Rising Costs Ate up This Company's Results
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Yum! Brands (NYSE: YUM) operates three of arguably the most popular restaurant names in the world. With franchises like Pizza Hut, KFC, and Taco Bell, investors get diversification in the restaurant industry with just one share. While domestically the company is at or near its saturation point, internationally the company expects to continue growing at a decent pace. However, Yum! Brands faces significant competition to all three of its food chains. Interestingly, it wasn't the company's competition as much as its own costs that hurt results in the most recent quarter.
I'm sure investors could tell immediately that there was a cost input issue when they saw that revenues increased over 12%, yet EPS increased just 6.15%. What's really amazing is, for all the press that Yum! Brands gets for its expansion in China, it was actually the United States that drove bottom line profitability. Let's take a look at each of the company's major divisions and see exactly what happened.
With nearly 38,000 restaurants worldwide, and the majority of them located within the United States, the U.S. is still the company's most important market. In an ironic twist, revenues actually decreased over 7%, while operating profit increased by more than 25%. In a somewhat strange quarter, same-store sales were up 7%, even though overall revenues were down. A lot of this has to do with competitive pricing by the company's major competition. For instance, McDonald's (NYSE: MCD) competes directly with all three chains, as it's just as easy for a consumer to stop by a McDonald's restaurant as it is for them to order pizza from Pizza Hut, chicken from KFC, or tacos from Taco Bell. McDonald's has recently been heavily diversifying its menu away from the standard burger and french fry options. In fact, the company has begun making customers aware of its “under 400 calorie” options. Combined with McDonald's value menu and expanded McCafé beverage line, the company is growing same-store sales by attracting a different segment of the population than the company traditionally catered to. Another competitor, Starbucks (NASDAQ: SBUX) has also recently expanded its food menu to attract customers to its stores for something other than just coffee. Both of these competitors have thousands of locations, generate huge free cash flow, and have at least the same name recognition of the Yum! Brands chains. On the international front, Yum! Brands faces the same competitors, but again it was costs that affected results more than sales.
The company's two most important growth markets are China and India. This operating segment saw revenue growth of 31.86%, which you would normally assume would lead to huge earnings growth. However, the company's cost of sales increased by 35%, which led to operating profit that was basically flat on a year-over-year basis. In the remainder of the world, revenues increased 4.76% and operating profit increased just 2.74%. Across the globe, the primary issue for Yum! Brands was food and paper expense. Looking at the company's financial statements on the other hand, you can see that this lower EPS growth did not hurt the company's cash flow growth as much as you would think.
Yum! Brands' operating cash flow, on the basis of net income and depreciation, increased by more than 25% year-over-year. Investors looking for better dividends in the future, will be happy to know that the company's free cash flow payout ratio was just over 39% in the most recent quarter. The company also repurchased shares worth $289 million at an average price of nearly $67 per share. While the company operates more locations than any other restaurant combination that I'm aware of, Yum! Brands is not done growing.
The company opened 342 new restaurants during the quarter, and anticipates continuing to open a significant amount internationally. The question for investors is, does Yum! Brands represent the best choice for their funds? The company that Yum! Brands is compared most closely to is McDonald's, based on each company's significant size and international expansion plans. While McDonald's has the higher dividend yield at about 3.1%, the company is expected to grow slower at 9.48%. The more challenging comparison, would be for investors to choose Yum! Brands over Starbucks if you believe analyst growth expectations. Starbucks is expected to grow earnings at over 19% and sells for a P/E ratio of about 26. Yum! Brands growth rate of 13.68% can be had for about 20 times forward earnings estimates. In theory, Starbucks represents the better value, because though the shares have a higher P/E ratio, relative to their growth rate they are actually cheaper than Yum! Brands. Investors could hardly go wrong choosing any of the three companies, and if Yum! Brands can better control costs in the future investors should be pleased with the results.
MHenage owns shares of McDonald's. The Motley Fool owns shares of McDonald's and Starbucks. Motley Fool newsletter services recommend McDonald's, Starbucks, 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.