Why Yum Brands' Recent Weakness Looks Like A Buying Opportunity

Aug.28.14 | About: Yum! Brands, (YUM)

Summary

Yum Brands' shares have dropped after the company released weaker-than-expected results and ran into trouble regarding the freshness of meat used in its products.

Yum, however, has faced problems in China earlier, and has bounced back well. It is already working to fix the current problem.

The long-term prospects in China are strong, due to the impending growth in the consumer class, and this will benefit Yum, as it derives 53% of its revenue from China.

Yum Brands (NYSE:YUM) has performed sluggishly on the market this year, as the company has struggled in the key market of China due to a food safety scandal. In addition, Yum's results have not been up to the mark. Even though the company delivered a year-over-year increase in both revenue and earnings in the second quarter, it failed to match Wall Street expectations.

As a result, Yum lost the momentum that it had gained so far this year, and has now dropped considerably from its 52-week highs. However, it cannot be ignored that Yum delivered decent growth in the previous quarter despite concerns in China. It reported revenue of $3.2 billion, a 10.3% increase compared to $2.9 billion last year. This was marginally below analysts' estimates of $3.23 billion. Its net income rose from last year's $281 million to $334 million. Going forward, management expects its earnings to increase around 20% this year.

Although the numbers were below estimates, but on a year-over-year basis, the company improved its metrics. Also, it is taking the necessary steps on a global front to sustain its double-digit earnings growth in the next fiscal and beyond.

A closer look at China

KFC did well in China, even though there have been concerns around the quality of meat. However, there might be some issues in the current quarter, as the stale meat scandal has come up just recently. According to International Business Times:

"Yum! Brands Inc., owner of the KFC and Pizza Hut chains, said Wednesday that a food-safety scandal in China, which involved the sale of spoiled meat by one of its suppliers, has significantly hurt sales over the past 10 days and raised concerns about the company's profitability for the year.

In a filing with the U.S. Securities and Exchange Commission, Yum Brands did not disclose financial details, saying that it was too early to predict when sales might bounce back. However, the Louisville, Kentucky-based company said that if the fallout from the reports about the tainted meat, which "has shaken consumer confidence" and "impacted brand usage" is prolonged, it might hurt the company's profits for 2014."

Management is looking to fix the stale meat scandal in China, which otherwise could mar its image. Consequently, it has stopped using meat from Husi, which is a subsidiary of OSI Food that supplies meat products to Yum. This will result in a temporary shortage of cheese pork hamburger and BBQ hamburger at some KFC restaurants. But in a statement to Fox Business, the company said, "We have already transferred the materials from other suppliers urgently to tackle the supply shortage."

Why China should not be a worry in the long run

However, Yum is focusing on the long-term opportunity in China. It recently launched 15 new products across 4,600 restaurants in China. According to Yum, the long-term opportunity in China is strong. The company currently has "four restaurants per million people in China, where the consuming class is expected to grow from 300 million people just a couple of years ago to over 600 million by 2020."

Thus, the company is making the right moves to improve its standing in the Chinese market, as this is expected to grow at a good pace going forward. Moreover, since China accounted for around 53% of Yum's overall revenue last year, the company seems to be in a good position to tap this market.

Also, investors should not worry much about the food safety scandal, as Yum has come out of such problems before. As IB Times reports:

"In December 2012, Shanghai authorities said that tests conducted from 2010 to 2011 by a third-party agency found high levels of antibiotics in eight batches of chicken supplied to Yum by Liuhe Group."

Since then, the company has bounced back well. For instance, in the previous quarter, the company's business in China grew at a good pace. According to a press release:

"China Division system sales increased 21% as we opened 104 new restaurants and delivered same-store sales growth of 15%. Restaurant margins were 16.8%, which was 6.2 percentage points above prior year. We are especially pleased with the initial success of our KFC Menu Revamp and excited about our plans balance of year. Overall, we remain on track to open at least 700 new restaurants in China as we further capitalize on the world's largest and fastest growing consuming class."

With East Dawning, Yum Brands is offering customized cuisines for its Chinese customers. In fact, more than 40% of the menu consists of Chinese foods. So, along with pizzas, its Chinese offering in a small box is expected to see aggressive expansion.

Some more positives

Yum is also focused on enhancing the customer experience by way of a complete revamp of its restaurants. In addition to design changes at its outlets, KFC has redesigned packaging, included a new menu board, and has improved staff uniforms. Pizza Hut is also doing well, and Yum plans to expand Pizza Hut to lower-tier cities across the globe, establishing more than 1,200 units in the current fiscal year.

Yum's India operations are also moving fine, and management sees strong opportunities ahead. Currently, it has more than 700 units in the region, and anticipates opening another 150 stores during the current fiscal year. Moreover, with the new government in place, Yum is optimistic about India as the new leadership unveils its policies, which are expected to be more pro-business.

Conclusion

So, the recent weakness at Yum Brands could be a classic "buy on the dip" opportunity. The company is undertaking measures to overcome the recent problems in China, a market where it is already seeing impressive growth. Moreover, China is its largest market, and the company sees a big opportunity in the country, as discussed above.

Moreover, Yum's valuation also looks enticing. Currently, it has a trailing P/E of 29, which is almost in line with the industry P/E of 27.6. Moreover, its forward P/E looks even more promising at 17.8, and indicates earnings growth. Also, its earnings are expected to grow at a CAGR of 15% over the next five years, double of the growth seen in the last five. So, considering all angles, since the stock has declined post its results, I think it will be a good idea to pick up some shares, as Yum could be a good long-term investment.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.