McDonald's Vs. Yum Brands: A Play On Emerging Markets

| About: Yum! Brands, (YUM)

One of the most important aspects of every portfolio is diversification. How you go about accomplishing this will ultimately depend on your overall investment strategy, personal goals, and risk tolerance. One way to accomplish this though could be to gain some exposure to emerging markets. The strategy that I would recommend to accomplish this would be to invest in an already established yet potentially undervalued American company that has a large growth potential in the developing parts of the world. After using P/E ratio as an initial screener, I decided that Yum Brands Inc. (NYSE:YUM) and McDonald's Corp (NYSE:MCD) fit the description of what I was looking for.

The P/E ratios for McDonald's and Yum are roughly 19 and 21, respectively, while the restaurant industry has an average P/E of about 30. Burger King, for example, has a P/E of 68. Using this metric alone one could label them both as a screaming buy, however, given the riskier nature of companies that are exposed to these new markets we must dig a little deeper. While McDonald's has been a favorite of both traditional and income investors for quite some time it is coming off one their worst performing years in recent memory in regards to share price, although it has regained its losses and then some from where it started last year. Yum has also performed in a very similar manner as McDonald's with 2012 being a year of consolidation for both companies. What happened during 2012 to cause this consolidation? Let's start by taking a look at some of the highlights, we will start with Yum.

According to Yum Brands Inc.'s most recent annual report, Yum operates over 39,000 stores in over 125 countries. The most well-known of these stores are KFC, Pizza Hut, and Taco Bell though they also operate some market specific stores such as "East Dawning" and "Little Sheep group Ltd" in China. They own 93% of Little Sheep, which is a Casual Dining concept and also has restaurants in the US and Canada. They also own and operate their distribution system in China.

Here is a breakdown of Yum revenues throughout the world in their 4 main divisions, as you can see they rely very heavily on China for their income.

  • The China Division comprises approximately 5,700 restaurants, primarily Company-owned KFCs and Pizza Huts. In 2012, the China Division recorded revenues of approximately $6.9 billion.
  • Yum Restaurants International (YRI) comprises of approximately 14,600 restaurants, primarily franchised KFC's and Pizza Huts, operating in over 120 countries outside the U.S., China and India. In 2012 YRI recorded revenues of approximately $3.3 billion.
  • In the US Yum have approximately 18,000 restaurants, primarily franchised restaurants, and recorded revenues of approximately $3.4 billion.
  • The India Division comprises approximately 600 system restaurants. In 2012, India recorded revenues of approximately $100 million.

Highlights from 2012 include:

  • Same-store sales grew 4% in China, 3% at YRI and 5% in the U.S.
  • Worldwide restaurant margin increased 0.6 percentage points to 16.6%.
  • Worldwide operating profit grew 12%, prior to foreign currency translation.
  • Record International development with 1,976 new restaurants opened, including 889 new units in China, 949 new units at YRI and 138 in India. 83% of this development occurred in emerging markets.

Recent Institutional purchases:

  • On January 30, 2013 BlackRock Inc. filed a 13G claiming a 5.39% or 24,371,453 share stake.
  • On February 13, 2013 Capital Research Global Investors filed a 13G claiming a 4.2% or 18,791,866 shares stake.

Two important upcoming dates for Yum are as follows:

  • March same-store sales for their China Division will be released on April 10, 2013
  • First-quarter earnings will be released on April 23, 2013. Both will occur after market hours.

Now for a look at McDonald's:

Taken from McDonald's most recent annual report, The Company franchises and operates 34,480 restaurants in 119 countries. The business is managed in distinct geographic segments these include the United States, Europe, Asia/Pacific, Middle East and Africa (APMEA), and Other Countries and Corporate (OCC). The U.S., Europe, APMEA, and OCC segments account for 32%, 39%, 23%, and 6% of total revenues, respectively. Here is the breakdown of McDonald's restaurants throughout the world in their 4 main divisions; they are much more diversified with regards to their global market exposures than Yum.

  • United States division operates 14,157 restaurants and recorded revenues for 2012 of $8.814 billion.
  • Europe division operates 7,368, restaurants and recorded revenues for 2012 of $10.827 billion.
  • APMEA division operates 9,454 restaurants and recorded revenues for 2012 of $6.391 billion
  • OCC division operates 3,501 restaurants and recorded revenues for 2012 of $1.535 billion.

The main measure used by management to gauge the effectiveness of their operations is Return on incremental invested capital (ROIIC) which is calculated by dividing the change in operating income plus depreciation and amortization by the cash used for investing activities.

McDonald's uses the following long-term, financial targets, these targets are as follows:

  • System wide sales growth of 3% to 5%;
  • Operating income growth of 6% to 7%;
  • ROIIC in the high teens.

In 2012, System wide sales growth was 3% (5% in constant currencies), operating income growth was 1% (4% in constant currencies), one-year ROIIC was 15.4% and three-year ROIIC was 28.6%. This makes 2012 the first year since 2003 that one of these targets has been missed (operating income growth).

Also taken from McDonald's most recent annual report, here are some highlights from 2012 by division:

  • In the U.S., comparable sales increased for the tenth consecutive year, rising 3.3% in 2012, while comparable guest counts rose 1.9%. This was in part due to expanding the McCafe beverages such as Chocolate Chip Frap, and Cherry Berry Chiller. Other Limited-time offers also contributed. Multiple order points and hand-held order takers also helped improve customer service times.
  • In Europe, comparable sales rose 2.4%, marking the ninth consecutive year of comparable sales increases, while guest counts declined 0.5%. Management states that low consumer confidence continues to negatively affect overall retail sales and the Informal Eating Out (IEO) segment, despite this they outperformed the market and grew market share in places like the U.K. and Russia. They also expanded their coffee business and have over 1,600 McCafe locations, which in Europe are generally separate areas inside the restaurants that serve specialty coffees, desserts and snacks. They also utilize extended operating hours, self-order kiosks, optimized drive-thru, and have opened over 250 new restaurants.
  • In APMEA, comparable sales rose 1.4% and comparable guest counts rose 2.2%, this was all despite Japan's uneven recovery and China's slower economic growth. Positive performance was driven by China, Australia and many other markets. Breakfast business has expanded and is offered in approximately 75% of APMEA restaurants. Desserts offerings also played a role, especially in China, where they are one of the largest ice cream retailers. Of the over 750 new restaurants in APMEA over 250 were in China, where they have the goal of 2,000 restaurants by the end of 2013. Nearly two-thirds of APMEA restaurants offer extended operating hours and over 5,400 restaurants are open 24 hours. Delivery is also offered in many APMEA markets and is now available in over 1,700 restaurants, including nearly 550 in China.
  • In the OCC segment the Indian operations are the highlight. Although the Indian segment is not as large as the other segments it's no less important for the future growth potential of the company. According to McDonald's India division website, India operations are locally owned (owned by Indian businessmen) and broken into two segments. Ms. Smita Jatia, Managing Director, "Hardcastle Restaurants Private Limited", operates West & South India, while McDonald's restaurants in North & East India are managed by Vikram Bakshi's "Connaught Plaza Restaurants Private Limited". Combined they consist of 300 restaurants with plans to increase significantly in the coming years. This local ownership brings a level of cultural awareness that will be crucial in growing this segment of operations.

Other highlights from worldwide operations include:

  • Comparable sales grew 3.1% and guest counts rose 1.6%, building on 2011 increases of 5.6% and 3.7%, respectively.
  • Revenues increased 2% (5% in constant currencies).
  • Diluted earnings per share were $5.36, an increase of 2% (5% in constant currencies).
  • Cash provided by operations was nearly $7.0 billion.
  • The Company increased the quarterly cash dividend per share 10% to $0.77 for the fourth quarter bringing the current annual dividend to $3.08 per share.
  • The Company returned $5.5 billion to shareholder; this consisted of $2.9 billion in dividends and $2.6 billion in share repurchases.

Again, stated in their most recent annual report management has the following expectations for 2013:

  • McDonald's anticipates a continued flat to declining IEO segment in many of the markets where they operate. Growing market share will remain their focus to attain sustainable and profitable long-term growth. The Company expects to open between 1,500 - 1,600 restaurants worldwide in 2013 (The numbers in the following bullets are included in this total number).
  • In Europe they see growth opportunities in breakfast, core menu items, beverages, and extended hours. They also plan to open nearly 300 restaurants and despite the near-term economic uncertainty and austerity measures implemented in many countries, they feel that they are well-positioned to capitalize on this segment's growth potential in the long term.
  • In APMEA they plan to grow breakfast traffic through increased marketing efforts, value, accessibility, and operations excellence. They also plan to open approximately 850 restaurants, 300 of which will be in China, consistent with their goal of reaching 2,000 restaurants in China by the end of 2013.
  • Effective August 1, 2012, they authorized the purchase of up to $10 billion of the Company's outstanding common stock with no specified expiration date. In 2012, approximately 8.4 million shares were repurchased for $ 748 million under the new program.

Recent Institutional purchases:

  • On Feb. 13, 2013 The Vanguard Group filed a 13G claiming a 5.08% or a 52,026,166 share stake.
  • On Feb. 12, 2013 State Street Corp filed a 13G claiming a 5.0% or a 50,534,654 share stake.
  • On Feb. 5, 2013 BlackRock Inc filed a 13G claiming a 6.53% or 65,554,280 share stake.

Upcoming dates for McDonald's are the quarterly earnings release on April 19, 2013.

In conclusion, While there is no arguing that YUM is a great company with great growth potential especially in emerging markets so is McDonald's and I feel that McDonald's is better positioned to capitalize on this, especially in the long term. The primary reason I believe this is because McDonald's is much more evenly distributed globally whereas Yum relies heavily on the Chinese market for their revenues.

Yum also has two outstanding issues that make them unattractive to me. First is the potential for a $1.355 billion tax penalty with regards the "taxable value of rights to intangibles used outside the U.S. that YUM transferred to certain of its foreign subsidiaries", now to be fair this is not a new revelation, it was mentioned in company filings as far back as 2010, and Yum maintains that they have done nothing wrong and plan to defend these claims vigorously. Secondly Yum has received some bad press in China due to a report on China's state media about excessive levels of antibiotics found in their chicken supplies. They have stated that they expect this to affect, at least, the first two quarters of this year. It also remains to be seen how this might adversely affect the cost of operations going forward after they implement the quality control measure that have been recommended to them by the Chinese government.

Going back to the low P/E of both companies I can only assume that this is the market pricing in the risks associated with doing business in emerging markets. The fact of the matter is that without economic strength in emerging markets these companies' growth prospects will remain stagnant. However, if you would like to gain some exposure to emerging markets but, like me, you are either not savvy enough or willing to expose yourselves to risks such as currency exchange rates, liquidity issues, or just the downright lack of regulation and transparency that runs rampant in many emerging markets. These two companies can give you some exposure to these new markets with the safety of well-known and respected names of their industry as well as a dividend to boot.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.