2 Warnings Signs in an Otherwise Outstanding Report

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

To say that YUM! Brands (NYSE: YUM) liked what they saw in the company's quarterly earnings is probably an understatement considering the stock is up over 8% as of this writing. While the overall report was generally positive, there were two specific issues that I noticed that investors should be cautious of going forward. I don't mean to be a buzz kill, but if we're going to laud the company for its positive accomplishments, we also need to be realistic about its challenges.

YUM is a Strong Company, But Competition is Fierce:

The restaurant industry in general is nothing if not competitive. YUM Brands faces some of the largest restaurant chains in the world as its primary competition on a day-to-day basis. With companies like McDonald's (NYSE: MCD), Starbucks (NASDAQ: SBUX), Chipotle (NYSE: CMG), and even Domino's Pizza as every day competitors, the list reads like a who's who of the restaurant business. Each of these competitors are working hard to improve their operations, so if YUM Brands hopes to continue its momentum, the company is going to have to work hard. McDonald's for instance, is beginning to test its M TV channel which will pipe in local news, sports, weather, but most importantly advertising. Considering McDonald's services over 27 million people per day worldwide, if M TV is a hit this could be a brand-new revenue stream to one of the world's largest restaurant chains. Starbucks also is trying to improve its operations by expanding its bakery section with its La Boulange purchase. The company will begin offering hot sandwiches and other options to try and draw in a broader base of customers. When it comes to Chipotle and Domino's Pizza, both companies have improved their operations, are consistently expanding, and represent real threats to YUM Brands, Taco Bell and Pizza Hut chains.

Impressive Results Considering Slow Sales in the U.S.:

The company showed sales up 6%, and EPS increased 19% excluding special items. The company's weakest division was actually YUM U.S. which showed overall sales of just 1% even though same-store sales increased by 6%. However, the company managed expenses well which allowed earnings to increase 13%. YUM Restaurants International (YRI) represents the majority of international restaurants excluding China and India. YRI actually turned in pretty good results considering the challenges in Europe in particular. At this division, sales increased 4% and earnings were up 14%, while the company opened 181 new stores. The true growth driver of YUM Brands as most people know, is their Chinese division. In China, sales increased 22% on the back of strong same-store sales up 6%. These impressive sales results led to an increase in earnings of 22%, and the company opened 192 stores in this region. The company is beginning to realize that India can be its next huge growth opportunity. With just 495 stores, it will be decades before YUM even begins to saturate this market. With sales up 29%, and same-store sales up 5% this shows the potential for growth in this area. 

2 Big Challenges:

Though YUM Brands generally exceeded everyone's expectations with this earnings report, there are two specific challenges the company faces going forward. First, I noticed the companies operating cash flow increased just 6.75% versus last year. This is slightly disconcerting since earnings increased 19%. While it's possible this trend will continue, it's certainly something for investors to keep an eye on. The second challenge has less to do with the Company's results and more to do with market expectations. Investors expect a lot, with the stock currently trading at just less than 22 times forward earnings estimates. This would be fine if we were talking about a company expected to grow earnings by 15% to 20%. However, management at YUM is suggesting a lower growth rate with the comment they expect, "at least 10% EPS growth in 2013 and well into the future.” This expectation could mean just 10% growth and not the 13% growth the company is expecting this year. Given the disconnect between the company's earnings growth and operating cash flow growth, and the potential for lower earnings-per-share growth going forward, investors may need to temper their expectations.

Conclusion:

While it's certainly true that YUM Brands performed well in the last three months, I'm just not sure that the stock deserves to sell for the multiple it currently commands. The company's dividend yield is not the highest of the group, and neither is their growth rate. In fact, its two fastest-growing competitors actually sell for a lower PEG ratio than YUM Brands at the current time. Chipotle's current PEG is about 1.52, and Starbucks sells for a PEG of 1.42. After today's jump in price, YUM Brands PEG ratio is nearly 1.6. While this doesn't sound like a huge difference, consider that Starbucks is expected to grow at almost 19%, Chipotle is expecting 21% growth, verses 13.7% at YUM Brands. Given the massive markdowns we have seen in stocks like Chipotle when they didn't deliver on investors highest expectations, YUM Brands' investors need to make sure they are not setting themselves up for a similar problem in the future. This was an impressive quarter, but a jump of nearly $2.5 billion in market cap from these results seems a bit overdone.


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