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YUM Just Left a Bad Taste in This Investor's Mouth

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

I was nearly done with YUM! Brands (NYSE: YUM) this morning. 

I've been a shareholder for less than two years, and as a buy-and-hold investor, it's rare for me to give up on a company.   Here's the recent Q4 earnings announcement that almost did me in:

"For the quarter, total revenues came in at $4.15 billion, more or less flat over the same period the previous year. Net income was $337 million ($0.72 per diluted share), down from the $356 million of Q4 2011."

But that's not what had me ready to click the "sell" button.  Down years happen.  But while one quarter is a blip on the radar, a full year looks more like a trend:

"Yum! also provided some guidance for fiscal 2013. The company wrote in its earnings release that it anticipates a 'mid-single digit EPS decline in 2013 versus prior year, excluding Special Items.' "

And that's not what I signed up for.  When I bought YUM in 2011, I was expecting to be getting on this wagon:

<img alt="" src="http://media.ycharts.com/charts/85ee9ebda6b3f2c6ffa6424345d5f4db.png" />

YUM Revenue TTM data by YCharts

While YUM Brands' revenue was growing moderately, earnings were increasing at an even faster rate.  The market has richly rewarded shareholders over the past decade, to the tune of over 400%.  Throw in a dividend now around 2% and it's been a nice ride. 

But all that's coming to an end, right?  Best days are over?

Yes and no.  While the fastest days of growth are over, it's important, as I've said in other articles, that we get past the headlines, and the summaries, and get to the heart of the matter. 

In a nutshell, I made a decision to sell my shares without even reading the company's announcement. Honestly, it's not even fair to call what I did a "decision."  It was an overreaction.  An emotional response.  And the worst part of the whole experience was that I was ready to congratulate myself for moving on, making an "unemotional decision" to sell one of my favorite holdings, based on the projected (lack of) growth, and how that didn't fit with my portfolio and investing plan. 

But I realized that was all nonsense, and decided that it was time to actually take a few minutes, and do some real research.  Here's what I found in the company announcement:

"KFC sales in the last two weeks of the fourth quarter were significantly impacted by the intense media attention surrounding an investigation by the Shanghai FDA (SFDA) into poultry supply management at Yum! China. The investigation was prompted by a report broadcast on China’s national television (CCTV), which aired on December 18, 2012. The report showed that a few poultry farmers were ignoring laws and regulations by using excessive levels of antibiotics in chicken. Regrettably, some of this product was purchased by two poultry suppliers of KFC China."

I was aware of this event, but the impact that it was having was much more significant than I knew.  And here's the real kicker:

"The first quarter for our China business includes only the months of January and February and is highly impacted by consumer spending during the Chinese New Year holiday.....We expect that the underlying performance of our China business will remain relatively unchanged for the balance of the first quarter, with a same-store sales decline of approximately 25% for January and February combined (China’s first quarter)."

The impact on earnings in Q4 was much larger than I expected, and honestly, the hangover effect couldn't have happened at a worst time for the company, with the hugely important Chinese New Year almost upon us.  That's why the company is forecasting flat earnings growth for all of FY13. A 25% decline in KFC China in Q1 is a powerful event. 

So it's a "lost year."

In terms of earnings growth, yes.  But not in terms of earnings in general.  Let's look at YUM compared to its peers:

<img alt="" src="http://media.ycharts.com/charts/5bf339f99f1b64fc0a9ce17912af3e3e.png" />

YUM EPS Diluted TTM data by YCharts

The EPS numbers are only useful if we also look at PE ratios, and understand what the growth projections are:

<img alt="" src="http://media.ycharts.com/charts/44c0fb84d81fdf57810bc2cac448557a.png" />

YUM PE Ratio TTM data by YCharts

Only McDonald's Corporation's (NYSE: MCD) annual revenues are more than double YUM Brands, at over $27 billion, and has essentially the same valuation, which is honestly quite fair based on what management is projecting for FY13. 

Papa John's International (NASDAQ: PZZA), with just over 4,000 locations, has plenty of room to grow, and with less than 1,000 international locations, certainly has room to expand.  But the simple reason that I won't invest in Papa John's is simple.  There is a lack of menu diversity, and that's one of the benefits owning a YUM Brands carries.  Can you imagine if YUM was simply KFC?  The "China situation" could be crippling. 

Chipotle Mexican Grill (NYSE: CMG) is one of the fastest growers in the restaurant business.  Factor in a powerful competitive advantage with their focus on delivering locally-sourced ingredients, including organic whenever possible, and expansion into Asian cuisine with the "Shophouse" concept currently in development, and the high PE ratio is just the premium for such growth potential. 

Panera Bread (NASDAQ: PNRA) is another powerful brand with strong growth, menu diversity, and while not directly competing with the fast-food crowd above, a viable competitor for your investment dollars.  As the domestic economy improves, (this recent post I made talks about why I think it will) Panera has as much room to grow as any, maybe more than most. 

So what does all of this mean?  Sell time?

Not for me.  YUM is near it's 52-week low, and is priced for very little growth going forward.  And while that's quite fair for the market to do, especially with management projecting essentially no earnings growth this year, all of the reasons that I bought YUM still apply. 

The company is still expanding rapidly, especially internationally.  And while earnings may not grow this year, the YUM that I own today will be a larger company more capable of delivering profits in a year. 

Additionally, I think it's worth considering that management may be low-balling us, and I'm okay with that.  Honestly, it's difficult as of yet to determine how large the final impact of the "China situation" will be on earnings, so taking a conservative approach to FY13 is laudable. 

Foolish bottom line

At 2% of my portfolio, my exposure to YUM is very low.  And with my "cash out" time-frame still measured in decades, this could very well be a great opportunity to buy.  There's a good chance that the market may further punish the share price, and depending on earnings for Q1, there is a very good chance I will buy more.  I'll leave you with a comment from CEO David Novak:

“Although we cannot predict how long it will take to restore sales, we are steadfast in our belief that the power and popularity of the KFC brand in China will ultimately drive a full sales recovery. Having weathered other storms in the past, we know that our brands are resilient. As a result, we will stay the course with our target to develop at least 700 new units in 2013 in China to lay the foundation for future growth, and will not let this event detract from our unparalleled China growth opportunity. "

Sounds like a company unfazed, and focused on performing.  And those are the right companies to own.

Jason Hall owns shares of Chipotle Mexican Grill and Yum! Brands. The Motley Fool recommends Chipotle Mexican Grill, McDonald's, and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, Panera Bread, and Papa John's International. 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.

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