A Solid Share Buyback Program Meets A Solid Growth Play
- Yum! Brands appears to be chasing McDonald’s in a battle of Billion Dollar fast-food chains with its latest focus on growing its stalwart Taco Bell brand into a $15 Billion.
- Yum doesn’t have a particularly attractive dividend yield – but investors can expect its generous share buyback program to provide price support and boost future earnings.
- Meanwhile, we expect Yum’s Taco Bell strategy, if executed properly, to add as much as $500 million to its earnings over the next 6 years.
- This means that the stock is trading at a significant multiples discount to its industry peers. This is our case for why fair value of the stock is around $83 per share.
Chasing the Golden Arches
Yum! Brands, Inc. (NYSE:YUM) capped the first half of 2017 with a 16.7% gain, right in line with the performance of the Dow Jones US Restaurants & Bars Index, which added 16.8% during the same span.
Yum’s performance trails that of McDonald’s, which added 28% in the first half. The disparity in performance is seemingly the result of weaker comparables growth – McDonald’s, now reaping dividends from its Experience of the Future initiative, saw global same-store sales rise by 4% – or double the 2% rate that Yum reported.
Still, Yum’s adjusted earnings grew by 17% in the first quarter compared to a year earlier (in Yum’s case, the adjustment removed $0.12 of earnings driven by re-franchising) – essentially on par with the 18% earnings growth that the Golden Arches reported. The question for investors is whether there’s scope to value Yum higher, considering its current 30-times trailing earnings multiple.
Average Dividend Yield but Strong Share Buyback Plan
Investors looking for a nice passive income pick-up from Yum can expect a fairly average dividend yield of around 1.64% compared to the industry average of 1.81%.
Even so, dividends aren’t the only capital being returned to Yum’s shareholders; the company is in the middle of a $13.5 Billion share buyback program (which is about halfway completed) that it expects to complete over the next two years (i.e. by 2019). This should reduce the company’s current share count by another 22% to 30% depending on its share price, while boosting the company’s earnings per share by as much as 43%.
The Mexican Connection
Unlike McDonald’s, which is still over 10 percentage points away from achieving its 95% refranchising target, Yum is already quite close to its 98% targeted franchise mix at 94%. A lot of this can be traced to its decision to spin-off its Chinese operations via Yum China (YUMC) – previous to that, the percentage of Yum’s franchised stores was just 77%.
This is why it’s beneficial that Yum excludes the impact of refranchising from its earnings – there just isn’t much upside left from there and investors can’t really expect too much cash flow to come Yum’s refranchising efforts going forward. In that sense, Yum’s intellectual property-related cash flow is close to its ceiling. It needs to expand in order to restart its refranchising train.
This is likely why Yum’s efforts are focused on its Taco Bell unit, which helped drive Yum’s global comparable sales with 8% comparable growth on its own. Comps isn’t the only area where Taco Bell demonstrated strong results: the Mexican fast food chain added 19% core operating profit growth in the first quarter. A lot of this has to do with demographic shifts: according to Yum’s investor report, Millennials are the key demographic for Taco Bell and this group is increasingly expanding its buying power.
Consequently, it’s easy to see why Yum is betting heavily on Taco Bell, hoping to turn this unit into a $15 Billion a year business over the next 5 years, which is up from around $10 Billion – investors should note that this figure represents total system sales for the brand, or the gross value of tickets punched at all Taco Bell outlets, rather than Yum’s actual revenues from operations which mainly consists of franchise fees and a small portion of global system sales of all its brands. To do this, Yum intends to open 3,350 new restaurants (bringing its total to 9,000 stores) and expand its presence to 40 countries from its current footprint of 23 countries.
It’s easy to see why Yum is pursuing this strategy – by the company’s own admission, this brand is ‘just getting started internationally’ while its other brands KFC or Pizza Hut are either mature or stagnating in key markets. Of course, the question is whether this strategy will pay-off – flooding the US with more Taco Bells may not be the best strategy at a time when spending on restaurants trails overall retail spending. Meanwhile, Taco Bell’s menu may not have the same traction in markets such as China compared to the United States.
Still, if Yum’s Taco Bell strategy pays off, it could add another $1 Billion in operating profit by 2022 – or roughly $200 million per year. This would translate to a net income contribution of $504 million, all else being equal, which in the future (factoring in the successful completion of Yum’s share buyback program, of course) would mean an additional $2.18 in profits -- for an additional $0.43 per share per year over the next half-decade.
This is not inconsequential: the current consensus calls for a $0.32 per share improvement in Yum’s earnings this year (or 13% per share), which would suggest that the market may be underestimating Yum’s earnings run rate in light of Taco Bell’s expansion as well as the potential improvement in its other brands.
To be sure, earnings won’t reach their fully-integrated run-rate until stores have operated for a year but our view is that the consensus could be underestimating Yum’s earnings by as much $0.10 per share – which is what happened in the last four quarters when earnings came it at a cumulative $0.13 above estimates.
In our view, Yum’s earnings are likely to come in at $2.87 per share in 2018 considering its planned store rollout strategy, the improvement in its core margins and the impact of buybacks. This works out to a forecast that is $0.10 above the current consensus (and in-line with the top-end of expectations) and implies that Taco Bell is trading at 25.5-times earnings.
Most of Yum’s peer group is actually trading at nearly 42-times earnings, so even if we apply a relatively ‘modest’ 29-times multiple to Yum, we’d still get a price target of $83 per share, which works out to a 13.9% return from current levels – for a total return of 15.5% after factoring-in Yum’s current dividend yield.
Ultimately, we’re comfortable with applying a 29-time multiple to Yum – a rate that is commonly associated with growth stocks – because that’s essentially what Yum’s forward strategy makes it: a growth stock in the fast-food business.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in YUM over 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.
Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.
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