Big Problems in China for This American Company

As the U.S. fast-food market has reached maturity, Yum! Brands has bet its future on China. The company has been building new stores, mainly KFC, at a blistering pace, and China now accounts for a significant part of the company's revenue.

But serious issues have plagued Yum!'s efforts in China. Fears of an Avian flu epidemic along with a poultry supplier being investigated have led to a collapse in same-stores sales in China. Sales have yet to recover, and the stock is well off of its highs as a result. Does this decline offer a buying opportunity, or are the long-term prospects not good enough? Let's also take a look at how other notable peers, such as McDonald's and Starbucks are faring in the land of opportunity.

Rapid growth in emerging markets
Yum! has been expanding the KFC and Pizza Hut brands in China at a rapid pace. Since 2008, the number of KFC stores in China has risen by 70%, and today that number is around the number of stores in the U.S. The number of Pizza Hut stores has nearly doubled in China during this time, although KFC makes up a bulk of the total.

China has a population which is four times the size of the U.S., leaving plenty of room for future growth. The company notes that, in the United States, it has 58 restaurants per million citizens. In the top 10 emerging markets, the company has only two restaurants per million citizens. The international growth story has clearly just started.

India is another focus. While currently there are only a few hundred stores in India, the company is planning for rapid expansion going forward. This year, Yum! plans to open a total of 1,450 restaurants outside of the U.S, which comes out to about five per day. India also has an enormous population, about 1.2 billion, and the eating-out market is set to grow to $94 billion by 2020.

Big trouble in little China
The problem with this story is that Yum!'s strategy in China seems to be falling apart. A bird flu scare last year, coupled with an investigation of a supplier over high levels of antibiotics, has tarnished the brand and caused same-store sales to plummet.

This has caused profits to take a hit, and the company now does not expect a sales reversal until next year. Originally, Q4 of this year was expected to show positive same-store sales in China.

The issue is trust, and the process of rebuilding the trust of Chinese consumers may take years.

Amazing prospects
Once the company recovers from this snafu, the growth prospects are incredible. Based on current populations, 58 restaurants per million citizens in China and India combined would lead to more than 150,000 restaurants in those two countries alone. That compares to a total restaurant count of about 40,000 today.

Now, it's hard to say whether these markets will ever reach the level of saturation of the U.S. market, but I think it's safe to say that decades of strong restaurant growth is in the cards.

Of course, there's competition, and the chance that these brands won't resonate with Chinese and Indian consumers. But the prospect of double-digit earnings-per-share growth for years to come is very real. The stock isn't cheap, trading at 19 times last year's earnings and 22 times expected earnings for this year, but the potential for fantastic growth is there.

Different approaches
Yum! is not the only food and drink company expanding into emerging markets. While Yum! is expanding in China like there's no tomorrow, fast-food behemoth McDonald's is taking a more measured approach.

While McDonald's is building plenty of new restaurants -- around 1,500 per year-these locations are spread out across many different markets. This diversification protects the company against the kind of shock experienced by Yum!, and allows the company to to be far more methodical.

The result will be slow, steady revenue and earnings growth. While Yum!'s strategy makes very rapid growth possible, albeit with more risk, McDonald's is trying to do exactly what it's been doing for the past decade. Its historical success has been extraordinary, and the 3.4% dividend yield investors are paid while McDonald's slowly expands makes the stock fairly attractive.

Another company expanding into international markets is Starbucks. While there seems to be a Starbucks on every corner in the U.S., the chain has plenty of room to grow in China and other emerging markets. Starbucks already has about 1,000 stores in China, a country where coffee is not the preferred hot beverage. Recently Starbucks bought Teavana, a chain of tea shops, and the company is looking to do for tea what it did for coffee. This should help international growth.

Starbucks has been criticized lately by the state-owned Chinese media for charging high prices for its coffee in China. This is one of the big problems for American companies in China. China is ultimately a communist nation, and the state-owned media has not been shy about criticizing foreign companies. Apple came under fire in March for having different warranty policies than in other countries, and Volkswagen was accused of selling cars with substandard transmissions. There are certainly risks involved with operating in China, but the enormous population makes the rewards well worth it.

The bottom line
Yum! is rapidly expanding in China and now India, and its all-in strategy exposes it to big short-term risks. Trust is an issue, and the brand needs to win back the Chinese consumer before it can see truly impressive growth. McDonald's is taking a more measured approach, and the safer expansion plans should lead to slow and steady growth in the future.

McDonald's is certainly no growth stock. Starbucks is trying to sell coffee to countries more accustomed to tea, and, the Chinese media issues notwithstanding, so far the company has been successful. All of these companies have plenty of room to grow, but as Yum! has shown, smooth sailing is not a guarantee. 

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends McDonald's and Starbucks. The Motley Fool owns shares of McDonald's and Starbucks. 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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