Yum Brands: Solid Revenue Generator, But Upside Is Suspect (NYSE:YUM)

Dear readers/followers,

Yum Brands (NYSE:YUM), like most consumer staples, is continuously on my list of companies that I look at. The reason is simple – the company’s brands are appealing to a degree that goes beyond recessions and the like – they’re stable even in such environments. However, a very low yield and an overall valuation issue mean that we want to make sure we buy the company at a cheap price.

This goes doubly in today’s environment, where overvaluation seems to lurk at every corner, and where the potential for a recessionary landing makes investing in this type of business somewhat uncomfortable.

Let’s see where we are for Yum brands in 2023.

Yum Brands in 2023 – Massively Overvalued?

So, as I said – Yum brands are up at a time when the market is up as well. Only Yum Brands is up more since my last piece. The company isn’t issue-free, and some of its issues, such as the non-IG rating, should be viewed as more serious given the peer group in which YUM operates.

However, YUM still has an attractive market cap, and it owns some of the most well-known restaurant brands in the world. What’s more, these brands are spread across 157 countries in the entire world, and they include ubiquitous brands such as KFC, Taco Bell, and Pizza Hut. They also include smaller brands that frankly, I have never heard of, let alone tried the food of. I have however had my fair share of KFC buckets, Pizza Hut slices, and delicious Taco Bell tacos.

The Franchising model of Yum Brands has worked wonders not just for this company, but for other businesses in the same fields as well. With over 52,000 franchised units, the company is majority franchised, and 30% of them are under a master franchise agreement, especially those found in China, while the rest operate under single-level/store franchise agreements.

I explained the company – and franchise companies in general – in detail in my introductory article on the company. So read that one if you’re interested in more of the “basics” here. In this one, we’re talking about more recent results and appeal.

YUM takes revenues and drives them through COGS as at an average gross margin range of 42-50%, which then goes through SG&A and overall operating expenses towards the bottom line, resulting in operating margins of around 25-35% depending on what year you are looking at. On a high level, this is attractive.

I’ve put YUM’s margins on a peer comparison here, and as you can see, the company isn’t the best – but it’s pretty much the second-best out of that entire peer group. That McDonald’s (MCD) is better with more scale and organization was to be expected, and you could argue that Starbucks (SBUX) doesn’t exactly share the same operating model or can be argued to be comparable – but Chipotle, and MCD are comparable , I’ll argue. At the very least it can be said that YUM is not doing anything worse or less precise than its peers are doing – and trends have been going in the right direction overall.

A company like this is largely about the strength of its brands, and how these are holding up in a difficult and more competitive environment. Thankfully, the results here are definitely quite impressive as far as things go. For the latest quarter, that of 3Q22, we find worldwide sales growing by 7%, 5% on the same-store level, and 4% overall unit growth. GAAP Operating profit grew by 4%, and core profit grew by 8% – and this includes a 3-point Russian headwind.

GAAP EPS at $1.14 means that the company is doing quite well. It’s more or less what I was expecting out of what is essentially a market leader in the fast-food industry.

With regards to Russia and the company’s operations in that geography, there is a transfer of ownership of the Russian KFC which also includes a transfer of the master franchise rights to a new business called “Smart Service Ltd”, which is a business operated by an existing franchise holder. This means that the franchise holder will be responsible for rebranding and retaining employees and restaurants, and this also means that the company is completely leaving Russia behind. Whether we see a return of KFC and YUM to Russia will no doubt be left for us to discover when the conflict is over, but for now, the company has removed Russia from its business results, as well as from prior year comps.

Other than that, the results were very good.

Oh, you may argue that things are still heavily impacted here – but I say that these results, in light of inflationary, wage, and macro pressures, are nothing short of fairly amazing, even with nearly $40M of unfavorable FX due to the massive currency shifts we’re currently seeing. The various divisions, which usually include the largest brands for the company, have all seen good growth, with same-store growth in Pizza Hut, Taco Bell, and KFC. Habit, the much smaller segment, grew even more, with 12% system sales growth, and opening 4 new restaurants opening across the US.

With Pizza Hut already out of Russia for the company, KFC is the last chapter in YUM’s story there, and it’s almost done.

When I last wrote about YUM, the yield was over 2%. That’s no longer the case, which means that on a broader peer basis, this company is now one of the lower yielders in the entire group.

Let’s look at what this valuation increase has done to the upside we can see for YUM in the next couple of years.

YUM’s 2023 valuation – is not something I’d wanna eat

Now, I like investing in the food business. It’s a solid revenue generator, and that means as long as the margins are good, growth is somewhat there, and I don’t see near-term risks, that’s pretty much solid “guaranteed” growth in both earnings and shareholder returns.

However, when companies like YUM reach the heights we’re seeing here, things are starting to be a bit tricky. You only need to look at the historicals to see just how low this company can go, if volatility strikes.

What you’re looking at here is no less than a 28.5x premium P/E compared to a 20-23x P/E range of a premium, for a BB+ company that’s yielding less than 1.8%.

Granted, growth is expected to average double digits, and the 5-year average valuation is around that 28.5x level, which means that if this valuation holds, and if growth rates turn out to be accurate, then you might be in for some outstanding returns to the tune of 16-19% per year, which is as high as some of the better investments I’m currently targeting in my portfolio.

Here is why I don’t think this is good enough.

First off, the company’s forecast accuracy is abysmal. More than 60% of the time with a 10-20% margin of error, the analysts fail to forecast this company, instead showcasing a miss. This fills me with no confidence that these growth prospects are actually as good going forward as is being suggested. Consider for a second the latest set of results, which more or less confirmed that 3-5% operating profit growth range – not 10-13%.

Such EPS growth would put us in the ballpark closet for 8-13% annualized rates of growth, which suddenly is much less appealing, even though it’s likely still market-beating.

Secondly, Yum brands is a company that should be able to be forecast positively under a DCF model, given its relatively solid historical rates of growth. But looking at even a relatively conservative discount rate, together with a high terminal growth rate of 4-6%, we get a price range of no more than a high end of around $110, $115 at most.

YUM is currently trading at nearly $130.

That’s strike two out of three.

To the third, when it comes to comps, YUM is one of the more expensive ones out there. It’s more expensive than MCD, worse than Compass, higher than Restaurant Brands (QSR), more than Darden (DRI), and far higher than Domino’s (DPZ). By any allowance you make, YUM is not cheap here. Its revenues are valued lower only than McDonald’s at almost 7x, and I don’t see this as justified regardless of how stable some of its brands are.

Analysts have bumped their price targets – but analysts have consistently failed to account for significant downturns in the share price if you look at the 10-20 year forecast and targeting history – so in this case, I don’t give them much credence.

My current stance is based on the assumption that we’re on the way towards a “leg down” in the market, based on far too positive assumptions with regard to inflation and interest rates. Now granted, YUM will probably hold up better here, but the company is already extremely richly valued.

While I do see an upside for the company, I don’t see that upside as being market-beating on a conservative basis, and I won’t pay 28-30x P/E for a company like this.

A premium/optimistic upside for the business would be an RoR of about 16%+ annually at 2025E, and that’s at a 28.5-30x P/E based on current forecasts, or a total RoR of 60%. At normalized estimates of 20-22x P/E though, that number goes down to 8-10% annually, or 22-26.5% total RoR, and if we account for the margin of error these analysts put in, it can slide below that 8%, which is “breakeven” point for me, given that I can make that conservatively with the same money I would put in here through options trading on much safer names.

What I’d want to see before putting money to work is a price drop to around $105 or so – at that price, Yum Brands becomes digestible for me. I don’t see any reason to change my previous target of that $105 in light of these recent earnings.

Thesis

Yum brands is a very attractive business, holding four very attractive franchises/restaurant brands, three of which have undoubted international fame. The company has decent fundamentals (below-IG credit rating), and superb historical trends, making it a theoretically attractive investment at a decent price – even a premium. I’d like to see a 20-22x P/E before getting into the business, as I want a 15% conservative upside to work with, especially with a 2%-yielding investment. Because of that, I go with a “HOLD” at a PT of $105/share.

Remember, I’m all about :

1. Buying undervalued – even if that undervaluation is slight, and not mind-numbingly massive – companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn’t go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them (italicized).

This company is overall qualitative. This company is fundamentally safe/conservative & well-run. This company pays a well-covered dividend. This company is currently cheap. This company has a realistic upside based on earnings growth or multiple expansion/reversion.

Once again, this company does not fulfill my valuation-related criteria, and works to be a “HOLD” at this time as well.