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This article is part of a three-article series looking at investing in fast-casual and quick-service companies. Each article will investigate price targets, analyze the company's current and future prospects, and compare it with other companies in the industry. This is the third of three articles. To view our first article featuring why 2013 could be a bounce back for McDonald's (NYSE:MCD), click here. To view our feature on why Chipotle (NYSE:CMG) could be headed to $700 in 2013, click here.

Ticker: Yum! Brands, Inc. (NYSE:YUM)

Rating: Maintain at Buy

Thesis:

The quick-service restaurant sector is growing at considerable rates due to emerging markets (China, India, Brazil), and Yum! Brands has benefited greatly from the growth of the consumer market in China. The other appealing aspect of YUM is its diversified lineup of restaurants with Taco Bell, KFC, and Pizza Hut. With a strong diversification of food offerings, we believe this gives the company the ability to appeal to a wide diversity of consumers especially in emerging markets. In the past (growth in China in last five years and growth overall)

In the past quarter, though, YUM showed signs of weakness in China due to what the company called cyclical weakness. In 2011, the company saw same store sales up over 15% in 2011, but in the company's latest quarter, they saw their sales drop 4%. The company is blaming the drop on macro-economic declines in China, which could be the case as GDP rose 7.4% year-over-year versus 9.1% in 2011. Yet, there was still growth in the economy. The same occurrence happened in 2009 when the company saw is Q2 2009 same-store sales drop by a similar. Over the next twelve months, the company saw its share price rise 15% over the next twelve months and was a great buy point. We see the same right now. While same-store sales dropping is a fear, the company has increased EPS by at least 10% for the past thirteen years, and we expect them to do the same for 2013. With the company's future PE sitting at 18, the company's value is strong as a growth stock.

The hiccup in China could be the start of some expansion slowdown, but YUM is expanding into other markets as well like India and Brazil. The company has the deepest penetration into these markets of all of its competition and should experience many more years of high growth. The company is anticipated to build 150 new units in India in 2013. The company only has 100 stores in Brazil, but they appointed a new General Manager of Brazil earlier this year in Andrea Rolim, who was the Business Director of Group Pao de Acucar, which is the second largest retailer in Brazil. The company has identified Brazil as a growth market, and if the company can successfully develop business in Brazil, YUM's shares are at an extreme discount.

Further, China's growth is not even close to done. The company built 800 new stores in China in 2012FY, entering a lot of new markets, and they are expecting to build another 700 in 2013. The consumer class in China will likely double by 2020, and the company expects to see many more lower tier cities experiencing growth in income that will allow them to eat out at fast-dining restaurants, and this short-term issue is just that short-term. When we look at the long-term prospects its very enticing. Competition is growing, but the company should see hundreds of millions new consumers in the next ten years in China alone. The company wants to see the same type of growth and saturation in India, Brazil, and even Russia. Yum is potentially the best play for emerging markets growth.

Another exciting aspect of Yum's future potential is their dividend growth. The current yield sits at 2.00%, and the dividend has grown from 0.53 to 1.34 for the 2013 FY. That is a 150% growth rate in the past six yeas, which is enticing. The company has noted they want to continue to grow the dividend by the same rate as the company is growing. On top of this, the company recently announced a share-buyback plan that is enticing as well. The company will be doing a $1B share buyback that will definitely help to increase the value of stock. The company's dividend growth and share buybacks give the company solid prospects moving forward. Can the company maintain these dividends? The company has $942M of cash currently with $605M in dividend payments to go out next year. Further, they have $1.2B in free cash flow. The company looks very safe right now to continue to pay out dividends.

Some of the risks that we see for YUM is that competition is always heavy in food services, and that will not decrease. Economic moats are very limited. YUM has done a great job of continually developing their menu to increase traffic, but we expect a continued move to fast-casual dining away from fast food towards companies like Chipotle , which we have Buy-rated and Panera (NASDAQ:PNRA). Additionally, we are expecting a bounce back in 2013 for McDonald's in the States as well as increased Chinese exposure that will challenge YUM. Even with these developments, we still believe in YUM. The company has actually increased some of their offerings in the direction of fast casual like their Cantina Bowls at Taco Bell but has kept their quick-service image.

Overall, YUM looks very solid right now. The company has great growth prospects but with solid value right now. We look for 2013 to be a bounce back year for YUM as Chinese sales rebound, India develops further, and the company ramps up production in Brazil.

Price Target:

Ticker

New Price Target

Old Price Target

New Rating

Old Rating

New Buy/Sell Range

YUM

$92

$88

Buy

Buy

$73/$102

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

2285

2633

2830

2900

2945

Taxes

548

632

679

696

707

Depreciation

631

660

665

675

661

Capital Expendit.

-1065

-1060

-1080

-1100

-1225

Working Capital

75

100

100

100

125

Available Cash Flow

1228

1501

1636

1679

1549

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for YUM: 6.17%

2012

2013

2014

2015

2016

PV Factor of WACC

0.9419

0.8871

0.8356

0.7870

*

PV of Available Cash Flow

1156

1332

1367

1321

*

* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate.

Cap Rate for YUM: 3.17%

2016

Available Cash Flow

1549

Divided by Cap Rate

3.17%

Residual Value

48871

Multiply by 2016 PV Factor

0.7870

PV of Residual Value

38463

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

5176

PV of Residual Value

38463

Cash/Cash Equivalents

942

Interest Bearing Debt

3021

Equity Value

41560

We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.

Step 5.

Divide equity value by shares outstanding:

Equity Value

41560

Shares Outstanding

451.80

Price Target

$92

In the end, we have found that YUM is worth around $92, which we believe accurately reflects the company's five-year projections.

Profitability:

Q1-Q3 2012

Q1 - Q3 2011

Operating Margin

21.7%

17.8%

Gross Margin

71.4%

83.0%

Return on Equity

54.9%

50.3%

Profitability is strong at YUM in its industry, and the company has done a great job of increasing profits over the past year in operating margins and return on equity. The company has done this through better sales in he USA and decreasing costs. How does this compare to competition?

McDonald's has operating margins at 32%, 45% at gross margin, and 11% ROE. Sonic (NASDAQ:SONC) has operating margin at 16%, gross margin at 79%, and ROE at 61%. Mexican food foe CMG has operating margins at 18%, gross margins at 67%, and ROE at 18%. Finally, Wendy's (NASDAQ:WEN) has operating margins at 5%, gross margins at 24%, and ROE at -1%. YUM only trails MCD in operating margins, SONC in gross margins, and no one in ROE. The company has solid profitability due to their franchise model, and they should continue to maintain high margins, which makes them attractive.

Value:

Current

Industry Average

P/E

19.6

20.2

Future P/E

17.9

N/A

For value, PE is solid for a growth stock below 20, and their future PE at 18 is also fairly solid. These values also do not reflect the $1B share buyback plan, which will make the shares even more valuable. YUM's value compares to WEN with a 28 future PE, CMG with a 31 PE and 25 future PE, SONC with 17 PE and 13 future PE, and MCD's PE at 16 and future PE at 15. We believe YUM's premium to all companies other than CMG is reasonable due to strong growth and financial health, and we see this multiple as attractive for entry.

Source: Yum Brands Headed Over $90 In 2013, Will Bounce Back In China