Yum: Slowed 2Q growth in China won't hinder expansion

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Officials for Yum! Brands Inc. acknowledged during its second-quarter earnings call with securities analysts that slower growth in China and lapping dramatic growth in that division from a year earlier would pressure results, but they cited the company’s investments there and around the world for Yum’s long-term optimism.

“There’s no question that China’s economy is slowing and that sales for retailers like us will soften, especially as we overlap strong performance from last year,” chief executive David Novak said during the call. “But we expect to build a record number of new units [in 2012], so we feel good about our development driving substantial growth over the long term.”

The parent to the Taco Bell, KFC and Pizza Hut brands plans to open around 700 new restaurants in China during the year with an eye on future sales recovery. And while Yum lays the groundwork for those restaurants, the company will also expand at a more rapid pace in emerging markets and look to shore up stabilizing sales in the United States, Novak said.

Yum’s net income grew 5 percent for the June 16-ended quarter, a rare occasion in which China’s operating profit fell slightly and the resurgent U.S. division led the way with a 26-percent increase in operating profit.

Preparing to bounce back in China

In an uncharacteristic miss for its most profitable division, Yum’s China unit experienced a 4.1-percent decrease in restaurant margins in the second quarter, leading to a 4-percent decline in operating profit.

Yum president Rick Carucci acknowledged that commodity volatility, labor cost inflation and economic uncertainty in China contributed to the profit fall, even as same-store sales grew 10 percent. But he added that Yum probably had some “teething pains” and experienced some inefficiencies because it decided to increase new-unit development in China this year.

However, he and fellow Yum officials think the investments the company is making to accelerate unit growth would bear fruit in the second half of 2012 and set up Yum to sustain restaurant margins of 20 percent over the long haul.

Novak added that virtually all KFCs in China serve breakfast, and the brand is “still in the early innings” of initiatives to expand delivery and 24-hour service.

“The good news is we’re making the investment to grow these strategic sales layers,” chief financial officer Patrick Grismer said. “Yes, there’s an upfront investment slightly dilutive to margins, but we’re creating a platform for future growth. When you ramp up new-unit development to something north of 700 restaurants a year, you have to invest in people capability.”

Carucci noted that competition from local Chinese chains as well as Western brands like McDonald’s has “definitely” intensified in China’s coastal “Tier 1” cities. But Yum is building upon its first-mover advantage in smaller, lower-tier cities, he said, meaning it should be harder for rivals to expand to those areas, where operating costs and profit margins are more favorable compared with Shanghai and other major cities.

“The Tier 1 cities are growing at a slower rate because exports appear to be slowing in those coastal cities,” Carucci said. “So we feel fortunate to be doing very well in Tier 3 through Tier 6 cities, and we’re achieving higher same-store sales in those areas.”

Grismer added that Yum’s unit development in China had skewed toward these lower-tier cities over the past few years and noted that the trend would continue. The company is accelerating investment in unit growth there to take advantage of China’s increased spending on infrastructure across its interior regions, as well as Pizza Hut’s improved performance in smaller towns, Grismer said.

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Yum officials also noted that the company completed the phased rollout of a pricing increase in China, with menu prices now running about 7 percent higher than a year earlier. The company implemented an increase of between 3 percent and 4 percent in the first half of 2012, following hikes of approximately 2 percent in September and November of 2011.

The increases have not negatively affected traffic so far, according to officials. “The last thing a customer is going to see in China is sticker shock,” Novak said. “The primary objective is being affordable, and that continues to be the case. … We’re making each brand stronger this year.”

Optimistic in the U.S.

Novak also made the case that Yum’s three chains were getting stronger in the United States — particularly Taco Bell, whose 13-percent same-store sales increase in the second quarter resulted largely from the March launch of Doritos Locos Tacos.

But Novak added that Yum is “extremely optimistic about the future” with other initiatives at Taco Bell, including the Cantina Bell platform that launched nationally this month. The chain’s First Meal breakfast platform is on pace to roll out systemwide by 2014.

“I met with Taco Bell’s franchisees weeks ago, and they’re enthusiastic about where we’re headed and committed to growing this great brand,” he said.

Novak added that Pizza Hut’s menu strategy continues to resonate with consumers and that business is stabilizing at KFC.

Plans to refranchise its brands in the United States continues apace for Yum, officials said, with KFC and Pizza Hut essentially finished with reducing corporate ownership to 5 percent for each. Taco Bell currently is 22-percent company-owned but looks to refranchise itself down to about 16-percent corporate ownership over the next few years.

Room for growth abroad

Not to be outdone by China, Yum Restaurants International, or YRI, also will add a record number of new restaurants in 2012. Including the 100 openings planned for the India division and 900 YRI openings planned for this year, the milestone of 1,000 new restaurants outside the United States and China would be the most Yum has ever opened in a year.

Novak noted that Russia would be a particularly strong growth market, as the country’s same-store sales grew 32 percent in the second quarter. The company expects to be open in 20 countries in Africa, another potential blockbuster market, by the end of the year.

Though McDonald’s has first-mover advantages and large advertising clout in Western European markets like France and Germany, Yum is still optimistic for its chances in those countries, Novak said, because those restaurants have some of the highest average unit volumes in the world for Yum, even on a smaller unit count and with little to no TV advertising.

The executives said 60 percent of new-unit development in YRI would occur in emerging markets, which are expected to drive the bulk of future same-store sales increases. Novak expects leaders from up-and-coming markets like Russia, Africa and especially India to benefit from the example of China.

“The China model is clearly a winner,” Novak said, “and we want to spread it across to all our emerging markets.”

Louisville, Ky.-based Yum operates or franchises nearly 38,000 restaurants in 120 countries.

Contact Mark Brandau at mark.brandau@penton.com.
Follow him on Twitter: @Mark_from_NRN