Reasons to Add YUM to Your Portfolio

By Gayatri Sharma - August 9, 2012 | Tickers: CMG, JACK, PEP, YUM | 0 Comments

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YUM! Brands (NYSE: YUM) posted good same store sales growth in Q2 in all its divisions (YUM U.S 7%, YUM Restaurants International 4%, Yum! China 10%, YUM India 7% ). The company is likely to grow EPS at a low-double-digit percentage rate, return substantial amounts of cash to shareholders, and generate high returns on capital. The company continues to see high-growth in emerging economies (contributing ~60% of profits) where unit penetration is low, new-unit ROIC is high, and consumer-class growth is healthy. We believe that even in the midst of strong macro headwinds, the company can perform better than market expectations due to the following reasons:-

Commodity price moderation to alleviate margin pressures

Due to reduced Chinese GDP outlook, investors were worried about same-store-sales in China while heading into 2Q. Soon after the announcement of impressive China 2Q SSS of 10% (KFC grew 9%, and Pizza Hut grew 10%), the concern got shifted to the Chinese margins. Margins fell quite a bit during the 2Q, due to labor and food inflation and investments for more aggressive unit growth. We believe this decline in margins to be of short term in nature as commodity pressures are expected to decline on top of an additional 7% price increase on its menu in Q3. Moderating commodity prices in China should alleviate margin pressure in 2H12, and we expect Yum Restaraunts International margins to benefit from positive sales leverage. Additionally, with a 7% additional price on menu, net profits on food margins are expected to increase considerably that will counterbalance the continued pressure of the labor line.

Foray in Mexican food business

With all three divisions posting positive SSS growth in domestic locations (Taco bell 13%, Pizza hut 4%, KFC 1%) for the second consecutive quarter, we believe that Yum! will carry its current momentum. The impressive SSS increase in Taco bell could be attributed to the partnership with its former parent PepsiCo’s (NYSE: PEP) Frito-Lay to release the Doritos Locos Tacos which increased the traffic considerably. Additionally, Taco Bell has revised its menu and has started to offer Chipotle-esque items to complement its relatively vast and inexpensive menu. Currently, customers interested in Mexican gourmet offerings are largely shared by Chipotle Mexican Grill (NYSE: CMG) and Jack in the Box (NASDAQ: JACK) owned Qdoba Mexican Grill. But now with the introduction of the Cantina Bell menu ( closely resembles that of CMG and Jack), Yum! has started gaining market share from these two high growth Mexican food chains as evident from Taco Bell’s 13% SSS gain relative to Qdoba’s SSS of 3% and Chipotle's SSS of 8%.

Growing Presence in China

We believe the primary reason to own Yum! shares is that it represents a relatively inexpensive way to invest in a proven, high growth consumer business in China.  Yum! has a growing presence in this emerging market through its highly franchised Yum Restaurants International division. Yum! has further upgraded its new unit growth target in China to 700 (from 600 prior) in FY12; helping it monetizing this expansion to the best possible extent.

With a Forward PE of 18.06, Yum! seems to be undervalued as the strong qualitative and quantitative factors like moderating commodity prices; growth prospects in China, and the strong focus over menu innovation suggest the company's solid EPS growth in the near term.  The market share gain from other Mexican food chains and brand diversification further make it an attractive stock. With a strong focus over expansion into the high-growth and high-return (typically emerging) economies, we anticipate an upside to the current valuation and won’t be surprised to see the company trading at a forward PE over 20 in the near future and hence rate it as a buy.

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