Yum! Brands remains one of our favorite names for 2013, despite the China controversy in January which, given the nature of the event, took many people by surprise. For people looking for a longer-term idea in consumer, we think they would be hard pressed to find a more attractive opportunity than YUM at these levels. YUM reports 4Q12 EPS on 2/4.
It’s only February 1st and, already, so much has happened in such a short period of time. Since YUM hosted its analyst meeting on December 6th, the following sequence of events has transpired (annotated in chart below):
1. 12/18-12/20: A story emerges that a Chinese chicken supplier had “used excessive additives in chicken feed”. We believe the stock has been punished three additional times for the same story being rehashed in the media news cycle since first emerging
2. 1/07: YUM guides down FY12 EPS and warns that, as a result of negative media exposure, KFC China significantly impact during last two weeks of the year
3. 1/10: YUM CEO issues online apology
4. 1/17: Argus downgrades to Hold. Xinhua publishes article stating that KFC supplier didn’t process sick chickens
5. 1/18: Shanghai vows “severe” punishment on KFC “violation”, according to the China Daily
6. 1/25: Bronstein, Gewirtz, & Grossman LLP announces a class action lawsuit against Yum! Brand. Xinhua says, “Shanghai finds excessive animal drugs in Yum Chicken”.
7. 1/30: Yum! Brands shares cut to market perform versus outperform at Bernstein
It is worth noting that, between the Analyst Meeting on December 6th and today, there has been a significant swing in consensus expectations for 4Q12, 1Q13, and FY13 EPS:
Sell-side sentiment on YUM has changed drastically in the last six months. The percentage of buy ratings among sell-side analysts covering the stock peaked at just over 70% in May (29% hold, 0% sell). The latest reading is 55% buy, 41% hold and 3.5% sell.
It’s Not All China
News flow on YUM is focused almost exclusively on China and none of it is positive. The company needs to do its part to counteract the negative stories (often repetitive rehashes) to highlight the positive things that are happening within the company. As we highlighted in December, Yum! Brands is a resilient company because of its diversification. It is perceived to be a “China-stock”, and China is an important component of its future, but 42% of the company’s operating profits are derived from markets outside of China. Over time, this and other attributes have led to steady gains in its share price and consistent EPS growth while competitors such as SBUX have seen more volatility over the years.
Reaction to Chinese News May Be Overdone
The company has resolved its issues with the Chinese government and, as concern over the food scandal gradually dissipates, the company should be able to spend a greater portion of its time focusing on continuing to grow the business. We expect the management team to articulate a clear plan of action to reach out to the Chinese consumer, including the acceleration of new food introduction schedules in the market. It would also not be surprising to hear of an increase in the China division’s advertising budget with a view to reassuring the Chinese consumer that KFC is a trustworthy brand.
US Business Transformation From Class Clown to Teacher’s Pet
The US business is now a bright spot in the company’s press release, after years of disappointment. We expect Taco Bell, in particular, to be a positive with same-restaurant sales at roughly 6% versus consensus of 5.5%. On a consolidated basis, operating margins are expected to improve by 87 bps to 13.8%, driven by the US and YRI, offset by China. Seasonally, YUM’s business tends to produce its thinnest margins in the fourth quarter.
While surfing for some light weekend reading, I stumbled across an interesting article that appeared in the Review of Industrial Organization back in 2005 (yes, yes, I need to get out more). The title is “The Supreme Court and Beer Mergers: From Pabst/Blatz to the DOJ–FTC Merger Guidelines.”
At a minimum, it is an interesting retrospective on the history of the beer industry in the U.S., with mention of some venerable beer brands (Hamm’s, anyone?).
The paper argues, compellingly, I believe, that the review of mergers and associated antimerger rules needs to progress as “economic understanding” progresses. Word of warning, the article is bone dry, so a cup of coffee next to your computer is very much in order. On the plus side (for you), I had to read the whole thing (yay me?). It was also written prior to the merger of Anheuser-Busch and InBev, but the findings are still very much relevant. Let’s get started.
“The first antimerger action in the beer industry was taken by the Antitrust Division in 1958 against the industry’s leading firm, Anheuser-Busch. Anheuser-Busch had purchased the Miami brewery of American Brewing Company. The government successfully argued that this merger would eliminate American Brewing as an independent brewer and end its rivalry with Anheuser-Busch in Florida.”
What’s interesting here is that the government appears to have a long history of thinking (and acting) locally when examining beer markets. What is also interesting is that Anheuser-Busch completely abandoned acquisitions as a means to growth for over two decades subsequent to this unsuccessful deal. Instead, Anheuser-Busch spent its time and capital building efficient brewing capacity across the country (Florida included). Anheuser-Busch’s market share leadership has been undisputed since 1957.
“Bottom line: mergers have not made much of an imprint on the structure of the brewing industry, and have not resulted in market power for merging partners. The most active merging firms, Stroh and Heileman, eventually failed. Much of the increase in concentration in the past three decades was due to the growth of Anheuser-Busch, Miller and Coors, whose expansion has been largely internal.”
The DOJ has taken the beer industry before the United States Supreme Court twice - U.S. v. Pabst (1966) and U.S. v. Falstaff (1973). In both cases, the mergers were seen as anti-competitive, for different reasons in each case, but thinking that largely reflected the belief that mergers that took place in an industry with an existing trend toward industry concentration were anti-competitive.
“The mid-1970s saw the beginnings of a radical shift in antimerger enforcement doctrine – a major change in what Bork (Judge Robert H. Bork) called “the economic rules.” In response to the work of Bork and others, the Chicago School of economics gained ground, and its focus on economic rigor in legal reasoning and an emphasis on consumer welfare as the goal of antitrust enforcement had a significant influence on antitrust law.”
This change in thinking ultimately led to the adoption of the DOJ-FTC Horizontal Merger Guidelines, where the focus shifted from simple concentration of market share to a discussion of “market power”. Market power was defined as “the ability profitably to maintain prices above competitive levels for a significant period of time.”
“Contrary to the precepts of Pabst and Falstaff, under the Guidelines, ‘although large market shares and high concentration by themselves are an insufficient basis for challenging a merger, low market shares and concentration are a sufficient basis for not challenging a merger.”
The paper concludes with the following:
“Increases in concentration in brewing are neither the result nor the cause of market power. The reasons, rather, are benign: the exploitation of scale economies and the demise of suboptimal capacity; new or superior products; changes in packaging and marketing methods; poor management on the part of some firms; and the strategic use of product differentiation. As a consequence, Anheuser-Busch, Miller and Coors no longer face an array of robust domestic brewers. Brands like Schlitz, Pabst, Old Style, Stroh, Ballantine, Schaefer, Falstaff, Olympia, Rheingold, Ruppert, Blatz, Lucky Lager, Hamm’s, and the firms that produced them, are gone or are shadows of what they once were. But the big three domestic brewers now face significant import competition, in some cases from large brewers with operations in many countries, and significant competition from specialty brewers.”
We would add to that last point that brewers are also facing competition from wine and spirits makers, as beer continues to lose share of liver as a multi-year trend. The DOJ gave little thought to the substitutability of these products.
Interesting stuff, and intuitively compelling. As we pointed out in our prior note, we believe a critical and honest examination of the fact pattern in the proposed Anheuser-Busch InBev/Modelo transaction would support the notion that the transaction be allowed to proceed as contemplated. The idea that Modelo’s 50% control (through Crown) of 6.5% of the U.S. market has been some mitigating factor on pricing across the rest of the 94.5% doesn’t exactly ring true to us, particularly in light of what has been an extraordinarily benign pricing algorithm throughout history.
Further, we don’t believe that the DOJ gave any credit to the indirect nature of the control that ABI will have over Crown, preferring to call it a façade. We believe that the parties are talking, and will continue to talk. Both STZ and BUD make sense when the deal gets done, with STZ seeing the greater upside potential in the near-term, but also more downside in the event of incremental negative news flow.
Enjoy your Sunday,
HEDGEYE RISK MANAGEMENT, LLC
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