Yum! Brands: Opportunity in an Overreaction

I recently took advantage of an overreaction in one of my favorite stocks to buy into a great company. Yum! Brands (YUM) is the second largest fast food restaurant operator in the US, after McDonald's (MCD), with brands such as KFC, Taco Bell, Pizza Hut, Long John Silver’s, and A&W. In recent months, its stock price has gradually trended downwards from $41, capped by a dramatic move to $33 when the company revealed in its second quarter’s report (see conference call transcript) that inflation has caused a decline in its US profits, despite same-stores sales rising 2%.

This is patently a ridiculous reaction to the news, since the company then raised its earnings forecast for 2008 by $0.02 to $1.89 EPS, on the back of KFC’s torrid growth in China, representing a 15% increase in EPS over the previous year. Furthermore, management reaffirmed its commitment to achieve at least 10% EPS growth year after year.

At this point, slightly over half of Yum’s earnings is derived from international sales, which is in keeping with my strategy of holding stocks with significant international exposure. The rapid growth of sales in Yum’s international and China divisions should enable it to reach and even exceed its 10% EPS growth target despite anemic US domestic growth. Furthermore, I believe that the compression in US margins due to inflation is temporary. Prices of goods and services are often “sticky” in the face of inflation, as companies do not want to incur the expenses of adjusting their prices if they think the cost surge is normal volatility, or if their competitors have not done so yet.

However, the recent inflation is likely to be more persistent, and it is only a matter of time before all prices get adjusted upwards; already, the high costs of food and oil are beginning to seep into the core CPI. Inflation alone does not change the competitive landscape in the restaurant industry, and therefore should not result in changes in Yum’s profit margin. It is unclear whether consumers will react to surging inflation and a recession by eating less at full-price restaurants and more at fast-food restaurants (thereby increasing Yum’s sales), or simply skip eating out altogether (thereby killing Yum’s sales).

To ensure further profit growth, Yum has multiple initiatives both domestically and abroad. Overseas, it is starting an initial foray into the Russian market, with the hope of replicating its success in China. To capture a greater share of the Chinese market, it has started a new brand specific to the Chinese market called East Dawning, which serves Chinese cuisine. Domestically, Pizza Hut has just started offering pasta, and Yum has several products in its pipeline for health-conscious consumers.

I consider Yum a low-risk moderate return stock. It has strong barriers to competition stemming from its economy of scale and its managerial expertise as a major player in the fast-food industry. The strength of its competitive position can be seen from the fact that it has consistently achieved greater than 10% EPS growth for the last 8 years, despite encountering numerous problems including SARS, cases of contaminated dye at KFC and contaminated onions at Taco Bell, and a prominent YouTube video depicting a mass exodus of rats from a Taco Bell restaurant. Management is competent and conservative, and consistently repurchases shares. I consider a PE of 25 reasonable for a company of this quality, and have a target price of $47 on Yum.

Disclosure : I have a long position in YUM.