Yum! Brands Looks Appetizing, Especially With a Hedge

NEW YORK (TheStreet) -- Yum! Brands (YUM) reported tepid sales for locations open at least a year in China, at 1%. The gains it did receive were from vigorous marketing and promotions. Absent promotions, sales declined. China accounts for about half the revenue and 17% of profits.

Overall revenue declined 8%, disappointing; however, analysts expected worse. That's why the stock is holding up so well. Excluding special items, the restaurant chain served 56 cents a share profit. Profit was down from 67 cents for the same period last year.

The size of China's market and potential market can cloud investors' eyes if not careful. The country is full of booby traps and landmines awaiting domestic and foreign corporations alike. It's not easy to sidestep every possible problem when Chinese suppliers are notorious for cutting corners, and little regulatory oversight doesn't help matters.

The food industry faces a particularly tough dilemma of pursuing revenue and profit increases in a rapidly growing economy while simultaneously monitoring an ever-expanding full supply chain. For Yum! Brands, parent of KFC, Pizza Hut, and Taco Bell, China is a love-hate relationship.

I've eaten at KFC and Pizza Hut in China. Like its North American restaurants, they serve primarily a younger clientele. Unlike KFC and Pizza Hut near my home, in China -- at least when I was there -- they served a much more affluent Chinese customer. I haven't eaten at a Taco Bell in China.

Wealthy customers, in my opinion, are more likely to consider food quality issues. Based on isolated supply quality control issues, it shouldn't be surprising to experience some softening in sales. With that said, as China expands and the food chain becomes more reliable (for the entire country) investors should anticipate greater sales and margins.

YUM EPS Diluted (Quarterly) Chart

It's the wild, wild west, and with half of revenue generated in the region investors need to keep perspective and understand seatbelts are required on this ride. By using options, investors can remove much of the volatility and receive cash while sitting and waiting while Yum! grows revenue.

For example, compare buying shares at $76 versus selling an equivalent put option using the same amount of cash. When you own shares outright, you're exposed to the entire amount as a possible loss. In order to make money, you also need the shares to appreciate (other than the 1.9% dividend yield). The shares may move higher and lower -- but if at the time you want to sell they are at the same price, that's all you will receive. After reviewing the last two years of overall sideways action, that's a real possibility.

However, if you sell an April 2014 $72.50 strike put option for about $3, your total risk is reduced to $69.50. If at the April expiration date Yum! shares are trading at the same price as they are now, you profit the entire $3, compared to an expected 74 cents in dividends received. Actually, the shares can even decline, and you gain the entire option premium until and if they decline below the strike price. As long as YUM is above $69.50, the option seller gains at least some profit.

The downside is if YUM moves higher by more than $3 during the same period, the option writer misses out on any further potential gains. You can use a covered call strategy (mathematically the same as a short put) if you want to capture expected dividends. I recently read a fantastic book for investors who want to dive in deeper to the world of options. Keene On The Market from Wiley by TheStreet's Andrew Keene is a perfect place to start.

At the time of publication, the author had no position in any of the stocks mentioned.

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

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