On Jan. 7, 2013, Yum Brands (YUM) announced revised same-store sales expectations of -6.0% for its China division. This revision is on top of a previous revision for China of -4.0% announced on Dec. 6, 2012. In total, the stock price has dropped over 12% from $74 prior to the first revision, down to $65 per share. Everyone is familiar with how much YUM depends on China, with 44% of 2011 sales and 50% of 2011 operating income coming from the region. However, not everyone may realize that YUM owns 90% of its 5,400 stores in China and franchises only 10%. This is the opposite of the traditional 20% / 80% own / franchise model. Due to operating leverage from owning the stores, YUM China's operating profits could fall by 13% (in my illustrative example below). Operating leverage (positive or negative) affects not just YUM, but all restaurant stocks that own a portion of their stores, including McDonald's (MCD), Burger King (BKW), Wendy's (WEN), Starbucks (SBUX), Chipotle (CMG), etc. This article will explain the concept of operating leverage and will provide an example of the possible magnitude of its affects on YUM's China profits.
As always, let's start out with the big picture valuation and financial summary on the stock. At $65, YUM currently trades at 2.3x 2013E Sales, 19.1x 2013E EPS, and a dividend yield of 1.9% (38% payout ratio). The company has experience strong sales growth (average 8%) and EPS growth (average 13%) in the past few years, mainly due to the China region's performance which I will highlight later. Note that 2013 sales and EPS are expected to slow down to 3% and 5% growth, and then pick up in 2014.
Looking at YUM's current LTM 2012 P/E of 20.1x, it is towards the high-end of its historical LTM P/E multiple range (15.1x to 21.4x with an average of 18.2x).
Store Count and Mix by Region
Let's first take a look at where YUM's restaurants are located worldwide: 16,000 stores in the U.S. (44%), 5,400 stores in China (15%), and 14,700 stores in the rest of the world (40%).
Now let's look at the owned versus franchise store mix by each region. As you can see, while the rest of YUM's regions have 10-20% owned and 80-90% franchised stores, China is the opposite with 90% owned stores and 10% franchised (note that Affiliates are entities in China where YUM has partial/indirect ownership).
Notice that while China only has 15% of total stores, China sales comprise of 44% of total sales and 50% of operating profits (will show details later). This is not because China stores have higher average sales per store - it's because YUM owns most of its stores in China and therefore consolidates all the restaurant sales, compared to franchise stores where YUM only can only recognize the franchise fee (typically 5% to 10% of franchise store sales).
Owned vs. Franchise Revenue and Profit
Now let's look at how much of YUM's sales and operating profit is attributable to owned-stores versus franchised stores. As shown below, owned-stores sales is 87% and franchise fees is 13%. However, if we look at operating profit, company-owned profit is only 55% and the franchise fee is 45%. This is because owned-stores get to consolidate 100% of the restaurant sales, and owned-stores have operating profit margins of 17% (or said in a different way, a typical restaurant incurs 33% COGS, 23% wages, and 28% rent and other costs, result in average restaurant operating profits of 17%), while franchise profit margins are very high at 93%. This is fairly consistent with McDonald's owned and franchised margins of 18% and 83% (for my recent analysis on MCD, click here).
Given that China is 90% owned stores (10% franchised), you would naturally expect China to contribute the most to overall company owned operating profits. As shown below, China's contribution is 62% of owned-store operating profits in 2011 (up from 47.7% in 2009). This is due to a few factors: 1) strong sales growth in China of 29.7% a year, which helped offset a -10.4% a year decline in the U.S. (if you look at U.S operating profit decline, it's even worse at -16.5% a year), and 2) China restaurant margin of 20% is significantly higher than U.S. and YRI margins of 12% (low labor costs in China, but it's increasing).
For franchise fees, not surprising that China with just 10% franchised stores compared to 80-90% in other regions, contributes less than 5% of total franchise fees for YUM.
Illustrative Case Study on Operating Leverage
We've now established that YUM owns the majority of its stores in China (90%), and China has been the primary driver of overall company growth for the past few years (24% annual profit growth in China), helping to offset slowdowns in the U.S. (-16.5% annual store profit decline, but note they could be replacing some of this with franchise fees in the U.S., franchise fees has grown 3.4% a year). In summary, YUM is heavily dependent and levered to its owned-store strategy in China. When you own the stores, you are exposed to operating leverage, which can work for you as well as against you. It's probably easiest to explain this concept with an example:
In the example above, when you own the store and sales change by +/-5%, your operating profits change by +/-13%. The reason that profits are amplified or leveraged is because 34% of the total costs are fixed (ie: you still have to pay fixed rent expense every month regardless of sales). When you have certain expenses that are fixed, then you get operating leverage that amplifies your profits. This is no different than when you own a manufacturing plant, and every new widget you produce becomes cheaper and cheaper to produce due to economies of scale (because your largest cost component, the cost of the plant, is fixed).
In this illustrative example, if YUM China's sale continue to decline by -6%, then operating profits could decline by greater than 13%. Note also that some of the wages in the restaurant industry are also fixed (ie: you can't easily fire/hire store managers and staff employees every month to compensate for sales fluctuations), but for this example, I assumed its 100% variable (for reference, if we would have assumed 100% of wages were also fixed, then operating profits would change by +/-20% for every +/-5% change in sales).
On the other hand, franchise fees is almost all profit to the franchisor. As a result, when sales change +/-5% at the franchisee's store, YUM's 7.5% franchise fee also only changes +/-5%.
Is Recent China Same-Store Sales Decline Temporary or Permanent?
Granted China's same-store sales declined -6.0% in December 2012, however, is this temporary or permanent? Well, let's look at same-store sales for past six years:
As you can see, China's same-store sales have declined in only 5 months in the past 7 years (82 months). Bulls of YUM will argue that this is a temporary blip in China and that sales will rebound. They will also argue that China's growth is not only dependent on same-store sales growth, but also expansion of new stores opening in China (only 5,400 stores in China with 1.3 billion people, compared to 16,000 stores in U.S. with 300 million).
The purpose of this article is not to argue whether YUM is a buy or a sell (I don't own - or short - YUM, but in general, I do like recession resilient fast food industry stocks and own MCD). The primary purpose of this article is to highlight the level of risk when a restaurant operator owns a majority of their stores in a particular region (and that region's sales begins to decline). The own instead of franchise strategy pays off handsomely when sales are increasing (as evidenced by YUM's stock performance in the past 5 years). However, remember that operating leverage is a double-edge sword. If you own YUM, monitor closely its China sales trend, and if the declining sales trend continues, be aware of the potential magnitude of the impact on YUM's bottom line.