As China Slows, Yum’s Margins Could Bear the Brunt: Pros

Customers line up to buy Kentucky Fried Chicken in Beijing.
Teh Eng Koon|AFP|Getty Images
Customers line up to buy Kentucky Fried Chicken in Beijing.

Yum! Brandsis surging after the company reported strong earnings in the face of a Chinese slowdown, yet analysts warn margin pressures could be building.

The world’s second-largest economy is the subject of a heated debate among market watchers about whether it faces a mild slowdown, or something worse. Depending on the outcome, earnings for companies like Yum — whose stock recently caught a chill from the ill-winds blowing out of the Far East — hang in the balance.

Even though the parent of Kentucky Fried Chicken raised its outlook for the year, “the shares underperformed over the past quarter on the fears that China slowed even more than anticipated,” Barclays analyst Jeffrey Bernstein told CNBC in an interview on “Squawk on the Street.” “Ultimately with them coming out with a 6 percent comp in the region, while it is a deceleration, people demonstrated some relief that it wasn't worse.”

Pricing offset increased labor and commodity costs. Still, China margins and profits could come under pressure as input costs rise and same-store sales growth moderates, according to Susquehanna Financial Group analyst Rachael Rothman.

That could also translate into compressed margins for Yum, home of fast-food staples such as Pizza Hut and Taco Bell, Rothman said.

Following the U.S. drought, “as we look at the futures pricing for next year, specifically in the protein category, you should expect to see some margin headwinds as input costs inflation, meaning soybeans, wheat, and corn are at near record highs which will translate into higher chicken, dairy and beef in 2013,” she said.

Still, the analyst noted that the fast-food chain was able to increase prices even though traffic slowed in the quarter in China. That suggests there is "pretty strong demand underlying the fundamentals,” the analyst said.

Yum might be able to raise prices, which would help it manage a potential Chinese slowdown, she said.

Having a strong brand could help boost Yum, as well as some of its competitors. Rothman said that in addition to Yum, Paneraand McDonald’s have strong brands and should be able to offset increasing commodity prices by raising prices if needed.

Rothman has a positive rating on Yum! Brands, and a $76 price target, which implies another 7 percent upside after Wednesday's surge.

Barclays’ Bernstein, meanwhile, has an “equal weight” recommendation on Yum. Instead, he likes companies with diversified brands. In casual dining, he recommends Brinker, which operates the Chili’s restaurant chain.

He is also positive on McDonald’s. “It wasn't their best year in 2012, but we expect a bounce-back in 2013 benefiting from improving sales trends and pricing power to protect margins,” he said.

—By’s Justin Menza

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