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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