Yum Brands: The Transition

| About: Yum! Brands, (YUM)

Summary

Company is making correct strategic decisions which will allow it to improve its growth and reduce risk.

Company needs to concentrate more on strengthening its delivery network and digital platform.

Stock is trading at a forward P/E of 21.5x, versus MCD’s forward P/E of 18.6x.

Yum Brands (NYSE:YUM) provided some clarity over its plan to separate its China business at the investors' day, earlier this week. Yum is transitioning to a much more capital efficient growth model. The planned spinoff will allow it to achieve faster growth and reduce risks. As the company plans to increase franchise mix after the spinoff of its China business, its cost structure will improve, and its capital expenditure requirements will reduce. Also, the company will benefit in the future from the license fee from restaurants in China. Moreover, the company will be able to focus more on its U.S. business operations, which have been facing challenges. However, investors should wait for more information on the planned spinoff and better entry point before initiating a buy position in Yum Brands; the stock is trading at a forward P/E of 21.5x, versus McDonald's (NYSE:MCD) forward P/E of 18.6x.

Financial Performance and Transition

The company recently reported mixed financial results for 3Q16. The company reported adjusted EPS of $1.09 for the quarter, missing the consensus of $1.10. However, adjusted EPS for 3Q16 grew by 9% YoY. Total revenues for the quarter were down 3% to $3.32 billion, missing the consensus by $200 million. The performance for the quarter was adversely affected by protests in China after the international court ruling on the South China Sea. For the ongoing 4Q16, the management expects same-store sales to be positive. Moreover, in the near-term, the company's performance in China will be positively affected by the expansion of last year's Christmas promotions and an introduction of snacks platter at KFC.

Recently, during the investors' day, the company provided an update on its plan to spinoff its China unit. The spinoff will allow the company's transition to a leaner and efficient growth model. Yum plans to increase the franchise mix (excluding China) to 98% by 2018, from the current level of 93%, which will allow the company to reduce its general and administrative (G&A) expenses, and improve its profit margins. It plans to reduce G&A expenses by $300 million or to 1.7% of total system sales by 2018. The company already has low G&A as compared to its peers. Moreover, I believe, the company can increase its franchise mix target to 99% in the future, which will further lower its G&A and capital expenditure requirement. Also, the company will earn license fee, as the restaurants in China will pay to license Yum's brands. The following charts show the company's franchise mix and G&A in comparison to its peers.

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Source: Investors Presentation

Moreover, after the separation of the China business, the company will be able to focus more on its U.S. business operations, which have been facing challenges due to intense competition and sluggish consumer spending. Moreover, the company's capital expenditure requirement will reduce to $100 million by 2019, from $500 million in 2015. However, the company should continue to make investments to strengthen digital platform, as mobile and digital sales are increasing; mobile accounts for almost 20% of the company's total sales, as compared to 10% in 2015.

Also, the company needs to expand and make its delivery platform more efficient, which will augur well for its long-term sales. Domino's Pizza has much more effective and efficient delivery system and digital platform, which is positively affecting its sales. In 3Q16, Pizza Hut posted flat system sales and a 1% drop in same-store sales, in comparison Domino's Pizza enjoyed 9.7% domestic same-store sales growth.

Summation

The company's is making correct strategic decisions which will allow it to improve its growth and reduce risk. The separation of the China business will allow Yum to lower costs and increase profit margins. Also, the company will be able to focus more on its U.S. business, which is facing challenges due to intense competition and sluggish consumer spending. Moreover, the company needs to concentrate on strengthening its delivery network and digital platform, which will augur well for its stock price. The stock is trading at a forward P/E of 21.5x, versus MCD's forward P/E of 18.6x. I recommend investors to wait for more information on the separation of China business before initiating a buy position in the stock.

Disclosure: I/we 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.