Chinese Costs Forcing Yum's Q4 Margin Drop

Oct. 7.10 | About: Yum! Brands, (YUM)

Like it or hate it, but you cannot ignore China in almost all sectors of international business and trade. For its sheer size of its vast population, China continues to be the prime mover of a lot of segments. Even as China offers a good incentive for investors and organizations to tap the Asian markets, there are a lot of headwinds associated with China, which have been on the rise in the recent past. Testimony to the fact is the growth of Yum Brands Inc. (NYSE:YUM), the owner of KFC, Pizza Hut and Taco Bell. It is expecting another year of at least 10% earnings growth, but is facing a severe headache from higher commodity costs that could seriously dent profit margins in China, which is Yum's primary growth market contributing almost one-third of the company's profits.

Although the preliminary guidance for fiscal 2011 earnings growth puts Yum's 2011 guidance at a baseline of $2.73 a share, after the company on Tuesday raised guidance for the current year to $2.48 a share, Yum expects $15 million of higher labor costs in the fourth quarter in China and $40 million for the full year. Yum has seen year-to-date China commodity deflation of $35 million but is now expecting a commodity inflation of about $15 million in the fourth quarter.

The rising stiff competition from other quick-service restaurant operators, cost escalation as well as wage inflation in China, and macroeconomic factors influencing consumer spending patterns have emerged as the most immediate concerns for Yum in its Chinese business. Yum is now trying to offset some of the higher costs by raising prices, a prospect that may be more palatable to Chinese consumers with higher wages but that would mean ignoring the majority of China's vast population base that have been contributing to almost one-third of the company's profits.

Yum reported a 6.9% increase in third-quarter earnings, helped by positive same-store sales in each of its three operating divisions. Facing pressure on the cost side, Yum has said that profit growth this year will increasingly come from better sales, a tough prospect in a shaky economic recovery.

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