The quarter Yum Brands (YUM) just reported forces investors to reconsider this company's core story and whether it deserves to be valued as a high growth company. Adjusted EPS of $0.85 was down 15% year over year, and for all of 2013, earnings will be down double digits to roughly $3.00. On this news, Yum shares tanked, falling 7% to $66 where they still trade at a lofty 23x multiple, a multiple which I believe is overly bullish.
For years, YUM, the owner of Taco Bell, KFC, and Pizza Hut, has been able to deliver double digit earnings growth, mostly thanks to its China division. Thanks to this earnings growth, YUM has consistently traded at a multiple of at least 20x. At some point though, high growth companies slow down, either through operational missteps or by saturating the market, which causes multiple contraction and losses for shareholders.
YUM's growth has been absolutely slammed in China this year after tainted chicken led to an outbreak of the avian flu. KFC had become the dominant fast food player in the country, but this news spooked Chinese consumers who have been reluctant to order chicken ever since. At first glance, the company's China numbers don't look so bad with 1% revenue growth. However, this is because the company is still expanding its store count (adding 364 stores globally). Same store sales, a better metric of consumer engagement, were down 11% with KFC stores down 14%.
Investors have hoped these problems were behind the company, and that KFC could begin to rebound, but management offered no such assurances. They admitted that September has been another lousy month, which was the perpetrator for the weak full-year guidance. Historically in the United States, retailers and restaurants who see same store sales declines of 10% or more struggle mightily to recover, as investors in J.C. Penney (JCP) have learned the hard way.
I am certainly not saying YUM in China is doomed to disappear, but I do believe analysts and management who are promising a quick and forceful turnaround are being glib. Management continues to affirm 20%+ EPS growth next year, but with KFC still struggling, I see no catalyst for China to drive results higher next year, especially if their economy continues its gradual cool-down. Remember, the Chinese economy is growing at 7.5%, so KFC same store sales should be growing 7.5% just to keep pace; the company is lagging economic growth by 20%! That is suggestive of a more secular move away from chicken. Fortunately for KFC, consumers who are still eating chicken will likely continue to eat chicken (barring another health issue), but I suspect reclaiming hesitant customers will be exceptionally difficult.
With sales in September still weak, I believe Yum will be fortunate to grow sales in China by 5%, making their 20% EPS target a suspect one, especially because their US segment has left much to be desired. In the US, same-store sales have been flat, with Taco Bell growing 2%, Pizza Hut declining 1%, and KFC falling 4%. At the same time, the company has shown limited pricing power with store margins falling 0.7%. The government shutdown could also put some pressure on fourth quarter earnings with less confident consumers choosing to eat at home instead of picking up a pizza.
I also believe Yum's stores are poorly positioned for shifting tastes in the United States. As I explained in a recent article on McDonald's (MCD) here, Americans are becoming more health-conscious and choosing fast-casual restaurants over fast food. Yum's three chains almost run uniformly counter to this. KFC, which has seen the weakest sales, has tried to adapt by offering baked chicken in addition to fried chicken, though it will take much time and marketing muscle to alter its brand perception. Pizza Hut has been slow to react to improving quality at pizza chains, like Domino's (DPZ) artisan offerings. The company has been investing heavily in stores to increase in-restaurant in dining, but sales have yet to reflect this investment. I foresee Domino's continuing to take share from competitors.
Last, Taco Bell has made no effort to shift towards the healthy, fast-casual segment, probably recognizing that would be an unwinnable battle against Chipotle (CMG). The store has done well thanks to its Doritos Locos Tacos, though sales growth has seriously lagged CMG's. Taco Bell continues to lose share to Chipotle and will seriously struggle if the Doritos fad begins to wane.
Looking out several years, YUM is poorly positioned for secular shifts in the domestic market, and I expect it to serially underperform domestically, especially compared to companies like Chipotle, Domino's, and Buffalo Wild Wings (BWLD). I suspect the company will even struggle to match McDonald's same store sales. With its China story all but derailed and challenges in the United States, projections for 20% growth next year and double digit growth after that seem untenable to me. I believe management and bullish analysts are incorrectly downplaying downside risks.
This year's lack of growth is not merely a bump in the road but a foreshadowing of the struggles YUM could continue to face. This is a low-growth stock that is trading like a high-growth one. With sales stagnant, I see this company earning $3.20-$3.30 in the next year with no to low growth in the year after that. With its decent dividend yield of 2%, I am comfortable with no more than a 15x multiple for this company, or $48-$50, which represents 24% downside from here. YUM is more than fully pricing in management's case while ignoring potential pitfalls. As such, it is a poor risk/reward profile and I would not be long the stock, preferring a tactical short.