How to Profit on an Earnings Surprise From China's Rise

By William Patalon III, MBA
Managing Editor
Money Morning/The Money Map Report

Every American consumer who's ever eaten Chinese take-out has either heard, or repeated, that well-worn chuckler: "The only problem with Chinese food is that half an hour after I'm finished, I'm hungry again."

Let me tell you the flip side to that one-liner.

When Gannett Newspapers (GCI) sent me to China on special assignment in 1996, my photographer and I were "hosted" by several journalists from the state-run Xinhua News Agency. They were great guides, taking us to the Great Wall, the Forbidden City, a Chinese "opera," and even on a work-related tour of the state-run China Lucky Film Co., later bought out by Eastman Kodak Co.

They also treated us to the very best Chinese cuisine. There were fine-dining restaurants, including one where they brought the fish our guides had chosen to our table - still swimming in a bucket, so that our hosts could "approve" it. Even better were the hidden neighborhood "joints" (here in American we'd refer to them as either a "greasy spoon," or a "diner"), where the food was sublime, and the prices laughably low.

We wanted to return the favor. I offered to take our two guides anyplace they wanted to go. Being working journalists, like us, I figured they'd choose some globally known five-star place that they couldn't afford and had never tried.

No way. They chose Sunday brunch at McDonald's in Beijing.

The new McDonald's in China's capital city was this multi-decked affair with multiple counters on every single level - and our two Xinhua friends who weren't from that part of the country really wanted to pay Mickey-D's a visit. Indeed, they viewed this visit as a real "treat," they told me.

Let me say this: McDonald's franchises in this country would be jealous as all get out to see a mall-sized fast-food joint with patient patrons lined up and waiting 12 deep at every single register. There was almost no place to sit down. Yonghong, a promising young journalist and our lead guide, ordered two Big Macs, double fries, a quarter pounder, and a quart or so of soda. I was so enthralled watching him demolish these burgers that I almost forgot to eat my own "brunch."

A few enlightening hours later, we're walking back to our hotel rooms in Beijing, and I see Yonghong holding his stomach. That'll learn him, I thought to myself (as I mentally held my own stomach).

But, as usual, I was wrong.

As we walked by Beijing's Tiananmen Square, Yonhong turned to me - still holding his stomach - and said: "Those Big Macs are really quite a delicacy. But they just don't stay with you all that long." Only he wasn't joking.


I learned many things during that month or so in Asia, growing a great deal as a journalist, but even more as an investor. I saw, and have never forgotten, how China's consumers loved virtually all things American.

To the Chinese consumer, McDonald's in synonymous with "hamburger." When you speak of fried chicken, well, there's only KFC. Pizza? That means Pizza Hut. Mexican? You can only be speaking of Taco Bell.

Well, McDonald's is just that - a straight play on McDonald's Corp. (MCD). But KFC, Pizza Hut and Taco Bell are all in the fast-food stable of Yum Brands Inc. (YUM). And as that company's profit report demonstrated yesterday, Yum Brands also means China.

Our Formula for Global Profits

In Money Morning yesterday (Monday), we told you that the pathway to stock-market profits during this newest quarter would have everything to do with earnings performance, global growth and companies that were free and clear of the subprime mortgage crisis.

Yesterday, global restaurant operator Yum Brands proved us right on all three counts. And China provided much of the fuel.

As investments go, companies such as Yum Brands combine the safety of the U.S. financial system (with its transparency, regulatory oversight and detailed financial reporting), with the growth of the promising overseas markets of Asia, where it's a very strong player. For that reason, we're going to look at this earnings report as a kind of case study on how to look at such a "best of both worlds" investment.

The owner of those three worldwide brands yesterday reported a higher-than-expected 17% jump in quarterly profits. And it boosted its forward-looking financial outlook.

The company's shares rose to an all-time high of $36.48 in regular trading yesterday, closing at $36.29. That represented a gain of $1.94 - or 5.65% - per share. The stock soared an additional $1.44, or 3.97%, to $37.73 in after-hours trading, according to Google Finance.

The Louisville-based Yum said it now expects profits per share for the year to climb 13%, and not just the 12% it predicted earlier. The company is now forecasting full-year profits of $1.65 per share, instead of the $1.63 forecasted earlier.

Analysts currently expect a profit of $1.64 a share for the year, according to Reuters Estimates.

And we believe this latest boost in outlook is just the start. One good reason: Yum said it would use the flush times to buy back up to $4 billion of its shares over the next two years - reducing its shares outstanding by 20% - and would increase debt.

Research studies have demonstrated time and again that companies that buy back shares, as a group, tend to outperform the broader market. And adding some debt can actually be good for a company, creating what's known as an "optimal capital structure." That means the company's mix of stock and debt has enabled the company to achieve the lowest possible average cost of capital needed to fuel growth.

Yum yesterday reported that its net income for the third quarter jumped to $270 million, or 50 cents a share, a total that was 17% ahead of the net income of $230 million, or 42 cents a share.

Wall Street analysts, on average, had been expecting a profit of 45 cents a share, also according to Reuters Estimates. Yum had 2% fewer shares outstanding in the quarter as a result of buybacks, the company said.

When a company buys back stock, its profits are apportioned across fewer shares, meaning its experiences earnings per share growth even if its actual profits don't increase. But when a company is building profits as Yum Brands is doing through organic growth - and is also buying back shares at the same time - the impact on earnings per share growth can be remarkable and substantial. And that usually bodes very well for the company's stock price, too.

The China Factor

Yum said strength in China and in other international markets more than made up for softer-than-planned-for results here in the United States.
Total revenue rose 13% to $2.56 billion - $100 million more than the $2.46 billion analysts expected.

Sales at stores open at least a year rose by an average of 4% worldwide. But that overall average consisted of gains of 11% in mainland China, an average of 7% in the international division and 1% in the United States.

In Yum Brand's China Division - which includes mainland China, Thailand and KFC Taiwan - operating profit rose a stunning 28% to $135 million. But fast-rising food-and-labor costs in mainland China did squeeze profit margins, albeit only slightly for now, the company said.
At the international division, which excludes China, operating profit rose 21% to $127 million.

U.S. operating profit rose 1% to $187 million, but profit margin at company restaurants fell because of higher labor and dairy (cheese) costs.
U.S. operations did improve in the third quarter. But Yum Brands said that domestic sales-and-profit growth remained "below our target level" because of results at Taco Bell, which has struggled since last year, due to an E. coli outbreak in the Northeast that was associated with the chain.
Yum's board approved the repurchase of as much as $1.25 billion of additional company stock over the next 12 months - part of the afore-mentioned plan to buy back up to $4 billion in shares over the next two years.

The stock trades at about 19.8 times analysts' average 2008 earnings estimate, compared with a multiple of about 18 for rival McDonald's. If both stocks were valued like their peer companies, both companies could experience substantial share-price growth during the next several years. Since both are solid plays on China's growth, that makes sense. Add in PepsiCo Inc. (PEP) and The Coca-Cola Co. (KO) for good measure, and you have a portfolio of four U.S.-based plays on China's growth.

[To check out our Contributing Editor Keith Fitz-Gerald's analysis of Pepsi and Coke in China, please click here. This report from our resident Asia expert - he and his family live roughly half the year in Kyoto, Japan - are free of charge.]

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About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.

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