Is Yum Brands A 'Buy' After The Earnings Report?

| About: Yum! Brands, (YUM)

Yum Brands (NYSE:YUM) is a company with an excellent growth record of 11 consecutive years of double-digit growth. More specifically, it managed to more than quadruple its earnings per share (EPS) from $0.81 in 2001 to $3.4 in 2012. Its rapid worldwide expansion and its very popular brands (KFC, Pizza Hut, Taco Bell) have rendered the company extremely popular in the investor community. This is proved by the extremely high P/E ratio of the stock, which has not fallen below 19 at any moment in the last 3 years! Due to the disappointing performance in Q3-2013, the current P/E is extremely high (28) so the big question is whether one should invest in YUM at the current elevated levels.

First of all, the recent earnings report was as disappointing as it could get. In the Q2 report (3 months ago), the CEO of the company, David Novak, forecasted a single-digit decline in this year's EPS and a recovery in China, as he expected the antibiotic scandal and the issue of the avian flu to fade away. However, in the Q3 report he admitted for the first time that he now expects a decline of about 10% in this year's EPS, as the recovery in China is much slower than he anticipated; the same-store sales in China declined 20% in Q2 and 11% in Q3.

A disappointing aspect that the CEO did not mention was the absence of growth in the same-store sales in every division of the company. There was no growth in the US and there was only 1% growth in the same-store sales of the international division (all countries apart from US and China). This means that the company can continue to grow only by opening new stores in emerging countries.

The above fact highlights the major risk that the company faces; the increasing health-consciousness in the developed world has led many consumers to healthier choices than fast food and hence most of the developed markets seem to have already saturated for fast-food companies like YUM and McDonald's. Of course there is still plenty of room for growth in the emerging markets but the competition has strengthened among companies in these areas and, even worse, consumers of these countries will eventually become health-conscious too.

YUM is expected to earn $2.92 this year (excluding the special write-off of $0.55), which means that it currently trades at a P/E 28. The very optimistic CEO of the company expects 20% growth next year, which may prove too high once again. However, even he is proved correct, according to the PEG theory a stock represents a fair value only at a P/E below its growth rate, i.e., below 20. Therefore, the stock seems quite overvalued at the moment.

Investors should carefully consider the risk of investing at extremely high P/E ratios. Even if their company grows, the stock may be assigned a lower, more normal, P/E in the future, which may completely offset their profit. Of course the stock may continue to be rewarded an abnormal P/E ratio, which will reward its investors. However, most astute investors, like Warren Buffett, stick to the strategy of selecting sound valuations and do not bet on a hope that the market will continue to be exuberant.

My personal opinion is that YUM, which had an excellent growth record till last year, will recover and will continue to grow its EPS as long as it can expand in new areas in emerging countries until the consumers in those countries become health-conscious in their dining preferences, just like the consumers in the developed countries. I also think that the market will continue to value the company with high P/E ratios and hence the investors will probably be rewarded. However, I have a principle of not betting on the abnormalities of the market because the fear in the first headwind will make me sell at a loss.

Nevertheless, for the extreme fans of this company who cannot help holding the stock, I advise them to view this position as a short-term trade and sell the stock at around $71, as this will be a decent, quick profit (~8%) and the stock will hardly carry any value above that point. An encouraging short-term fact is that the volume has returned to normal levels after the sell-off following the earnings report, which means that there are no more panicked sellers in the market. Moreover, I set the target at $71 because I believe that the stock will soon fill in the gap formed after the earnings report; I have noticed that all the solid stocks always fill in their gaps sooner or later.

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.