I was attracted to Yum Brands (NYSE:YUM) because of its stable of brands and history of strong financial performance and have been reading a lot of commentary on the company's outlook. Most of the articles are quite bullish on the stock and with good reason. Yum! has a strong operating history over a long period of time and a positive long term outlook. I have listed several of these articles on Seeking Alpha below for interested readers (apologies to any authors I have excluded):
- Yum Brands an Appetizing Stock By Steve Simpson Smith
- Yum Brands Strong Growth Potential Despite Recent Setbacks By George Lee
- Yum Brands is Looking Tasty By S. Michael Mandala
I believe there is considerable emerging market risk associated with Yum!. Operating earnings are increasingly derived from emerging markets, in particular China due to increased stores numbers and the franchising of company owned stores in the US. This presents an additional risk to be considered by investors.
Yum operates in the Quick Service Restaurant (NYSE:QSR) segment, owning leading QSR brands Pizza Hut, KFC and Taco Bell. As per 2012 Annual Report, total stores were approximately 39,000 including 28,600 franchised stores, 7,600 Company owned stores and 2,700 licensee and affiliate stores. Key growth is coming from emerging markets; 5 Year compound annual store growth with China (17%) and India (21%) leading percentage store growth (US 3% and International 3%).
Yum! Brands Strategy
Yum has outlined its vision and strategy for growth in its 2012 Annual Report with a focus on expansion in Chinese and International markets:
- Build leading brands across China in every single category
- Drive aggressive International expansion and build strong brands
- Dramatically improve US brand positions, consistency and returns
- Drive industry leading long term shareholder and franchise value
Management have also provided a clear commitment to "deliver at least 10% growth annually"
Clearly, management has identified emerging markets as the future of the company's growth given the maturity of the US market. There are approximately 58 restaurants per million customers in the US compared to 2 restaurants per million in International Markets. Management believes there are substantial growth opportunities in China, India as well as Russia and Africa.
Yum! are selling their mature US Company stores to franchisees, in particular Taco Bell stores in order to reinvest proceeds into growth segments such as China, India and other Emerging Markets. A key reason for this is the maturity of the US market, as evidenced by negative same store sales growth in recent years, albeit improved slightly in FY12.
Yum have historically achieved above 10% earnings growth and diluted EPS for the past 5 years, recording $3.38 per share for FY12 (P/E of ~21x).
The company continues to generate strong operating cash flows ($2.3 billion in FY12) with steady dividend increases and a share buyback program in place. Management is continuing to invest for growth, with ~$1.2 billion invested in FY12 and expectations of similar expenditure during FY13. This continued investment into emerging markets is expected to continue to drive earnings over the long term.
Franchise and license fees contributed $1.8 billion in FY12 or 13% of total revenues. As US corporations stores are franchised, this is expected to continue to grow at the expense of sales revenue (although percentage contribution may not due to aggressive company store roll out in emerging markets).
A Changing Operating Structure
Yum Brands profile has changed dramatically over the past 3 years due to store growth in international markets and their increasing revenue contribution. For example, in FY10, the US contributed operating profit of $668M (38%), in FY12 its contribution was $666M (29%). China, in contrast contributed $755M in FY10 (43%), $1,015M in FY12 (44%) and International segment, $592M (33%) in FY10 and $715M (31%) in FY12.
The increased contribution from China and Emerging Markets will continue given the company's corporate strategy and sale of mature stores in the US. Pictures can also provide valuable insight and the 2012 Annual Report is littered with China focused pictures.
Challenges in China
Yum! experienced firsthand the challenges operating in emerging countries recently with several suppliers to KFC outlets in China by using excessive levels of antibiotics in chicken, ignoring applicable laws and regulations. This resulted in an investigation by the Shanghai FDA into poultry supply chain management and considerable negative publicity on national television. Yum! China has been required to improve their supply chain practices with resulting media coverage having an adverse impact on China sales in the last quarter of FY12 and into FY13.
During this period, consumers in China were also concerned about the impacts of the Avian bird flu virus which affected sales further.
As a result it was outlined in 2Q13 Earnings Release that same store sales declined 20% in 2Q13 with operating profit down 63% in China as a result of lower KFC sales. The company's Pizza Hut stores continued to trade well with management indicating sales are improving in the region.
The brands owned by Yum! are distinctively American. The company continues to transform its business from its core being operations in America to significant contribution from China and a growing emerging country network. This is resulting in strong earnings growth but is also increasing the company's exposure to emerging market risk. This risk will increase as management refranchise its mature US stores to fund expansion in China and other emerging markets including India, Russia and Africa.
Risks associated with this strategy includes political and regulatory risk, in particular in China, currency risk which may impact earnings in FY13 due to an improving US dollar, supplier risk (as evidenced by supply issues in China) and a general slowdown in emerging market economic activity.
Due to the changing profile of the business, it is increasingly important investors are aware of these risks involved with the business and are comfortable with them.
With a current P/E of 21x FY12 earnings and a strong long term growth profile, I believe the company is fairly valued and a good purchase for long term investors who have the temperament to withstand the short term volatility and risk that comes with investing in emerging markets.
A Thought on American Companies Searching for Growth
Given the maturity of many US sectors and continued uncertainty in Europe, it is my expectation that in order to achieve sustained growth, US Corporations will need to increase their investment in markets outside of the United States.
Yum! Brands are an example of emerging countries embracing American investment and Western culture which has resulted in a sound future for the company and its stable of brands. But this potential growth does not come without a risk-reward tradeoff that management and investors must assess carefully.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.