Yum Brands Is Still A Great China Play

| About: Yum! Brands, (YUM)
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The Chinese consumer will eventually forget about the OSI scandal.

Yum Brands' growth and operating margins should increase when the Chinese economy recovers.

Yum Brands is still a great Chinese demographic play, with the middle class set to double by 2020.

Yum Brands (NYSE:YUM) is currently suffering from two negatives.

First, the Chinese economy is decelerating as the country transitions from a fixed asset investment led economy into a more consumption based economy. China's most recent manufacturing PMI was 50.3, barely above the breakeven 50 level. Similarly, China's housing prices are beginning to fall. As China's economy decelerates, many premium consumer discretionary/consumer staples stocks suffer. Consumer staple company Unilever, for example, reported slower Chinese growth for its third quarter. Given that Yum Brands derives 43% of its operating profit and 60% of revenues from China, a slower Chinese economy means slower top and bottom line growth.

Second, Yum Brand is still reeling from the OSI supplier scandal, in which Chinese media showed footage of OSI workers making chicken nuggets from allegedly expired meat (OSI Group LLC was a former supplier to KFC). Due in large part to the OSI scandal, Yum Brands' 3Q same store sales dropped by 14% and operating margin fell 4.6% to 14.9% in China.

Because of the two negatives, Yum Brands management recently lowered EPS growth guidance from the previous consensus 17% to ~10% for 2015.

With that being said, there are reasons to believe the worst is behind Yum Brands.

History shows that the consumer forgets about scandals after a couple of quarters. Wendy's, for example, saw its same stores sales slow by 2-2.5% due to a fake chili finger incident in 2005. The average consumer moved past the incident by 2006, and Wendy's same store sales continued to increase. The same scenario will likely occur to Yum Brands, as the average Chinese consumer eventually forgets about the scandal and reverts back to old habits.

In addition, the Chinese economy should recover in the coming years as President Xi Jinping's market reforms kick in. If Xi's reforms are successful, the Chinese consumer will save less and consume more, thus increasing the amount of money spent at KFCs and Pizza Huts in China.

There is reason to be optimistic. The Chinese middle class still loves Yum Brands. There are, for example, more KFCs in China than there are in the United States. Given that the Chinese middle class is predicted to double to 600 million people by 2020, Yum should have plenty of growth ahead once the consumer forgets about the scandal.

Yum Brands currently trades at a reasonable 23 PE, which puts it right at the sector average. Given the 2.28% dividend yield and the stock buyback, I think the downside is limited.

In the long term, as the Chinese economy recovers and the Chinese consumer forgets about the OSI scandal, Yum Brands operating margin should increase 2-3%, and EPS growth should accelerate back to the 17-18% pace. When that occurs, Yum Brands' PE should trade at a premium versus the sector average. From my calculations, there is 15-20% upside by next year.

Yum Brands' near term future may look weak, but the company's long term future remains as promising as it was before.

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.