Yum’s Mixed Earnings Mean Further Downside Risk

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On Wednesday afternoon, the world’s second-largest fast food chain restaurant owner, Yum Brands (NYSE:YUM), reported its second-quarter earnings. The stock, which hit an all-time high on Tuesday, pulled back on the news. This shouldn’t surprise investors, as the stock had been priced for perfection. But a 2 percent slide isn’t enough to discount the mixed results we saw from Yum Brands in the second quarter. While the company is standing out as a leader in the fast food space, I think the downside risks are not yet priced in, and investors should proceed with caution.

Specifically, the company reported earnings per share of 73 cents on $3.2 billion of revenues. These figures represent 20 percent and 10 percent growth rates, respectively. The vast majority of the company’s growth came from its Chinese division, which grew sales at 21 percent, and most of this growth came from the company’s KFC restaurants. As was expected, the company’s Pizza Hut sales lagged, and they actually declined.

The good news is as follows. First, the company is growing its earnings and its sales, and it is even growing its margins, which is no easy feat in the fast food business considering the recent strength we’ve seen in commodity prices, especially livestock prices. Second, the company is growing rapidly in China once again after reporting lousy 2013 numbers. The company’s Chinese growth is what is driving most of its overall growth, and it is driving investor interest more generally. Thus, there is probably a floor under the stock.

But as I said, the quarter was a mixed bag, and there are some red flags that lead me to believe that the shares should be avoided at the current valuation, which is lofty to begin with. My primary issue is that the company’s Chinese growth is decelerating. In the last quarter, the company reported unusually strong Chinese numbers, but this was on a rebound after the company saw its Chinese sales fall last year due to a food safety concern.