Breakfast is Going to Get Yummier

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As proof that big companies can still find new ways to expand their growth, YUM Brands (NYSE: YUM) recently announced that its Taco Bell chain will begin rolling out a breakfast menu. The company is currently testing its breakfast menu in about 800 restaurants, and CEO David Novak said that he expects to begin serving breakfast at Taco Bell units nationwide by 2014.

YUM serves more than 36.8 million customers per week at the nearly 5,600 Taco Bell restaurants in the US. If Firstmeal (which is Taco Bell’s word for breakfast) is even marginally successful, the company could see a big impact on its bottom line. Don’t believe me? Years ago McDonald's (NYSE: MCD) added breakfast to its offerings; today the company owns about one-quarter of the fast-food breakfast market, a market estimated to be worth about $25 billion. In addition, the Bloomberg Businessweek article linked above estimates that for every restaurant breakfast, the typical American orders 2.5 lunches and 2 dinners. This just shows that there is potential for expansion in this market going forward.

There are two challenges that YUM will face in making Firstmeal a success. First, the company needs to market this offering heavily, as most people don't associate Taco Bell with anything related to breakfast. Second, the company must expand its breakfast menu to give customers sufficient choices to make it work. The menu is understandably limited because it’s confined to a test market. Currently the company is only offering one item: eggs, bacon, and a hash brown wrapped in a tortilla. If the company makes this offering work, they could see both faster earnings growth and some margin expansion as well.

YUM Brands’ competition in the breakfast market includes the previously mentioned McDonald's, as well as Starbucks (NASDAQ: SBUX), which offers pastries along with its signature coffee selections. Since both of these companies benefit from the additional revenue generated by morning sales, they are both able to spread their fixed costs across a larger sales base. This helps explain why even though YUM Brands has three different restaurant chains that cater to different tastes, the company's margins can't match those of its competition.

For example, McDonald's has the benefit of seeing sales at about 40% of its restaurants 24 hours a day. Though this does require staffing and other costs, the company is seeing a positive return on these operating hours. In its most recent earnings announcement McDonald's reported a gross margin of 39.26% versus Taco Bell's gross margin of 26.17%. Starbucks is at a bit of an unfair advantage in the gross margin department, since the company makes a lot of money on its high-end beverages. That being said, Starbucks' gross margin of 56.22% shows why companies like McDonald's, with its McCafe lineup, are trying to move into the beverage market.

You can also see the benefit of having longer hours at McDonald's and Starbucks in their free cash flow generation. Both companies generated about $0.11 of free cash flow per $1 of sales in their most recent quarters. By contrast, YUM Brands generated about $0.07 of free cash flow per $1 of sales. Across the board you can see that having breakfast options and more selling time in the day, equates to better margins and better cash flow. So how much could breakfast add to YUM's bottom line?

In the last full fiscal year, YUM reported sales of about $12.6 billion. This level of sales generated almost $1.32 billion in net income, which equated to $2.87 in EPS. Even if YUM's new breakfast menu at Taco Bell only captures 5% of the total fast-food breakfast market, this would add $1.25 billion to the company’s bottom line, creating an additional $130.5 million in earnings. With about 455 million shares outstanding this additional income would have meant about $0.28 of additional earnings per share last year. Using these assumptions, YUM would have grown earnings by an additional 9.76%.

Analysts are expecting 13.68% long-term earnings growth from the company without these additional potential sales. The market already places a premium valuation on YUM Brands due to the company's consistent growth. If the company successfully rolls out breakfast and captures even a small amount of the market, the company's growth rate will surely come in higher. The stock was valued at about $63 prior to this announcement and today sells for about $65.80. This 4.4% increase doesn't seem to take into account the significant difference this upcoming Firstmeal impact could have.

The bottom line is, YUM Brands was already attractive based on its earnings growth and income from its steadily increasing dividend. With this development not only will customers get more choices for breakfast, but YUM stock looks like an even tastier bargain than before.

MHenage owns shares of McDonald's. The Motley Fool owns shares of McDonald's and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend 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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