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.

Investopedia Broker Guides: Enhance your trading with the tools from today's top online brokers.

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.

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  3. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  4. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  5. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  6. Markets

    PEG Ratio Nails Down Value Stocks

    Learn how this simple calculation can help you determine a stock's earnings potential.
  7. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  8. Investing

    Retailers Rebel Against Black Friday: Bad Move?

    The Black Friday creep may have hit a wall as some stores are shutting their doors on Thanksgiving and even Black Friday to give employees the day off.
  9. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  10. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  1. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  2. Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
  3. Can a company's working capital turnover ratio be negative?

    A company's working capital turnover ratio can be negative when a company's current liabilities exceed its current assets. ... Read Full Answer >>
  4. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  5. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  6. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>

You May Also Like

Trading Center