The Chicken Is Good, But What About the Stock?

Shas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Yum! Brands (NYSE: YUM) is one of the nation’s largest restaurant chains. It is also the world’s largest restaurant company in terms of system restaurants with around 40,000 restaurants in more than 125 countries. If you like fast food giants KFC, Pizza Hut and Taco Bell, note that they all come from the same corporate parent, Yum. The company has a wide reach throughout the world due to its extensive network of franchisees. Investors have aggressively moved into the company over the past five years, but now there is a slight dip in performance and I feel skeptical about investing in this stock. Let me explain why.

Impressive Past Performance

In 2012, Yum traded at around $74.75 (52 week high) and had revenue of over $13 billion. The stock’s 50 day moving average is currently $67.89. As per its earnings data on Feb 4, the company’s quarterly revenue has increased by 1% compared to the same quarter last year. With a market capitalization of $30 billion and a P/E ratio of 19.89, it has high growth prospects. Last year it reported growth in earnings, sales and profits in all of its divisions, including China and India. But if you look at the stock price of Yum recently, it has sharply fallen from $72 to $67 in the past 10 days.

Chinese Business Affected Due to Avian Flu

On April 10, Yum released March same-store sales for China, which have declined an estimated 13%. This included an estimated drop of 16% at KFC and 4% growth at Pizza Hut Casual Dining. The reason can be attributed to a growing number of H7N9 avian flu cases in China. Recently China reported five new cases, including a death in Shanghai. There are also rumors that Chinese customers are planning to give up chicken on safety concerns. It is not the first time these bird flu cases are happening, and Yum is witnessing a slump in demand in foreign markets. Historically, during these cases, the company had taught people that properly cooked chicken is perfectly safe to eat and causes no harm. Yum might be witnessing a temporary demand fall now but my guess is it will fade away after sometime as it had done in the past.

But There Is a Bigger Problem Than Sick Chicken

The bigger problem that should concern investors is not the demand slump, but the fact that a considerable amount, over 50% of business, comes from China. 70% of the operating profit comes from the international business division. The wide international exposure is the primary growth catalyst for Yum, and that is what has been making the company’s growth valuations both reasonable and sustainable. But now the dip in same store sales in China can be a sore spot for Yum. Earlier in 2011, Yum faced a dip in sales, but that was mainly prevalent in the US, which is not the main revenue generator. Now, probably, making up for the loss in China will be difficult and time-consuming since they are so over-represented there. Reducing prices might be a short-term solution, but it will aggravate the problem long-term.

Serious Competition

Competitor McDonald's (NYSE: MCD) is a serious threat to Yum owing to the fact that McDonald’s is more evenly spread globally while Yum relies too heavily on the Chinese market. Although McDonald’s P/E of 17.5 is much lower than Yum's (21.2), Yum should closely keep an eye on McDonald’s, which has further expansion plans in the pipeline to open more than 1,500 restaurants across the world. Despite the economic downturn, revenues rose, which means that it is practically downturn-resistant. Another unique factor for McDonald’s is that it adjusts itself with the local tastes pretty well, both in terms of menu and price. Both companies have been affected due to the demand slump in China, but in my opinion the effect will be less on McDonald’s. It has already reduced its prices on chicken nuggets in reaction to the demand worries.

Domino's Pizza (NYSE: DPZ) also has a significant international presence and is a tough competitor for Yum, especially to its Pizza Hut chain of restaurants. Domino’s has experienced a high growth in its EPS in the last five years and is expected to grow further. Moreover, Domino’s is priced relatively cheaper than Pizza Hut, which gives an edge to its offerings.

Future Outlook

Yum Brands should see a correction in price in the short term. The next earnings release date on April 23 will clearly indicate how much the company has been affected by the bird flu cases. One positive for Yum is that it plans to expand its international reach outside China and India by opening 40 restaurants in the UK and Ireland where McDonald’s and Domino’s already have a significant presence. Unless Yum copes with the challenge of increasing sales in China and beats the competition in other markets, I would prefer to hold the stock now and make a decision after seeing the next quarterly results.

Shas Dey has no position in any stocks mentioned. The Motley Fool recommends McDonald's. The Motley Fool owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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