Yum! Brands Gives Its Skeptics Indigestion

By Stephen D. Simpson, CFA | February 09, 2012 AAA

Looking back, maybe it's not so hard to see why quick-service restaurants would do well in a tougher economy, but the performance of the top brands has been nothing less than blistering. In the case of Yum! Brands (NYSE:Yum), the story continues to be all about China. With Yum! still set on turning China into a fast food nation, it would be dangerous to assume that the company's remarkable growth is due to slow anytime soon. (For related reading, see Investing In China.)
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Q4 Earnings Trade a Little Margin for Growth
There was no question that Yum! Brands saw fine growth in the fourth quarter. Total revenue rose 15%, with reported U.S. revenue down a little (though up in the mid-single digits on an adjusted basis), International up about 7% and China up a torrid 39%. Not surprisingly, same-store sales show a similar breakout - China's same-store sales growth was an eye-popping 21%, while International growth was much more modest (up 3%) and U.S. results were fairly soft (up 1%).

Higher costs pressured Yum's restaurant-level margins for the quarter. Overall restaurant margins slid more than a point, with the worst erosion in China (down about 240 basis points) due to higher food and payroll costs. This theme of higher food and payroll costs was repeated across all operating segments, though, so it may be something for investors in other chains like McDonald's (NYSE:MCD), Arcos Dorados (NYSE:ARCO), Starbucks (Nasdaq:SBUX) and Panera Bread Company (Nasdaq:PNRA) to keep an eye on in the next few quarters.

Yum management recaptured much of this through leaner overall operations. Overall operating income rose 15%, with the U.S. operations showing the most improvement (up 200bp) and International showing the best overall performance (19.7%). (For more information, read Analyzing Operating Margins.)

Do the U.S. Ops Need More Attention?
Comparing Yum's U.S. operations to McDonalds' shows some interesting details. McDonald's is showing better growth, but Yum runs a more profitable business. That would seem to corroborate some quick-service food chain ratings (QSR) surveys that I've read lately - Yum's stores Pizza Hut, KFC and Taco Bell score really well on metrics like price and value for money, but not so well on menu or perceived quality. Now surveys can be very misleading (simply changing how a question is presented can change the answer), but it raises some interesting questions.

Should Yum invest more in its U.S. operations? The company recently jettisoned long-underperforming brands like Long John Silvers and A&W, and it's hard to fault them for this move. But is the company investing enough in existing stores and menu expansion to keep pace with McDonald's, a refurbishing Wendy's (NYSE:WEN) and growing alternative QSR concepts like Panera or Chipotle Mexican Grill (NYSE:CMG)?

Clearly, Yum management is giving a lot of time, attention and capital to the China ops, and it shows. Moreover, given the sheer size of the opportunity, it's hard to argue that money shouldn't be poured into this market. Still, not many companies can manage to simultaneously operate both growth and value businesses under the same umbrella, so this may only intensify the need to break this company up somewhere down the line.

The Bottom Line
With the huge run in QSRs, there just aren't many values left to be found. It's difficult to recommend selling Yum with such strong fundamentals underpinning the business. What's more, given that the stock is trading around fair value (and therefore is not significantly overpriced) there's no pressing need to do so. By the same token, investors not already in these shares should likely look elsewhere or wait for a pullback, as there is little room for error in today's valuation. (To learn more, check out Stock-Picking Strategies.)

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

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