YUM thoughts

I actually felt compelled to write this earlier in the week, but here goes.

I'm a buyer of YUM at $49 for the following reasons -

- china inflation is running hotter than expected - intuitively, inflation is bad news for restaurant companies, since the first thing people think about are higher input costs.  However, it's great for a restaurant operator, and even better for a restaurant franchisor.  Why?  Because inflation means increased pricing power.  Restaurant menu prices will increase for the same reasons base foods will increase.  Higher inflation, all else equal leads to higher margins.  Here's an illustrative example.

Assume base revenue = $1, with 30% margins (i.e.., input costs are 70%)
Now run 20% inflation through the P&L.  The operator runs the costs thru higher menu prices.  Revenue is now $1.20.  Input costs DOES NOT increase 20%. The operator extracts leverage from fixed costs like real estate, depreciation, long-term contracts, etc.  Say input costs rises 15% to $1.15.  Your margins just expanded by 300bps to 33%. Which leads me to...

by the way - yum's guidance for china SSS is 4%.  assuming they increase prices at HALF the rate of inflation, the guidance implies organic traffic growth of just 2%... VERY conservative in my view given that the economy is growing 10%+ a year.

- inflation is even better for franchisors -  franchisors take a percentage (I think 5% for YUM) of the top-line with zero exposure to the franchisee's cost.  Think of it as free money.  The franchisee raises price by 5% to offset rising input costs.  YUM Corporate takes 5% of that 5% cost free.  Why does this matter? Because 90% of YUM's units outside China are franchised.  Inflationary environment = free money.  Moving on to more recent news...

- disposition of A&W and LJS are incrementally bullish - quick service restaurants have been shedding concepts for years (MCD, CKR, JACK).  Peripheral businesses (as LJS and A&W are) invariably cost more than they contribute.  Said another way, they're ~10% of the revenue, but represent 40% of the lineup and 20% of management's time (making up numbers here).  There's also no growth, and virtually no product innovation in these two brands.  Finally..

- valuation is still reasonable - ~18x 2011 earnings with the S&P trading around 15x. nothing really i could say here except SONC with much lower growth is trading at 18x.  my sum of the parts gets me to $60.  remember, the two biggest risk in this stock is execution in the US, and SSS growth in China.  the roadmap to answering both is pretty clear.



Disclosure: I am long YUM.