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A Hidden Treasure

|Includes: Yum! Brands, Inc. (YUM)

Anyone visiting China will be impressed by the nearly ubiquitous presence of KFC restaurants. The well-located stores are almost always packed with customers. Menus are strangely unfamiliar, filled with local items such as soya drinks, egg tart, seafood and the new breakfast line. This is the China Division of YUM Brands Inc.(NYSE:YUM), the largest restaurant operator in the world.   

KFC restaurants, together with Pizza Hut, are a hugely successful business in China.There are now 3300 restaurants (2870 KFCs and 450 Pizza Huts) in over 600 cities. More than 500 new stores are being built in 2010. There will be a lot more as China urbanizes further and middle class population swells from the current 300 million. With an infrastructure fine-tuned over the past 20 years, YUM plans to eventually build 20,000 stores in China. It owns its own distribution system. A vast network of suppliers supports its expansion deep into the country. Its excellent management team is locally hired and trained. Its food menus are adapted to local tastes.  KFC has been considered one of the top consumer brands in China for many years. This business is also hugely profitable. An average KFC restaurant grosses US$1.4 million. Margin is 20%. Cash payback on investment is less than 2 years. Unlike the franchise systems used by YUM elsewhere, these profitable Chinese stores are company-owned.

However, the value and growth prospects of this fantastic China business may not be fully recognized in the stock price of YUM.  Its current-year PE ratio is about 14 ($33.79, 2/19/2010, with 2.5% dividend).  This is at the bottom of the range in the past five years. This is despite a consistent 25-30% ROC, 13% annual EPS growth and ample free cashflows. If priced at a current-year PE of 18, toward the low end of the range, YUM may rise to $42 for a 20% upside. Further appreciation is conceivable if PE ratio expands to reflect the growing domination of the China Division in YUM’s valuation metrics.  There are three temporary issues that are holding back the stock price of YUM.

First, consumer restaurant spending has lagged recovery trends. Global recession has resulted in discount pricing and lower restaurant sales. This is aggravated further by investors’ myopic fixation on the fluctuations of same-store sales comparison. The China Division has been no exception. It has suffered slight decline in same store sales (-1% in 2009) as restaurant spending in China is possibly more discretionary than in other developed markets. This has led to questioning of the China success story. This is short-sighted. It ignores the fact that operating income actually grew 25% and store margins improved to 20.2% in 2009 from 18.4% of 2008.But store sales may be turning corner. In its recent quarterly conference call, management indicated that consumer confidence index was on the rise. McDonald’s and local chains such as Café de Coral reported increasing sales in recent months.

Second, the mature US business may be drawing disproportionate investor attention even though it represents only about one third of operating income. The KFC and Pizza Hut business are now fighting declining sales and income due to poor economy and some internal issues. However, YUM is working on three fundamental initiatives. It is re-franchising KFC and Pizza Hut in the US. Company ownership will drop to 5% from the current 20% in 2 years, freeing capital and capturing the more stable franchise fee income. It is also focusing on the growing strength of Taco Bell, taking it into international markets. Lastly, YUM is pushing into emerging markets, such as India, Russia and Vietnam. These international markets are growing faster than the US market.

Third, the China Division will grow to dominate the results and valuation of YUM over time. Below exhibit from 10K compares the growth trajectory of China Division with the rest of YUM business.

 Operating Incomes, in millions      2009           2008        2007

US                                                   647             641         685

International (YRI)                           491             522          474

China                                              602             480          375     

China business currently contributes to 35% company income. But with higher growth and therefore a higher valuation multiple, China arguably may represent close to half of total company valuation. YUM is now targeting 15% growth for China, 10% for International and 5% for the US. At this pace, China will approach 50% company profits in five years and possibly 65% company valuation. The implications are that issues in the mature US market may not significantly impact overall YUM results in the future. The valuation of YUM may more fully reflect the outstanding profitability and growth prospects of its Chinese business.

In conclusion, YUM is trading at a modest 20% discount to a fair price. Downside risk, however, may be limited as recovery in global restaurant spending takes hold. This represents a good risk-adjusted opportunity for long term investors to gain exposure to the fast growing markets in China and emerging markets. YUM is a good company now available at a better than fair price.


Disclosure: the author owns YUM shares.


Disclosure: Wallace owns YUM shares