Taken as a whole, Yum! Brands (NYSE:YUM) is still an exceptional global restaurant concept. You could argue that the company has "out-McDonald's (NYSE:MCD)" McDonald's, with its exceptional success and excellent growth platforms in Southeast Asia, Latin America and the Middle East. All of that said, Yum! Brands has long carried a premium valuation due to that Chinese growth kicker and while the company is likely to continue to be quite successful, valuation may be an issue with the shares.
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Profitability a Bigger Challenge in Second Quarter
Although Yum! Brands barely missed at the bottom line (and beat on the top line), the moving parts may worry some investors - particularly as they relate to the prime growth engine of China.
Overall, company-wide revenue was up more than 12%. On a same store basis, China continues to lead, but the 10% growth this quarter was down 400 basis points (BPS) from the first quarter. On the flip side, United States comps were up 7% (up 200 BPS sequentially) due to a strong recovery at Taco Bell. International (which is pretty much everything outside of the U.S. that isn't China) saw a 4% comp growth (down 100 BPS from the first quarter), with emerging markets up 9%.
The profit picture was not quite as bright, despite a strong improvement in U.S. operations. Gross margin declined nearly a full point and restaurant-level operating margins fell 60 BPS. Margins in China plunged 410 BPS due to wage and food cost pressures, while U.S. margins improved almost six points. The International segment saw a modest 110 BPS decline.
SEE: Analyzing Operating Margins
China Wobbles, but Won't Fall down
I'm pretty confident that the biggest discussion point around Yum! Brands coming out of this quarter will be China, and that makes sense given how much of the company's future growth is tied to this country.
Unlike other American restaurant concepts like McDonald's or Starbucks (Nasdaq:SBUX), Yum! Brands has located many of its units in smaller cities where there is arguably more pent up demand for QSR concepts. While that may be better news for comp-store sales, it doesn't shield the company from the wage and food inflation that is occurring throughout China.
The fact is, though, that this is just part of the maturation process of a large emerging market. There is still enormous store growth potential for Yum! Brands in China, and wage inflation will likely work itself out before long. If nothing else, the Chinese government realizes that it walks a fine line with wage costs - knowing that there's a balance between improving wages for citizens but not letting the inflation genie out of the bottle, nor spoiling the company's labor cost advantages.
SEE: Timeless Ways To Protect Yourself From Inflation
U.S. Ops Spin Reliable Cash
In the U.S., Taco Bell seems to have regained some momentum ((helped in part by the Doritos taco it launched with PepsiCo (NYSE:PEP) )as comps grew more about 13%. While a 4% growth at Pizza Hut doesn't sound great, it is better than the recent performance of Papa John's (Nasdaq:PZZA) and Domino's Pizza (NYSE:DPZ). KFC continues to be more of a challenge, with a sluggish 1% comp growth.
While Yum! Brands would seem to have more work to do with KFC (perhaps including a bigger emphasis on value pricing), the overall U.S. operations are doing what management needs them to do - spinning off solid free cash flow streams to help finance global expansion. With that in mind, I wouldn't be surprised to see management take a "don't fix what really isn't broken" approach - adding concepts like A&W and Long John Silver's didn't really help much at all, so it probably makes sense to play things conservatively.
The Bottom Line
Yum! Brands is yet another example where I see a big difference between the quality of the company and the quality of the stock. Although I think many sell-side analysts are too starry-eyed about China (it's not going to grow 15% forever with no inflation), there is still very real growth potential here. Likewise, growth opportunities in markets like Indonesia, Russia and India are not trivial.
SEE: The Risks Of Investing In Emerging Markets
But how much do you want to pay for that growth? Yum! may not carry the same valuation as Panera (Nasdaq:PNRA) or Chipotle (NYSE:CMG), but it also doesn't have the same growth momentum and while multiples are similar to McDonald's, Mickey D's produces more free cash flow from its revenue base.
Even with low teens free cash flow growth over the next decade, fair value on these shares looks to be only slightly more than the current stock price. I'd happily consider these shares on a real pullback, but the risk of multiple compression (and/or further economic issues in China) and the high growth expectations already in the stock make it look like more of a hold than a buy to me 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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