Has Yum Bitten Off More Than it Can Chew in China?

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Yum! Brands (NYSE: YUM) was down over 4% on Jan. 8 after the company assured investors that its 2012 earnings would indeed come in within its forecasted earnings range but lowered its guidance for Chinese same-store sales. The company claimed that this revision was primarily due to a government investigation of chicken that hurt demand; however, even before this announcement Yum had been expecting lower same store sales in the region.

Yum! Brands has followed a strategy of growth in China; in the third quarter of 2012, 56% of company revenue came from China as opposed to 49% a year earlier. A similar share of operating profit came from business in the country. Chinese sales were up 24%; revenue in the rest of the world declined 6%. So any sign of bad news in China, or even less than good news, has the potential to be a problem for the company. Overall, revenue and earnings were up 9% and 23%, respectively, from their levels in the third quarter of 2011.

After the pullback in the stock price, Yum trades at 19 times trailing earnings. That is a bit high from a value investing perspective, but it is actually cheap compared to many other quick service restaurants. Pizza Hut, Taco Bell, and KFC, the three core brands at Yum, can be (more or less) compared to Domino’s Pizza (NYSE: DPZ), Chipotle Mexican Grill (NYSE: CMG), and Buffalo Wild Wings (NASDAQ: BWLD). The trailing earnings multiples at these three companies are 26, 35, and 26 respectively. Chipotle and Domino’s do have high earnings growth rates, and Chipotle can certainly be said to offer a more premium product than Taco Bell, but the valuation gap between these three stocks and Yum is still quite high. Even the forward P/Es of these three peers are 20 or higher, while Yum is valued at 18 times consensus earnings for 2013. We don’t think that Yum is a good value, particularly given how exposed it is to macro conditions in China, but it’s important to note that the quick service restaurant industry in general trades at high multiples.

McDonald’s (NYSE: MCD) is cheaper at a trailing P/E of 17, but its revenue and earnings were about flat in its most recent quarterly report compared to the same period in 2011 with sales not holding up particularly well recently either. It does have a low beta at 0.3, and pays a dividend yield of above 3%, so perhaps a more defensive-minded investor would find it interesting.

Yum! Brands was the third most popular restaurant stock among hedge funds in the third quarter of 2012 (see the rest of the top ten); it had actually been the most popular stock in Q1 before funds and other notable investors began to pull out. Billionaire Steve Cohen’s SAC Capital Advisors increased its stake by 55% to a total of 1.5 million shares (check out Cohen's stock picks). Chilton Investment Company, managed by fellow billionaire Richard Chilton, reported a position of about 640,000 shares (find Chilton's favorite stocks). Another major holder of the stock was Donald Chiboucis’s Columbus Circle Investors, which reported a position of 1.6 million shares. McDonald’s, Chipotle, Domino’s, and Buffalo Wild Wings were also among hedge funds’ favorite restaurant stocks.

Quick service restaurants, including Yum, are currently at too high valuations to really get a value investor excited about any particular stock. While Yum is cheaper than some of its peers, consumer tastes seem to be shifting towards more premium offerings and these other restaurants are in some cases showing good growth rates. The China exposure, which for some time was seen as a strength for Yum, is now looking even more like it could cause problems going forward.

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 recommends Buffalo Wild Wings, Chipotle Mexican Grill, and McDonald's. The Motley Fool owns shares of Buffalo Wild Wings, Chipotle Mexican Grill, and McDonald's. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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