Last week I updated my valuation of McDonald's Corporation (NYSE:MCD) and the price appears to offer a decent value. You can read the full analysis here. As more of a growth play I wanted to take a look at its largest competitor YUM! Brands, Inc. (NYSE:YUM). YUM! Brands is heavily focused on international expansion which could lead to a long growth curve. Shares of YUM! Brands closed trading on Friday, March 28th at $74.20 giving a current yield of 1.99%.
Analysts followed by Yahoo!Finance expect YUM! Brands, Inc. to grow earnings 12.32% per year over the next 5 years and I've assumed they can grow at 9.24% (75% of 12.32%) for the next three years and 4.50% in perpetuity. Running these numbers through a discounted earnings analysis with a 10% discount rate and summing over 30 years yields a fair value price of $84.41. This means the shares are trading at a 12.1% discount to the discounted earnings analysis.
The Graham Number valuation method was conceived of by Benjamin Graham, the father of value investing, and calculates the maximum price one should pay for a company given the earnings and book value. YUM! Brands earned $2.36 per share in fiscal year 2013 and ended with a book value per share of $4.89. The Graham Number is calculated to be $16.11, suggesting that it's overvalued by 360.5%. Since we invest for the future, let's replace the earnings per share with forward looking earnings of $3.63 for FY 2014. Keeping the book value per share the same and re-running the calculation gives a fair value of $19.98. Shares are still overvalued by 271.3%.
Average High Dividend Yield:
YUM! Brand's average high dividend yield for the past 5 years is 2.45% and for the past 10 years is 1.97%. This gives target prices of $60.50 and $75.16, respectively, based on the current annual dividend of $1.48. There's quite a big spread between the two historical yield measures, so I'll use the average of the two in my target entry price calculation. The average high dividend yield comes to 2.21% giving a target entry price of $67.83. Shares are currently trading for a 9.4% premium to the average high dividend yield.
Average Low P/E Ratio:
YUM! Brand's average low P/E ratio for the past 5 years is 17.33 and for the past 10 years is 16.26. This corresponds to a price per share of $62.91 and $59.02, respectively, based off the analyst estimate of $3.63 per share for fiscal year 2014. I'll use the average of the two low P/E ratio models in my target entry price calculation. This gives a low P/E target of 16.79 and a price target of $60.96. YUM! Brands is trading at a 21.7% premium to the low P/E ratio valuation.
Average Low P/S Ratio:
YUM! Brand's average low P/S ratio for the past 5 years is 1.68 and for the past 10 years is 1.44. This corresponds to a price per share of $52.05 and $44.65, respectively, based off the analyst estimate for revenue growth from FY 2013 to FY 2014. 2014 revenue per share is estimated at $31.04 is calculated from revenue growth but not accounting for potential share buybacks. Currently, YUM! Brands' P/S ratio is 2.48 on a trailing twelve month basis. Once again I'll use the average of the two P/S ratio models, $48.35, in my target entry price calculation. YUM! Brands is trading at a 53.5% premium to this price.
Gordon Growth Model:
The Gordon Growth Model is a quick way to calculate the fair value of a company using the current dividend, the expected dividend growth rate, and your required rate of return or discount rate. Assuming a constant 7.50% dividend growth rate and a discount rate of 9.50%, the GGM valuation method yields a fair price of $74.00. YUM! Brands is currently trading right at this price.
Dividend Discount Model:
For the DDM, I assumed that YUM! Brands will be able to grow dividends for the next five years at the lowest of the 1, 3, 5, 9 year growth rates or 15%. In this case that would be 15% since all the annualized growth rates are higher than 15%. After that I assumed YUM! Brands can continue to raise dividends at 12% (80% of 15%) for the next four years, and in perpetuity at 6.50%. The dividend growth rates are based off fiscal year payouts and don't necessarily correspond to quarter-over-quarter increases. To calculate the value I used a discount rate of 9.50%. Based on the DDM, YUM! Brands is worth $68.03, meaning it's trading at a 9.1% premium to this valuation.
YUM! Brands' trailing P/E is 31.44 and its forward P/E is 17.79. The PE3 based on the average earnings for the last 3 years is 26.25. I like to see the PE3 be less than 15 which YUM! Brands is currently well over. Compared to its industry peers YUM! Brands is overvalued versus McDonald's 17.52 and undervalued versus Burger King Worldwide (BKW) 40.23. Above comparisons are on a TTM basis. On a forward P/E basis, YUM is overvalued versus MCD 15.39 and undervalued versus BKW 23.77. YUM! Brands is trading at a PEG ratio of 1.66 which has shares undervalued against both MCD 2.12 and BKW 1.76. None of the companies are trading at a discount based on the PEG ratio where 1 is generally considered fair value, although YUM! Brands is currently the cheapest of the three.
YUM! Brand's gross margins for FY 2012 and FY 2013 were 27.7% and 27.4%, respectively, and they have average a 27.4% gross profit margin over the last 5 years. The net income margin for the same years were 11.8% and 8.1% with a five year average of 10.2%. YUM! Brands' gross margin has been on a bit of a downtrend but seem to have stabilized around the 27% level. I'd really like to see a bounce back up from the 27% level. Net profit margin had been in a nice uptrend increasing for 5 years in a row before taking a huge dip in FY 2013. I'll be looking for a return to the 10%+ levels for FY 2014. Since each industry is different and allows for different margins, I feel it's prudent to make a company to company comparison. Over the TTM, Burger King Worldwide's gross margin was 70% with a net income margin of 20.4%. McDonald's gross margin was 38.8% with a net income margin of 19.9%. YUM! Brands is trailing both BKW and MCD on gross margin and net income margin of the last year. I don't expect YUM! Brands to be able to make up a lot of ground over a short time but I would like to see progress made in FY 2014.
Since the end of FY 2003, YUM! Brands has been great at reducing the share count. From 2003 to the end of 2013, the share count has decreased from 612M to 461M. That's a total of 24.7% of the shares outstanding since the start and is good for an average annual decrease of 2.8%.
A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.
YUM! Brands is a dividend contender with 10 consecutive years of increasing the dividend. The dividend has been increased at a 15.55%, 16.04%, 15.12%, and 33.81% annualized rates over the last 1, 3, 5, and 9 year periods, respectively. Dividend increases are based off fiscal year payouts and don't necessarily correspond to quarter-over-quarter increases. YUM! Brands has done a great job increasing the dividend since initiating one back in FY 2004 and given the expected earnings per share growth of 12.32% over the next 5 years and expecting continued 2% annual share count declines could lead to 14%+ annual dividend growth while maintaining a constant payout ratio.
The payout ratio based off earnings per share has increased since the dividend was initiated but is still at a solid level of just 37.9% for FY 2013. Over the last five fiscal years, the payout ratio has averaged 36.6% with a low of 35.1% and a high of 38.0%. As mentioned above, the dividend can grow at 14%+ annualized rates without increasing the payout ratio as the earnings per share growth meets analyst expectations.
YUM! Brands increased operating cash flow from $1.521B in FY 2008 to $2.139B in FY 2013 with an average annual increase of 7.1%. Capital expenditures have increased as well but at a much lower rate. Capex was $970M in FY 2008 and $1,049M in FY 2013 for an average annual increase of just 1.6%. Free cash flow, operating cash flow less capital expenditures, has grown from $551M to $1,090M over the same years for an average annual increase of 14.6%. Everything is looking good so far but I also like to calculate the free cash flow after paying the dividend or FCFaD. The FCFaD has increased even faster, increasing from $229M to $475M for an average increase of 15.7%. However, when you include the share buybacks a different story gets painted. Free cash flow after paying the dividend and accounting for buybacks has been negative over the last two fiscal years with an annual deficit of $252M and $258M. Something will have to give with either operating cash flow increasing, capex decreasing, or the total shareholder return decreasing to allow YUM! Brands to be cash flow positive without taking on more debt. The FCF payout ratio doesn't look quite as good as the EPS payout ratio from above. Over the last 5 fiscal years, the FCF payout ratio has averaged 47.2% and has generally been increasing. Given the cash flow negative situation after paying the dividend and buyback and the relatively high FCF payout ratio dividend growth could be muted over the next few years, especially if the growth doesn't play out as expected.
Return on Equity and Return on Capital Invested:
YUM! Brands' ROE has averaged a very strong 75.5% over the last five fiscal years with ROCI averaging 26.4%. I expect the ROE to come down from these levels as 75% is fairly unrealistic to expect on a regular basis and signs of decline have already been shown in FY 2013 with an ROE of 49.1%. Long-term and total debt levels have been on the decline which is great to see. You can't go bankrupt if you don't owe anyone money. Long-term debt to equity has improved from 3.13 in FY 2009 to 1.35 in FY 2013 with the long-term debt to capitalization ratio improving from 75.8% to 57.4%.
Revenue and Net Income:
Since the basis of dividend growth is revenue and net income growth, we'll now look at how YUM! Brands has done on that front. Revenue growth since the end of FY 2008 has been decent with a 3.0% annual increase; growing from $11.279B to $13.084B. Net income over the same years has grown at an average annual increase of just 1.99% increasing from $964M to $1.064B. This has led to declining net income margins. Revenue growth is expected to really ramp up over the next two fiscal years with analyst forecasting 11.1% and 10.7% rates. If this growth materializes then shareholders will be very pleased.
This chart shows the historical high and low prices since FY 2004 and the forecast based on the low, average, and high P/E ratios and the expected EPS values from the discounted earnings calculation above. I have also included a forecast based off a P/E ratio that is 75% of the average low P/E ratio. I like to buy near the 75% low P/E ratio price although this price doesn't usually come around very often. In the case of YUM! Brands, the target low P/E ratio is 16.8 and the 75% low P/E ratio is 12.6. This corresponds to an entry price of $60.96 based off the expected earnings of $3.63 for FY 2014, with a 75% target price of $45.72. Currently YUM! Brands is trading at a $28.48 premium to the 75% low P/E target price and a $13.24 premium to the target low P/E price. If you look at the chart the current price line intersects the average P/E line towards the middle of FY 2014 suggesting that it's slightly above fair value currently. The current price line intersects the low P/E line towards the end of FY 2016 meaning you're paying for about two years of growth currently.
The average of all the valuation models gives a target entry price of $60.51 which means that YUM! Brands is currently trading at a 22.6% premium to the target entry price. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the Graham Number and discounted earnings valuations are removed and the new average becomes $63.83. Shares are currently trading at a 16.2% premium to this price as well.
Assuming that YUM! Brands can grow their earnings and dividends at the rates that I assumed, you're looking at solid returns over the next 10 years. In 2023, EPS would be $8.84 and slapping an average P/E of 19.66 gives a price of $173.75. Over the next 10 years you'd also receive $32.40 per share in dividends for a total return of 177.83% which is good for a 10.76% annualized rate if you purchase at the current price. If you purchase at the target entry price of $63.83, the 10 year total return jumps to 222.97% or a 12.44% annualized rate.
According to Yahoo!Finance, the 1 year target estimate is $81.22 suggesting that the share price has about 9.5% upside over the next year. Morningstar's fair value estimate is $78.00 suggesting only about 5.1% upside and has it rated as a 3 out of 5 star stock, meaning it's trading close to their fair value estimate.
YUM! Brands, Inc. operates in five divisions including the three global brands KFC, Pizza Hut, and Taco Bell with China and India being their own separate segments. YUM! Brands, Inc. operates and franchises over 40,000 restaurants across the world in 128 countries. In 2013 alone, the company opened 1,952 international restaurants.
2013 was a tough year for YUM! Brands as full year EPS declined 9% from FY 2012. Most of the issues were related to the KFC China brand as they suffered through issues along their chicken supply chain; however, the rest of the company delivered results that were on-target. Despite the issues with the chicken supply, KFC is still the number one foreign brand in China.
China is obviously the huge focus for growth for YUM! Brands as the 2013 Annual Report is heavily spent on operations in China. YUM! opened 428 new KFCs in China in 2013 and they now have over 4,600 KFC restaurants there. According to the annual report that's twice the size of their nearest competitor. Over 1/3 of the new restaurants opened by YUM! Brands in 2013 were located in China and they plan to open at least 700 more stores in 2014. I mentioned in my analysis on McDonald's how there is a huge market for expansion of store count. If McDonald's had the same ratio of restaurants to population they would nearly double their store count in China alone. This is much the same for YUM! Brands, except even more so. In China YUM! has 4 restaurants per million people where as the ratio is closer to 60 per million in the United States. What's even more amazing is that China's consuming class is expected to grow from 300 million people to 600 million people by 2020 which would be like adding another United States to the mix.
China isn't the only growth driver. Let's not forget about India which has a population of well over 1 billion people and is forecast to have the largest consuming class in the world by 2030. YUM! has struggled some with expansion into India, but getting brand loyalty is very much a first come first serve basis. The first mover advantage is huge and hard to overcome. It'll be well worth it in the long run even if there's short-term struggles. Across the three brands, YUM! opened 157 restaurants in 2013 and expect to open 150 more throughout 2014.
Given the amount of business that YUM! does in the developing (China, India) and emerging (Argentina, Mongolia) markets, the results of the company are highly correlated to the growth in emerging markets. This will usually lead to a bit higher volatility as the growth of the emerging markets usually comes in fits and starts, but it allows for long-term investors to patiently wait for great entry points.
Among U.S. operations, Taco Bell is the clear leader and provides two-thirds of the domestic profits. The Pizza Hut and Taco Bell brands are still growing quite well in the U.S. but despite the success the KFC brand has seen abroad, domestically it leaves a lot to be desired. Management is confident that they can deliver 20% EPS growth in 2014 with further expansion internationally and improved operations domestically.
Overall I feel that YUM! Brands, Inc. offers a great opportunity when you can purchase at a great price. Right now it's not priced for perfection but results will have to be darn good to justify the current prices. I could probably talk myself into starting a position in YUM! Brands closer to $70 per share but I'm not overly excited here near $74. I'd like to see the balance sheet improve over the next year as well as cash flow improve. Given the fairly tight cash flow I would expect dividend growth to track EPS growth. Although that will still be a hefty level assuming the 12%+ growth and 2% share restriction. I'll be looking for strategic opportunities to purchase shares at what I deem a good value and don't mind paying up for a bit of growth because there's a long growth trajectory between China and India alone. The starting yield leaves a lot to be desired, with a current yield of just 1.99%, but the long-term dividend growth could easily turn YUM! Brands into another dividend champion with some outstanding growth rates.
What do you think about YUM! Brands, Inc. as a dividend growth investment? How do you think the long-term dividend growth prospects are?
A full list of my holdings can be found here.
Disclosure: I am long MCD. 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.
Additional disclosure: I have no position in YUM, but may initiate a long position over the next 72 hours. I am not a financial professional and all thoughts/ideas here are my own and for entertainment purposes only. Investing involves risks. Please consult a financial professional and do your own due diligence before investing. The author is not responsible for losses of any kind by readers. All charts/images and data are sourced from my personal stock analysis spreadsheet, Morningstar, Yahoo! Finance, or YUM! Brands, Inc.'s Investor Relations page.