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On Feb 26, we downgraded our recommendation on Yum! Brands Inc. (YUM - Analyst Report) from Neutral to Underperform based on the dim outlook for Yum!’s flagship China division, which in turn, compelled the company to slash its 2013 outlook.

Why the Downgrade?

After contributing immensely to the growth of Yum! Brands in the last few years, the Yum! China division, which holds the key to the company’s overseas expansion plans, faltered in the fourth quarter of 2012 mainly due to allegations regarding the quality of chicken supplied to KFC as well as economic slowdown.

In Dec 2012, China’s state television CCTV reported that two poultry farms in the Shandong province of China that supplied chickens to KFC and competitor McDonald’s Corp. (MCD - Analyst Report) had fed the chickens with unapproved levels of antibiotics. The Shanghai Food and Drug Administration (SFDA) investigation followed soon after. SFDA reported that 8 out of 19 chicken batches supplied to KFC, which were sent for examination in 2010 and 2011, contained a very high amount of the antibiotic amantadine.

Though the company claimed to be concerned regarding the safety of its food products, the negative publicity led to a steep fall in the company’s sales during the last two weeks of December.

Management is unsure about how long it will take to recover sales at KFC and expects the negative sales scenario to remain unchanged in the first quarter of 2013 in China.

Further a tough year-over-year comparison and muted consumer discretionary spending in the wake of a slowdown in China added to Yum!’s woes,. Additional costs associated with the acceleration of restaurant openings are also hurting the company’s margins persistently,

Owing to the China issues, management expects mid-single digit earnings per share decline in 2013 much lower than its long-term target of at least 10% earnings per share growth. According to management, solid results from the US and YRI businesses will not be able to contain the decline in earnings per share.

Other Stocks to Consider

Some other restaurant industry stocks with a favorable Zacks Rank include AFC Enterprises Inc. and Krispy Kreme Doughnuts Inc. (KKD - Snapshot Report) with a Zacks Rank #2 (Buy).

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