Analysts weigh China survival strategies for Yum, McDonald's

Ahead of meetings with management in Shanghai this week, securities analysts noted that the two biggest Western brands in China, Yum! Brands Inc. and McDonald’s Corp., cannot simply count on China’s slowly accelerating economic growth and the dissipation of food supply concerns to improve their same-store sales meaningfully in the country.

Louisville, Ky.-based Yum hosted investors Sept. 9–10 in Shanghai to discuss its nearly 6,000-unit system in China, while Oak Brook, Ill.-based McDonald’s was scheduled to lead meetings there Sept. 11.

In the case of both brands, same-store sales in the country have faltered since late last year, when televised reports of widespread antibiotic use in chickens raised there prompted food safety concerns. China’s economic growth also has slowed from its post-recession highs of 2010, pressuring consumer spending there and weighing on restaurant sales.

One securities analyst for Deutsche Bank noted in a preview of this week’s investor meetings that, while those challenges are getting better for Western brands operating in China, Yum and McDonald’s would not necessarily benefit from better macroeconomic trends there if they did not focus on unit-level profitability and devise a strategy for growing beyond China’s largest markets.

“Overall, we are not looking at the improving economy as the driving force for Yum’s and McDonald’s operations, but rather as a barometer for the direction of the China economic landscape,” analyst Jason West wrote in a “Shanghai Survival Guide” research note recently. “Should the positive trend for GDP growth continue, it is possible that company-specific same-store sales might follow suit. We would need to see evidence of the improved macroeconomic factors, coupled with strong and consistent recovery of Yum’s and McDonald’s same-store sales, materialize before we get excited about near-term prospects in China.”

Bigger than bird problems

Earlier this week, Yum reported that same-store sales in China decreased 10 percent in August and 11 percent in the third quarter, citing lingering effects of bad publicity generated by the December 2012 state television report questioning the safety of poultry raised in China. New fears of avian flu also emerged this past March and April in China, further damaging sales at KFC.

While West did not discount Yum’s anomalous difficulties in China this year, he noted that same-store sales in the country had been decelerating even before these crises began. Yum’s comparable sales in China had slowed from a 21-percent gain in the fourth quarter of 2011 to a 6-percent increase in the third quarter of 2012, the period before the chicken supply controversy.

Additionally, West wrote, McDonald’s same-store sales in China were increasingly negative the past three quarters even though the brand’s more diverse menu insulated it somewhat from the poultry issues that caused KFC’s sales to crater in China.

“We believe this suggests the broader macro slowdown in that market is impacting consumer spending at restaurants, similar to what was seen in late 2008 and early 2009,” West wrote. “During that cycle, Yum’s and McDonald’s same-store sales were sluggish for about five quarters before rebounding strongly in 2010 on the back of massive government stimulus and a global economic recovery.”

However, he added, while China’s economy is showing early signs of stabilizing, Deutsche Bank’s economists are forecasting a softer recovery after this downturn. They project gross domestic product growth in 2014 and the second half of 2013 to range from 7.8 percent to 8.5 percent, compared with China’s 10-percent rebound in GDP in 2010.

Focusing on margins

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In a review of the unit-level economics for KFC and Pizza Hut Casual Dining in China, West noted that average unit volumes for both brands had been increasing in new and existing markets, but cash margins had been declining. On average, Yum spent about $560,000 per KFC unit opening in 2012 and about $570,000 per Pizza Hut opening. Both brands generated an average unit volume between $1.4 million and $1.5 million.

While those annualized sales were better than the average unit volumes around $1.2 million in 2011, restaurant-level margins did not keep pace. According to Deutsche Bank, KFC China’s cash margins fell to a range of 20 percent to 22 percent in 2012, decreasing from 25 percent and 27 percent in 2011 and 2010, respectively. Pizza Hut’s margins went to a range between 23 percent and 26 percent in 2012, compared with 25 percent in 2011 and 23 percent in 2010.

For 2013, Yum has guided investors toward “mid-teens” cash margins because of difficulties stemming from the avian-flu outbreak and the poultry supply controversy.

Among the nuances of Yum’s results in China, West added, was that new units opened in smaller markets were producing cash margins that were 3 percent to 6 percent better than locations opened in Tier 1 or Tier 2 coastal cities like Shangai and Beijing. The investment costs and average unit volumes are identical in small and large markets, but rents and labor costs are much higher in China’s major cities.

“Not surprisingly, Yum is shifting more of its growth to these smaller markets,” West wrote. “Pizza Hut Casual Dining new-unit returns have also improved relative to KFC in recent years, leading Yum to ramp up growth at that concept. Overall, given that KFC continues to generate the lion’s share, or about 80 percent, of Yum China profits, we would like to better understand the dynamics of the slowing new-unit returns at that brand.”

In a research note filed after the first day of meetings with Yum in China, David Tarantino of Robert W. Baird & Co. said KFC China’s long-term efforts to grow margins via new value platforms, breakfast, 24-hour service and delivery “appear largely intact.”

He added that the outlook for Pizza Hut was more bullish, as “ongoing tactics of strengthening menu variety, including the expansion of breakfast, and affordability appear to be working for the dine-in business.”

West of Deutsche Bank wrote that McDonald’s does not release details about its unit-level profitability in China, but the investment firm estimates average unit volumes there to be about $1.3 million, with investment costs between $600,000 and $800,000 and margins “in the mid-teens.”

McDonald’s is forecasting 300 unit openings in China in 2013, which would ensure it achieves its projected goal of 2,000 units in China by the end of the year.

Yum operates or franchises more than 39,000 restaurants worldwide, and McDonald’s has more than 34,500 locations around the world.

Contact Mark Brandau at [email protected].
Follow him on Twitter: @Mark_from_NRN