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Yum Brands Makes a Strong Case Against China

YUM's quarter is a warning flare for anyone holding similarly exposed stocks

For the past six months, China has taken center stage among U.S. investors because of its economic slowdown. The Shanghai Composite Index has fallen 40% off its 52-week high in recent months.


But then there are those like Alibaba (BABA) CEO Jack Ma who say that Chinese people save money better than U.S. consumers, and that a growth slowdown is not that big of a deal because Chinese consumers have money to spend.

However, Yum Brands (YUM) might have just told U.S. investors everything they need to know about the Chinese stock market and China’s economy.

And it differs greatly from Ma’s outlook.

What Happened to Yum Brands?

Yum Brands is essentially a holding company that restaurants like Taco Bell, KFC, and Pizza Hut fall under. It is a global brand, and after its fiscal third quarter, it’s clear YUM’s problems are decidedly global. Yum Brands stock was down between 15% and 20% on Wednesday thanks to poor performance in China.

While YUM’s Taco Bell brand performed well with same-store sales growth of 4% and the company was able to achieve overall sales growth of 2.4% in the quarter, it missed analyst expectations badly because of China.

Specifically, YUM’s same-store sales in China rose just 2%. That was well off the nearly 10% increase that analysts had expected. If you remember, YUM’s fiscal third quarter last year was horrible due to the OSI Group’s meat and chicken scandal, which thereby caused YUM’s same-store sales to decline 14% in the comparable period last year. Therefore, YUM’s fiscal third quarter this year should have been a slam dunk.

The fact that it wasn’t raises some serious questions about China and how bad of shape its markets are really in.

Watch Out for Others Like YUM

With that said, U.S. investors already don’t trust Chinese economic growth numbers, and haven’t for many years. As a result, the best way to determine the state of China’s economic growth and consumer spending is to review the performance of companies that have heavy exposure to the country.

In recent months, investors have witnessed a significant slowdown in sales of luxury cars, along with wine and alcohol sales. These are things that investors expect to see during an economic downturn, as it is a direct correlation to how consumers are spending their disposable income. Hence, if the economy is worsening, Chinese consumers may not be as likely to spend on items they don’t need.

However, YUM is cheap fast food, specifically KFC and Pizza Hut. This is a business that one would expect to thrive in a down market. The fact that YUM did struggle so badly in China suggests more disappointments this earnings season.

Furthermore, the massive hit to Yum Brands stock suggests that not all bad news in China is priced into U.S. equities. Therefore, investors should be wary of investing in companies that have high exposure to China, mainly because consumer demand appears worse than previously thought across all industries of the market.

Here are a few companies of concern, including their respective revenue exposure in China, according to Goldman Sachs:

Skyworks Solutions (SWKS) 83%
Wynn Resorts (WYNN) 70%
Qualcomm (QCOM) 61%
Broadcom (BRCM) 55%
Micron (MU) 55%

What makes this list intriguing is that these five companies have higher exposure to China than even YUM, whose Chinese exposure is pegged at 52%, according to Goldman’s research.

The takeaway: I’d keep a close eye on all of the above stocks this earnings season.

What About Yum Brands?

In regards to YUM, it’s not wise to own the stock right now, and that’s because of how nasty things got for Yum Brands, and how quickly.

During YUM’s fiscal second-quarter conference call three months ago, its CEO was calling for both KFC and Pizza Hut’s same-store sales growth to turn “strongly positive” and for YUM to deliver EPS growth of at least 10%. Just three months later, the company is hoping to achieve a low single digit EPS growth rate.

All things considered, things got bad in a hurry for YUM, and who knows if its performance improves or worsens from this point forward. If YUM achieves 1.5% EPS growth and earns $4.60 per share this year, then it trades at nearly 15 times earnings. While not expensive, 15 times earnings does not represent a discount to the market, and is still a bit pricey for a company that’s experiencing such serious (and unexpected) problems.

I would not own Yum Brands stock, and unless you have a serious appetite for risk, it’s probably not wise to either.

As of this writing, Brian Nichols was long BABA.

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