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Yum's China Problem

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Taco Bell, KFC, and Pizza Hut face the same competition in Asia.

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Yum Brands (YUM) maintained its full-year earnings outlook and expects 2009 earnings to increase about 12% over last year's earnings of $1.96 a share, suggesting 2009 profit of about $2.20 a share.

That would beat the consensus earnings estimate of $2.16 a share.

But the news wasn't all good. The company said it expects fourth-quarter same-store sales to come in lower than analysts expect, and that "a difficult consumer environment" will continue to weigh on them.

In 2010, analysts expect the company to earn about $2.38 a share, or about 8% above this year's expected earnings.

Yum Brands cited lower food prices, improved productivity, and lower administrative costs for the higher earnings forecast. The company is the world's largest fast-food operator based on locations with about 36,000 outlets in about 110 countries, giving it the clout to get good prices from suppliers.

But there may be trouble -- or at least higher expenses -- ahead, despite the company's strong Taco Bell, Pizza Hut, and KFC brands.

Worldwide sales were about flat in the third quarter, but new store openings helped offset so-so same-store sales. In the US, the company faces stiff competition from McDonald's (MCD), Burger King (BKC) and Wendy's/Arby's Group (WEN).

Yum Brands is strong in China, where future growth is almost certain to outpace the mature US market. But expansion probably won't come cheaply because it's difficult to imagine that McDonald's will be content to lag Yum Brands in China. Expect competition -- and expenses -- to increase as the companies battle for market share in China.

The company said it expects same-store sales in China will fall by 3% in the current quarter. According to Bernstein Research analyst Sara Senatore, that news will likely disappoint investors, "especially as trends in China appear to have decelerated further, and the stock is likely to come under modest pressure."

By some estimates, there are about 600 million potential urban customers in China, or about twice the current population of the US. Yum Brands plans to expand to about 20,000 restaurants in China. The company now operates about 2,700 restaurants in 550 cities in China.

Domestic growth will be much slower and probably more expensive as competitors battle each other for market share in a mature, slow-growth market.

Despite the solid potential for growth in China and the rosy earnings outlook for 2009, investors grabbed the here-and-now as Yum Brands' stock fell $1.06 a share, or 3.02%, to $34.06.

Long-term, the company will continue to cut costs by moving to more franchises.That and expansion in China should send the stock higher in the future, despite Friday's dip on a solid earnings outlook. Morningstar pegs the company's fair value at $46 a share.

No positions in stocks mentioned.
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