Why Yum! Brands May Have a Rough Road Ahead

Judging by stock price alone, there doesn't seem to be anything wrong with Yum! Brands. The purveyor of fast-food brands Pizza Hut, Taco Bell, and KFC has seen its stock price appreciate by 21% since the start of the year. But if you look underneath, what seems like great performance is a concerning trend.

Yum! Brands' core market is China, which represents half the company's total revenue.Unfortunately, Yum!'s performance continues to deteriorate there.

After suffering through some high-profile public scandals related to the safety and quality of its products in China, Yum! still has not recovered. This is clearly a major issue that the company needs to overcome before investors should jump in and buy the stock.

Image source: kfc.com

Considering how well Yum!'s stock has performed, one might assume the company was growing revenue and profits at high rates. But that is not the case. Last quarter, earnings per share came in at $0.69 per share on revenue of $3.2 billion. Both figures beat analyst projections as analysts expected Yum to earn $0.63 per share on revenue of $3.19 billion.

But more importantly than whether Yum! beat analyst forecasts is the overall trend regarding how the company is performing. Yum!'s revenue and net income declined 3% and 30%, respectively, year over year. Earnings per share were down 17% through the first two quarters of the year. The biggest factor was another weak performance in China, where same-restaurant sales, which measure sales at stores open at least one year, fell 10% last quarter, year over year.

Image source: yum.com

Why China matters so muchChina is a critical region for Yum!, and most other large companies, for that matter. China is the world's most populous nation, with more than 1 billion residents. China is a key emerging market, with tens of millions of people entering the middle class, and with that comes the potential for millions of new customers. In fact, Yum! estimates the "consuming class" in China is poised to double by 2020, to 600 million.

This is why Yum! has set its crosshairs squarely on China for future growth. Yum has over 6,800 restaurants in over Chinese 1,000 cities and remains on track to open 700 new restaurants in China this year. Normally, this would be a smart strategy, but Yum! is still feeling the effects of a public-relations scandal. In July last year, a televised news story reported that one of Yum!'s suppliers was using meat that was past its expiration date.

Because of its woes in China, Yum! has reported falling sales for four straight quarters. Rather than focus so intently on aggressive new store openings, Yum! would be better off by first fixing the damage that's been done to its brand image in China. In May, Yum! said it would remove artificial colors and flavors from food served in Pizza Hut and Taco Bell, but the issues in China should be the top priority.

Stock price rally may be prematureIn light of the huge gains that Yum! stock has enjoyed, it's easy to assume the company is thriving. But investors appear to be betting on a quicker recovery than is likely in Yum!'s core market, China. Yum! is aggressively opening new restaurants there, but still hasn't repaired the damage done to its image in China because of the various food-safety scandals there. Sales are still in decline; until that reverses, Foolish investors should be wary of the stock.

Thanks to its strong stock rally, Yum! trades for more than 35 times trailing earnings and 21 times forward EPS estimates. Both of these figures are significantly more aggressive than the broader market as measured by the S&P 500 Index. Without a stronger recovery in China, it's unlikely Yum! will put up the future growth necessary to justify its valuation.

The article Why Yum! Brands May Have a Rough Road Ahead originally appeared on Fool.com.

Bob Ciura has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.