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Morning Update

On Monday Yum Brands reported that fourth quarter sales dropped 6% in China, the first drop in 3 years. CFO Patrick Grismer added on the conference call that comparable same store sales could slide 25% in the first quarter. This sent the stock down almost 3% on the day though it closed well off its lows. The stock has been pummeled since December when the Chinese government announced that some batches of KFC chicken contained higher levels of antibiotics than was allowed. Despite the gloomy outlook on the Yum conference call, one option trader used the stock’s weakness to sell out of the money puts on the stock to lock in a future purchase price. The biggest trade of the day was the sale of 1000 March 57.5 puts for $0.62 with the stock at 61.84.

This is a bullish trade that suggests this trader is willing to buy 100,000 shares of YUM at 56.88, 8% lower, at March expiration. If the stock does not fall below the put’s strike price the option will not be exercised and the option will expire worthless. In this case the trader will make $0.62, which comes to an 8% annualized return.

Before running out to sell puts yourself, it is important to take a look into why this stock is selling off. The issue at hand is unacceptably high levels of antibiotics in KFC chicken. The chicken in question was purchased from the Liuhe Group, and Yum says that they stopped buying from them in August. Nevertheless, the damage was already done to the brand’s image in the consumer’s eye. The story went viral on China’s equivalent of twitter and Yum’s advertising campaigns and in-store promotions have not been able to jump start sales. On Yum’s earnings conference call the company said that time, not ad spending is the cure for the sales decline. They are taking the “time heals all wounds” philosophy right now, which could hurt the stock in the short term. Time very likely will fix the problem, but the question is how much time will it take?

This option trader is willing to bet that the selloff continues for about another month and then stops. By selling the 57.5 put this trader is picking a point he thinks the stock is a value buy and getting long there. I am confident Yum’s sales will come back, and the market, which is forward looking, will recognize this soon. But in the meantime trading in the stock can be overly emotional and irrational. Therefore I would keep any position small for the time being and keep an eye on same store sales. Management announced that they will report monthly same store sales to give investors more transparency, and these will be a good indicator of when the Chinese consumer is back.

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