Weighing China's Consumer Favorites

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

While earnings season comes around four times a year, it never gets old for me. Quarter after quarter we as investors try to dissect every conference call, transcript, and question and answer segment in the hopes of benefiting financially. Though the current season is just in its early stages, we've already had a number of powerhouse brands and companies report their results. Yum! Brands (NYSE: YUM), the parent company of some of the world's leading quick-serve restaurant brands including KFC, Pizza Hut, and Taco Bell, reported its second quarter earnings last week amid broad market strength.

I love the chicken but not the stock

The company reported a weak quarter on a comparative basis, but largely in line with the expectations of the Street. Second quarter net income fell to $281 million, or $0.61 a share, from $331 million, or $0.69 a share, a year earlier. The poor earnings data was largely a result of poor revenues and same stores sales in the company's China markets. Negative 20% same store sales figure out of its China business segment drove revenues lower by 8.5% for the quarter to $2.9 billion. The majority of analysts have attributed the great weakness to safety scares. Over the last year, numerous headlines have scared customers away from the brands , especially KFC, as consumers look to stay away from the antibiotic rich and possibly contaminated chicken.

I do agree with analysts, but feel the declining popularity of the brand may stem from additional headwinds. Much of the turbulence in global equity markets over the last few weeks has been a result of an economic slowdown in China. Interest rate spikes, declining wage growth, declining real estate demand and GDP growth, have all caused some to fear the country is on the brink of an economic meltdown as the symptoms are giving some investors deja vu. Many of these indicators, including interest rate spikes within inter-bank lending, occurred just before the 2008 financial crisis here at home. 

While fast food may be an inferior good to the majority of us in developed economies, the price tag in terms of income is significantly higher in emerging markets. In China, Yum! offers consumers a normal good as far as I'm concerned. As any entry level economics student knows, as the level of disposable income declines, the level of spending on such normal goods declines. Hence, if the level of income growth declines, the level of normal good spending growth will decline in a similar fashion. Moreover, I don't feel the Chinese consumer will forget these safety scares anytime soon either. Its tough to convince a consumer to pay up for a good which is causing them health problems, wouldn't you think? Going forward, I fear the company will continue to feel the consequences of its past mistakes, hence I would encourage investors to sit on their hands and wait for more data before jumping into this name. 

Whats up next?

Starbucks (NASDAQ: SBUX), one of my favorite companies and favorite stocks, will be reporting later this month. I have been bullish on the company for some time; however I fear shares might need to take breather before heading higher. Year to date shares have returned nearly 30% to investors: Just last Friday yet another 52-week high was registered.

Shares sit just below $70, and look far more expensive than they did just a couple months ago. Up until recently, the market failed to price in the exceptionally high growth projections and potential within the company's Asian business segment. Time and time again, CEO Howard Schultz has preached the regions potential, yet the market failed to understand until recently. It is his belief, and mine, that over the coming decade China will represent the company's largest market by revenue.

Going into the earnings report at the end of this month, I would advise investors to be careful as shares have moved up fast ahead of the announcement. I have similar fears regarding a growth slowdown due to an income slowdown within China, as discussed above. However, I would advise investors to use any pullback as a long-term buying opportunity. Domestically, the company is looking to add thousands of additional locations before it hits market saturation. The company has taken steps to diversify its growth through a number of countries besides China including the U.S., India, and Indonesia. 

Broad Exposure

Perhaps you are one of the many investors looking to easily diversify your portfolio through exchange traded funds. If you are, you should check out the iShares China Large Cap ETF (NYSEMKT: FXI) for a spread approach.

<img alt="" src="http://g.fool.com/editorial/images/57781/fxi-breakdown_large.PNG" />

The fund is heavily weighted in financials, telecommunication and energy which bodes well for a trend of increasing incomes within the country. The financial sector in particular could perform especially poorly if we see a continuation of rising interest rates on inter-bank lending. As the rise in incomes slows, the demand for upgraded telecommunication, a normal good, will slow at a correlated rate. This fund will provide you exposure to 25 large companies, therefore it will perform in tandem with China's overall economy.

Foolish wrap-up

While Yum! Brands may have a great product, I would advise investors to sit on the sidelines at this moment. It is unclear whether the broad Chinese slowdown will affect growth on a significant scale. Additionally, I have concerns regarding demand for the product as fears of product quality linger. Starbucks reports later this month, July 25, along with a number of other large companies. I would suggest waiting for a pullback before entering a position, as shares have risen quite drastically over the last few weeks. The long term growth potential remains solid and diversified. Lastly, the fund mentioned above, will provide exposure and diversity to a basket of China's largest companies.

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Nathaniel Matherson owns shares of Starbucks. The Motley Fool recommends Starbucks. The Motley Fool owns shares of Starbucks. 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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