Is This Quick Service Restaurant a Good Investment?

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

Earlier in July, Yum! Brands (NYSE: YUM) released its results for the second quarter of its fiscal year. As the restaurant company (whose concepts include Pizza Hut, Taco Bell, and KFC) shifted its store composition more towards franchises, lower costs did not successfully offset reduced revenue and as a result, earnings decreased 15% versus a year earlier. This resulted in profits being over 20% lower in the first six months of the current fiscal year compared to the prior year period.

A closer look at the company

While operating profits actually ticked up outside of China, a variety of factors, including food safety concerns in that country (which should prove temporary), caused operating income to be less than half of what it had been in last year’s fiscal Q2. Since China is Yum!’s largest geography, making up about half of revenue, the company is highly dependent on conditions there.

Cash flow from operations was also down, though Yum! dipped into its cash reserves in order to fund its dividend and roughly $330 million in buyback activity. The stock currently trades at 23 times trailing earnings, which is actually not that out of line for a quick service restaurant company. In addition, Wall Street analysts believe that Yum!’s troubles in China will work themselves out next year and so, earnings per share will rebound somewhat; their forecasts imply a forward P/E of 19.

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Comparing Yum! to its peers

Other budget quick service restaurants include McDonald's, Burger King Worldwide (NYSE: BKW), Wendy’s, and Jack in the Box (NASDAQ: JACK). McDonald's, at a trailing P/E of 19, is the cheapest of this peer group. However, it too has been struggling with little change in either revenue or earnings compared to a year ago. It might be of interest to defensive investors with a beta of 0.3 and a dividend yield of 3%, but even in that case, there should be concerns about its valuation.

Jack in the Box has been having problems as well: in its most recent quarter, revenue slipped 3% compared to the same period in the previous fiscal year, with net margins shrinking as well. The sell-side is forecasting an improvement in earnings per share next year, but even if Jack in the Box hit analyst targets, the forward P/E would be 19 and so, the company would need decent growth from that point on.

Burger King and Wendy’s have had fairly low earnings numbers on a trailing basis compared to where their stocks currently trade, but analysts are optimistic in terms of their future EPS as well. In each of these cases, the most recent data shows that 14% of the float is held short, so many market players are apparently skeptical that these restaurants will grow enough to justify their current valuations.

Wendy’s has seen stagnant revenue and somewhat lower net income, and with the stock valued at 28 times forward earnings estimates following a rally this year, it should be avoided. Burger King has also been converting to more of a franchise model, fairly successfully: revenue has plunged, but costs have been slashed by even more, generating a rise in earnings. Still, even with analysts expecting high EPS growth to continue, the forward P/E is 22.

Conclusion

As such, it doesn’t seem like a good idea to be buying Burger King at these levels either, and in fact, it appears that Yum! and the rest of its peers aren’t very good values right now. It is possible that Yum! could recover from its current troubles in China, but even if it performs in line with sell-side expectations -- which in many cases are often too optimistic -- the forward valuation would still incorporate quite a bit of growth and so, the current price does not look attractive.

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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 Burger King Worldwide. 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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