A New Trend in China?

05/16/2013 8:30 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

The recent news out of China suggests a new trend in China that could impact one stock in particular, says MoneyShow's Jim Jubak.

For a lot of investors, Yum! Brands (YUM)—the company that owns KFC, that owns Pizza Hut, that owns Taco Bell, and in China Little Sheep—is a most interesting way to play China.

They own a lot of restaurants in China, and those are big. They have most penetration of the fast food sector in China. They were supposed to start 700 additional restaurants in China this year. They're moving into India; that's the next big growth market. But this is really a company that has US bookkeeping and also the growth of China, so it's one very, very interesting way to play China for a lot of investors.

The problem is that Yum! has been caught up in a crackdown in China on food quality, on food safety. It all started with what seems to be real evidence that some chicken suppliers (and unfortunately some suppliers for KFC) were selling chicken that was tainted with materials and chemicals that aren't allowed in the Chinese system. So that was the first bit of bad news.

The second bit of bad news is Avian flu. The company has no connection with this, but apparently fears of Avian flu associated with chicken have made people think, "Oh chicken, Avian flu, I don't want to eat at KFC."

The connection is pretty tenuous, but it has had an effect on Yum! in China, and from all I can tell from reports from McDonald's (MCD), it's had an effect on McDonald's sales in Europe. So that was the second one.

The last one was that recently Chinese food authorities have discovered a company outside of Shanghai doing about $1 or $2 million in sales of things that they were calling lamb and mutton but that weren't. They were either mislabeled, so that they weren't fresh lamb if that's what they were supposed to be; or they actually weren't lamb or mutton at all. Species included mink, rat, and a few other things that clearly don't bear a whole lot of resemblance to sheep.

Yum's exposure here is through their 2011 acquisition of Little Sheep, which is a Hot Pot restaurant and therefore specializes in mutton. There is no evidence that Yum! and Little Sheep was caught up in this. Their suppliers seem to be clean. But nonetheless, you've got a company where customers were already hesitant about going back because they were in the news and now this one more thing.

The company said that they think the same store sales in April will be down about 30% year over year, so this has had a big effect. They've also said that they think that the sales growth will be back to its normal trend by the end of 2013.

I think that probably would be true, except that the company is being caught up in what is a government crackdown on food safety; the Chinese have decided that they need to do something very, very visible to protect the food supply. They've had too many scandals, so we're going through a period where I think all the officials who are supposed to inspect this stuff are really inspecting the stuff.

It happens in the United States like this; it's not unique to China. You get people suddenly paying attention to what their job is, and you get a lot more crossing of Is and dotting of Ts, or the other way around. So we're going to have a lot of attention on this.

I think these are not the end of episodes about this, and every time some crackdown which may or may not involve Yum! and KFC and Pizza Hut and Taco Bell happens, it's going to remind people of the initial problem, which involved Kentucky Fried Chicken about chicken suppliers.

The reason that the stock hasn't gone down under all this is that you've a great sort of revival turnaround story in the United States. Taco Bell has picked up growth, launched new products. Pizza Hut seems to be picking up share competition, and the pizza industry seems to be lessening. Those good stories have really made investors reluctant to sell.

The stock really has not gone down; it has been in the mid-$60s, the upper $60s. So you're looking at this and going, "OK, I've got a lot of risk that the turnaround in China is going to take longer, but there's not a whole lot of upside, because people are already saying I really don't want to sell...so I'm holding on here and the stock hasn't dropped very much."

I think a target on Yum might be $72. Right now, it's trading around $68. That's not enough of a premium. If the stock dropped to the low $60s, I certainly like it, because I think the story in the emerging markets really does work in Yum's favor. But not at this price.

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