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Yum! Slides to Underperform

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On Oct 24, we downgraded our recommendation on Yum! Brands Inc. (YUM - Free Report) from Neutral to Underperform based on the dim outlook for Yum!’s China division as well as lackluster performances in the company’s other two divisions – U.S. and YRI (Yum! Restaurants International).  All of these compelled the company to lower 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, started faltering since the fourth quarter of 2012 mainly due to allegations regarding the quality of chicken supplied to KFC as well as the result of an 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 had fed the livestock 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.

Although the company stated its commitment toward ensuring food safety and assisted the government in the investigations, the negative publicity due to the whole incident continues to mar the company’s performance in China.

The outbreak of avian flu in China in early Apr 2013 further added to the company’s woes. Tough year-over-year comparison and a sluggish retail environment in China due to an overall economic slowdown are likely to threaten the company’s growth momentum.

Also, growth in the U.S. and YRI divisions slackened in the recently concluded third quarter of 2013.  The U.S. Division posted flat comps in the third quarter, much lower than 6% growth in the year-earlier quarter while comps nudged up merely1% in the YRI Division.

Owing to the steeper-than-expected decline in China and positive but sluggish comps performance in some other divisions, management reduced its full-year earnings guidance. Earnings are now expected to decline in high single to low double-digit percentage range in 2013 from mid-single digit earnings per share decline expected earlier. The guidance is in contrast to its long-term target of at least 10% earnings per share growth. Yum! currently carries a Zacks Rank #5 (Strong Sell).

Other Stocks to Consider

Companies from the restaurant sector that are worth a look include Bob Evans Farms, Inc.  , Cracker Barrel Old Country Store, Inc. (CBRL - Free Report) and Dunkin' Brands Group Inc. (DNKN - Free Report) . All of these carry a Zacks Rank #2 (Buy).

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