Yum's Earnings Deserve Praise (YUM)

By Glenn Curtis | October 10, 2007 AAA

Yum Brands (NYSE: YUM), the operator of Pizza Hut, Taco Bell and KFC, recently reported its third-quarter earnings, and once again the numbers beat consensus estimates. The company deserves accolades for its strong performance, but it may be trading at a little beyond its depth.

Read on as we explore the reasons behind the company's latest strong quarter, and examine some problems it could have despite this success.

Another Solid Quarter
The company reported a profit of 50 cents per share, which is a roughly 20% improvement over the 42 cents per share it posted in the comparable period a year ago. It's also about a nickel north of what Wall Street expected.

The reason for the better than expected growth? A strong top line. Very simply, its revenue came in at $2.56 billion, well ahead of the roughly $2.46 billion the Street had been expecting. This growth was in part fueled by solid international sales. The big driver abroad was China, which posted same-store growth of 11%.

There were other reasons for the strong numbers. The company's share count was reduced about 2%, thanks to ongoing share repurchases. The company posted a roughly 0.5% improvement in its worldwide operating margin, and a favorable foreign currency conversion boosted EPS by about 2 cents per share.

The other tidbit of good news is that, in conjunction with the earnings announcement, management is now expecting full year earnings of $1.65 per share, which is up from the $1.63 per share previously forecast and the $1.64 per share that Wall Street analysts had been expecting. (To learn more about analyst predictions, see Earnings Forecasts: A Primer.)

The Downside
If you dig a little deeper, it is pretty clear that not every facet of the business is firing on all cylinders. The key U.S. market was sluggish, as same store sales grew by just 1%. This lackluster performance was caused by a roughly 6% drop in comps at its Taco Bell concept.

Why is Taco Bell having a rough go? The company didn't provide too much color. However, my feeling is that Taco Bell never really regained its stride since the E. coli scare last year. It's also facing fairly intense competition from up-and-coming chains such as Chipotle Mexican Grill (NYSE:CMG). Also, a number of other major chains, including McDonald's (NYSE:MCD), Burger King (NYSE:BKC), Wendy's (NYSE:WEN) and even Starbucks (Nasdaq:SBUX) have been advertising their wares pretty heavily here in the U.S. and are almost certainly luring away some fast food traffic.

My Take On the Stock
At roughly 20-times this year's earnings, it is a little too pricey for me. In addition, I am concerned that the company continues to garner so much benefit from international sales, and more specifically China. While I think that region of the world offers a tremendous amount of opportunity over the long run, I am concerned that even the slightest stumble could send the shares spiraling downward, particularly since U.S. sales appear unable to fill the void.

As mentioned above, there's also the competition issue (and more specifically the number of new menu offerings by those major players) that has me worried. And finally, I just wonder where the company can go from here. Can Yum keep beating Wall Street estimates as it has been doing? I think the investment community has almost come to expect this kind of upside surprise.

The Bottom Line
There's little doubt that overall Yum has been a pretty solid performer, and over the long haul the potential to expand its presence on the international stage has me believing that even more growth is possible. However, in the near-term I think the upside may be limited, and there could be sizable downside if the company disappoints investors in any way.

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