Now if Yum! Brands could only fix its U.S.business

02/07/2012 3:07 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Expect to see more of this in earnings reports from China: Companies that are trading lower margins today for bigger market share tomorrow.

That’s the message in the 2011 results reported by Yum! Brands (YUM) yesterday, February 6.

The operator of KFC, Pizza Hut, and Taco Bell restaurants reported that margins in its Chinese restaurants fell 2.4 percentage points in 2011 to 19.7% from 2010. The culprit was rising costs from commodities—about 8% year to year—and wages. Wages went up 20% for its Chinese businesses in 2011.

In the year sales in China grew by 29% as the company opened 656 new restaurants. But operating profits were up just 15%.  (Both results are before currency translation). Same store sales climbed 19%.

But there’s an upside to the pressure from wages on restaurant margins. Higher wages in China mean more Chinese will be able to afford regular purchases from KFC and other Yum! Brands chains. When first introduced in China KFC and Pizza Hut were premium priced brands, but with the growth of China’s middle class to an estimated 450 million, the two chains have become more affordable to more Chinese. That trend will continue or accelerate with wage inflation in China. Estimates put growth of the middle class at 4% to 5% annually.

The one problem in Yum’s earnings report is the continued slow growth—actually a decline for 2011--in the company’s U.S. sales. The KFC unit, which owns 40% of the market for chicken on the bone quick service restaurants, saw U.S. same store sales fall 2% in 2011. At Taco Bell, which has a 52% share of the quick service Mexican market, same store sells fell by 2% as well. Operating margins for the U.S. business declined by 0.7% in 2011.

I like Yum! Brands as a long-term play on growth of the middle class in China—and India, Russia, Vietnam, Indonesia, etc. But I don’t much like the current valuation. I get a 12-month target price of $67 for the shares and with the stock trading just a hair below $65 today, there’s just not enough upside at this level. I’ll wait for the next pullback.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of Yum! Brands as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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