Should Investors Worry About Yum! Brands' Sluggish Third Quarter Results?

Should Investors Worry About Yum! Brands' Sluggish Third Quarter Results?

China has a huge population of more than 1.34 billion people. The big population in China makes the consumer goods industry pretty attractive there, an industry which includes the restaurant business. Michael Finarelli, Motley Fool Consumer Goods Analyst, recently mentioned quite an interesting figure: here were 58 restaurants per 1 million people in the United States, but there were only 2 restaurants per 1 million people in China. This indicates that there's still plenty of room for restaurants to run.

Disappointing third quarter earnings due to intangibles writedown
With significant exposure in China, Yum! Brandsis set to benefit from that huge potential growth. However, in the third quarter Yum! Brands' earnings disappointed investors. Yum! Brands' earnings per share fell by 67%, from $1 last year to only $0.33 this year. The big decline in EPS was due to a $0.52 per share special item charge. Excluding this non-cash charge, its EPS came in at $0.85 in the third quarter, 15% lower than its EPS last year.

The special item charge was from the writedown of the intangibles of Little Sheep, the casual-dining chain, which was acquired by Yum! Brands last year in a deal worth around $860 million. Little Sheep, the hot pot restaurant chain, increased Yum! Brands' exposure to Chinese consumers and also diversified its dining concepts. However, after the acquisition Yum! Brands increased its goodwill and intangible assets significantly from $980 million in December 2011 to nearly $1.83 billion in June 2013.

After writing off Little Sheep's intangibles, Yum! Brands' goodwill and intangible assets figure is still quite high. At more than $1.52 billion it accounts for nearly 17.50% of the company's total assets. McDonald's , another big global franchise fast food chain, has a much lower percentage ratio of goodwill and intangibles in comparison with its total assets at only 8.06%. Interestingly, Burger King Worldwide , the fast growing hamburger franchise chain, has the highest amount of goodwill and intangibles at nearly 60% of its total assets.

China will be the main driver of international growth
The fate of Yum! Brands really depends on its operating performance in China. China provided nearly 60% of its revenue and nearly 51% of its total operating profit in the third quarter. McDonald's also has good sized business operations in China. The company reported that China represented as much as 30% of operating margin dollars for its Asia Pacific, Middle East and Africa region. McDonald's also considers China to be a long-term growth opportunity in emerging markets.

In the second quarter, Burger King Worldwide saw most of its international business growth coming from four countries: China, Turkey, Russia and Brazil. In China, the company is in the process of adapting its menu offerings to drive higher traffic and volume. In the Asia Pacific region, Burger King Worldwide managed net restaurant growth of 156 stores in the past twelve months, many of which were located in China. The company believes that Asia Pacific, including China, will be the main business growth driver in the future.

My Foolish take
Of course, because of several incidents like a poultry supply with too much antibiotics, avian flu, and the Little Sheep intangible writedown, Yum! Brands' China operation has kept declining. However, I personally think the problem is only short term. Yum! Brands will keep growing by opening at least 700 new units this year in China, allowing it to capture the fastest growing consumer class in the world. In the long run, China will give Yum! Brands a lot of upside potential and drive its share price much higher.

Yum! Brands is not the only restaurant chain to benefit from huge China market potential
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Anh HOANG has no position in any stocks mentioned. The Motley Fool recommends Burger King Worldwide and McDonald's. The Motley Fool owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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