How The Yuan Devaluation Is Killing Yum Brands

In a report published Thursday, Morgan Stanley analyst John Glass maintained an Equal-weight rating and price target of $82 on Yum! Brands, Inc. (NYSE: YUM).

According to the Morgan Stanley report, "While the direct FX translation impact of the yuan devaluation on YUM's EPS is modest, the broader implications of weaker currency in the region could pressure an already tepid sales recovery as well as intensify the debate for a China spin off."

Concerns regarding the devaluation of the Chinese currency led to a 10 percent sell-off in the shares, given that YUM China is responsible for 35 percent of the company's operating profit for FY15, and if there is even a modest sales recovery, it would account of 40 percent of the FY16 operating profit.

Related Link: China's Yuan Devaluation: What You Need To Know

However, Glass explained that "[b]oth YUM's costs and sales are recorded in the local currency, so YUM's FX risk is translational, rather than transactional," while adding, "We estimate the FX risk to be relatively small."

This would mean that a large part of the recent sell-off could have been due to investors positioning themselves or expectations of additional deterioration in the yuan. If the currency moves meaningfully, it would either impact the sales recovery at YUM's China or decrease the changes of the company undertaking a China spin off.

At the same time, the Morgan Stanley report said that it was uncertain whether "a devalued currency actually manifests itself into lower SSS in the short term. Investors may be assuming that the Chinese stock markets and YUM's fundamental sales are more connected than they actually are."

In addition, Yum Brands remains bullish on China, expressing confidence in being able to execute a full recovery in China sales in the long term, with margins recovering to the 20+ percent levels.

Image credit: Mike Mozart, Flickr