Weakness At Yum Extends Beyond China

| About: Yum! Brands, (YUM)

Global fast food player Yum! Brands (NYSE:YUM), owner of KFC, Taco Bell, and Pizza Hut, reported weak second quarter results Wednesday afternoon as the Chinese poultry scandal and an outbreak of avian flu weighed on the firm's sales in China. The company's revenue fell short of consensus expectations, declining 8% year-over-year to $2.9 billion. Earnings-per-share was even weaker, falling 16% year-over-year to $0.56 per share on an adjusted basis-slightly above consensus estimates. Year-to-date, free cash flow has totaled $257 million or 18% of revenue-a relatively strong number, in our view.

The most obvious problem at Yum! Brands remains its China division, specifically KFC. If a tainted poultry scandal weren't enough, the outbreak of avian flu in several of China's largest cities has scared consumers even more. This led to a 20% same-store sales decline in China, led by a 26% decline at KFC offset partially by a 7% increase at Pizza Hut. With sales declining so sharply, the company experienced severe fixed-cost deleveraging resulting in operating margins falling 500 basis points year-over-year to 10.6%.

Image Source: YUM Q2 FY2013 Earnings Release

On the positive side, Yum! Brands has not let the incident deter the growth of its restaurant footprint in China (shown above). The firm also suggested that the pace of sales declines are decelerating, mentioning that May same-store sales dropped 19% while June same-store sales fell only 10% (KFC: -13%; Pizza Hut: +6%). If we remember back to the first quarter, the company was able to mitigate the poultry issuerelatively well, and we are confident Yum! Brands will get back on track going forward. The firm will be providing monthly sales reports in China until the situation resolves itself, so we will be able to monitor developments very closely going forward.

(Click to enlarge)

Image Source: YUM Q2 FY2013 Earnings Release

In the US, same-store sales growth registered just 1% after achieving 7% expansion in the same period a year ago. Although the company was positive about its results, 2% growth at Taco Bell, 3% growth at KFC, and a 2% decline at Pizza Hut isn't very exciting, in our view. Still, Taco Bell's innovation remains an industry best, and we think McDonald's (NYSE:MCD) could take a lesson from Taco Bell's experimenting with new products and tastes. Further, Wendy's (NYSE:WEN) North American same-store sales grew just 1% during its first quarter, suggesting that the broader US fast-food market simply isn't strong at the moment.

Though comparable sales weren't fantastic, the firm's operating margin in the US jumped 410 basis points year-over-year to 24.5%, boosted by an 80 basis-point jump in restaurant margins. Lapping costs from an employment lawsuit in the prior-year quarter primarily contributed to the increase in profitability. Still, we like the margin expansion we saw in the US.

India's same-store sales growth wasn't robust either, increasing just 2% year-over-year. However, India is far from a mature market, so system sales increased 24% year-over-year as the company added new restaurants at a rapid clip. India is an enormous country, but the firm's current store footprint is a small fraction of what it is in China. In the intermediate term, we believe India will be a massive growth market for Yum! Brands.

Valuentum's Take

As if the poultry scandal weren't enough, the avian flu has given Chinese consumers another reason to fear consuming chicken. As we stated in the wake of the poultry scandal, we think consumers will eventually come back to KFC once fears have calmed down.

Through the duration of Yum! Brands' China issues, we haven't altered our long-term outlook on the firm, and we continue to believe shares look fairly valued. We are huge fans of the firm's international expansion efforts, especially since the company is strong where McDonald's is weak. Taco Bell's continued innovation is also providing serious competition in the burgers-and-fries space. Still, we don't think the Yum! Brands' current valuation warrants a position in the portfolio of our Best Ideas Newsletter at this time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.