YUM: A Lucrative Buy At $63

| About: Yum! Brands, (YUM)

Yum! Brands (YUM) operates some of the world's most iconic fast-food establishments, including Taco Bell, Pizza Hut, KFC, and Long John Silver's. Additionally, Yum! Brands is trading at some of its historical highs, though recent prices fell in response to concerns about the global economic outlook. Despite this, I think that Yum! is a buy and that these economic indicators are not the harbingers of doom, as many have argued. Though economic downturn is a non-trivial risk for an investor in Yum! Brands (and the majority of stocks on the market), I think the present decrease in price represents an entry point for Yum! stocks.

Valuation

Yum! Brands is presently trading at around $63 after shares fell 9% on June 1 over economic concerns about China. I will discuss the China question below, but I believe that, though the recent downgrades for Yum! adequately reflect the risks associated with an investment in the company, Yum! shares remain an attractive option for those with sunny economic expectations.

Yum! Brands is in a period of growth, a fact reflected in its valuation. The company's P/E is 20.2, which is around my target P/E for the company. The company's price/sales of 2.3 is below that of Chipotle (CMG) at 5 and McDonald's (MCD) at 3.3. The company has an inflated price/book multiple of 14, largely due to the fact that it presently holds a fair amount of debt (about $3 billion, or a debt-to-equity of about 1.5). That will be decreasing over the coming years as management trims down debt and as expansion into Asia becomes slightly less aggressive. A price target of about $80 seems reasonable given my P/E expectations and the number of expanding ventures that Yum! is overseeing.

What's the Real Deal with China?

Yum! is making major headway in the China market with expansion of Taco Bell and KFC. In 2011, the company opened 656 new stores in China and saw an increase in sales of 19%. KFC has over 3700 restaurants in over 700 cities, while Pizza Hut maintains over 600 units in the country.

On June 1, prices of Yum! fell among economic anxieties stemming from sub-par growth and sales reports from China. McDonald's year-over-year sales growth in the region fell 1.7%, fueling sentiments that the Chinese market might not respond well to a world-wide recession. In my view, there are three mitigating factors to soften these sentiments. First, the Euro-pessimism need not be so bleak. At the European Union summit last week, leaders agreed to expand the power of central bank administration and increase bailout initiatives--signs that leaders are beginning to see the Euro-issue with greater clarity. Additionally, this preliminary agreement softened the U.S. dollar slightly compared to the Euro, which is actually a point in Yum!'s favor.

Second, perhaps the major issue for Yum!'s investment in China is the possibility of price inflation. The burgeoning Chinese middle class is the primary consumer of fast-food in the country. As the average pay for Chinese workers increases, they will have greater purchasing power, causing prices to rise. Taco Bell, for example, would have to charge more for their traditionally inexpensive menu items to compensate for increased cheese and meat prices, and this could hurt margins. This is a long-term trend and poses some risk to an investment in Yum!.

However, Yum! brands has made impressive headway in China. In the first quarter 2012, the Taco Bell comp rate for China was up 14%, and this could very well continue sustainably at about 10%. Taco Bell is also better positioned in the so-called "tier two" cities of China than McDonald's, one of its major competitors. Higher tier cities (two to six) are generally located in the interior of China and, though very important for development, are often neglected by developers. In fact, tier two cities receive about 56% of incoming U.S. imports to China. About 80% of Yum! China's franchise growth has been in tier two to six cities. Additionally, 31% of McDonald's stores occupy tier one cities, compared to 25% for Yum!. This strengthens the argument that, despite risks associated with short-term economic factors, the company is well-positioned to benefit from China's long-term development and growth.

New Items To Spark Visits

In the Unites States, Taco Bell's new product offerings are attracting new customers and repeat visits. From March to May 2012, Yum! launched a strong advertising campaign to launch Taco Bell's new Doritos Locos Taco, which will be selling for about $1.29 at its franchises. This permanent menu item, along with its new Cantina Bell offerings, will keep interest levels high in the restaurant. In all, Yum! reported earnings per share of $0.76 in the first quarter 2012, up 21% year-over-year from $0.63 in 2011.

Investment Strengths

In the first quarter of 2012, Yum! spent $78 million to repurchase 2% of its total shares outstanding. The company also intends to maintain an annual dividend yield of 1.8%. Both of these practices actively return value to shareholders. In all, given the premise of strong growth in China and the success of marketing strategies in the United States, Yum! Brands will make a strong buy as it opens new franchises and strives to maintain the 12% annual growth that management believes that it can sustain.

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