More Indigestion for Yum! Brands

07/19/2012 4:31 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

China is the key market for Yum’s long-term growth…and the most recent earnings uncovered a couple of troubling hiccups there, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.

Another disappointing quarter for Yum! Brands in China.

Yesterday, the company reported second-quarter earnings of 69 cents a share. That was up a meager 6.2% from earnings of 65 cents a share in the second quarter of 2011.

So what if it was just a penny short of Wall Street estimates of 70 cents a share for the quarter? 6.2% annual earnings growth isn’t what I expect from a stock that sells for a trailing 12-month price-to-earnings ratio of 22. (Although some investors disagree—the shares were up 1.7% as of 2 p.m. New York time on July 19.)

I’ve written about this stock a number of times since I suggested adding it to your watch list back in April. Then I suggested waiting until the shares pulled back below $68.

I still like Yum! Brands in the long run for its exposure to China and other developing economies. But even though the stock is currently trading below my recommended price, I’d give this one some more time. I’d like to see if the negative trends highlighted by the company in today’s earnings report turn more negative in the next few months before trending upwards.

The problem at Yum! Brands for the quarter reported today was China—and that’s the source of the uncertainty for the next few months. While overall company earnings climbed, operating profits in China fell by 4% year-over-year. Wages in China were up 13% in the quarter—not exactly a small problem for a company planning to staff 700 new restaurants in the country in 2012. Food costs for Yum! rose by 6%.

Those two factors helped reduce profit margins to 15.6% in the second quarter of 2012, from 19.7% in the second quarter of 2011.

Not that everything went sour for Yum! this quarter in China and elsewhere. Same-store sales in China still rose by 10%, certainly respectable even if down from the 19% growth in 2011. And operating profits in the United States climbed by 26% year-over-year, as the company’s Taco Bell unit continued its recovery.

But there is enough that’s uncertain in the China details to make me want to wait for more clarity on where and when growth in China might turn upwards.

The company said that it doesn’t expect double-digit same store sales growth to continue in China, especially after the rapid growth in 2011. Middle-single digit same store sales is a more reasonable expectation, Yum! Brands management said. (Add in new store openings, and growth gets back into above 10% in my calculations.)

But there’s a wrinkle here that I’d like to watch for a couple of months or so. Much of Yum’s same-store sales growth in China comes from increasing traffic into its stores, rather than from increased spending per visit. In fact, per-visit spending was actually lower in 2011 than in 2010.

To some degree this is a good thing: Yum! is expanding its customer base. On the other hand, if China’s economy does slow more than I expect, some of this new customer base could simply decide that Pizza Hut or KFC was an expensive treat that the family budget can’t afford.

Food inflation is a likely key to Yum’s margins and sales growth in the next six months. If Yum’s food costs drop as China’s rate of food inflation falls from the 15% peak of the last 12 months to something like the current 4% rate of food inflation, then Yum! Brands should be able to keep prices low enough to continue to expand its customer base and increase operating margins.

If food inflation kicks up again—or if the company’s food costs don’t come to follow the national rate of food inflation—Yum could lose some of that expanded customer base, and see margins stuck at current levels.

I’d like to see either September on the calendar or a price nearer to $63 a share—or even better, both—before I move this one from watch list to buy.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Yum! Brands as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.

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