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Fast food giant Yum! Brands (YUM) announced solid fourth quarter results early last week, though the company warned investors that problems lie ahead. Revenue during the fourth quarter increased 1% (5% on a comparable basis) to $4.2 billion, in line with consensus estimates. Earnings were slightly better than expected, growing 10% year-over-year on an adjusted basis to $0.83 per share during the period. For the full year, YUM! earned $3.25 per share-better than the firm anticipated.

However, these results were completely overshadowed by incredibly negative news coming out of China. Not only did same-store sales fall 6% year-over-year, with operating margins declining 190 basis points to 13.9%, but the company is experiencing a terrible reaction to a report that aired on China's national TV network in mid-December of 2012, which exposed poor practices from poultry farmers throughout the nation. Ignoring regulations, two of KFC's poultry providers purchased chicken from farmers, and the issues have since spread like wildfire via social media and the press causing great damage to KFC's reputation.

Management added some commentary on the press release with regards to handling a review of the situation, stating:

"On January 25, 2013, the SFDA concluded its investigation and released its recommendations. We appreciate their thorough and diligent review. The SFDA identified issues and provided Supervisory Recommendations to Yum! China to strengthen our poultry supply chain practices including refined voluntary self testing procedures, improved reporting and communications and enhanced supplier management. Our team in China has taken a comprehensive review of our current system and is in the process of incorporating all of the SFDAs recommendations. We have always recognized the importance of building a world-class supply chain in China, which is why we have implemented a wide range of quality assurance and testing practices over the years above legal and regulatory standards. The SFDAs recommendations will further strengthen those practices. The SFDA did not bring a case against Yum! China and no fine was assessed."

Though Yum! seems as though it is clear of any official crime, the harm to the company's reputation might even be more detrimental to KFC's sales. Throughout January and February (thus far), same-store sales fell 25%! That will take a real toll on the Chinese segment's profitability, and we're not surprised the firm assumes a single-digit decline in profitability on a company-wide level for 2013. Still, management believes the same-store sales decline will decelerate throughout the year, with positive growth returning when the company faces an easy comparison in the fourth quarter of 2013. Yum! intends to open 700 new units throughout the year regardless, which could be disastrous if the brand damage is permanent. Scandals like this tend to blow over in the US, but the reaction in China could be significantly different.

We'll continue to keep eye on the firm's China division, but Yum! still runs a fairly successful business across the rest of the world. In the US, same-store sales jumped 3% year-over-year-a stark departure from the anemic growth rate we saw at competitor McDonald's (MCD). Pizza Hut and KFC grew same-store sales 3%, but Taco Bell remained the standout, with same-store sales jumping 8% year-over-year. We think the Mexican themed chain is stealing share from both Chipotle (CMG) on the high-end and McDonald's on the low-end, making it one of the best performing fast-food chains in the country. Yum!'s segment operating margins in the US soared 290 basis points year-over-year to 19%, and restaurant margins jumped 330 basis points during the period to 16.7%. Even if China looks weak, the US is experiencing a strong turnaround.

Key Growth Markets Sales Trends% of YRIQ420122012
Africa7%2117
France4%58
Germany / Netherlands2%1211
Russia2%4746

Source: Yum! Brands

In its International segments, Yum! continues to do a nice job of expanding in its key growth markets (shown above). Total international revenue jumped 1% year-over-year, driving operating income growth of 8% to $224 million during the fourth quarter. We do not anticipate the news out of China to impact growth in any other international market.

Aside from the disaster that lies ahead in China, Yum!'s fourth quarter results and its path to growth in 2013 look relatively strong. Still, a mid-single-digit decline in profitability for 2013 is not something investors are cheering about. We won't be looking to add the company to the portfolio of our Best Ideas Newsletter at this time.

Source: Will Poultry Problems Continue To Plague Yum Brands?