Yum! Brands Knocked Off Stride In China

By Stephen D. Simpson, CFA | January 09, 2013 AAA

For those investors who've been waiting for a pullback in perpetually expensive Yum! Brands (NYSE:YUM), here's your chance. Tougher consumer conditions in China, combined with a scandal related to excess antibiotics in chicken served by YUM's Chinese KFC stores, have led to a major slowdown in Chinese sales and taken the shares with them. Given that the impact of this scandal/scare will almost certainly be fleeting, this could be a rare opportunity to get shares at a more reasonable price.

Top Investment Trends For 2013: We go over a few investment trends for you to think about for 2013.

A Scandal Guts December Sales
Although value-priced quick service restaurants (QSRs) such as McDonald's (NYSE:MCD) and Yum! Brands actually outperformed during the U.S. recession, these companies are positioned at a different price point in markets like China and have seen their sales compressed by the tougher economic conditions.

To that point, Yum! Brands has been indicating for a while that fourth quarter comp sales would reverse the year-ago 21% gain. While Yum! had once thought sales would be more or less flat, the company revised that guidance to negative 4% before announcing Monday night that guidance was now for a 6% decline in Chinese comps, with comps down significantly in the last two weeks of December.

What has made a bad situation worse is a scandal involving two of KFC's small chicken suppliers. These suppliers have been found to use excess amounts of antibiotics in raising their chickens, and China Central Television broke the news. While the company has pointed out that this involves only two of 30 suppliers (and one was terminated as a supplier a little while ago), the report has also indicated that this happened before at Yum! Brands' KFC restaurants in prior years, with no notice given to the public.

SEE: Stock Scandals: Why Some Companies Survive

Will This Scandal Grow Legs?
It remains to be seen how far the impact of this scandal will go. While McDonald's used the same suppliers (and has also ended its relationship), McDonald's gets far less of its sales (as an overall percentage) from China than Yum! Brands.

It's also worth noting that this is not the first food safety scandal in China or for Yum! Brands in China. Back in 2005 Yum! Brands was found to be using the banned (and reportedly carcinogenic) Red Sudan 1 food dye in two of its dishes. Yum! Brands blamed a supplier, pulled the dishes, and ultimately only saw a momentary disruption in sales.

Elsewhere, the entire Chinese dairy industry saw a major scandal back in 2008 over melamine contamination. While consumption momentarily plunged (as did the stocks of companies in the industry), players like China Mengniu Dairy (OTC:CIADF) have continued to grow rapidly - even with additional scandals since then (including contaminated feed and altering expiration dates).

Said differently, the Chinese consumer seems to be relatively forgiving when it comes to these matters. That's really not too surprising. While a handful of companies in the U.S. have been badly hurt by contamination or food poisoning outbreaks, the reality is that companies such as Unilever (NYSE:UL) and ConAgra (NYSE:CAG) have withstood these problems in the past. That leads me to believe that Yum! Brands will not see any lasting damage from this development, particularly if the company is careful to appear dutifully concerned and chastened in front of the Chinese public.

SEE: Playing The Sleuth In A Scandal Stock

The Bottom Line
While Yum! Brands' slowdown in China is a known problem for Q4 earnings and likely a threat to 2013 growth, I don't believe it changes the long-term value picture all that much. Provided that Yum! Brands can continue to grow its revenue at a mid-to-high single-digit rate and improve its free cash flow (FCF) margin into the mid-teens (as the company's need for aggressive new store construction slows relative to its established base), these shares should be worth $70 or more.

That doesn't make the stock a screaming bargain today, but these shares rarely get very cheap. While there could be more downside from here (if the scandal/economic issues start chewing into 2013 or even 2014 expectations), the long-term risk/reward would seem to favor adding Yum! Brands at these levels.

At the time of writing, Stephen D. Simpson did not own shares in any company mentioned in this article.

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