months of 2013. As a result, Yum is going to perform positively in the stock market in the future and this makes it a good candidate for long-term investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.