Yum China Swings To Recovery But Long-Term Remains Cautionary

| About: Yum! Brands, (YUM)
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KFC China

According to the Goldpebble Consumer Product Monitor, YUM! (NYSE:YUM) has quietly increased prices by 0.5 to 2 RMB, depending on the item on the menu recently. We followed up with store visits in Beijing, Shanghai, Shandong, Chongqing and our findings have confirmed price hike of around 5% year-on-year. The price increase has been unannounced and rarely noticed. We suspect it is to avoid further friction with the government and local media.

We are also seeing new product offerings, including golden extra-crispy chicken, larger buckets of chicken wings and new openings of dessert corners to cross-sell to existing traffic within stores. KFC China has started to swap out its main product of 'finger lickin' good' fried chicken to golden extra-crispy chicken, to lower the cost. Golden crispy chicken is easier to make and spices are locally sourced.

As such, we now expect approximately 5% year-on-year SSSG (Same Store Sales Growth) for KFC China in December and into 2014, higher than the street consensus.

The long awaited recovery follows a catastrophic year of endemic food hygiene and safety concerns, starting from the 45-day chicken scare in Oct. 2012 and a CCTV expose on the issue in Dec. 2012. That was quickly followed by the bird flu outbreak and scandals over bacteria-ridden ice cubes, tissue paper with fluorescent agents, and barrels contaminated with whitening chemicals in the spring of 2013. I have provided detailed analysis of the events in my latest book Tiger Woman On Wall Street.

As a result, SSSG for KFC China slumped to -20% in Q1 and Q2 2013 and -10% in Q3 2013. It further narrowed to 0% growth in November. YUM China management appears to be under increasing amount of pressure to re-deliver growth before Q2, a seasonally weak quarter.

Pizza Hut

Both Pizza Hut brands (Pizza Hut Casual Dining, Pizza Hut Home Service, Pizza Hut Express) continue to grow at approximately 10%. Pizza Hut brands combined represent just under 10% of YUM China's total revenue. However, they are an important growth driver in China. In 2013, among approximately 400 new stores openings, half are Pizza Hut stores.

In China, Pizza Hut offers a premium dining experience, with localized flavors and alcohol offerings, and the chain is popular among young Chinese as a venue for dates and parties.

Long-Term Trends Still Cautionary

Nevertheless, we continue to believe that the KFC brand has passed the peak cycle of growth in China especially in the populated big cities. In addition, the strengthening of food safety practices by the local and central governments implies that supermarkets and established chain restaurants will be frequent targets of rigorous inspections if problems are found. Relative to the local businesses, multinational operators are more likely to be targeted of the heightened crackdown.

According to Goldpebble's broad Consumer Pricing Monitor, the food price inflation in China is likely to be higher than the reported CPI (Consumer Price Index) of 2.5%. YUM China's profit margins are unlikely to rebound back to the 20% level in 2012.

Research is contributed by Yifeng Mao, the Head of Research at Goldpebble Research based in Singapore. Opinions expressed are our own.

Disclaimer: We currently do not have a position in YUM.

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. I have no business relationship with any company whose stock is mentioned in this article.