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A China Conundrum

The recent volatility in YUM's (NYSE:YUM) stock provokes a vital question: What is the right valuation for a company that conducts 50% of its business in China, a country with little to no policy and regulatory visibility?

Almost all analysts "front ran" the company's earnings report on Monday, Feb 4 by cutting their 2013 SSSG and price targets. However, none connected the dots between recent events and the underlying risks. YUM has had a strong, nearly 30-year run in China. But its recent debacle illustrates the significant commercial and regulatory risks faced by multinationals doing business in China.

Looking beyond the near-term "noise," the real long-term risk for the stock is this: A multinational with heavy exposure to China inevitably faces many unpredictable and uncontrollable regulatory and policy shifts, which we call "X factors." Stocks should only be rewarded with high multiples when they have predicable earnings streams and are at the peak of their product cycles. YUM has neither.

For that reason, YUM deserves a China haircut, not a China premium.

Headline Risk

At YUM's analyst day on December 6, 2012, we asked CEO David C. Novak what his "defense" was to media exposes that one of KFC China's suppliers had pumped its chicken full of chemicals to expedite their growth. The story prompted a furious social media reaction. His answer was "No worries. It will blow over." When asked how, he shrugged: "It always has."

A month later, Chinese media still haven't let the story go. Why? Speculation abounds. It could be YUM didn't buy enough commercial time from CCTV to appease China's largest broadcaster. Or it could be that YUM imprudently revealed that it paid a "protection" fee to a subsidiary of the Shanghai FDA after being caught off guard when local media confronted it with the supplier scandal. Rumors say the embarrassed government agency then turned the company over to CCTV.

But whatever the truth, and even assuming this "one-time" event blows over as Novak hopes, YUM's long-term China prospects still look grim.

Brand Erosion and Saturation:

We see significant brand erosion on the ground in China. YUM's first-mover advantage is turning into a first-mover disadvantage as stores become run down and the American fast food concept is no longer in vogue. Brand saturation from fierce competition in Quick Service Restaurant (QSR) concepts is also leading to pricing power erosion, especially in the context of lease renewals. The bulk of YUM's existing leases are up for renewal in the next five years. Because YUM has lost its appeal as a traffic aggregator, landlords are demanding steep increases and in some cases refusing to renew leases, forcing YUM to relocate to less desirable locations.

On average, in China the commercial rental costs have soared by up to 300-500% during the past decade.

Looming Multiple Contractions

China is now more than ever one of the most competitive commercial environments. Every year, dozens of new fast food brands come into the market. The lack of switching costs and ultra-low barriers to entry makes quick service restaurants a very unstable business.

In addition, poor business ethics and practices add tremendous complexity and stress to supply chain management. Obviously, YUM is not immune. One could argue the chicken scandal is just a one-time event, but undesirable chemicals could be found in its beverages, bread or even store uniforms. X factors of all kinds could ambush the company, especially under the reign of a different government.

YUM currently trades at around 11x EV/2013 EBITDA and 20x P/2013E, above its historical means of 9.5x and 17x respectively. China remains the reason for the premium.

We expect valuation to gradually contract as the company continues to guide down its China growth and margin compression becomes acute in 2013 and beyond.

As a QSR which faces low consumer stickiness and fierce competition located in China's under-regulated and aggressive commercial environment, YUM China deserves no more than 7x EV/EBITDA. By applying 8x multiple to the rest of its business, we arrive at a valuation of around $41 per share, or more than 35% downside in the stock. Valuation assumptions include SSSG=-3.5% and occupancy costs/sales=32% in China.

Conclusion

That fact that a $30 billion market cap company with an admirable track record of success lowered its guidance twice within a few weeks raised a red flag. It shows the business has near-zero visibility and no control of its fate in its country of operation. To add insult to injury, the overly optimistic management hasn't taken the China risks fully into consideration.

Even absent of any imminent negative news in the future, YUM does not deserve a high trading multiple relative to both its own historical range and peer group. The company's two recent guide downs are evidence of its slowing growth rate, declining margins, and limited earnings visibility.

Appendix:

News Is Still Unfolding

On November 23, 2012, Chinese media accused one of KFC China's Shanxi province-based suppliers of pumping its chicken full of noxious chemicals to expedite the growth cycle to 45 days.

On December 18, 2012, CCTV, China's national broadcaster, reported the toxic chemical issue.

On January 7, 2013, YUM lowered its sales forecasts for its China Division citing "adverse publicity associated with a government review of China poultry supply."

On Jan 15, YUM canceled its scheduled appearance at the annual ICR Consumer Conference in Miami 2013. Rumor had it that management didn't want to discuss its China business.

On January 25, the state-run Xinhua news outlet was still reporting on government findings of excessive levels of chemicals in KFC's chicken supply.

Wall Street Estimates Revisions in Jan 2013:

Morgan Stanley: Downgrade from Outperform to Market Perform, China 1Q SSSG negative 10%, Reduce Target Price from $77 to $72

Goldman Sacks: Maintain BUY, China 1Q SSSG negative 6%, Maintain Price Target at $77.

Wells Fargo: Maintain Hold rating, China 1Q SSSG negative 10%, Reduce Target Price from $69-72 to $67-70 (last sentence first paragraph).

Bernstein Research: Downgrade from Outperform to Market Perform, China 1Q SSSG negative 17%, Reduce Target Price from $80 to $72

Buckingham Research: China 1Q SSSG negative 15%, Reduce Target Price from $78 to $75, Maintain BUY

Source: YUM! China's X Factors Driving Valuation Contraction

Additional disclosure: Research contribution to Sandra Lu