Yum! Brands (NYSE:YUM) was flying high just last week as the company was rapidly growing its sales, expanding its profit margins, and overcoming the health concerns it had faced in China. Shares traded at an all-time high, and I warned investors that while the company was executing that the risk had been priced out of the stock. The company wound up reporting in-line earnings that were perceived as a “sell” signal from investors. I argued that the report showed signs of decelerating growth in China, and with the stock market falling on Thursday Yum! shares took a large hit and fell down to $77/share.
Then on Monday morning another shoe dropped—the company reported that it had used expired meat in some of its Chinese locations, and with the health concerns back on the table the stock fell some more—nearly 4 percent.
So now, with the stock trading about $8/share lower in just a week is it time to buy, or is there further downside risk?
On the one hand, this sort of correction is exactly what I was looking for. As I mentioned investors had priced a lot of the risk out of the stock, and in a period of just a few days we have seen this risk surface. Now not only do we have evidence that the company’s Chinese growth is decelerating, but this deceleration will now likely have further momentum considering that Chinese consumers now have a reason not to go to Kentucky Fried Chicken. And now that Chinese consumers are seeing this play out for a second time it is likely that several consumers will simply give up entirely on KFC: why should they take the risk when the chain is a repeat seller of unsafe food?
While this is bad news, I’m not sure that it hurts the company’s long term growth story so much. The safety scare comes from one of KFC’s distributors who has already been cut off, and management is doing what it can to prevent this from turning into a PR nightmare. And while there are going to be some irate consumers who will simply avoid KFC China is so vast and its middle class is growing so rapidly that I don’t think that this problem will be more than a minor blip that lasts for a couple of quarters.
However, there is still the issue of valuation. While the stock has come down, I don’t think it has come down enough. As I said the stock had been priced for perfection even though we knew last week that perfection is a very unlikely scenario. With the stock down 10 percent, I think some risk is starting to be built in, but I’m still not buying. The stock still trades at 22.5 times this year’s earnings estimates and at 20 times next year’s earnings. Given the recent safety scare, I wouldn’t be surprised to see this number come down somewhat to reflect lower Chinese sales. Given how important China is to Yum! Brands, the stock probably trades at closer to 24 times this year’s earnings and at 22 times next year’s earnings.
Now because I think the company can grow in the high single to low double digits, and given that it is largely recession resistant given how inexpensive its products are, Yum! Brands is probably worth around 18 – 20 times next year’s earnings depending on interest rates, giving the stock another 10 percent to 20 percent downside from here.
With this in mind, I expect further downside, but I think this downside can bring a buying opportunity. Yum! Brands is still a quality company that has a dominant position in China and in other emerging markets that are just being introduced to fast food. These will be growth markets, but there will be growing pains, and when these are being felt you want to buy.
Disclosure: Ben Kramer-Miller has no position in Yum! Brands.
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