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Plunge in Yum: If You Want a Play on China’s Consumer, It Just Got Cheaper

The appetite of Chinese consumers for Yum Brands’ (YUM) fried chicken, tacos and pizzas isn’t quite as healthy as it once was – or at least, not robust enough to see off potential rivals and continue to drive same-store sales higher. So the company itself admitted late last year, suggesting that investors brace themselves for a decline in same-store sales in China for 2012 – one that had little to do with a slower pace of economic growth in China.

YUM Chart

YUM data by YCharts

Given that Yum’s share price had priced into it the expectation that the company would continue to succeed in China the way that it had been doing – and the fact that growth in China accounts for the lion’s share of Yum’s overall sales growth and about half of its profits – the news delivered a powerful blow to a stock that has been, for a fast food chain operator, a relative highflyer. The perennial allure of China (how many companies over the last century have pondered the difference that selling a single pair of shoes/tube of toothpaste/t-shirt/chicken dinner to every one of the 1.2 billion or so Chinese citizens would make to their bottom line?) has helped keep the company’s valuation -- its PE ratio -- well above that of the broader market in recent years.

YUM PE Ratio TTM Chart

YUM PE Ratio TTM data by YCharts

The company has invested heavily in China, opening new stores on an almost daily basis; its total reached nearly 4,500 at the end of last year. Thus far, that strategy has paid off, with the rate of growth in profitability exceeding that of its capital spending programs.

YUM Total Operating Expenses Annual Chart

YUM Total Operating Expenses Annual data by YCharts

The question that confronts investors today is whether to buy on the current (very large) dip in Yum’s share price. Has the selloff created a genuine value for investors looking for a way to play the China story? There’s a short-term answer, and a long-term one. From a short-term perspective, with more earnings releases to come and possibly some more warnings from the company’s management, the risks may well outweigh the benefits.

YUM Gross Profit TTM Chart

YUM Gross Profit TTM data by YCharts

But – and this is a big “but” – Yum’s restaurants have become established brands in China. Growth rates may be slower in the years to come, but it’s unlikely that Chinese consumers will abandon the taste they have discovered for fried chicken or pizza. Indeed, to the extent to which economic growth recovers in China (preliminary indications suggest an uptick in industrial activity is taking place), there are still millions of consumers in the country that have yet to have been given a chance to taste Kentucky Fried Chicken and who Yum may transform into loyal customers. This is a long-term growth story that is taking place, and the company’s profit margins so far have shown few signs of weakening. An additional upside? Yum plans to buy back about $1 billion of its own stock between now and the end of the year. Wait for the turmoil to settle down a bit and for emotion to stop driving Yum’s stock, and to see what Yum executives say during the end-of-year conference call about their growth strategy – and then consider finding a way to pick up some exposure to Yum near its lows.

Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post.

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