The economy still remains the key issue. Based on a consumer survey by AlixPartners, people are not dining out as much now as they did in early 2013. Dining rates dropped from an average of 5.8 meals/month in Q1 2013 to only 3.8 meals/month in Q3 2013. Consumers plan to dine out even less in the future, particularly at restaurants. However, fast food demand is rising with the increasing young population. Rising urbanization, a change in lifestyle trends and with an increasing number of people working in office environments, consumers under time constraints are opting to eat outside, while price-conscious consumers are turning to fast food options instead of cafés and restaurants.
According to MarketLine, fast food restaurants are growing faster than other restaurant models because of relative cost advantage and an increasing youth population. Consequently, fast food restaurants are expected to grow at a CAGR of 4% in 2014. The growth rate of restaurants is coming down on the other end. From 2006 to 2010, the restaurant annual growth rate was at 3.7% and is expected to decrease further to 3% by the end of 2015. For this article, I picked YUM! Brands (NYSE:YUM), a leading fast food restaurant, to see how well it appears to be heading out in front of these headwinds. Let's dig into the company to analyze how trends are impacting its financial situation and, consequently, return for investors.
How YUM! Brands is a Safe Investment
YUM! has almost 40,000 fast food restaurants in around 130 countries operating primarily under the Pizza Hut, KFC and Taco Bell brands. These top three brands are the worldwide leaders in the quick-service pizza, chicken and Mexican-style food categories. Of the nearly 40,000 restaurants, 75% are operated by franchisees and unconsolidated affiliates, 20% are operated by the company, and 5% are operated by licensees. YUM! Brands is operating under four reporting segments: YUM! China, YUM! Restaurants International, YUM! United States and YUM! Restaurants India.
YUM! Brands is focused on these three key strategies:
1. Building a leading brand in China in each important category
2. Building strong brands everywhere by driving international expansion
3. Improving U.S. brand positions
Because the China Division, YRI and Taco Bell-U.S. represent close to 85% of its operating profits, the company's business strategy is focused on these regions. YUM! Brands wants to build leading brands in China in every significant category. China has a growing economy and a population of around 1.4 billion. YUM! China is rapidly adding KFC and Pizza Hut casual dining restaurants, combined with the additional restaurant concepts of Pizza Hut Home Service and East Dawning. Its recent acquisition of 66% interest in Little Sheep Group Ltd. represents one more step toward building leading brands in China in every significant category. However, the sales from China drastically decreased from a poultry supply incident and from subsequent news of avian flu. Same store sales decreased 13% with the intense media surrounding avian flu in China, and operating profit went down to 26%.
To cope with an uncertain environment, the company has undertaken a comprehensive review of its supply chain with the State Food & Drug Authority's recommendations. The company has taken additional steps to strengthen its poultry supply chain practices, which includes testing products. However, as the rumors regarding these events subsided, the company's sales momentum again started to build in the fourth quarter, and the company is now expecting operating profit to again reach $1 billion by the end of 2014. To do this, aside from food safety measures, YUM! is bringing new, innovative products backed by strong marketing and good news. The company has been working with two Chinese celebrities who are promoting its extra-crispy and original-recipe chicken. The campaign has been working; the company has received over 8 million votes online on this promotional advertisement.
The company also plans to drive aggressive international expansion and to build strong brands everywhere, including France, India, Germany, Russia and Africa. Last year, when it opened 1,200 new restaurants, it was the 14th straight year it opened more than 700 restaurants. Consequently, it has been able to generate 12% growth on a compounded annual rate over the past 10 years in its international business. YUM! is significantly investing in marketing and product innovation to drive this growth.
· Financial Position and ability to sustain returns
The company, with a higher-than-expected tax rate and slower-than-expected sales recovery at KFC China, has experienced nearly a double-digit decline in earnings per share. Company earnings were negative throughout the year from the poultry supply incident, as well as subsequent news of avian flu in China. Even in the challenging current environment, KFC is undeniably the category leader in China, and its Pizza Hut business in China continues to generate strong results, while Taco Bell has produced eight quarters of positive same-store sales growth.
Soft growth in its top and bottom line over the past two quarters has impacted YUM!'s cash flows. Nevertheless, the company is still generating strong cash flows to invest in growth opportunities, along with returning cash to investors. Its operating cash flows were standing at $2.1 billion at the end of 2013, which are providing cover to capital spending of around $1 billion. Consequently, it has more than $1 billion remaining in free cash flows. The company, however, has been increasing dividends by double-digit percentages over the past nine years. Still, its free cash flows are proving complete cover to its dividend payments of $615 million. Its payout ratio based on income went up to 58% in the last year from a decline in earnings; however, with an expected growth rate in earnings per share, payout ratio may come down again to the normal levels of around 35 to 40%. That will allow it to continue its trend of making double-digit increases in dividend in 2014.
Being a fast food restaurant, YUM! has some exceptions from challenges other sorts of restaurants have been facing. YUM! Brands has been hit harder by the recent controversies that appeared in the Chinese region. However, the company has been coming out of that and looking to regain its momentum with increased advertising and product innovations along with taking additional food safety measures. Aside from China, it is generating strong growth, particularly in emerging markets like India. It is also making investments in its U.S. and global fast food restaurants to generate a consistent growth year over year.
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.