Market Neutral Investing in China's Fast Food Industry

Dec. 3.10 | About: Yum! Brands, (YUM)

As I mentioned in previous posts, I've started putting cash to work in market neutral trades every couple of weeks. I'm borrowing a game plan here from a Short Screen member who has run a market neutral portfolio with impressive returns for the last ten years: adding a paired long and short position every two weeks, and then eventually closing out old positions as I add new ones, to keep the portfolio capped at 52 positions (26 pairs). I may exit positions before I get up to that cap, but given the number of positions and the small relative size of each one, if I add stops they will be wide ones.

For today's market neutral trade I shorted CCSC at $22.80 and bought an equivalent amount of YUM at $50.65. As I've done with the last few market neutral trades, I shared the trade idea with subscribers of the Market Neutral Notification List the night before I placed the trade.

CCSC is Country Style Cooking Restaurant Chain Co., Ltd., an upstart fast food chain serving Chinese cuisine in China. CCSC went public in the the U.S. at the end of September at $16.50 per share (above its expected offering range of $14-$16) and spiked up 47% on its first day of trading. It peaked at close to $35 per share toward the end of October, and has plummeted since then.

Even after this steep drop, CCSC looks pricey, trading at about 6x trailing sales, 57x trailing earnings, and 39x analysts' average earnings estimate of 2011 earnings (58 cents), with a PEG ratio of 2.09. CCSC may see additional selling pressure when the lock-up period for insiders ends and they can start unloading shares.

Yum! Brands, Inc., operator of KFC, Pizza Hut, and other fast food brands, is the dominant fast food restaurant operator in China, and China is YUM's largest market.

YUM breaks out its operating results by three divisions -- China, U.S., and International, which covers all of its markets excluding the U.S. and Mainland China. In its most recent quarter, 46% of YUM's operating profits came from its China division. Operating profits also grew the fastest in its China division, on a year-over-year basis: 24% versus 18% in YUM's international (ex-China) division, and -2% in its U.S. division.

Of the 3,664 restaurants YUM had in China at the end of its Q3, 3,054 were KFCs and 575 were Pizza Huts. The handful of others were a new concept YUM is testing in China, "East Dawning", which sounds like it could represent direct competition for CCSC's restaurants. From YUM's website:

East Dawning, the company's Chinese quick-service restaurant brand to provide affordable, great-tasting, authentic Chinese food to the Chinese customer. The East Dawning menu is 100% Chinese and offers a wide range of options for all day parts including breakfast, lunch, dinner and snacks.

YUM isn't exactly cheap here, but trades at a more reasonable valuation relative to its estimated growth and earnings, with a PEG Ratio of 1.63.

Disclosure: Long YUM, Short CCSC