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Yum! Brands Still Has Indigestion, But Investors Have An Opportunity

Stephen D. Simpson, CFA

Yum! Brands (NYSE:YUM) has stumbled into a perfect storm in China. Concerns about contaminated chicken at what is still a relatively expensive dining option have sent Chinese same-store sales plunging, robbing the company of its primary growth driver. The company has reset expectations significantly lower for 2013, and now the question is just how quickly (and perhaps "if") the company can put this stumble behind it. In the meantime, investors are looking at the nearest thing to a bargain in the shares as they are likely to see.

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Troubles in China Outweigh Progress Elsewhere
China dominates the story at Yum! Brands, so whatever positives there were for the company in other reasons is largely moot. What's more, all of that is likely to be overshadowed by bracing guidance for the year.

Reported revenue rose 1% as reported this quarter, with system sales rising 5% on an adjusted basis. Adjusted system sales in China were up 20%, up 7% in the Yum! Restaurants International (YRI) segment and up 5% in the United States. As the company previously provided updated information on comps, there weren't many surprises here - China was down 6% (against 21% growth last year), YRI was up 3% (up 3% last year) and the U.S. was up 3% (versus 1%), as 5% growth at Taco Bell and 4% growth at KFC offset a 1% decline at Pizza Hut.

One of the biggest risks to YUM's quarters now is deleverage tied to lower Chinese sales, and that started showing up this quarter. While company-reported gross margin was flat and adjusted operating income was up more than 5%, the company-wide restaurant margin improved only 10 basis points. U.S. restaurant margins improved more than three points and YRI margins improved more than two points, but the restaurant margin in China dropped nearly two points and went from the company leader to the company laggard.

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Guidance Was Startling but Probably Pragmatic
To its credit, management at Yum! Brands doesn't seem to be trying to wave off the issues at the Chinese KFC stores. Management not only guided Chinese same-store sales down a shocking 25% in the first quarter, but also guided for full-year earnings per share to decline by a mid-single digit percentage - breaking a long streak of double-digit growth.

The question is now both whether management has fully captured the magnitude of the risk to sales and margins, and how quickly the business can turn around. To be sure, these are not easy times in China. Neither McDonald's (NYSE:MCD) nor Starbucks (Nasdaq:SBUX) has YUM's problem in China, but neither has exactly been planning parades for their near-term growth expectations in the country. Even seasoning manufacturer McCormick (NYSE:MKC) has noticed an impact from this decline in quick service restaurant (QSR) traffic (and Yum! Brands is a significant customer).

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With the Chinese economy still looking wobbly and KFC representing something of a luxury/splurge option, Yum! Brands could have its work cut out repairing the damage to store traffic in 2013. Looking at the situation on a longer term basis, it's easier to be calmer about the situation. Yum! Brands didn't succeed because it was the only American-style dining option in China and people will eventually return to the stores. What's more, India (and to a lesser extent, Indonesia) still represents a "China, Part Two" growth opportunity - sales were up 16% this quarter, and the company has years of aggressive store expansion in its future.

The Bottom Line
Investors looking at Yum! Brands today need to be aware of the risk that sales and margins in China could fall even further and/or recover more slowly than expected. That isn't likely to matter much to investors with a truly long-term focus, but Yum! Brands has long carried a premium valuation due to its consistent above-average growth, and that multiple could be vulnerable if the next couple of quarters disappoint.

I believe that Yum! Brands can continue to grow its revenue at a long-term rate in the mid-single digits. At the same time, I believe good store-level and system-wide operating leverage can lead to better margins and free cash flow generation down the line. That points toward low teens free cash flow growth and a fair value in the low $70s.

Yum! Brands clearly carries the risk that the situation will get worse before it gets better, but that's what it takes to get a previously bulletproof stock at any sort of real discount. Patient investors may want to consider taking a position here, but this isn't likely to be an easy stock to own for a few quarters.

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