New Trade YUM: Likely to Succumb to Weak China Nums

by Dan August 10, 2012 12:08 pm • Commentary

Earlier this spring/summer we were fairly well focused on shorting U.S. multi-nationals with a good deal of revenue exposure to Europe, which proved to be a profitable endeavor.  At this point in the cycle we are getting pretty close to a sort of “put up or shut up” situation for European political leaders and central bankers.  Clearly they have reassured investors that they will do what it takes to avoid runs on risk assets, but without sustained and measured policy response, this newfound “honeymoon” period they bought since the “Draghi Bottom” is likely to end soon in tears.

For the last few weeks the financial press has been looking at U.S. corporate earnings through rose colored glasses and has almost all but forgotten the risks to the re-emergence of the European fears.

One Country that has not been given a “pass” this summer is China, and the major equity index, the Shanghai Composite, mirrors the downbeat economic data that seems to be ever so slightly accelerating to the downside.

On a week that saw MCD report July same store sales that missed estimates badly, and were actually down in all 3 major regions for the first time since 2004, we would be remiss not to try to extrapolate this weakness to other U.S. multi-nationals.

YUM sticks out to us like a sort thumb as they got 43% of their sales from China alone in 2011, compared to only 30% in the U.S.   Much of YUM’s growth lies in faster growing emerging markets such as China, which is one of the main reasons the stock trades at almost 18x next years earnings that are expected to grow at 14% and sales growth expected to be 9% vs MCD at about 14x 2013.  

Interestingly, while MCD is struggling overseas, and CMG’s growth decelerates domestically, YUM’s sales appear to be tracking OK if you listen to their “award winning CEO” (Bloomberg interview last week here, as an aside, Enis and I wanted to puke listening to all this guy’s generally useless management speak and talk of products instead of financial substance).

Our View: Obviously this is a stock we want to take a shot on the short side, the slightest headlines of continued slowdown in China should see stocks like this re-test the June lows and likely make new ones.  The big risk to the trade is that the stock is basically 10% from the 52 week highs and about 9% off of the recent lows, so the stock is in no man’s land on a near term basis.  Timing is of the utmost imporatnce for a trade like this.

The Shanghai Composite is one of the worst performing major market indices down 1.4% ytd and trading at 3 yr lows, the market is clearly anticipating bad news in the months to come.  China has been easing fairly aggressively of late, so any continued easing and stimulus measures could cause a fairly decent squeeze, as names levered to China are likely to trade up with it.

Conviction Level:  As I said above, timing will be everything, and if the stock rallies straight to 70 in the next couple weeks it will be hard to make money on this trade, so I am going to stick my toe in the water right here and initiate about 1/3 of a position. SO while I really like the idea, and it fits into my generally bearish world view, I would be foolish to suggest that this is a “slam dunk” entry point.

TRADE: YUM ($66.66) Bought Oct 62.50 / 55 Put Spread for 1.12

-Bought 1 Oct 62.50 Put for 1.51

-Sold 1 Oct 55 Put at .39

Break-Even On Oct Expiration:

Profits btwn 61.38 and 55 make up to 6.38, max gain of 6.38 at 55 or below.

-Losses of up to 1.12 btwn 61.38 and 62.50 and max loss of 1.12 at 62.50 or higher.