SUN RISING IN THE EAST FOR YUM

"Hide your brightness; bide your time"

-Deng Xiaoping

 

On the second day of my trip to Shanghai, I turned to a person sitting next to me and remarked that one can easily lose sight of the fact that China is a communist country.  At that point, I was told about Richard McGregor’s book, The Party: the Secret World of China’s Communist Rulers.  As Richard McGregor says in his book, China’s economy is one that appears on the surface to be a “uniquely unbridled form of capitalism.”  Travel in China with two global restaurant companies and that comment becomes very clear.

 

There are few companies better positioned than YUM to capture the “unbridled form of capitalism” which is growing rapidly alongside the megatrend of the urbanization of China.  This is not new, but it’s also not going to slow down any time soon.  Driving away from China’s east coast, as I did last week, presents the chance to witness firsthand the phenomenon of urbanization in the country.  YUM and MCD are pointing to the significant number of retail spaces and transportation centers that are going to be built to accommodate the concentrated consumer demand that will partly define this trend. 

 

The “megatrend of urbanization” is a critical aspect of the China story for YUM.  YUM’s operations are accordingly focused on the opportunity; the company has roughly 700 people on the development team focused on, among other things, any possible changes that “The Party” may make as they continue to spend on new infrastructure projects.  For the time being, 35% of KFC and 25% of Pizza Hut new unit development is coming from the central and west provinces which represents about 50% of the population.

 

Suffice to say, my first “YUM China” experience was truly eye opening.  In a small part, I also feel better about Hedgeye’s macro call to be bullish on China.  My view of China is somewhat impacted by two of the biggest restaurant companies there anticipating significant unit growth potential over the next 10 years.   In addition to this, the companies will also benefit from a doubling of the minimum wage over the next 5 years.  This is a challenge from a P&L perspective, but will certainly help to further efforts of “The Party” to stimulate and diversify the Chinese economy.    

 

The YUM presentation on China was very different from MCD’s, stemming from the face that YUM gives detailed financials every quarter about the trends in the business in China.  This point does not make one better than the other, it's just a function of the level of commitment to the country.  Looking at the whole, YUM needs China to work now more than MCD does.  China is an important part of the MCD story, just less so given the strength of the overall business in nearly every region of the world. 

 

The read on current YUM China trends:

  • The company previously stated, “we are experiencing double-digit comps in 3Q11." I believe that commentary still stands today!
  • 1H 11 Chinese businesses was strong across all brands and across all tiers; the business is stronger in smaller cities.
  • 50% of KFCs units and 73% of Pizza Hut delivery units are being built in T1/T2 cities.
  • In 2Q SSS grew 18%, driven by an 21% increase in transactions.  KFC was up 17% and Pizza Hut up 22%.  System-wide sales growth was 28% with operating profit growth of 25%
  • SSS were driven by transaction growth through strategic initiatives like breakfast (13% of transactions), delivery (1,600 units) and 24-hr operations (1,300 restaurants)
  • Average guest check in 2Q was RMB 26 ($4) at KFC and RMB 122 ($19) at PH
  • Inflation is a net positive for YUM in China as stronger brands flourish in an inflationary environment.  For YUM, the ownership of the supply chain gives the company increased flexibility
  • YUM experienced inflation of 5% and 6% in Q1 and Q2, respectively.  Over Q3 and Q4, the company expects to see inflation of 9% and 12%, respectively, in China.  The company has chicken locked for the next three months and expects priced to decline from current levels. 

Two decades ago Deng Xiaoping set the tone for how China should enter the world of capitalism - hide your brightness; bide your time.  Today, the trends in China are very bright and YUM is extremely well positions to capitalize on the current trends.    

 

SUN RISING IN THE EAST FOR YUM - yum china sss

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst


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