Hot Wings Instead of Peking Duck

The U.S. fast-food company Yum Brands will soon earn more from their Chinese operations than from the rest of the world combined. Stockholders are grateful.

Takeout fast-food has long been a tradition in China. Mobile kitchens have always offered people-on-the-go freshly made meals from steaming woks. But even in the People’s Republic, the trend to the American way of life is unmistakable. Instead of chopstick food, more and more pizza, burgers or fried chicken wings appear on the menus. The American fast-food company Yum Brands recognized this trend early on with their introduction of the Pizza Hut, Kentucky Fried Chicken (KFC) and Taco Bell brands into China.

The company opened its first KFC branch there in 1987. Initially looked at askance by marketing experts, the expansion of the company in the most populated land on earth has become a model of business success. There are now more than 3,000 KFC restaurants in over 650 cities, with a new one opening almost on a daily basis. Added to that are nearly 500 Pizza Huts. Yum Brands can rightly claim the title of China’s largest fast-food chain. Long-range plans are to have at least 20,000 branches in operation.

The rapid growth in China comes just in the nick of time since outlets in the United States are having operating difficulties, as shown by the latest third-quarter figures. While currency-adjusted sales rose about 18 percent in China, the rest of the world reported just 5 percent sales growth, and sales didn’t rise at all in the United States. In terms of operating results, the results were similar: Most noticeable were Yum China (plus 23 percent) and Yum Restaurants International (plus 16 percent), while U.S. operations fell by 2 percent. Jack Russo of the investment firm Edward Jones said the quarter was a good one overall for Yum Brands but didn’t acknowledge the fact that not all markets contributed to the success in growth.

Stock markets are less fussy and are crowing about the growth in China. Nearly 42 percent of the company’s sales and just under one-half its bottom line are generated in China. Yum is on track to earn more in the People’s Republic of China than in all other regions combined. The company from Kentucky thus offers Chinese fantasies like no other Western concern.

Investors are ignoring the rising costs of labor and raw materials in China, but CFO Richard Carucci is predicting stagnating and possibly even slightly declining margins.

The current achievement of 25 percent is a goal, but the firm’s operations in other regions are only about half as profitable. Carucci puts the burden of higher labor costs at about $40 million for the whole year. Still, he wants to avoid balancing that out with higher prices but does not completely exclude that possibility in the future.

Increased labor costs are both a curse and a blessing for Yum: They burden the bottom line but also contribute to the creation of a middle class eager to consume — a trend that is becoming apparent in other developing countries. Because of this, Yum is expanding operations in Indonesia, the Philippines, Malaysia and Vietnam. Carucci says he expects 60 percent of Yum’s profits to originate in developing countries by the year 2015.

The growth is having an impact on Yum’s stock price, which is at record highs in New York. Despite the short-term pressure on margins, Yum expects 2011 to be the company’s 10th year in a row of two-digit growth. That much continuity naturally has its price.

These days, investors pay around 17 times the expected earnings for the stock. Competitor McDonald’s stock, with a price-earnings ratio of about 15.5, is a bit more of a bargain. The stock deserves the premium valuation since it has out-performed the S&P industry index for restaurants and the total market overall — not only since the beginning of the year, but also over the two- and five-year periods. You may think whatever you want about pizza and breaded-chicken parts, but Yum stock looks as if it will continue to be a very tasty investment.