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Share price of Yum Brands (NYSE:YUM) has dropped by 12.5% over the past 3 months primarily due to the company's chicken supply chain issue in China. At $64.87, the stock is trading near its 52-week low of $59.68 achieved just recently and offers a 2.1% dividend yield. I am of the view that investors should avoid the stock in the near term due to its unfavorable risk/reward outlook. There are 3 compelling reasons backing my opinion:

1. From a relative valuation perspective, Yum shares are priced somewhat expensively based on the company's financial performance relative to its peers' (see chart below). Consensus estimates on average predict Yum's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 6.2%, 5.5%, and 7.3%, respectively. Those estimates are notably below the averages of 6.5%, 10.7%, and 16.6%, respectively, for a group consisting of Yum's primary industry peers. Similarly, Yum's long-term EPS growth rate is forecasted to be 11.9%, markedly below the peer-average estimate at 15.8%. On the profit side, however, Yum demonstrates a solid performance as most of the company's profitability margins and capital return metrics are above par. The firm's debt load is fairly in line with the group as reflected by its above-average debt to capitalization ratio, but below-average debt to EBITDA multiple. In terms of liquidity, Yum's trailing free cash flow margin is slightly below par. Both the company's current and quick ratios are below the peer averages, reflecting a mediocre balance sheet condition.

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To summarize, Yum's solid profitability performance should be supportive to the stock valuation. However, given the firm's lackluster growth potential and mediocre liquidity position, I believe the stock's fair value should trade in line with the peer-average or even at a small discount. Nevertheless, the current valuation at 11.3x forward (next 12 months) EBITDA represents a 15.6% premium over the peer-average EBITDA multiple at 9.8x, suggesting that the stock is likely somewhat overpriced. Further, although Yum's forward P/E multiple of 21.0x is trading in line with the peer average at 21.5x, the stock's PEG ratio of 1.76x is 26.7% above the peer-average ratio at just 1.39x, again indicating an expensive valuation level (see chart above).

2. Over the past 6 months, Yum's forward P/E multiple has expanded by 13.9% from 18.5x to 21.0x at present (see chart below). However, market's consensus revenue, EBITDA, and EPS estimates for the company have all experienced multiple downward revisions over the 6-month period. Moreover, since 6 months ago, the stock has seen 2 analyst downgrades and a drop of its average target price from $76.20 to $67.08. All those facts together evidence an elevated valuation trend despite the deteriorated fundamentals (see charts below).

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3. In a research note dated February 6, 2013, Jeff Farmer at Wells Fargo Securities elaborated on his near-term bearish view on the firm, which I tend to agree on (sourced from Thomson One, Equity Research):

"We believe YUM shares reflect an investor expectation for a highly probable China segment SSS recovery in 2014…Many investors incorrectly believe, in our view, that despite the 2013 China hiccup, the prior 2014 EPS trajectory is still achievable with a return of high-single digit or greater China SSS in 2014 - we disagree…Considering average unit volumes (AUVs) are the key margin driver, we note that had China delivered back-to-back years of 5% SSS growth in 2013 and 2014 - AUVs would have grown more than 10% from 2012 to 2014. However, a 10% SSS decline in 2013 followed by 10% SSS growth in 2014, would result in a roughly 1% AUV decline from 2012 to 2014 and what would likely be only a partial margin recovery."

Bottom line, investors should avoid buying Yum shares as the current valuation level appears to have baked in the somewhat optimistic expectations and thus provides limited margin of safety.

All charts are created by the author and all financial data used in the article and the charts is sourced from Capital IQ unless otherwise specified.

Source: 3 Reasons To Dislike Yum Brands