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Commentary

Are McDonald's and Yum Opportunities Today?

Concerns over a key supplier to both Yum and McDonald’s in China have hurt sales and stock prices in the short run, but Morningstar's R.J. Hottovy expects the firms to bounce back.

 Yum Brands (YUM) and  McDonald's (MCD) shares have come under pressure after Yum disclosed in a July 30 8-K filing that media reports over improper food handling by Shanghai Husi, a key supplier to Yum, McDonald's, and other food-service firms across Asia, has resulted in "a significant, negative impact to same-store sales at both KFC and Pizza Hut in China over the past 10 days" and that "if the significant sales impact is sustained, it will have a material impact on full-year EPS."

Yum immediately terminated its relationship with OSI globally and we do not view this development as indicative of structural supply chain concerns at any of the restaurant chains affected, but this announcement corroborates our fears that negative publicity could adversely affect top-line and operating margin results for Yum's China and McDonald's APMEA divisions over the foreseeable future.

We've already cut our second-half same-store sales outlook for Yum China to low- to mid single-digit growth (versus guidance calling for high-single-digit growth) and expect a low-single-digit decline in McDonald's APMEA segment comps, but acknowledge there could still be downside risk based on current consumer sentiment toward Western QSR brands. We also concede that it may take longer for traffic to rebound compared to previous food quality scares in the region given that this comes on the heels of last year's poultry supplier controversy. Nevertheless, we believe both Yum and McDonald's brand intangible assets--factors behind our moat ratings for each firm--are strong enough to weather this development through new menu innovations and food quality marketing campaigns. Both firms face heightened near-term volatility, but we believe the pullback creates potential buying opportunities for longer-term investors. Yum and McDonald's are both trading at discounts to our $82 and $103 fair value estimates, respectively, with Yum currently looking like the more compelling risk/reward proposition at a 16% discount.

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