Is Taco Bell Carrying Yum! Higher After All?
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One critical argument in David Einhorn’s short recommendation of Chipotle Mexican Grill (NYSE: CMG) at this month’s Value Investing Congress was that the trendy restaurant would soon start to lose market share to Taco Bell, one of the “concepts” owned by Yum! Brands (NYSE: YUM). Despite offering a consumer survey conducted by Greenlight Capital in support, Einhorn was mocked for this point- did the billionaire not understand that Taco Bell and Chipotle were completely different restaurants? Had he ever visited one?
Shortly afterward, Yum! Brands issued its 10-Q for the quarter ending in August. Revenues were up 9% from the same period last year, roughly even with the growth rate from earlier in the year despite concerns about Chinese macro. Net income rose sharply, at a 23% rate. Revenues were down in the U.S.- China, responsible for over half of sales, drove overall growth- but operating profits rose 13%.
To some degree these changes were due to refranchising initiatives. According to the 10-Q, Taco Bell operations in the U.S., China, and the International division (which excludes the U.S., China, and India) are responsible for 90% of Yum!'s operating profits. Given the strong increase in U.S. operating profits, it seems logical to conclude that Taco Bell is making significant contributions.
It’s good to see profit growth, but Einhorn had noted in his presentation that he was not long Yum! Brands, and it’s possible that the reason for that is the company’s valuation. At 21 times trailing earnings and 19 times forward earnings estimates, the market seems to be expecting growth to pick up. While it’s possible that good U.S. consumer numbers will continue to push domestic operations higher and contribute to a stronger Chinese economy, the valuation does seem aggressive to us.
Yum! took the #2 slot on our list of the ten most popular restaurant stocks among hedge funds in the second quarter, as more funds and other notable investors- likely worried about Chinese exposure- sold out of the stock than of McDonald’s (NYSE: MCD). Billionaire Steve Cohen’s SAC Capital Advisors diverged from this trend, as the fund added shares and had about 940,000 shares in its 13F portfolio at the end of June (see more stock picks from SAC Capital Advisors). Legg Mason Capital Management, managed by Bill Miller, slightly reduced its stake but still owned 1.3 million shares at the end of the second quarter (find more stocks that Legg Mason owned).
Yum!’s peers include Chipotle, quick service restaurants McDonald’s and Burger King (NYSE: BKW), and pizza restaurant Domino’s Pizza (NYSE: DPZ). Domino’s recently reported strong third quarter earnings, with earnings per share coming in at $0.43 versus $0.35 a year earlier. Much smaller than Yum! at a $2.3 billion market cap, Domino’s trades at a forward P/E of 18. Even with its good growth, that does not seem like an attractive valuation, including relative to Yum!.
Chipotle has an impressive growth history behind it, but Einhorn’s action and other short activity (shortly before his presentation, about 12% of the company's shares outstanding were held short) reflect skepticism that the company can preserve its market share. Trading at trailing and forward P/Es of 35 and 27, respectively, it is highly sensitive to a lower trajectory of earnings.
McDonald’s, somewhat surprisingly, is the cheapest of these peers on a forward basis. The $94 billion market cap quick service restaurant trades at 15 times estimates of 2013 earnings, and also offers a 3.1% dividend yield. Its recent growth may not be particularly high, but is still respectable and despite Yum!’s expansion opportunities we see McDonald’s as a better value.
Burger King, fresh off its IPO in June, carries a forward P/E of 22--higher than what we see at McDonald’s or Yum!. The investment thesis is that Burger King will be able to expand its business, but we are skeptical that it should get this kind of earnings premium.
Yum! does seem to have the potential to chip away at Chipotle. However, there’s no reason that both companies can’t be overpriced, and we think that McDonald’s is a better value in the restaurant industry.
This article is written by Matt Doiron and edited by Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article. The Motley Fool owns shares of Chipotle Mexican Grill and McDonald's. Motley Fool newsletter services recommend Burger King Worldwide, Chipotle Mexican Grill, Chipotle Mexican Grill, McDonald's, and Yum! Brands. 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.