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KFC, Pizza Hut Owner Says Profit Shortfall in China is Short-Term

--Yum Brands' profit margin in China fell 4.1 percentage points to 15.6% in 2Q --Yum still sees margins hovering around 20% long term --Wage inflation, higher food costs, more unit openings contributed to setback By Annie Gasparro Yum Brands Inc. (YUM) says its China business, which is the biggest contributor to its profit, will rebound in the second half, after the division's profitability took a beating in the recent quarter. The owner of KFC, Pizza Hut and Taco Bell saw its profit margin in China fall 4.1 percentage points to 15.6% in the second quarter, but Louisville, Ky.-based Yum contends that China is simply facing short-term setbacks. "Clearly, we're not happy with the 4.1 percentage point margin decline in China," said Chief Financial Officer Pat Grismer on a conference call. But, he added, "We expect our China margin will improve modestly in the second half of the year.... And it will contribute more to profit in the back half of the year." The newly appointed Mr. Grismer blames Yum's pullback in China on higher food costs, wage inflation, opening more restaurants than last year, and implementing some menu price increases later than expected. But he still sees margin hovering around 20% there in the long term. "We have recently adopted a more targeted and strategic approach to our pricing in China to have everyday affordability for the growing consumer class while achieving about 20% margins over time," Mr. Grismer said. "While we're confident in this approach, it has taken more time to implement than we expected." Yum is the biggest Western restaurant company in China, with 4,785 restaurants--mostly KFC and Pizza Hut Casual Dining locations. Many U.S. investors use the company as a way to bet on China from home. As a result, signs that the country's economic growth is cooling this year have caused a pullback in Yum's share price from April highs of nearly $75. Shares were recently trading around $66. McDonald's Corp. (MCD), which is scheduled to report its second-quarter results Monday, has said the weakening consumer trends in China, on top of economic volatility in Europe and the U.S., are making it harder to increase its operating profit. Yum's operating profit in China fell 4% excluding foreign-currency exchange in the latest quarter, while its sales growth at established restaurants slowed to 10%, from 14% in the first quarter and near 20% before that. Yum says it expects deceleration to the midsingle digits in the remainder of the year. "China is a pretty difficult business to forecast now than compared to five years ago, when we pretty much were able to grow our bottom line with our top line," said Yum President Rick Carucci on the conference call. "There's just more moving pieces today." He said there is now more wage inflation, up 13% in the quarter; more volatility on commodity costs, which rose 6%; and some inefficiencies from ramping up new restaurant development to 700 openings this year from 500 last year. "I think we did have some teething problems around new unit development and its impact on operations, and perhaps maybe we could have anticipated that better," said Mr. Carucci, formerly Yum's chief financial officer. Also, he said Chinese consumers became more sensitive to prices throughout the quarter amid economic concerns, causing Yum to slow down its planned menu price increases because of the way customers were reacting to them. Yum has been focused on adding services to its fast-food restaurants in China, such as breakfast menus, delivery and staying open for 24 hours, to attract customers. It also is adding more stores in less-developed markets, which is boosting its competitive position. Chief Executive David Novak said he is far from concerned about Yum losing its footing in China or the latest round of price increases deterring customers. "The last thing the customer is going to see in China is sticker shock," he said on the call. "We've done a very prudent job of managing pricing, with the primary objective of being affordable, and I think that continues to be the case." Write to Annie Gasparro at [email protected] Subscribe to WSJ:

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