Emerging Markets Bright Spot for Yum Brands

Jeremy Glaser: For Morningstar.com, I am Jeremy Glaser. Yum Brands reported a solid second quarter. I am here with Senior Analyst R.J. Hottovy to take a deeper dive and see where the opportunities lie for Yum.

R.J., thanks for joining me.

R.J. Hottovy: Thank you for having me.

Glaser: So, first off, can you give us an overview of what worked for Yum this quarter and what didn't work so well?

Hottovy: Yeah. I think the highlight of the quarter, again, was China for the company; impressive sales growth there, continued to develop a lot of new restaurants and impressive operating margin growth. But I think the real encouraging story coming out of the second quarter results was the strength of emerging markets. And while China gets all the attention here, I think emerging markets could be the bigger long-term story.

U.S. remains something of a mixed bag. Pizza Hut continues to do pretty well. The $10 pizza price point for everything on their menu seems to be working very well. But on the other hand, KFC seems to be struggling, admittedly they were lapping some pretty tough comparisons from a year ago. But generally speaking, a pretty solid quarter for the company.

Glaser: Moving to China, which is a large part of Yum's business, there has been a lot of talk about upward pressure on wages and on prices in China. Is that going to be a big headwind for Yum?

Hottovy: Yeah. I think it could be a headwind in the second half of the year. And this is one of the themes we called out in our retail quarterly overview from a few weeks ago, and I think we're starting to see that play out. Management said that there could be a second half pressure and we agree with them, but over the long haul, we think that there will be offsets.

Frankly, the appreciation of the yuan, I think, will help them out over the long run. It will probably be a gradual multiyear occurrence, but I think that will help them out, as well as just having some sustainable competitive advantages in China, having a local development team, having a distribution systems that's wholly-owned, I think those give them a nice advantage over their peers in that area and I think that will offset any labor pressures over the long run.

Glaser: What does demand look like among Chinese consumers? I know there's been some concern that there may be a potential slowdown in China. Has Yum seen anything like that?

Hottovy: No. I think we've seen it rebound quite a bit. We saw some weakness in the late part of last year. But generally speaking, things have rallied, and this is the second straight quarter that China has really been at the strong point of results for Yum Brands.

Glaser: With emerging markets, they are going to push Taco Bell into India. Are these kinds of initiatives, something that can really move the needle on the stock?

Hottovy: I think it's a little early to say it's going to move the needle a whole lot. But over a 10-year period, I think these could really be home runs for this company. India, as you mentioned, I think is a very compelling growth opportunity for the company. Russia, Korea, Vietnam even is another market, I think, the Company, again, is kind of following the roadmap they used in China and developing some first mover advantages in these territories.

Glaser: In mature markets like the United States, will Yum be able to push forward and display some of the larger players or are they kind of settled down in kind of a middling position?

Hottovy: Yeah. The big question is whether or not the turnaround can really happen in the U.S. It's been kind of a rocky road for the company over the past couple of years. And I think the success they've seen in Pizza Hut with finding a menu that works and a price point that seems to work, I think that some of the learnings they've taken from that can be applied in other places.

And again, KFC is the one brand that seems to be struggling right now. I think with some menu innovations, we've seen wraps there, we have seen Kentucky Grilled Chicken in the past year, the Double Down, we've also seen that. I think as they continue to innovate that menu, I think it bodes well for the Company. It's going to take some time, but I think if – a little bit of patience, I don't think it's too early to give up on the U.S. business.

Glaser: Great. R.J., thank so much for talking with us today.

Hottovy: Thank you.

Glaser: From Morningstar.com, I am Jeremy Glaser.