This Fast Food Giant Is Eyeing a Turnaround

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

One of the world’s leading fast food giants and the owner of Taco Bell, KFC and Pizza Hut, Yum! Brands (NYSE: YUM) released its quarterly results about two weeks ago in which it managed to beat the earnings estimates, but missed the revenue estimates.

But the company, particularly KFC, continues to face headwinds in China on the back of negative publicity related to the Avian flu and last year’s poultry supply incident. However, the company has been showing signs of improvements and could start hitting growth in same-store sales in China in the near future. 

Yum! Brands has a total of 5,982 restaurants in China, of which 74% are KFC. In terms of revenue, China is the biggest market for Yum! Brands. This is also evident from the fact that in China, the company runs its restaurants itself, unlike in other parts of the world where franchisees form a crucial part of Yum!’s operations.

Unimpressive earnings

Yum!’s total quarterly revenue dropped by 8% year-over-year to $2.9 billion, which missed analysts’ estimates by $30 million, while its net income dropped by 15% to $281 million. The adjusted EPS also dropped from $0.67 to $0.56, but was above Wall Street’s expectations of $0.54. The only positive number was free cash flow of $257 million, which represents nearly 18% of its sales.

In China, Yum! Brands' growth was already under pressure due to the poultry scandal, but the outbreak of avian flu has multiplied its woes by scaring away those customers who were still coming to its restaurants. While the company’s same store sales at its Yum Restaurant International division and the U.S improved by 1%, they dropped by 20% in China led by a 26% drop in China KFC sales.

However, the drop in China appears to be slowing down from 29% in April, 19% in May to finally 10% in June.

More bad news

The company has once again attracted negative Chinese PR. The country’s state-owned CCTV has reported that ice being served at a Beijing KFC outlet had 13 times as much bacteria as toilet bowl water and was 20 times over the national limit. Its rival McDonald’s (NYSE: MCD) ice was also above the national limit but was not as bad as Yum!

The report has been shared on Chinese social media sites several hundreds of thousands of times. However, I believe that the report is just a temporary setback since it is based on a single ice cube being served in just one of Yum Brands’ nearly 6,000 outlets. Furthermore, this news is actually minuscule compared to the massive food safety issues Yum! has faced in China in the last 10 months.

Competitors

Meanwhile, McDonald’s has also released its quarterly results just a few days ago that were a disappointment, as its revenues and income trailed market’s expectations. Sales were $7.1 billion, which translated into an EPS of $1.38, below estimates of $1.40. Moreover, the company has also stated that the sluggish economic environment will continue to hurt McDonald’s throughout the current year.

The company’s current strategy is to lure customers with cheaper meals such as the Dollar Menu or the Combo meals as its global same store sales rose by just 1%. With increasing competition in the industry with Yum! Brands’ $1 menu at Taco Bell and Burger King’s (NYSE: BKW) smoothies and no significant increase in purchasing power, McDonald’s shares will remain under pressure throughout 2013.

On the other hand, Burger King is now looking much more attractive as it tries to turn its business model entirely franchise based (similar to McDonald’s, which owns just 19% of its outlets), particularly in the Asia Pacific. The company has now got a new CEO Daniel Schwartz, who has been responsible for driving the company’s expansion in the international markets. With Schwartz at the top, I believe that Burger King will become more aggressive in increasing its international footprint.

The company is eying expansion in Vietnam as McDonald’s is also looking to enter into this lucrative market in early 2014. Next year, the company is planning to take its bigger rivals McDonald’s and Yum Brands’ head-on in South Africa by opening 12 new restaurants to tap into the country’s growing middle class. The new ‘BKDelivers’ initiative is also a good move towards increasing the delivery sales. Therefore, I am bullish on Burger King.

Conclusion: positive outlook

Yum! Brands is a very strong player in the emerging markets. Although it currently has little operations in India, from where it gets nearly 1% of its sales, it is certainly a promising market with enormous potential.

The current pattern of improvements in China’s same store sales indicates that Yum! Brands could produce a positive number in the final months of the current year, which will be followed by significant improvements in 2014. So far, its shares have trailed behind the S&P 500 ETF (SPY), but I believe that it will have outperformed the market by the time it starts hitting positive numbers.

The company has effectively managed the poultry scandal, and despite the slowdown in China, it has remained undeterred and continues to open more restaurants. This year alone, it will open more than 700 new KFCs in the country. The overall long term outlook of the firm is positive.

Yum! Brands’ shares are a little more expensive than McDonald’s at the moment since they are trading at higher multiples of trailing twelve months and current full year’s earnings estimates. However, they are trading just 2.5 times its annual sales as opposed to McDonald’s, which is trading 3.5 times. Yum! Brands also generates a solid return on equity of 60%, which is well above the industry’s average of ~14%. 

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Sarfaraz Khan has no position in any stocks mentioned. The Motley Fool recommends Burger King Worldwide and McDonald's. The Motley Fool owns shares of 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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