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Shares of Yum! Brands (NYSE:YUM) sold off following the release of a weak third quarter earnings report. A continued underperformance of the so important Chinese activities triggered a renewed sell-off as the recovery will take longer than recently anticipated.

Yum!'s shares should find some support as long as management does not withdraw its current projections in the coming months. The solid outlook for 2014 earnings and strong payouts to shareholders, in the form of share repurchases and dividends, should provide a floor under the current valuation.

Third Quarter Results

Yum! generated third quarter revenues of $3.47 billion, down 3% on the year before. Consensus estimates for revenue stood at $3.5 billion.

Mainly as a result of $300 million in impairment charges, net income fell by some 68% to just $152 million. GAAP earnings per share fell from $1.00 to $0.33 per share on the back of this.

Non-GAAP earnings came in at $0.85 per share, falling short of consensus estimates at $0.93 per share.

CEO and Chairman David C. Novak commented on the performance, "I remain as confident as ever in our ability to deliver strong, sustainable growth in the years to come. Our revised full-year EPS outlook is obviously well below our 11-year track record of double-digit growth through 2012. We also recorded a significant non-cash Special Item charge for the write-down of Little Sheep intangible assets."

Looking Into The Results

Sales in local currencies were up by 1% for the quarter, while the decline in reported revenues was entirely driven by adverse currency movements.

Growth was driven by new restaurant openings, with net openings of 364 new restaurants, of which 79% was in developing countries. This was offset by an 11% decline in comparable store sales in China. Chinese Pizza Hut sales grew 6%, while KFC reported a 13% decline in sales in the country.

Direct restaurant expenses rose some 60 basis points to 71.8% of total revenues on the back of higher food, paper, and payroll costs. $300 million impairment charges, resulted in operating profit of just 10.1% of total revenues, down 870 basis points on the year. Add to that higher taxes, and net earnings came in at just 4.4%, down from 13.2% of total revenues a year before.

Outlook

Based on the disappointing performance, YUM! now believes it is unlikely that same-store sales will be positive in the fourth quarter.

On the back of this and higher taxes, Yum! now sees a decline in full-year EPS from high-single to low-double digits, excluding special items. Previously, Yum! guided for a decline in earnings per share in the mid-single digits.

While 2013 will be a disappointing year, Yum! sees at least 20% earnings per share growth in 2014, restoring the track record of double-digit EPS growth.

Valuation

Yum! ended its third quarter with $753 million in cash and equivalents. Total debt stands at $2.93 billion, for a net debt position of close to $2.2 billion.

Revenues for the first nine months of the year came in at $8.90 billion, down 6% on the year before. Net income fell by 39% to $770 million in the meantime. At this pace, annual revenues could come in around $12.8 billion while non-GAAP earnings are seen around $1.25 billion.

Factoring in losses of 7% at the moment of trading, with shares exchanging hands at $67 per share, the market values Yum! at nearly $30 billion. This values operating assets around 2.3 times annual revenues and roughly 24 times earnings.

Yum! currently pays a quarterly dividend of $0.37 per share, for an annual dividend yield of 2.2%.

Some Historical Perspective

Yum! has created a lot of value for its shareholders over the past decade, driven by its expansion in China, mainly through KFC.

Shares have steadily risen from $15 in 2003 to highs in the mid-seventies by the start of 2012. Ever since, shares have traded in a $60-$75 trading range, currently exchanging hands around $67 per share.

Between 2009 and 2012, Yum! has increased its annual revenues by a cumulative 26% to $13.63 billion. Net earnings rose by 49% to $1.60 billion in the meantime. The company has initiated share repurchases in recent times to offset the disappointing developments through the year, retiring roughly 4% of the share base outstanding.

Note that both revenues and earnings are set to decline markedly in 2013.

Investment Thesis

Almost a year after Yum! started to struggle in China, the situation still has not improved yet. Obviously, we are no longer seeing falls in comparable store sales of more than 25% anymore, but a reported 11% decline is still steep.

Furthermore, the visibility is not great given that as recent as last month, Yum! guided for small growth again in China for the fourth quarter. At the presentation of the results, Yum! now calls this "unlikely." This disappointment is crucial as China is by far the biggest market for Yum!, making up 52% of all revenues in the first nine months of the year. In total, Yum! has over 6,000 stores in China.

Besides the backlash from Chinese consumers after an outbreak of the avian flu last year and investigations into the use of too much antibiotics by suppliers, Yum! is also seeing more competition from Chinese restaurant chains like Hua Lai Shi.

Back in December of last year, when Yum!'s problems started in China, I last took a look at the company's prospects. I concluded that the pace of the Chinese slowdown was shocking, given the freefall in comparable sales combined with the importance of the Chinese activities to the firm.

At the time, Yum! reported a mere 4% fall in comparable sales in China, compared to growth of 6% in the quarter before. While we have seen even worse results in the meantime, shares have held up quite well, trading essentially flat so far this year.

While shares are seeing a large sell-off on the back of the results, they are seeing some strength from the strong earnings outlook for 2014, which implies earnings of around $3.30 per share.

This relative strength has been driven by the outlook for 20% earnings growth in 2014, which implies earnings of around $3.30 per share. That values the business at 20 times annual earnings, a reasonable valuation if the long term growth prospects remain intact. Yum! has also raised the quarterly dividend to $0.37 per share, for a 2.2% yield. Add to that, $490 million in share repurchases so far this year, and Yum! returns cash to shareholders at a combined yield of roughly 4.4% at the moment.

While the latest sell-off is warranted given the prolonged issues in China, shares should see some support in the coming weeks on the strong 2014 guidance and shareholder payouts. Note that Yum!'s management has to deliver, as investors will most likely not tolerate another broken promise, or withdrawn outlook.

I do see long-term potential for Yum!, yet I think the current valuation is fair given the short and medium term uncertainties.

Source: Yum Brands - Not So Yummie As Chinese Recovery Takes Time