YUM: LOSING FAITH

We are removing long YUM from our Investment Ideas list.

We like YUM for many reasons, including its strong management team, its asset-light model and its exposure to emerging markets.  We really liked YUM, however, due to its easy same-store sales comparisons in China and its ability to deliver 40%+ operating profit growth in the region in 2014.  We thought YUM was ready to turn things around in China and we made it explicitly clear that our bull thesis hinged on this.  Unfortunately, we no longer believe this to be the case.

On Sunday, news hit that the Shanghai FDA launched an investigation into meat supplier Husi Food (Osi Group Inc.) after reports surfaced alleging the firm of selling expired meat products.  YUM is only one of several Western food companies linked to Husi (MCD, SBUX, BKW highlight others), but it is by far the most vulnerable to this negative event, with approximately 6,400 restaurants in China.  Everyone knows what happened the last time YUM had a food issue and, the fact of the matter is, Chinese consumers are still fragile.  YUM had just begun regaining their trust.

All told, this is a huge blow to the company, no matter how they try to spin it.  Today, the South China Morning Post published a disturbing report, featuring a Sina survey (with up to 25,000 respondents), that indicated severe damage has been done.  According to the article:

"77 percent of people in the poll said they believed the affected Western fast-food restaurant brands had been aware of Husi's faulty practices.  Also 69 percent said they would no longer dine at the restaurants run by the Western companies."

It is pretty clear, to us, that YUM will once again face an uphill battle in its most important region.  Are we overreacting to this news?  Maybe.  But we don't recommend stocks, long or short, that we lack conviction in.  It is now unlikely YUM will hit its numbers this year and management may have hinted at that on the 2Q14 earnings call by guiding down FY14 same-store sales estimates in China.  We're much happier on the sidelines, at this point, because something tells us this won't be the last we hear of this episode.

We've previously pegged YUM shares at a fair value range of $90 to $100.  This estimate assumed a full-blown recovery in China.  We don't see this happening, for a while, and expect shares to muddle along similar to the way they did for the majority of 2013.

Call with questions.

Howard Penney

Managing Director

Fred Masotta

Analyst