(YUM) Yum! Brands in Neutral Lane

We maintain our Neutral rating on Yum! Brands Inc. (YUM). While we are optimistic on the company’s lucrative China division and solid unit growth, negative impact from Taco Bell U.S. as well as commodity inflation compel us to remain on the sidelines.

We see the company’s overseas expansion as one of its key growth drivers. Moreover, Yum! Brand’s recognition, consistent performance and emerging market operations give it an edge over competitors.

The Chinese division of Yum! offers significant prospects with its two leading brands KFC and Pizza Hut. The company’s close competitor McDonald’s Corp. (MCD) has accelerated its unit growth in the Chinese market, but is still lagging.

To give a further boost to growth in China, Yum! also offered a bid to buy Little Sheep Group Limited –– the country’s chain of hot pot restaurants. The deal will raise the stake of Yum to 93.2% in Little Sheep, while the remaining 6.8% will be owned by the founders. Little Sheep’s hot pot concept is also in demand in other overseas markets and in the long term Yum! will make efforts to expand the concept and the brand internationally.

In terms of headwinds, commodity inflation remains a threat. Management expects commodity inflation of 7% in China and 6% in the U.S. in this year. However, commodity inflation is likely to have a lesser effect on the Yum Restaurants International (YRI) division as 90% of the business is franchised.

Additionally, Yum! expects wages in China to increase in the mid teens. Hence, margin expansion especially in China is expected to be muted in 2011. In 2010, Yum! posted record margins of over 26% driven by commodity deflation, which is no longer likely this year. Hence, margins are projected at above 20% for 2011.

Taco Bell, which accounts for more than 60% of total U.S. earnings, is presently the most important domestic brand. But negative publicity due to the lawsuit related to the content and quality of its beef products was a dampener last quarter.

Anyway, on April 18, Alabama-based Beasley Allen law firm, which filed the case in a California court on behalf of a Taco Bell customer, voluntarily withdrew the allegation. But with poor sales already in early April, Taco Bell will likely feel the brunt in the second quarter. Consequently, we have a Zacks #3 Rank (short-term Hold recommendation) on the shares.

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