Can Yum Get Investors Licking Their Lips Once Again?

| About: Yum! Brands, (YUM)

Yum Brands (NYSE:YUM) is preparing to release Q2 2013 earnings today, July 10, after the market close. The Louisville, Ky.-based restaurant operator is one of the world's largest, and is responsible for such ubiquitous brands as KFC, Pizza Hut, and Taco Bell. The last round of earnings for the company was fraught with controversy as their operations in China were hit with multiple highly publicized accusations in rapid succession, most recently regarding potentially substandard mutton (amid the gruesome rat-as-mutton scandal) and before that the suggestion of the presence of excessive chemical content in a small portion of KFC's chicken supplies in the country.

The quarter also saw a resurgence of avian flu, followed shortly by the appearance of a new strain of the virus. That resulted in poultry market closures and a general aversion to chicken and other fowl among Chinese consumers. These concerns are largely past, however, but the fast-food juggernaut's ability to recover lost brand equity in its largest market in the wake of large-scale concerns has been proven after other bird flu epidemics. It is understood that Yum's business in China is returning to bustling normalcy, but just how badly the business was hurt due to the controversies remains to be seen.

Despite claims that the Chinese market has a tendency to rebound rapidly, the proliferation of concerns regarding KFC's suppliers and the potential presence of pathogens led to a drastic, multi-month decline in consumption of the company's products in its single-largest market (prior to the latest incidents, Chinese operations accounted for a reported 51% of Yum's revenues). Last December reportedly marked a 6% decline in Chinese consumption of Yum products, and the slide worsened exponentially in the following months. The reappearance of bird flu cost China an estimated $6.5 billion, and KFC's sales were (as one would suspect) particularly vulnerable, sinking an additional 25% (in existing establishment sales) in May alone.

The losses in KFC revenues were partially offset by a notable gain in Pizza Hut traffic. However, the latter wasn't substantial enough to put more than a dent in what would amount to a 19% drop in all Yum Chinese sales that month. All of these concerns, on top of a somewhat troubling first-quarter earnings call, led to a period of deep uncertainty for Yum shares.

Despite the elevated levels of concern regarding the company's first-quarter earnings call, Yum still posted greater-than-expected earnings of $0.70 on the quarter, 10 cents greater than the $0.60 earnings per share that was expected. Although the most damaging accusations took place in the months following the period included in the report, even in the two months that were included, the general sentiment toward eateries in China was one of mistrust, exacerbated (in the case of Yum and other foreign firms) by excessive scrutiny from national and regional governmental bodies. That the stock was buoyed by signs of expansion in the company's general international operations in that report (19% growth in the most recent release vs. 5% in domestic growth), and expansion in southeast Asia and other peripheral regions is likely to have bolstered earnings again during the period to be described this afternoon. The recent opening of a KFC franchise in Ulaanbaatar exemplifies the company's enthusiasm for expansion and exploration of untapped markets; the planned addition of a drive-through location in the coming years would mark the first such establishment in the northern Asian nation.

Aggregate analyst earnings estimates have, despite the continual battering (though followed inevitably with strong recoveries) Yum shares have taken in recent months, remained the same over the past two months. Current estimates suggest that the company will post per-share earnings in the realm of $0.54, down from $0.67 a year earlier. Despite the relatively pessimistic earnings outlook, the company's stock is trading nearly $8 above where it was at this time last year.

The market is clearly appreciative of the expansionary policies at Yum, and is clearly taking into account the company's history of outperforming during earnings season (Yum has fallen short of consensus expectations in only one of the past eight quarters). As a result of the elevated share price YUM's current levels represent a P/E ratio of 22.83, which is above the industry average, despite an average rating of "hold" from surveyed analysts. Perhaps more telling is the fact that only one out of 25 analysts surveyed for the WatchListNews.com earnings preview placed a "sell" rating on the stock, and 11 suggested a "buy" rating.

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Source: Charles Schwab's OptionsXpress.

Given Yum Brands' history of earnings beats, as well as the increasingly promising fundamental situation, it would seem that the current price is fair and the stock is more likely undervalued than overvalued. Since the beginning of July, and as Yum has returned to the spotlight as one of this week's most notable earnings calls, the stock has climbed at a steady rate, and one cannot help but think that this pace can continue with relative ease. The Chinese earnings numbers to be included on the report have, to this point, been made out to be so dismal that with the greater temporal duration between the present time and the last of the major controversies, there will be room only for reconciliation and restoration of brand equity in the country that has shown such enthusiasm for Yum products in the past.

The continuing economic slowdown in the country will have driven down patronage at Yum establishments, but the relative brevity of the shock currently occurring in Chinese markets means that the darkest days of the Shanghai Index will be absent from the earnings call. The market is leaning on the success and future potential of the company's non-Chinese international locations, as well as its sales in an increasingly robust domestic market. The level of optimism is palpable to the point that traders appear certain that Yum Brands' earnings call will present an irresistible opportunity to buy into a growth-oriented, active company at a discount.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in YUM over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.