Investors may be wary about Yum Brands (NYSE:YUM) going into earnings with the stock trading at fair value. While there is the potential for a 3% to 5% downside on continuing China weakness and sentiment, the long-term picture is firmly intact. The company is one of the best plays on the emerging market consumer and has strong cash flows from its franchised U.S. operations.
One of the best emerging consumer plays out there
In 1999, Yum Brands had over 20,000 stores in the United States and just under half that amount internationally. The company made $14.5 billion on its U.S. operations and $7.3 billion internationally. While the international story was becoming a significant driver, growth was still firmly tied to the domestic market.
In the last fiscal year, the Great Wall of China pictured the cover of the company's annual report and that pretty much says it all. The company now franchises most of its U.S. operations and tomorrow's growth is all about China and the emerging markets. Just 28% of the company's operating profit is now attributable to U.S. operations with China accounting for 42% and 30% coming from other international markets.
Facing a sluggish economic recovery and high unemployment in the United States, the early switch to a franchise model is an advantage for the company. Franchise fees topping $800 million in 2012 make the U.S. operations a cash cow regardless of any weakness in consumer spending.
That cash flow strength helped the company announce its ninth consecutive double-digit dividend increase in September. Yum pays a 2.1% yield and targets a payout ratio between 35% to 40%, leaving plenty left over for growth.
The company has an ongoing growth target of 15% in China and 10% across the rest of its international segment, compared to a 5% growth target in U.S. operations. The company's acquisition of Little Sheep over a year ago has helped to diversify its overall menu offering in the country. Results from the hot pot chain are mediocre so far, helping to boost sales in the country while weakening margins slightly as management brings the stores into the fold.
The KFC brand was hit hard in China over the Avian flu epidemic this year and it may take time to rebuild customer faith. Seeking Alpha contributor Chris Katje discusses the recent large declines in Chinese same store sales across the company's stores but reasons that new menu items at Taco Bell may save the stock.
Besides long-term growth potential, comparables for same store sales, especially in China, could lead to a big surprise upside next year. Any return to target growth in the region could significantly improve sentiment. Even given the slowdown in Chinese GDP growth, there will still be an estimated 300 million moving to the cities over the next six years and this could lead to explosive growth for the company.
Short-term pain, long-term gain
Long-term optimism aside, expectations and a fair-value price multiple may hold the shares back over the next couple of months. The company is expected to post earnings of $0.93 per share on revenue of $3.54 billion this quarter. This represents a 6.1% decrease in quarterly earnings against a 1.1% decrease in sales.
Yum posted a decline of 8.3% in sales last quarter over the previous year and has averaged revenue loss of 1.5% over each of the last four quarters. Earnings per share fell 16.4% last quarter and earnings growth has averaged -0.1% over the last four quarters.
Results last quarter were hit hard by the impact of Avian flu in China with same store sales declining 20% in the country. Same store sales grew 1% in the company's other markets but margins declined 2.7% on the quarter. Shares fell 3.6% over a period of three days after the announcement and have traded in a tight range since then.
The shares trade for 23.4 times trailing earnings, just under the industry average of 23.5 times and over the company's five-year average of 18.5 times trailing earnings. The company's lead in China growth should support valuation but further weakness in sales as KFC tries to rebuild its brand could bring the shares down in the near-term.
I am expecting $0.95 per share on Tuesday's earnings, just over the consensus and $3.07 per share for the full year. Any news that Chinese consumers are still hesitant to trust the KFC brand will hit sentiment by a comparable amount seen last quarter, between 3% and 5%.
Over the next year, weakness for the American consumer should not affect the company much due to the majority of its U.S. operations being franchised. I expect the company to use its menu success at Taco Bell across KFC and Pizza Hut over the next year with a lineup of new items. A few may flop but all it takes is a couple really interesting and popular additions to bring people back. Margins may weaken a bit on the increase to marketing but then should bounce higher on volume.
Yum Brands has hedged its U.S. operations with a franchise model so the segment is basically a cash cow for the company. Its international stores, especially in China, hold a compelling long-term story with urbanization to be a big driver going forward. Investors wary about shares trading at fair value should look at the longer-term and wait out any near-term valuation weakness.
Disclosure: I 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.