Yum Brands (NYSE:YUM) is separating its Chinese business, Yum China (NYSE:YUMC), at the end of the month. As China currently generates about 60% of the total revenue for the company, this is a major spin-off. The big question is what the shareholders should do amid the upcoming spin-off.
First of all, the recent Q3 earnings release indicates that Yum is growing as per its targets and even above them. To be sure, the US same-store sales increased 6%, on top of the 2% increase recorded last year. It was the 9th consecutive quarter of same-store sales growth in the US and the management used that figure to justify the upcoming spin-off, as great focus on each segment is required for success in the highly competitive fast-food sector.
The Chinese Division posted somewhat disappointing results as its same-store sales declined 1%. However, this performance seems to have resulted from the regional protests and the prevailing negative sentiment against American brands, which resulted from an international court ruling. The setback seems to be short-lived as sales in China have already rebounded in the last few weeks while they were clearly satisfactory in the weeks before the incident. Therefore, Yum China is likely to quickly rebound from this short-lived setback.
The most concerning factor for investors should be the remarkably rich valuation of Yum at the moment. More specifically, the stock has enjoyed a 30% rally in the last 12 months and is currently trading at a forward P/E=21.3, which is certainly not cheap given the heating competition in the food sector. Moreover, the company is in a more mature stage now than it was a few years ago and hence expansion of P/E from its current level is really unlikely.
The rich valuation becomes even more pronounced if one takes into account the extraordinary increase of leverage in the last few quarters. To be sure, the total liabilities jumped from $7.1 B in December to $12.3 B in Q3 while the net debt (as per Buffett, net debt = total liabilities - cash - receivables) climbed from $5.0 B to $9.0 B during that period. Thus it is not coincidental that the book value plunged from a positive $1.0 B in December to -$1.8 B in Q3. The pronounced leverage resulted from the aggressive capital return program of the company, which has returned $5.3 B via share repurchases since the announcement of the spin-off while it also intends to return an additional $7 B via dividends and buybacks in the next three years. Although this capital return program is remarkably aggressive, it does not enhance shareholder value as it greatly increases the debt load and interest expense while the value of the buybacks executed at the prevailing all-time highs is questionable.
Due to the rich valuation of the stock, I believe that the long-term returns of the stock are likely to be limited from its current level. On the other hand, the long-term bonds of the company have a much better risk/reward profile. More specifically, the 6.875% bonds that expire in 2037 currently trade around 102 and hence they offer an essential annual yield to maturity around 6.7%. Given the safety of the bonds of this stalwart, I believe that the risk/reward profile of its bonds is clearly superior to that of its stock.
If the company faces problems due to its high leverage, its bonds will certainly outperform its stock, which will have ample downside in that adverse scenario. On the other hand, even if the company keeps servicing its debt without problem in the future, its stock is not likely to benefit from P/E expansion as its valuation is already full. Therefore, even in the positive scenario, it will be hard for the stock to beat the yield of bonds.
At this point, it is important to note that the markedly high yield of the bonds of the company has resulted from the downgrade by Moody's to the junk category about a year ago. Moody's attributed its downgrade to the announced excessive capital return program of Yum. However, while this capital return program has pronouncedly raised the leverage of the company, the company will certainly start deleveraging if it faces any headwinds. Moreover, if it has any problem servicing its debt in the future, it will first cut its buybacks and, if necessary, its dividends while its bonds will always be the first in priority. In other words, the company has significant safety pillars before it is forced to default on its bonds. Therefore, as the high leverage has resulted from the aggressive distributions to the shareholders and not from business deterioration, the company is very unlikely to have problem servicing its debt and hence its bonds offer an exceptional risk/reward ratio.
To conclude, spin-offs used to include much greater value in the past when investors hated uncertainty and dumped the shares of the newly formed stock as soon as they received them. As this behavioral pattern led to outstanding profits from spin-offs, investors have now learned their lesson and rush to purchase stocks before the spin-off. This has been the case for Yum Brands as well as it has enjoyed a great rally since the announcement of its spin-off. Consequently, the easy money has been made and there is limited remaining value in the stock at its current valuation. Therefore, I would highly recommend purchasing its bonds, which seem to offer great returns at a minimum risk level.
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.
Additional disclosure: I am long YUM bonds.