Yum! Brands Looks Appetizing Ahead of Earnings

NEW YORK (TheStreet) -- Saying that it's been a rough year for restaurant giant Yum! Brands (YUM) would be an understatement.

There was a China scandal involving two suppliers to the company's KFC restaurants, and there was also the threat of avian flu in its chicken supply, which scared off some customers.

But you wouldn't necessarily know that from looking at the company's share price, which is up more than 9% so far this year.

The stock's resilience in the face of such bad publicity is a credit to the company's management, which has done an excellent job of mitigating the damage while taking the appropriate steps to ensure consumers that the chickens (if cooked properly) were safe to eat.

With Yum! due to report second-quarter earnings results on Wednesday, I don't expect that these shares will get any cheaper, especially since it now appears that the aforementioned problems are becoming things of the past.

I'm not suggesting that Yum! is completely out of the fryer, but the situation in China is not as bad as initially expected. I say this because even though the April quarter revealed 41% drop in profits due to weak same-store-sales in China, McDonald's ( MCD) didn't fare any better. But we know that McDonald's wasn't tied to any scandals over health concerns.

Let's not also forget that the entire Chinese economy has faced fiscal headwinds for most of the year. So we can't entirely rule out that the magnitude of Yum!'s poor results were ballooned on the basis of the underperforming Chinese economy. I won't use the word "exaggerated" to describe the media's description of Yum!'s health concerns in China, but it certainly looks as if the Street arrived to my conclusion, which is there could have been other factors for the weak profits.

Don't get me wrong: I don't want to discount the impact of the avian flu. But given the fact that other restaurants in the region, including Country Style Cooking ( CCSC) -- although not linked to the scandal -- posted meaningful declines in same-store-sales, I believe we need a bit of perspective in evaluating Yum!'s total performance.

I'm not absolving the company of any wrongdoing. But I appreciate the manner in which the company has handled this situation. Likewise, the company continues to make significant capital investments to repair the damages to its reputation and brand.

The good news, though, is that allow China accounts for well over 50% of Yum!'s annual revenue, the company is still doing well in its Yum! Restaurants International division and its U.S. operation, which grew profits by 19% and 5%, respectively, in the recent quarter.

So that means, even though there may be some residual effects in the coming quarter regarding China, management has focused resources in other areas to help mitigate the damage on the bottom line. This is while the company continues to expand its lead against McDonald's in emerging markets.

Management still expect China to grow by 15% for the full fiscal year, including expansion plans of an additional 700 stores. I have my doubts about how realistic that is, given the revenue and profit deficit that the company has incurred in China. I'm a bit more optimistic, if not certain, that the company will meet its growth target for U.S. and YRI, which are projected to grow by 5% and 10%, respectively.

In my view, whether these targets are met this year is only important for the near term. The long-term narrative of this company won't be swayed. I like Yum!'s growth prospects in emerging markets, especially when compared to McDonald's. And I also like the company's long-term revenue growth potential of 4% to 6%, which (relatively speaking) is pretty high for a company this size.

What's more, with free cash flow expected to remain at historically consistent levels, I still see value here for long-term investors. And let's assume that free cash flow can climb in the range of 11% to 13% over the next three to five years, this puts the stock at a fair value target of $75. It's not a multicourse-meal type of premium from current levels, but it's nonetheless appetizing.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Richard Saintvilus is a private investor with an information technology and engineering background and the founder and producer of the investor Web site Saint's Sense. He has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.

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