Yum: What Does The Future Hold?

| About: Yum! Brands, (YUM)
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As China goes, so goes Yum Brands (NYSE:YUM).

Drama in China

On December 18, 2012, a national Chinese television news report showed a KFC chicken supplier using illegally high levels of antibiotic in their chickens. This report led to a government investigation of KFC's supply chain. While the actual severity of the health violation was low enough for KFC to just get a slap on the wrist, the negative media attention created legitimate problems for Yum.

The parent company of KFC, Taco Bell and Pizza Hut suffered a 6% decline in Chinese same-store sales in the fourth quarter of 2012 compared with the fourth quarter of 2011. Yum has 5,300 restaurants in China, most of them KFC. The company got about 44% of its revenue from China last year. Net income for the fourth quarter slipped to $337 million from the net income of $356 million that the company earned last year.

The scandal even impacted its Chinese Pizza Hut sales, with same-store sales in the country down 15% in the fourth quarter.

For the overall company, fourth-quarter revenue plummeted 12.67% to $3.6 billion, while profits declined 5.34% to $337 million.

While Yum suffered financial damage in China due to the scandal, its business in other parts of the world performed well. Yet, the China effect was extensive as shares in the company dropped from $70 a share to $63 immediately after the incident. The stock price has rebounded slightly to just over $65 a share.

The company expects sales at restaurants opened for at least a year in China to drop by 25% in the first two months of 2013. The company also doesn't expect to have earnings per share growth for the coming year.

China is Key

With more than 38,000 restaurants in 120 countries, Yum Brands is the world's largest fast food chain in terms of units. Yet its immediate future hinges on how quickly it can regain the public trust in China and get consumers of the world's second largest economy to eat in its restaurants.

Yum may have more outlets in the U.S., but China is a more profitable market as the cost of operation is lower. The company's growth heavily depends on its Chinese operation. To that end, the company announced it will soon launch a brand reputation quality campaign to re-assure consumers, along with aggressive marketing plans.

In the company's fourth quarter and year-end earnings statement, Yum Chairman and CEO David C. Novack said, "Although we cannot predict how long it will take to restore sales, we are steadfast in our belief that the power and popularity of the KFC brand in China will ultimately drive a full sales recovery. Having weathered other storms in the past, we know that our brands are resilient. As a result, we will stay the course with our target to develop at least 700 new units in 2013 in China to lay the foundation for future growth, and will not let this event detract from our unparalleled China growth opportunity."

Recent Growth

The news for Yum wasn't all bad in its latest earnings report. The company reported full-year earnings per share of $3.25, up 13% from the year before. Worldwide operating profit increased 12% for the year. Same-store sales for the full year grew 4% in China, 3% for its Yum Restaurants International and 5% in the U.S.

And the company set a record by opening nearly 2,000 new stores, including 889 in China. Emerging markets accounted for 83% of the new development.

Yum says it believes the YRI and U.S. businesses will deliver profit growth consistent with past results. However, China remains an uncertainty. Yum assumes that same-store sales in China will improve as the year progresses. But the decline in business will lead to a mid single-digit decline in full-year earnings per share in 2013.

Many analysts think the fall in value due to the China food scare provided a buying opportunity for Yum shares, with the stock trading at a price-to-earnings ratio of around 19. Just as McDonald's (NYSE:MCD) recovered well from a mad cow scare about a decade ago, so too can Yum rise from the ashes of this predicament and use its strengths to continue its growth.

Even in the midst of the setbacks, Yum still has plans for further business expansions. Also, its strong performance in other parts of the world might help the company maintain its position in the market.

Its second largest segment, its U.S. Division, experienced same-store sales increases of 5% for the year, including growth of 8% at Taco Bell, 3% at Pizza Hut and 3% at KFC. In the fourth quarter, same-store sales increased 3%, driven by growth of 5% at Taco Bell, 4% at KFC and offset by a decline of 1% at Pizza Hut.

Also, restaurant margins increased 4.2 percentage points for the year, driven primarily by strong sales leverage. In the fourth quarter, restaurant margins increased 3.3 percentage points.

Yum's management effectiveness ratios are solid compared with the industry. Its five-year average net profit margin is 10.2% compared with the industry average of 9.4%. Yum has a five-year average return on assets of 15.4%, compared with a 10% industry average. And its five-year average return on investments of 27.7% is almost double the industry average of 14%.

Sales have grown steadily each of the last four years, as has operating profit. Yum paid out an annual dividend of $1.34 a share, representing a payout ratio of 35%.

The company has a relatively low amount of long-term debt at $2.93 billion, which based on its recent earnings average, could be paid off with profits in just over two years, which analysts consider a strong indicator of financial strength. However, it's considered rather large when compared to its equity. Yum sports a nearly 3-to-1 ratio of debt to equity, though that number is lower than the 3.6 ratio it had in 2011.

Also, its cash position has fallen in half in the last three years to about $776 million at the end of 2012. It earned $2.29 of net cash flow from operations in 2012, up from $2.17 the year before.

What Does The Future Hold?

Yum has a strong track record of success and time will tell whether it reinforces that track record by recovering from the bad publicity in China, or whether the scandal will knock the company off its track toward growth.

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Business relationship disclosure: This article was written by an analyst at Catalyst Investments.