Yum Brands (YUM) has been a perennial favorite of the investment community for years, and for good reason. The company has increased EPS by 10%+ per year for the past decade and has experienced tremendous growth in emerging markets, where a burgeoning middle class seems poised to continue to drive sales far into the future. However, the stock is ~14% off its April highs due to concerns over a slowdown in China, and I think any continued pullback in the stock creates an excellent opportunity for investors seeking a very strong long-term investment.
Yum is highly levered to China. The parent company of KFC, Pizza Hut and Taco Bell built 656 restaurants in China in 2011 - approximately 1.8 new restaurants per day! KFC alone has 3,701 restaurants in over 700 cities throughout the country. There is no doubt that China's economy appears to be slowing. In Q2 China's economy grew 7.6 percent from a year earlier, its slowest pace since the first quarter of 2009, marking a slowdown for a 6th consecutive quarter. Additionally, Yum same-store sales (SSS) in China have slowed, growing only 10% YOY in Q2, following a 14% increase YOY in Q1, and 19% increase YOY for FY 2011. In the most recent quarter, the China business unit also experienced a 4.1% decrease in restaurant margins due to commodity and labor cost inflation. These are all negative signs.
I am bullish on Yum, despite the slowdown in China, because the company's long term growth story is very much intact and the Yum China management team is best in class. Despite a respite in SSS growth (only up 10%), high returns are driven more by new unit development than SSS growth in growing markets and Yum expects to build a record number of new units in China, and across international markets, in 2012.
Here are the specific reasons why I expect Yum to continue to experience robust growth for the foreseeable future:
Aggressively building new units in emerging markets: Management likes to point out that while Yum operates 58 restaurants per million people in the United States, it operates 2 restaurants per million people in the top 10 emerging markets (download 2011 Investor & Analyst Conference PDF from company website). In China, despite rapid growth, the company operates 3.1 restaurants per million people and in India Yum operates 0.3 restaurants per million people. These figures present huge upside potential and KFC and Pizza Hut are building tremendous brand equity with young, upwardly-mobile consumers in these markets.
At the end of 2011, David Novak announced that Yum was separating its India business into its own standalone segment for reporting purposes - a positive signal for investors seeking visibility to ongoing growth in the country. Although the company does not expect India to contribute to EPS to the degree of China for another decade, Yum predicts the India business unit to be a billion dollar business by 2015.
Company ownership shifting to emerging markets: In 2001, 84% of company-owned units operated in developed markets and 16% operated in emerging markets. In 2011, the company reported that 53% of company-owned units operated in emerging markets and that by 2014 that number is projected at approximately 70%. Yum is actively refranchising units in developed, low-growth markets (in the U.S and in Western Europe) and plowing capital into high growth international markets, allowing the company to capitalize to a greater degree from emerging market growth.
Building people capability: At Yum's December 2011 investor conference three presentations were given by Yum China executives. The first, by President and COO Mark Chu, focused solely on how the company is developing local leaders to keep pace with the breakneck speed of new unit development. He said that every store in China is a training store and that developing capable Restaurant General Managers (RGMs) is his number one goal; Chu boasts 4,000+ RGMs and counting. Novak often talks about replicating the China business model in other emerging markets and this relentless focus on people as a competitive advantage will surely continue to pay dividends.
Day-part expansion, local palates, delivery and 24-hour service: KFC and Pizza Hut do a tremendous job in international markets of leveraging assets throughout the day by offering a localized, robust, high-value menu of food and beverage products for breakfast, lunch, dinner, and everything in between. In China, KFC sells congee and PH Dine In draws customers for afternoon tea. Yum is also expanding delivery in China with Pizza Hut Home Service (135 units), and KFC is currently in the early stages of expanding delivery and 24-hour service. Delivery and drive through are much less significant in emerging markets than in developed markets, but as large Western brands continue to grow in emerging markets these channels will become much more familiar and significant.
Significant future catalysts for growth not baked into valuation: The best way to value Yum stock is using a sum of the parts approach, and I believe the stock is cheap on this basis. First, Yum China does not get a multiple as rich as a company like Chipotle (CMG), yet there is a much, much larger potential for total restaurants in China for Yum than for Chipotle in the U.S. Also, there is little appreciation for the fact that Yum now owns two Chinese QSR brands, East Dawning and Little Sheep, with tremendous potential.
Second, Yum's franchised stores create a revenue stream that behaves like an annuity with a growth rate that will continue to increase as franchisees build units in high-growth markets and new international markets are refranchised. A look at EBITDA multiples given to other public companies with very little company ownership in international markets, such as Domino's (DPZ) and Dunkin Brands (DNKN), makes Yum's royalty stream appear undervalued.
Third, many analysts use an enterprise value to EBITDA multiple of 6x-7x when valuing Yum's domestic business and I think this is too conservative. Taco Bell, the gem of Yum's U.S business, recently reported 13% SSS growth in Q2 and seems like it is finally past the infamous beef lawsuit of early 2011. Taco Bell is creating high-quality products at value price points and its relationship with Frito Lay seems to be paying off big time, sparking new innovation such as the wildly successful Doritos Locos Tacos.
Conclusion: I am not saying anyone should run out to buy this stock. I think you have time. Quite frankly, I think China is going to have a bumpy road ahead, and when China sneezes, this stock goes down.
This is one of those "don't over-think it" names. The company has a leading position in rapidly growing markets with brands that appeal to young consumers who will continue to become more affluent over time.
Disclosure: I am long YUM.
Additional disclosure: I previously worked for Taco Bell, a wholly-owned subsidiary of Yum Brands.