Is The Cost of Doing Business Too High?

AnnaLisa 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) has just suffered another setback in China as the focus of a Chinese Central TV investigation claiming the ice at KFC in China is worse than toilet water, with nineteen times the bacteria allowed in Chinese drinking water.

Reporters for CCTV tested the ice at KFC, McDonald's (NYSE: MCD), and fast food chain Kongfu. All three failed government standards for potability, but McDonald's ice was cleaner than toilet water. Yum! and McDonald's issued statements they would be investigating, and that food safety was their highest concern.

Yum! Brands, with 39,000 KFC, Taco Bell, and Pizza Hut restaurants, was beginning to recover from its December 2012 chicken controversy, in which its supplier Liuhe Group was providing chickens with excessive antibiotics and growth hormones. June same store sales at KFC China had improved, although they were still down 10%.

Yum! Brands was the China play for investors wary of investing in Chinese-based companies, and with China accounting for over half of Yum!'s revenue things were just Peking ducky.

Yum! has now reported three consecutive disappointing quarters, and a highlight of the most recent Q2 report on July 10 was a 20% drop in same store sales in China, a 63% decline in Chinese operating profit, and a 5.0 percentage point decline in margins, again, thanks to China.

CEO David Novak two weeks ago said, "The good news is that China sales are recovering as expected. The extensive media surrounding Avian flu in China has subsided and same-store sales at KFC are clearly improving... As KFC sales continue to recover, we expect to have solid momentum in China heading into 2014."

He also announced the company was on track to open 700 new China KFC restaurants this year, for a total of 1,600 opened over these last two years.

At least India sales offset miserable China numbers with a 24% increase. US sales were only up 1% and Yum! Resorts International division sales were up 6%, mainly driven by a 12% gain in emerging markets.

Whatever good news the company reports about successes like its Taco Bell Cantina Grill menu gaining traction against Chipotle Mexican Grill, or its new boneless chicken, is always overshadowed by one country out of 125...China.

Chinese consumers' reluctance to eat at KFC is understandable, what with China's dismal history in food safety--but one has to wonder if there is a concerted effort to discredit Yum! in China as the company was vindicated in May after false accusations over tainted lamb at its Little Sheep franchises.

KFC has been in China for 26 years, and these two safety scares, both publicized on Chinese television, have hurt a quarter century's worth of goodwill earned by KFC and the image of venerated elder Col. Harlan Sanders. James McGregor, author of One Billion Customers: Lessons From the Front Lines of Doing Business in China, told Bloomberg in 2011,"If Yum’s China business went south, it would kill the stock."

Obviously Yum! won't exit China; a market of a billion chicken-lovers is too good to pass up. The expected recovery of Chinese sales will likely be pushed back several more quarters, assuming another shoe doesn't drop. Yum! has a PEG of 2.09 and a trailing P/E of 22.09 with a 1.90% yield. It's a shareholder-friendly company and has bought back 5.7 million shares this year.

China hasn't been the profit driver for McDonald's as it has for Yum!. Less than 5% of operating income is from China, and the company announced during its latest earnings release that it wouldn't be expanding in China as much as planned. This ice investigation will barely affect them.

But McDonald's just reported disappointing numbers on July 22, and has underperformed the S&P 500 over the last year, gaining only 10.81%. It does offer a larger yield at 3.10% and is a Dividend Aristocrat, however.

It trades at a price/book of 6.42 and a PEG of 2.04. Margins have been declining over the last three years in Europe, Asia, and the US, even as the company scrambles to bring in traffic with promotions and new menu items. CFO Peter Benson stated in Q1 they were willing to sacrifice a little margin to win market share.

If you have to play China but want a US-based company, Wynn Resorts (NASDAQ: WYNN) would be my bet as it's the purest play on the Chinese gambling mecca Macau, offers a yield of 3.00%, has been performing well with a resurgence in Vegas (the stock is up 43.42% this last year), and has a founder/CEO in Steve Wynn.

Almost three quarters of revenue is generated by Macau for Wynn. Although analysts have seen a slow VIP play for the last few weeks, they seem to agree that the long term growth picture for Macau and Wynn is intact. Wynn has come up against " the cost of doing business" in China with charges of bribery and violations of the Foreign Corrupt Practices Act, as gifts to officials are customary but frowned upon by the US government and easily misinterpreted.

The cost not to do business

Companies can't afford not to do business in China (except Google). With the world's second largest economy and a rapidly growing and aspirational middle class, it's a higher risk to have rivals plant their flag than endure some setbacks.

I would prefer to play China through the Macau casinos and Wynn. Eventually, these Chinese headlines and Yum! will settle down, and the company can take its rightful place as one of the pioneers of trade with China. Maybe McDonald's is playing it too safe in China. We'll see who reaps the rewards of paying "the cost to do business."

Profiting from our increasingly global economy can be as easy as investing in your own backyard. The Motley Fool's free report "3 American Companies Set to Dominate the World" shows you how. Click here to get your free copy before it’s gone.

AnnaLisa Kraft 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!

blog comments powered by Disqus