Yum Brands: It's All About Right Moves At The Right Time

Nov.27.13 | About: Yum! Brands, (YUM)

In latest news, Yum Brands (NYSE:YUM) announced it would combine its business units and brands based on geography. This prompted me to analyze the reasons behind the company's decision and any benefits that it expects to gain through this move. According to the news, the company decided to combine the US and International Divisions and keep China and India separate as the company sees much higher potential of growth in China and India. These changes will come into effect January 2014. As always, I will also talk about the expansion prospects of this move which will ultimately impact the company's stock price.

Just two days after the reorganization announcement, the company approved a $750 million stock repurchase program which caused the company's stock to rise by 5.81%. This caused the stock to reach its highest price since the beginning of the current year as shown in the chart below. As a result, Deutsche Bank also upgraded the stock from Hold to Buy.

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Source: Ycharts

Now let's have a look at the overall financial performance and position of the company to understand the current repurchase program and its sustainability. I will perform a percentage and ratio analysis to do this and I will use competitive figures. Therefore I have selected McDonald's Corporation (NYSE:MCD) as a close competitor to Yum.

Financial Performance and Position

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Source: Morning Star

YUM's revenue achieved a 3-year CAGR of 7.95% and its operating profit achieved a 3-year CAGR of 13%. Net income grew at a 3-year CAGR of 14.25% and EPS grew at a 3-year CAGR of 15.04%. Third quarter results were not as remarkable as the EPS of $0.85 and revenue of $3.47 billion missed the market expectation of $0.92 EPS and $3.52 billion revenue. This was mainly due to an 11% decline in same-store sales in China instead of the 10.5% decline that was expected. The Chinese market is very important because it contributes more than half of the company's operating profit.

Decline in Chinese sales were negatively impacted in December 2011 due to a scandal when the Shanghai Food and Drug Administration investigation found the company taking chickens with high levels of antibiotics from 2010-2011. Additionally data reflects that consumer sentiments in China are weak but hopefully the company will recover soon especially since its consumer confidence index rose from 106 in Q2 2013 to 110 in Q3 2013. The rise in consumer confidence will likely cause an augmentation in YUM's sales in China. Another issue faced by the company in China is the higher-than-expected full-year tax rate which will likely adversely impact the EPS during Q4 2013. Upon release of the Q3 earnings the share price dipped as highlighted in the chart at the beginning of the article.

On the other hand, McDonalds has reported a 6.62% 3-year CAGR in revenue, a 7.95% 3-year CAGR in operating profit, a 6.29% 3-year CAGR in net profit and a 9.25% 3-year CAGR in EPS. The company has been experiencing a slowdown in its growth as customer traffic in the US declined and has also led to store closures. This was also due to aggressive competition in the market from rivals offering differentiation and a wider variety of products. It also reflects the saturation in the US market concerning fast-food retailers.

As far as financial position is concerned, the company has been successfully decreasing its financial leverage from 5.28 in 2010 to 3.98 for the current year. Free cash flows recorded growth from 7.02% in 2010 to 8.58% year to date. This bolsters support for the company's higher dividends and shares repurchase program and also reflects the company's confidence in generating future cash flows.

Reorganization Benefits

Let us continue the discussion on the effects of saturation experienced by players in the US. Year-on-year KFC Restaurants are declining as the company has been closing down its restaurants located in less profitable areas as shown in the table below. Pizza Hut units have been growing steadily since 2011 while Taco Bell has also increased nominally each year.

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Source: Yum Annual Reports

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Source: Yum Annual Reports

KFC has witnessed an increase in its number of units in YRI from 2010 to 2012 but units of Pizza Hut has been experiencing a negative growth rate since 2011 as illustrated in the table above. Taco Bell only had 282 restaurants in 2012 which is less than the 5695 restaurants in the US alone.

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Source: Yum Annual Reports

Combining both US and YRI results has turned most of the negative unit growth figures into positive which can be one of the reasons why the company has undergone this restructuring. Combining the company's major division with the 2nd largest will hide the shrinking unit growth in the US.

Furthermore, as a result of this reorganization, the company can concentrate more on emerging markets as their results will now be separately classified, accounted for and highlighted.

China and recovery there

Source: Yum Annual Reports

Double digit growth in the number of system units in China has been recorded and calculated in the table above for KFC and Pizza Hut over a three-year period despite the issues faced in China due to the scandal described earlier in the article. Taco Bell still does not have any presence in China. The significance of the Chinese market in terms of percentage of revenues and margins generated is crucial to my analysis.

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Source: 2012 Annual Report

The chart on the top left shows the highest restaurant margin earned from China over the past three years and reflects growth potential. The chart on the right reflects that above 50% company sales were generated from China. In 2010 China's share in revenues was 41.9% which reached to 57.85% in 2012.

The company sees long-term growth prospects in the country due to improvements in the Chinese economy. The country's GDP growth is predicted to double in 2020 against the 2010 figure because the consuming class is expanding from 300 million to 600 million. This means an increase in the company's target market.

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Source: 2013 China Investor and Analyst Meeting

Revenue generated from online shopping is expected to rise to $700 billion by 2020 and this will likely make China the largest economy and top retail opportunity in the world as shown in the chart above. This is of relevance to the company since it is a food retailer with customers who make online orders for delivery. Growth in retail sales is expected to be generated from improved government policies such as increasing income for the middle class, urbanization and investments in infrastructure so retailers as a whole would benefit from this. As a result the urban population is predicted to increase to 830 million by 2020. Urbanization will increase the number of people in the country's developed cities and an increasing population creates a bigger market for global brands such as Yum.

Due to poultry supply issues, due to the scandal mentioned earlier, 60% of consumers from the beginning of the current year admitted that their visit frequency was affected. However, improved quality checks and standards by KFC will likely cause a recovery of sales in China. Recovery can already be perceived as KFC ranked the most powerful foreign brand in China by BBC news in July 2013. The company has also fared well in competition against McDonalds in terms of store count as shown in the diagram below.

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Source: 2013 China Investor and Analyst Meeting

YUM's other brand, Pizza Hut, has also been expanding, taking advantage of the increase in food delivery market penetration as shown in the chart below.

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Source: 2013 China Investor and Analyst Meeting

Moreover, the company has also introduced another brand named Little Sheep in China with confidence in its future due to the encouraging pilot store results shown below. In most of the matrices which include value for money and menu variety, the company's pilot store performed above the benchmark.

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Source: 2013 China Investor and Analyst Meeting

I am very optimistic about the company's future in China. Now, let us examine the Indian Market.

Information on the Indian Market

The Indian division was categorized as YRI until 2012 when it was separated and made into a distinct division. By the end of 2012, the company had 280 KFC restaurants, 310 Pizza Hut restaurants and 3 Taco Bell restaurants in India. The company plans to operate 1000 restaurants in more than 100 cities in India and generate $1 billion in system sales by 2015. The company has decided that $10 billion will be allocated for investments in the emerging markets, including India, by 2020.

Growth potential has been witnessed since the company has 2 restaurants per million people in the top 10 emerging markets while in the US the company has 58 restaurants per million people. Attraction in India comes from the growing middle class and the large population. Out of 1.2 billion people 65% of the population is below 35 years old. This would mean an increase in the company's target market. It is forecasted that India will comprise the greatest consuming class on the globe by 2013. The retail environment in India is also very supportive for the company as the country has been ranked the 6th largest poultry consuming market in the world. The dine-out market in India is worth $94 billion with only 2% structured in domestic and global food retail brands.

KFC has grown as a quick-service eatery brand in India and Pizza Hut was ranked as the most reliable food service brand.

Conclusion

I can see that the company is making the right decisions at the right time. Saturation in the US has allowed China and India to become a breeding ground of opportunities. Reorganization will bring in more focus upon these emerging markets. The company showed satisfactory financial performance and is in good financial standing by supporting attractive returns to its shareholders through fruitful investments. This has tempted me to rate the stock as a good opportunity for long-term investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by a Blackstone Equity Research research analyst. Blackstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Blackstone Equity Research has no business relationship with any company whose stock is mentioned in this article.