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Yum China (YUMC) Banks on Unit Growth, Margin Woes Linger

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Shares of Yum China Holdings, Inc. (YUMC - Free Report) are riding high on unit growth, improvement in average check, menu innovations and robust earnings surprise history. Consequently, the stock increased 15.6% in a month, outperforming the industry’s collective growth of 7.5%. Let’s delve deeper.

Growth Catalysts

Following the separation from its parent company Yum! Brands, Yum China has been leveraging the power of its two most important brands — KFC and Pizza Hut — to drive long-term growth. Although the company’s brand portfolio includes East Dawning and Little Sheep, Yum China relies heavily on the potential of KFC and Pizza Hut. With chicken being the most-preferred form of protein among the Chinese citizens, KFC became the largest restaurant brand in the country. The brand witnessed considerable average check growth due to its affordability.

This Zacks Rank #3 (Hold) company is focused on relentless unit growth of its restaurants in order to drive incremental sales. In the first half of 2018, it opened 272 restaurants, reflecting 63% year-over-year growth of new builds. In the third quarter, Yum China opened 195 restaurants and remodeled 209. It 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 so that it triples in its current size, given the continued growth of middle-class discretionary spending. In fact, the company increased its store opening target from 550-600 to 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. KFC’s 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 offers signature menus for Chinese New Year. Yum China is also serving coffee across its restaurants and expanding the dessert category.

In the first nine months of 2018, Yum China recorded double-digit growth, sold 63 million cups of coffee and became one of the largest coffee retailers in China. The company expects its coffee sales to exceed CNY1 billion by the end of 2018.

Yum China holds a leadership position in China’s 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% of sales.

Concerns

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

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

Restaurant margin in the quarter came in at 17.6%, reflecting a 40-basis point (bps) decline from the year-ago quarter. The fall in restaurant margin was due to investments in product upgrades, promotions at both KFC and Pizza Hut, and Yum China’s sales deleverage at Pizza Hut.

Key Picks

Some better-ranked stocks in the same space are Dunkin' Brands Group, Inc. (DNKN - Free Report) , Dave & Buster's Entertainment, Inc. (PLAY - Free Report) and Darden Restaurants, Inc. (DRI - Free Report) , each carrying a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Dunkin' Brands Group has an impressive long-term earnings growth rate of 12.4%.

Dave & Buster's Entertainment delivered positive earnings surprise in each of the trailing four quarters, the average positive surprise being 13.7%.

Darden Restaurants reported better-than-expected earnings over the preceding four quarters, the average positive surprise being 5.1%.

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