Is Yum! Brands No Longer a Yummy Growth Stock?

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So far, 2013 has been a lousy year for Yum! Brands (NYSE: YUM), the parent company of KFC, Pizza Hut and Taco Bell. The company’s trouble in China, where it generates nearly half of its total revenue, has become a cautionary tale highlighting the perils of investing too heavily in a single growing market.

For several years, investing in China paid off handsomely for the Louisville, Kentucky-based company. Yum!’s shares doubled in value between 2009 and 2012, as CEO David Novak’s strategy in China generated double-digit top and bottom line growth as same-store sales soared. KFC became the most popular foreign fast food restaurant in the nation, outpacing even mighty McDonald’s (NYSE: MCD).

China’s not so hot anymore

Of course, that heyday could not last forever. It started with a gradual slowdown of the Chinese GDP, which dropped from double-digit growth to single digits by the end of 2012, as seen in the following chart.

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China’s slowing GDP convinced many investors that China was no longer the red-hot emerging market it used to be, and that its growth was not sustainable. That meant that China-dependent brands such as Yum! would be unable to meet high growth targets.

In the first quarter of 2013, Yum!’s same-store sales in China plunged 20%, with a 24% decline at KFC and 2% drop at Pizza Hut. In February, Yum! managed to post slightly better results, with same-store sales rising 2% across the country, mainly attributed to the week-long Chinese New Year holiday. Sales at KFC remained flat, while Pizza Hut rose 13%.

But hopes for a recovery were recently crushed after Yum! reported that its same-store sales declined 13% in March, primarily due to a 16% drop in KFC and 4% slump in Pizza Hut. Yum! also reduced the number of planned KFC openings in 2013 to 700, down from 800 in 2012.

45-day chickens

However, China’s macro slowdown isn’t the only reason Yum! has posted increasingly bleak sales reports in 2013. The company’s chicken supply chain is at the heart of the problem. Last December, the government claimed that KFC’s chicken suppliers had been using antibiotics and growth hormones to reduce the growth cycles of their chickens from 100 to 45 days. The Chinese government claimed that eight of 19 tested batches of Yum! brands contained unsafe levels of these chemicals.

Although KFC denied the accuracy of the report, stating that 45 days was the ‘industry standard’ and that is chickens were not tainted, the media backlash was so fierce that the company had to reduce its same-store sales estimates for the full year. This debacle also reduced Yum!’s fourth quarter sales by a third.

Avian flu

Just as Yum! slowly bounced back from worries of a Chinese slowdown and chemically tainted chicken, even worse news hit - the return of the avian flu. With over 4,200 KFC locations in China, Yum! is fully exposed to the new H7N9 strain of the avian flu, which has already hit Shanghai and three surrounding provinces. The virus has spread north to Beijing as well, with a 7-year old girl being the first confirmed case in the capital.

Widely circulated pictures on Sina’s Weibo (‘China’s Twitter’) show deserted KFC restaurants across the country during lunch and dinner hours. Internet users across the country have expressed their fear of a new outbreak of the avian flu.

While the Chinese government attempted to assure the public that its chickens are safe for consumption, with culling efforts are underway, there is seething doubt across the nation.16,000 dead pigs have also recently washed up in Shanghai, raising fears of the swine flu, and casting doubt on the government's credibility.

McDonald’s is a safer bet

Yum! isn’t alone in its struggles in China. Rival McDonald’s also has significant operations in mainland China. However, McDonald’s, which has a wider variety of menu items, isn’t as highly exposed to the avian flu fears. McDonald’s recently diversified away from chicken products, by offering its new “German style” beef and sausage burger to emphasize its beef-based burger products over its chicken-based ones.

However, McDonald’s recently made a mistake with an ill-timed chicken nugget promotion in China, which was introduced on March 13. McDonald’s cut the price of its 20-piece chicken nuggets from 36 RMB ($5.82) to 20 RMB ($3.23) to drive sales. The accompanying ad campaign hit at the same time as the news of the avian flu broke, which made it look like McDonald’s was dumping chicken at a bargain price to Chinese consumers as the government announced chicken culls across the country.

Although that move resulted in a slight media backlash against the company, I believe that McDonald’s is in a much safer position than KFC, due to the flexibility of its menu offerings. In addition, the company’s 1.6% same-stores sales decline in its Asia/Pacific, Middle East and Africa segment in February was much softer than Yum!’s  double-digit drop in China. In addition, being exposed to a wider range of global markets should insulate McDonald’s from the current problems in the Chinese market.

Effects on other companies

Yum! and McDonald’s aren't the only large companies being dragged down by the poultry problems in China. Tyson Foods, which generates 30% of its international chicken sales from China, also stands to lose a chunk of its business as demand of chicken wanes and flocks are culled. Tyson is depending heavily on strong Chinese sales to boost its international top line 12% to 18% annually.

Share prices of major Chinese airlines have also plummeted, on the fear of passengers being infected by the virus in the enclosed spaces of airplane cabins. The soybean market has also slid to new lows, since soybeans are often used in chicken feed, which will slide in demand as chickens are culled. A recent South China Morning Post article states that demand for live chicken has already declined 30% since the outbreak of the avian flu.

Only one company has profited from this mess - Biocryst Pharmaceuticals, which produces the anti-influenza drug Peramivir. China’s Food and Drug Administration stated that it recently expedited the approval of Peramivir to address the current demand. As a result, shares of Biocryst surged nearly 14% after the announcement on April 12.

The Foolish Bottom Line

Investors should avoid companies with heavy exposure to China’s poultry, since things are going to get much worse before they get better.

That means Yum! Brands should definitely not be in your portfolio right now, as I doubt that the company will really be able to add 700 new KFC locations in China while continuing to post same-store sales declines throughout the year. However, Yum! might be a strong buy in a year after all this drama finally ends and demand for chicken returns.

Leo Sun 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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