Invest in China's middle class with this stock

Rising wages hurt Chinese restaurant margins, but customers have more money to spend as well.

By Jim J. Jubak Feb 7, 2012 5:07PM
Image: China (© Brand X/SuperStock)Expect to see more of this in earnings reports from China: Companies trading lower margins today for bigger market share tomorrow.

That’s the message in the 2011 results reported by Yum Brands (YUM) Monday.

The operator of the KFC, Pizza Hut, and Taco Bell chains 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.

At the time of this writing, Jim Jubak didn't own shares of any companies mentioned in this post in personal portfolios. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not own positions in any stock mentioned. 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 the most recent quarter, see the fund's portfolio here. 

Tags: YUM
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