Even With Continued International Deceleration, Yum! Still Popular

By Stephen D. Simpson, CFA | October 11, 2012 AAA

Sometimes it seems that Wall Street just wants to like a company/stock, and even decelerating growth doesn't end the love affair. Yum! Brands (NYSE:YUM) is indeed a well-run company, but whereas investors have sold off many stocks on worries about slowing emerging market economies, the multiples here have stayed robust. Shares of this global quick service restaurant (QSR) remain a quality hold, but demanding growth assumptions make the "buy now" case a bit more difficult.

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Growth Still Slowing
Yum! saw growth slow sequentially from the first to the second quarter and now again into the third quarter. Nevertheless, bottom line results were still better than expected and management's solid guidance is likely to keep this stock in favor. Net revenue rose about 9% this quarter on a 6% increase in reported system sales. U.S. comps eased slightly from the second quarter (6% versus 7%), but all three concepts (Taco Bell, Pizza Hut and KFC) were solidly positive. International (which basically means "not the United States or China") comps were cut in half sequentially to 2%, with the company seeing about 1% headwind from Ramadan. China continues to decelerate, with 6% comp growth this quarter (versus 10% in the second quarter and 19% a year ago).

Profitability was a happy surprise. Gross profit grew almost 14%, with gross margin improving by a point. Operating income rose 16% (more than a one point improvement in operating margin), while restaurant-level margins improved nearly two points. The U.S. saw the biggest improvement (up 460 basis points), while China also eeked out an improvement of 10 basis points on more moderate food and labor cost inflation and less drag than expected from the Little Sheep acquisition.

Why Fix What Isn't Broken?
Judging by management's commentary, it doesn't sound like any big changes are coming to the company. Given the performance, I don't see why they would be in any hurry to change a winning formula. While it's true that China comps have slowed significantly, I don't believe there's a lot that Yum! can do in the short term to spur more traffic. After all, companies as diverse as Nike (NYSE:NKE), Coca-Cola (NYSE:KO) and even Alcoa (NYSE:AA) have pointed to slowing demand for consumer products in China. Domestically, comps are growing at all three chains and I don't expect major changes. The company arguably still has more work to do on value menu options for KFC, particularly given how much other QSRs such as McDonald's (NYSE:MCD) and Wendy's (Nasdaq:WEN) are pushing chicken options (though it's absolutely fair to say that a chicken nugget and fried chicken aren't direct comps).

I also believe more could be in store for Taco Bell. There seems to be more than a little controversy about the extent to which Taco Bell's Cantina menu has, or can, impact Chipotle Mexican Grill (NYSE:CMG), but less argument that the Doritos-flavored taco shell was a hit. As such, I would expect Yum! management to work with PepsiCo (NYSE:PEP) and McCormick (NYSE:MKC) to exploit the concept even further. And who knows, maybe the same idea could be applied in Yum!'s other concepts.

The Bottom Line
If China avoids a hard(er) landing, Yum! will be fine. Actually, even if the Chinese economy gets a lot worse in 2013, the long-term potential for Yum! in China is still enormous. With a trailing EBITDA multiple of nearly 12 times, however, the near-term impact on the stock could be more severe. The problem with this stock has long been the growth expectations already built into the stock. Assume a decade of low-teens free cash flow (FCF) growth (with revenue doubling by 2022) and a blue-chip discount rate, and the stock is still only 10-15% undervalued today. Consequently, I'd be in no hurry to sell Yum! shares (unless you believe China will get much worse), but I'd likewise not be in any great hurry to buy today.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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