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(KIM KYUNG-HOON/REUTERS)
(KIM KYUNG-HOON/REUTERS)

RESTAURANTS

Looking for a pure play on China's eateries? The pickings are slim Add to ...

For the past several years, it hasn’t mattered how much Original Recipe was eaten from Oshawa to Omaha. At least, not for the share price of Yum Brands Inc., the parent of KFC.

No, Yum’s fortunes were tied to Chinese chicken consumption. No matter how sluggish the North American performance of the company’s brands – KFC, Taco Bell, and Pizza Hut – it was KFC’s expanding Chinese footprint that made it possible for a company with nearly 40,000 restaurants to have a stock priced for growth.

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In the past year or so, however, cracks have formed in the China-loves-Yum thesis. After another disappointing earnings report earlier this month, the shares have retreated, creating what bulls say is a buying opportunity for a still-growing global giant.

On the menu of investment choices, though, Yum may best be left to the most adventurous speculators, given that it’s showing little sign of solving its Chinese problems. Investors with an appetite for risk and a desire to profit from China’s millions of diners might find a relatively obscure name more palatable.

But before exploring that option, let’s first go back a couple of years. In early 2011, Yum dazzled Wall Street by posting a 13-per-cent gain in Chinese same-store sales (revenue from locations open for at least one year). The company’s 4,000 restaurants in China, mostly KFCs, produced more revenue than its 17,000 North American locations, gaining 24 per cent year-over-year.

Then came a series of unforeseen mishaps. Late last year, Yum got caught up in a poultry-quality scandal, when it was revealed samples of KFC’s chicken had an excessive amount of antibiotics, violating Chinese regulations. (Ultimately, its suppliers took the blame). This spring, a wave of avian flu struck China, tempering consumers’ desire to eat birds.

The result: A shocking reversal in Yum’s Chinese performance. Same-store sales turned negative in 2012’s fourth quarter, and hit minus 20 per cent in each of 2013’s first two quarters.

Wall Street believed Yum would quickly recover, thanks in part to a public-relations campaign that invited customers to visit its farms and kitchens. However, results released earlier this month show little evidence the problem is solved: KFC’s China same-store sales declined 14 per cent in the quarter ending Sept. 7.

Analysts had hoped that the numbers would be on track to improve significantly in the fourth quarter, but Yum put a damper on those expectations, revealing that the full-month number for September was a 13-per-cent decline. (KFC’s woes were slightly offset by Yum’s much-smaller number of Chinese Pizza Huts.)

That, along with weakness across the world in Yum’s brands, now means 2013 earnings per share will decline from 2012 levels.

“The stock has been trading under the assumption that [year-over-year Chinese comparisons] would continue to recover, and achieve management’s targeted return to positive [fourth-quarter] growth,” says analyst Andy Barish of Jefferies, who has a “hold” rating and $63 (U.S.) target price, compared with recent trades around $66. “However, sales trends appear to have actually eroded coming out of the quarter.”

Mr. Barish notes Yum management believes it can achieve a full recovery from the poultry scare, but he thinks Yum “faces more than just lingering fears about chicken quality. We see real risk to China’s [long-term same-store sales growth] from increased competition and less robust consumer spending trends.”

Jeff Farmer of Wells Fargo Securities, who has a “market perform” rating and $69 to $72 “valuation range”, echoes those sentiments. “Prolonged China weakness from KFC lends weight to the argument that the concept’s once dominant competitive positioning is being encroached upon beyond [the poultry scare issues],” he writes.

What if Yum management is right, and the skeptics are wrong? It’s worth considering the upside. Analyst Paul Westra of Stifel Nicolaus said in initiating coverage of Yum this summer that “we strongly believe that investors have lost focus on just how profitable – and how valuable – Yum Brands’ growth prospects truly are.” The recent results have caused Mr. Westra to cut his target price – to $95, from $105, still implying a gain of nearly 50 per cent.

Mr. Westra says that Yum achieves a 21-per-cent return on equity for every new restaurant it builds in China and India, “essentially tripl[ing] shareholders’ money” since Yum’s cost of capital is around 7 per cent. And the Yum Restaurants International division, which covers most other emerging markets, has a head start in Africa against other Western concepts, he says.

For now, despite the recent pullback in Yum’s stock price, the bulls seem to hold sway. The stock’s forward price-to-earnings ratio, at just under 20 according to Standard & Poor’s Capital IQ, is actually higher than the 17 to 18 level it sported in early 2011, when the China story was intact. Buying now is a double bet that Yum can fix its problems sooner rather than later, and that the Chinese consumer will still be able to ante up for KFC’s meals.

There is, however, a little-known name in the space that offers a pure play on the Chinese consumer. Country Style Cooking Restaurant Chain Co. Ltd. operates 282 quick-service restaurants in China’s mid-size cities and trades on the New York Stock Exchange. Concentrated in the 110-million population Sichuan province, the chain says its competitive advantage is fast, affordable, everyday Chinese food.

At under $300-million in market capitalization, it has virtually no analyst coverage. But that could change: The shares have jumped more than 40 per cent in the past three weeks as the company pre-announced its third-quarter results. Revenue jumped 19 per cent year-over-year, with same-store sales growth in the mid-to-high single digits.

Country Style Cooking has a trailing P/E of nearly 35, which means the shares are more expensive than its affordable menu items. But there’s no telling where they’ll go – if investors decide it’s the next great China growth story.

 

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