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Yum! Brands (NYSE:YUM) has not had a particularly good time in 2013 following the horse-meat scandal in Europe and the outbreak of avian flu. However, the earnings release for the second quarter seems to suggest that the worst is over because the 12.2% decline in sales in June is lower than what analysts had expected. In May, sales in China were down by 19% while same-store sales at KFC declined by 13% in June compared to 25% in May and 36% in April. Though the trend is positive, it begs the question of when the company will start to once again generate satisfactory profits. The company's revenue was short of analysts' consensus expectations, declining 8% year-over-year to $2.9 billion. EPS was even weaker, declining 16% year-over-year to $0.56 per share on an adjusted basis though this was marginally more than consensus estimates. For the year-to-date, free cash flow has totaled $257 million equaling 18% of revenue, which is relatively strong.

Region-wise performance

The most obvious problems that the company faces are in China with KFC being the most affected by a scandal about tainted chicken and an outbreak of avian flu in some major cities, which has kept customers away. A 7% increase in Pizza Hut sales helped to partially offset the decline in KFC. Declining sales resulted in a 5% decline in operating margins to 10.6% because of the impact of fixed costs. However, the company has said that it will not let these one-off incidents affect the growth of its restaurants in the country. The importance of China is underlined by the fact that it accounts for more than half of the company's revenues but things should now slowly improve. Past experience suggests that health concerns in China resulting in temporary declines in business are followed by a rebound within a few months.

In the United States, sales grew by only 1% compared to 7% in the previous year. Although the company was optimistic, 2% growth at Taco Bell, 3% growth at KFC, and a 2% decline at Pizza Hut are not particularly impressive results. The performance of competitors such as Wendy's (NASDAQ:WEN), which also grew by 1% suggests that the domestic U.S. market may be saturated when it comes to fast food. However, operating margin showed encouraging growth by over 4% to 24.5% though the figures for the previous year were affected by the costs from an employee-related lawsuit.

In India, same-store growth in sales showed a growth of only 2% year-over-year but, because the market is far from saturated, the addition of new restaurants enabled system sales to grow by 24% from the previous year. India is a large country but the company's footprint is small compared to China and there is obviously scope for strong future growth.

The case for investment

Fitch has affirmed the present default ratings and regards the ratings outlook is stable. The ratings reflect the moderate size of debt, strong free cash flow and the economies of scale. At the end of 2012, 20% of the restaurants were operated by the company while the remaining 80% were franchised.

The main case for buying the stock lies in the belief that the difficulties in China are short term in nature and that revenue and margins should start to improve in the second half of 2013 and come back strongly in 2014. In particular, the company needs to see a strong rebound in KFC sales because these sales in China are going to be a major factor in determining the EPS in the future. Moreover, there is scope for optimism because the decline in sales seems to have stabilized. The company's other major restaurant chain, Pizza Hut, showed a growth of 7% in same-store sales in China for the quarter, which would suggest that KFC's problems are product-specific, not because of a general weakness in the Chinese fast-food market. This is also the case for emerging markets overall where same-store sales grew 5% in the quarter.

The bottom line

On the face of it, if you factor in the expected mid-single digit decline expected in 2013, the stock looks expensive with an earnings multiple in the region of 23 times forward earnings. However, if the company meets the analyst's estimate of an EPS of $3.70 per share in 2014, the forward valuation would be around 19 times earnings, which is more reasonable. I personally believe that the company will come out on top of its problems and that you should take this opportunity to consider YUM as part of your portfolio.

Source: Yum Brands Should Resolve Its Problems In China