Yum China Is Riding On New Locations Amid Increased Expenses

Yum China Holdings Inc YUMC has been harnessing the power of its two most important brands, KFC and Pizza Hut, to drive growth. The company is focused on unit expansion, menu innovation and technology to support revenue growth. However, lesser focus on franchising and increased expenses remain concerns.

Shares of Yum China have gained 26.8 percent in the past two years, outperforming the industry's rally of 11.4 percent. The appreciation in share price can be attributed to earnings that surpassed the Zacks Consensus Estimate in seven of the trailing eight quarters.

Unit Expansion And Other Initiatives

Yum China is focused on relentless unit growth of its restaurants in order to drive incremental sales. In the first half of 2018, the company opened 272 restaurants, reflecting 63 percent year-over-year growth of new builds. In the third quarter, Yum China opened 195 restaurants and remodeled 209.

The company currently possesses five restaurants per one million people in China, which is expected to grow to 15 stores per million. Moreover, there is ample potential to triple the size of restaurant base, capitalizing on continued growth of the middle-class discretionary spending. In fact, the company increased its store opening target from 550-600 to 600-650 in 2018, reflecting unit growth of 9 percent.

Yum China's continual menu innovation to drive top-line growth is another key catalyst. KFC's extraordinary performance is attributable to greater sales of menu offerings like crayfish burger, stuffed chicken wing and spicy chicken burger.

Yum China holds a leadership position in the Chinese restaurant space when it comes to delivery, mobile order and pay, and loyalty membership. The company is increasingly shifting toward digital and content marketing to expand its customer base.

In the third quarter of 2018, delivery represented 17 percent of the sales. The company also expanded its delivery for breakfast and late-night dayparts. Meanwhile, the KFC Prime delivery, launched in the fourth quarter of 2017, is expected to reap additional benefits.

Coming to loyalty membership, Yum Brands created a robust loyalty program that has more than 120 million loyalty members combining both the brands. Backed by delivery and digital sales, the company's loyalty membership increased at a high-double digit year over year for both the brands in the third quarter of 2018. As of Sep 30, 2018, the KFC loyalty program constituted more than 145 million members and the Pizza Hut loyalty program had in excess of 50 million members.

Concerns

Yum China is facing the structural high cost of labor and rentals. Apart from wage inflation, the company is also bearing additional costs stemming from promotion, menu innovation and technological novelty. In order to curb labor cost, the company is increasingly focusing on delivery channels, which is anticipated to curb margins in the near term. Further, costs related to transactions and franchises are expected to gear up in the near future.

Meanwhile, as majority of the restaurants are company owned, the non-franchised model makes Yum China susceptible to increased expenses. The company, not signing enough franchise agreements, is unable to pass on the burden of costs on the franchise and is solely responsible for the expenses of operating the business.

Notably, total costs and expenses increased 4 percent year-over-year to $1,943 million in the third quarter of 2018. The upside can be attributed to 5 percent increase in restaurant expenses, 7 percent rise in payroll and employee benefits expenses, and 9 percent hike in food and paper expenses.

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