KFC in China Is Still Killing Yum! Brands... for Now

I'll readily admit that I'm usually an optimist, but this morning, I received a blunt reminder that it sure can pay to be a skeptic.

You see, I've been pounding the "buy" table on shares of Yum! Brands (NYSE: YUM  ) since April. More recently, I even maintained my optimism largely based on the premise that Yum! management had repeatedly stated they believed the company's weak China segment same-store sales, which have been dragged down primarily by bad publicity at KFC in the region, would turn positive sometime in the fourth quarter.

And up until Wednesday, that point remained intact, and the stock had risen nearly 12% from its low point in April. That was, at least, until the company reneged on that promise with its third-quarter earnings report, saying September same-store sales declined an estimated 11% in China. Specifically, that includes a 6% gain at Pizza Hut, and a stubborn 13% fall at KFC.

As a result, Yum! finally admitted, "It is now unlikely China Division same-store sales will be positive for the fourth quarter."

Sigh.

For some perspective, here's an update of last month's chart outlining how Yum!'s same-store sales have fared in China since the company began reporting on a monthly basis in March:


Data source: SEC Filings.

I suppose that, as investors, we can only do so much with the information we're provided, and Yum!'s promise of better days to come seemed more than plausible. After all, as I pointed out back in April, this certainly isn't the first time Yum! has had to work through bad publicity with one of its core brands -- but that still doesn't make this morning's nearly 9% plunge in Yum! stock feel any better.

Worse, still, Yum!'s significant U.S. division's same-store sales came in flat, including 2% growth at Taco Bell, a 1% decline at Pizza Hut, and a 4% decline at KFC.

For those of you keeping track, that's in line with last quarter's 2% growth at Taco Bell, and Pizza Hut actually fared better this time around compared to its 2% decline in the second quarter. KFC's negative 4% same-store results, however, represent a stark reversal from the second quarter's 3% boost.

Curiously enough, I can't say that that one came as a huge surprise, considering that I suggested just over a month ago that McDonald's  (NYSE: MCD  ) incredible menu blitz lately -- which has included an outsize number of chicken-centric offerings -- could potentially cause KFC sales to falter here in the U.S. I can't help but wonder, then, whether KFC's weakness will translate to stronger results from McDonald's when it reports third-quarter earnings less than two weeks from today.

This black sheep also hurt the bottom line
To make matters even worse, the company also recorded a significant non-cash charge for the writedown of intangible assets at Yum!'s Little Sheep hot-pot restaurant chain, in which Yum! acquired a controlling stake in February 2012.

Yum! CEO David Novak still insists that Little Sheep remains "the number-one brand in China's largest casual dining category." However, sales and unit growth apparently haven't materialized as the company initially expected, thanks to a combination of delays in the purchase approval process as well as bad press stemming from quality issues at similar, but unrelated, hot-pot concept chains in China.

As a result, Yum! took a net impairment charge totaling $258 million, which dragged reported earnings per share down this quarter by a whopping 55%.

Foolish takeaway
I won't sugarcoat it: There wasn't a whole lot to like about this quarter, so I fully expect shares of Yum! Brands to continue drifting downward over the short term. But does that make this a business doomed to failure? Absolutely not.

Remember, patient long-term shareholders get to enjoy a 2.1% dividend while they wait for sales to rebound. And while I don't own shares of Yum! Brands as it stands today, I still like its long-term growth story, so I'll continue to watch the stock closely over the next few months. If it goes low enough, I plan on taking advantage of its current weakness to open a brand-new position of my own.

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