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Yum China's Shares Gain 0.3% in 6 Months: More Room to Run?

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Yum China Holdings, Inc. (YUMC - Free Report) , the largest restaurant company in China, is gaining solid momentum backed by a strong brand recognition. Following the separation from its parent company, Yum! Brands (YUM - Free Report) , Yum China has been leveraging the power of its two most important brands — KFC and Pizza Hut — to drive long-term growth.

The company’s shares have gained 0.3% in the past six months, outperforming the industry’s decline of 1.3%.  Earnings estimates for the current quarter and year have also gone up 20.7% and 0.6%, respectively, over the past two months, reflecting analysts’ optimism surrounding the future earnings potential of the company. Also, Yum China surpassed estimates in three of the trailing four quarters, with an average of 6.74%.

However, increased costs from labor, rent and operational initiatives may hurt the company’s margins. Also, a limited franchised business model remains a concern.

Initiatives to Drive the Top Line

Yum China is focused on relentless unit growth of its restaurants in order to drive incremental sales. In the first quarter of 2018, the company opened 203 new restaurants and remodeled 125. 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 grow the restaurant base to triple its current size, given the continued growth of the middle-class discretionary spending. In fact, the company increased its new store-opening target from the range of 550-600 to the band of 600-650 in 2018, reflecting 9% unit growth.

Another riveting growth potential of Yum China resides in its continual menu innovation to encourage top-line growth. KFCs extraordinary performance is attributable to greater sales of menu offerings like crayfish burger, stuffed chicken wing and spicy chicken burger. Apart from such consumer-preferred food items, the company also offers signature menus for Chinese New Year.

Yum China is also serving coffee across its restaurants and expanding the dessert category. In the first quarter of 2018, Matcha chocolate ice cream was launched and more new flavors are lined up for launch this year.

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 first quarter of 2018, delivery represented 14% of the sales, up 39% year over year. More than 3,300 stores across 917 cities offer delivery services. 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. The service offers its members with unlimited free delivery for 30 days at a subscription fee of 18 yen.

Coming to loyalty membership, Yum Brands created a robust loyalty program that has more than 120 million 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 first quarter of 2018.

Increasing Costs & Lesser Focus on Franchising Hurt

Yum China is facing 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 again expected to curb its margins in the near term. Also, costs related to transactions and franchises are expected to gear up in the near future.

Notably, in the first quarter of 2018, total costs and expenses increased 12% year over year, due to a 20% increase in restaurant expenses, 18% rise in general and administrative expenses and 12% hike in franchise expenses. Restaurant margin in the quarter came in at 17.9%, reflecting a 250-basis point decline from the year-ago quarter. The fall in restaurant margin was due to the investment in product upgrades, and promotions at Pizza Hut and its sales deleverage.

Also, unlike its major peers like McDonald's (MCD - Free Report) and Domino’s (DPZ - Free Report) , the majority of Yum China restaurants are company owned. This makes the restaurants susceptible to increased expenses. Hence, this Zacks Rank #3 (Hold) company, by not signing enough franchise agreements, is unable to put the burden of costs onto the franchisees and is solely responsible for the expenses of operating the business. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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