Who's Hungry for Profits?

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Yum! Brands (NYSE: YUM), the owner of Pizza Hut, Taco Bell, and KFC, just announced its impressive earnings for its third fiscal quarter. Reported EPS for the quarter was $1, marking a 25% increase compared to 2011’s third quarter. Prior to foreign currency translation, China is still the best place for YUM’s operating profit’s growth, with 22% for the quarter, whereas the growth is 13% in the US and 14% in Yum! Restaurant International (YRI). Comparable store sales increased 6% in China, 6% in the US, and 2% in YRI. Along with the impressive result for the third quarter, YUM raises its full-year EPS to at least $3.24, with growth of 13%, prior to Special Items.

The Chinese Tie

YUM’s operating performance is closely tied to the Chinese market, which accounts for around 45% of the company’s profit. Currently, there are approximately 5,200 YUM's restaurants in China. Many people have worried about the Chinese economy’s slowdown, which could lead to a slowdown in YUM’s business operations. The risks can be slower Chinese consumer demand, volatility in input costs, and a strong USD. However, the company is still bullish in the Chinese market; it increased expectations to opening 750 new restaurants in China this year, from a previous forecast of 700. 

Insiders seem to be expressing concerns by selling shares. Jing-Shyh Su, Vice Chairman of the Board, Chairman, and CEO of YUM Restaurants China; Johnathan Blum, Chief Public Affairs Officer; and Christian Campbell, General Counsel have kept selling their shares since July this year. Their combined sale value is more than $10 million.

Actually, YUM has the strongest tie to the Chinese market, compared to its franchise peers. For McDonald's (NYSE: MCD), although 75% of McDonald's restaurants globally were franchised; only 6 of them were in China. It is far fewer than 493 franchisees of YUM's. In the second quarter, the comparable sales' growth of McDonald's in China was only 2.2%, much lower than YUM's of 10%. For Starbucks (NASDAQ: SBUX), it has expansion ambition in China as well. Currently it has around 600 or less stores in China, and plans to reach 1,500 stores in 2015. For Chipotle Mexican Grill (NYSE: CMG), it hasn't got a presence in China yet. It has total 1,230 restaurants which are mainly located in the US, only two are in Toronto and two are in London. 

Still a Great Cash Generator

Franchising is considered the best business in the world. The most successful investor, Warren Buffett, loves it so much as it keeps generating growing cash flows without so much need to reinvest into the business. In fact, it’s true for YUM over the years. In the last 10 years, YUM’s free cash flow (FCF) has grown from $328 million in 2002 to $1.23 billion in 2011. The annualized compounded growth in FCF is 14.1%.

<table> <tbody> <tr> <td> <p><em>USD million</em></p> </td> <td> <p><strong>2002</strong></p> </td> <td> <p><strong>2003</strong></p> </td> <td> <p><strong>2004</strong></p> </td> <td> <p><strong>2005</strong></p> </td> <td> <p><strong>2006</strong></p> </td> <td> <p><strong>2007</strong></p> </td> <td> <p><strong>2008</strong></p> </td> <td> <p><strong>2009</strong></p> </td> <td> <p><strong>2010</strong></p> </td> <td> <p><strong>2011</strong></p> </td> </tr> <tr> <td> <p><strong>FCF</strong></p> </td> <td> <p>328</p> </td> <td> <p>390</p> </td> <td> <p>486</p> </td> <td> <p>663</p> </td> <td> <p>688</p> </td> <td> <p>825</p> </td> <td> <p>551</p> </td> <td> <p>607</p> </td> <td> <p>1,172</p> </td> <td> <p>1,230</p> </td> </tr> </tbody> </table>

After its earnings announcement, the share price jumped more than 4% in after trading hours, from $66.04 to $68.7 per share. The market capitalization after trading hours is $31.3 billion. If the full year EPS can reach $3.24, the market is valuing YUM at 21.2 P/E. YUM’s P/E is quite fair in the quick service restaurant industry, whereas McDonald's is trading at 17.3x, Starbucks is at 27.2x and Chipotle Mexican Grill is at 34.8x. As mentioned above, YUM’s FCF annualized growth is 14.1%, whereas FCF annualized growth of Starbucks, McDonald's and Chipotle are 26.6%, 29.3% and 87.4% respectively. 

My Take

Personally, I think the slowdown in the Chinese market will only be a short-term issue for YUM. However, it might affect YUM’s share price fluctuation in the short-term. A strong result for its third-quarter has shown YUM’s ability to grow fast in Chinese market. If investors are still concerned about YUM’s short-term Chinese market slowdown but don’t want to miss the long-term gain, they can buy YUM’s call options with the longest maturity date.





hoangquocanh has no positions in the stocks mentioned above. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. hoangquocanh has no positions in the stocks mentioned above. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Chipotle Mexican Grill, McDonald's, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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