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Introduction

Yum! Brands (YUM) was a first mover into the emerging market arena (especially China) and since then the company has been reaping the benefits is its foothold. For example, YUM's China Division, based in Shanghai, China, has about 5,700 restaurants. These locations, which are primarily KFCs and Pizza Huts, recorded revenues of approximately $6.9 billion and operating profit of nearly $1 billion in 2012. YUM has operations in locations from the USA to India too. Based on proprietary discounted cash flow analysis done by The Oxen group, YUM shares are a solid BUY with an implied price appreciation of just about 26%. YUM has superior bullish prospects compared to its peers. Some of these prospects include a cheap valuation, great gross margins, a conservative DCF model, and YUM serving up its competition.

Profile

Yum Brands was one of the original first moves in China opening up American fast food operations. While this market and business has matured over the years, Yum Brands (YUM) is still a major player with invigorating and prestigious opportunities worldwide. The firm owns KFC, Pizza Hut, and Taco Bell; which they operate, franchise, and licenses around the globe. The company oversees 39,000 units in 125 countries. YUM, based in Louisville, Kentucky, is the world's biggest quick serve restaurant, based on number of units.

Thesis

Valuation -

YUM trades at roughly 20.7x TTM EPS and 20.3x forward estimates. YUM is undervalued when compared to its peer group. YUM's peer group includes McDonald's (MCD), Chipotle Mexican Grill (CMG), Starbucks Coffee (SBUX), and Darden Restaurants (DRI) to name a few. The median forward and trailing multiple for the peer group are 23.5x and 28.1x respectively. YUM trades below these figures, but is YUM cheap for a reason or is this an opportunity to BUY shares of YUM inexpensively?

YUM's peer group includes some names that are a tad different than YUM itself; therefore there is reason to look at more direct comps. These names include MCD, DRI, and CMG. These three trade at 18.6 TTM/17.2x forward, 14.1x TTM/15.6x forward, and 36.7x TTM/31.4x forward respectively. YUM trades at a slight valuation premium to its direct competition, but YUM also has better revenue growth and gross margins than 66% of them in each situation, justifying the premium.

Moreover, YUM has been putting up better net income numbers than industry giant MCD. Most recently, YUM grew net income 23% YoY during its last quarter, while MCD saw net income drop 3% YoY. This is just another example of YUM deserving a BUY rating, as the firm is transitioning to best in class.

The company operates with a shareholder friendly cash policy. YUM returns 1.94% back to shareholders in the form of dividends, when the industry average is 2.3%. While the firm is below the average, with respect to its yield, the company has also decrease its float by 3% since 2008 … increasing EPS.

At the beginning of 2007, YUM traded near 20x forward EPS and only put up 2% revenue growth during the prior year. Fast forward five years, the company trades at the same forward valuation at 20x forward EPS and is putting up 8% revenue growth, a 6000 bps difference. We again this is an opportunity to get long.

Finally, from the prospective of management efficiency, YUM has an ROE of 80.3%. Compared to its peer group, YUM performs better than 97% of the competition in this category. YUM also dominates its direct competition, for MCD is at 36.82% and CMG at 24.28%. In the similar category of ROIC, YUM again grills the competition. YUM is able to allocate capital better than its direct comps. YUM has an ROIC of 24.82% while MCD is at 17.78% and CMG at 20.22%.

YUM has previously indicated the expectation of at least achieving 10% EPS growth for 2013, but recent events have made this figure come under pressure by Wall Street.

"KFC China same-store sales turned negative during the last two weeks in December of 2012," according to YUM's recently filed annual report. The company is currently pursuing efforts to increase consumer confidence in KFC China to correct this. According to the same release, "China operating profit will be negative versus the prior year and EPS, excluding special items, will be lower by a mid-single digit percentage in 2013."

KFC China represents 11% of YUM's total units, but we think this announcement is basically sandbagging expectations for this year. This announcement includes an expectation for a significant decline in EPS performance in the first half of the year and is too bearish. On a related note, the company expects to open at least 700 new units in China, an increase of about 16% for this market. If the situation was that bad in China, the company would not continue opening up stores and investing.

YUM's valuation and effectiveness of management firmly confirms that the company is a BUY. The firm is cheap from the prospective multiple analysis and is putting up great numbers, despite recent news and what the media purports.

Catalyst -

On February 1, 2012, YUM acquired and additional 66% interest in Little Sheep Group Limited (Little Sheep) for $540 million, net of cash acquired of $44 million. This move increased YUM's ownership to 93%. Little Sheep is a Chinese catering and restaurant company with 300 locations in Asia and North America. The firm specializes in food processing and 'hot pot' restaurants. 'Hot Pot' is a style of Chinese cooking similar to American fondue and stew techniques. This type of inorganic growth is a positive for the company and may present new efforts to grow via acquisitions in emerging and developed markets, the best of both worlds.

Another catalyst will be YUM's China Division March same-store sales. This number will be announced on April 10, 2013 after market hours. YUM will also release first-quarter earnings on April 23, 2013 after market hours.

Economic Moat -

YUM basically operates in an oligopoly. The fast food chain space has proven menu items that generate sales around the world, literally and figuratively. YUM's menu appeals to a variety of customers. The company has a solid portfolio of brands that cater to many different diets and likes. Moreover, each restaurant concept has proprietary menu items. YUM's management emphasizes the preparation of food with high quality ingredients as well as unique recipes and special seasonings to provide appealing, tasty, and attractive food at competitive prices. Specifically, with respect to KFC's menu, the company is continuing to put efforts into providing "burger" type options, catering to the lunch crowd. The KFC Zinger is a new item that is looking to gain traction.

Another factor "economic moat" wise that differentiates and separates YUM from start-up competition is its brand name. This name allows YUM to have consistent product expectations no-matter the location.

The number of YUM locations is also very difficult to replicate, and should a threat pop up, the company has demonstrated efforts to grow inorganically … as outlined in the "Catalyst" section.

Risks to YUM's economic moat include local food and health concerns. Health concerns are outlined in the "Variant" section. The local food alternative reflects consumers deciding to eat from smaller shops, but the demand for cheap American fast food has been vivacious and should continue.

Revenue and EPS Outlook -

The Oxen Group's DFC model matches our fundamental take on the company. Our model assumes a modest 7.7% annual average growth in operating income. This is well below YUM's historical average annual operating income growth figure of 9.1%. This gives us 140 bps of wiggle room, but given the plethora of other bullish factors presented here, the upper hand is given to the bulls.

Revenue growth, with respect to YUM, has been consistently hovering around flat to 10% growth since 2004. This type of growth is mostly in-line with its peers, but it is interesting to note that YUM beat fast food giant MCD in 2012 by nearly 600 bps in revenue growth. Historically speaking, these two firms have had similar revenue growth, but should 2012's trend continue … YUM is a raging BUY.

Historically speaking, YUM has usually come in-line with Wall Street's expectations. Over the last six quarters, YUM has beaten expectations two times, come in-line three times, and has missed once. On average, bottom line EPS has beaten consensus figures by 0.82%. Additionally, over the long term, out of the last 12 quarters YUM has beaten expectations six times, missed twice, and come in-line four times. A risk to this pattern is potentially relying on analysts too much, but on the other hand, they have been correct most of the time given their average EPS beat is low.

YUM's first quarter same-store sales declined about 20% for the China Division. February same-store sales growth was approximately 2% for the China Division. YUM estimates that the timing of the Chinese New Year had a positive mid-teen impact on February same-store sales growth, offsetting a similar negative mid-teen impact in January.

Price Target Analysis

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

2190

2600

2800

2885

2930

Taxes

613

728

784

808

820

Depreciation

650

660

665

675

680

Capital Expendit.

-1120

-1050

-1000

-1100

-1200

Working Capital

40

40

40

40

40

Available Cash Flow

1067

1441

1641

1612

1550

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 DHI: 8.7%

2012

2013

2014

2015

2016

PV Factor of WACC

0.941

0.885

0.833

0.783

*

PV of Available Cash Flow

1004

1276

1366

1263

*

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: 3.30 %

2016

Available Cash Flow

$1,549

Divided by Cap Rate

3.30%

Residual Value

46,957

Multiply by 2016 PV Factor

0.783

PV of Residual Value

$36,777

Step 4.

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

Sum of Available Cash Flows

$4,908

PV of Residual Value

$36,777

Cash/Cash Equivalents

776

Interest Bearing Debt

2,942

Equity Value

$39,519

Step 5.

Divide equity value by shares outstanding:

Equity Value

$39,519

Shares Outstanding

450

Price target

$88

Profit/Value Industry Comparisons


(Click to enlarge)

Firms in the chart include YUM and its closest comparables … MCD, DRI, and CMG to name a few. YUM is a distant second in the restaurant group in the gross margins category. While the firm is behind fast food giant MCD here, YUM is still ahead most of its other competition and already has inroads and an established footing in emerging markets, a key variable in the industry.

YUM has also consistently bettered itself. Figures like gross margins, operating margin, and ROE all have improved YoY. Should this trend continue, YUM is even more of a BUY

Variant

One of the risks to the YUM story includes the rejection of its products. The consumer around the world is increasingly becoming more aware of the detrimental effects of fast food. In the long run this may become a problem, but profits seem to be coming in hand over fist now. YUM is actually the owner of 30% of the top ten unhealthiest dishes in the fast food space. Taco Bell, Pizza Hut, and KFC are all represented. Specifically Taco Bell's XXL Grilled Stuft Burrito Beef came in at sixth, KFC's Chicken Pot Pie at three, and the dishonor of number one went to Pizza Hut's Triple Meat Italiano.

Additionally, should extra regulation from the government prevent the sale of such unhealthy items, YUM will be adversely effected. For example, the current New York bill getting mulled over preventing the sale of extra large sugary sodas could be a marginal spark for such regulation to gain traction. Finally, should there be more supply chain issues with YUM, the firm could suffer. This derives from the recent news that KFC has cut more than 1,000 farms from its supplier network in China because of chicken issues.

The Bottom Line

YUM seems to be a great opportunity from a DCF standpoint and fundamentally. YUM is a raging BUY according to The Oxen Group and should yield at least 26%. The firm has great margins, is historically cheap revenue growth, and has been putting up consistently great numbers despite their conservative guidance, and is cheap compared to itself and its peers. YUM is a BUY.

Source: Yum! Brands Has 30% Upside In Next 12 Months, Best Buy In Fast Food Dining