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. Fundamental Analysis

    10 Major Companies Tied to the Apple Supply Chain

    Apple has one of the best supply-chain models. Here are some of the top businesses involved, and the benefits and challenges for all.
  2. Term

    What are Non-GAAP Earnings?

    Non-GAAP earnings are a company’s earnings that are not reported according to Generally Accepted Accounting Principles.
  3. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI US 1000

    Find out about the PowerShares FTSE RAFI U.S. 1000 ETF, and explore detailed analysis of the fund that invests in undervalued stocks.
  4. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  5. Stock Analysis

    Fortinet: A Great Play on Cybersecurity

    Discover how a healthy product mix, large-business deal growth and the boom of the cybersecurity industry are all driving Fortinet profits.
  6. Stock Analysis

    2 Catalysts Driving Intrexon to All-Time Highs

    Examine some of the main reasons for Intrexon stock tripling in price between 2014 and 2015, and consider the company's future prospects.
  7. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  8. Charts & Patterns

    Understand How Square Works before the IPO

    Square is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
  9. Markets

    Why Gluten Free Is Now Big Business

    Is it essential to preserving your health, or just another diet fad? Either way, gluten-free foods have become big business.
  10. Technical Indicators

    4 Ways to Find a Penny Stock Worth Millions

    Thinking of trading in risky penny stocks? Use this checklist to find bargains, not scams.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  4. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  5. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  6. Net Present Value - NPV

    The difference between the present values of cash inflows and ...
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  5. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  6. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!