This Fast Food Chain is in for a Difficult Year

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Yum! Brands' (NYSE: YUM) recently reported results missed consensus estimate on the top line, but were a touch better in terms of profit. The quarter has been bad for the company, thanks declining sales in China. In comparison to the same quarter last year revenue decreased by 12.67% to $3.6 billion, and profits dropped 5.34% to $337 million.

The Chinese effect

The company has more than 50% of its operations in China, which currently exposes it to the risk of the chicken conundrum in the country. Yum! has had a strong hold in the fast food business in the country for the last three decades, but things have changed a lot over the last couple of months.

The company has over 5,400 stores in China and until now enjoyed comparatively lower costs in the world’s most populated country that helped it grow its profits over 10% for several years consistently. However, over the last ten years the commercial rental costs have increased three to five times in China, and to add to the troubles landlords are not renewing their leases, forcing the company to shift to undesirable locations.

McDonald’s (NYSE: MCD) and Yum! Brands have enjoyed market leadership in China, but with low barriers to entry many new fast food brands have come into the market. The competition has made the industry unstable and forced the company’s margins to contract. Further, to revive its brand image the company will have to spend handsomely on advertisements, adding to the costs and profits in the near future.

Happy Meal

McDonald’s was also negatively impacted by the chicken issue in China, but still was able to beat the consensus on both top line and bottom line because of its global presence, very much unlike Yum! Brands’ major concentration in China. The company’s comparable store sales had fallen for the first time in Oct. 2012 in the last decade, but refocusing on its “dollar menu” helped the company bounce back, to everyone’s surprise.

McDonald’s is a solid company, but if you are looking for growth it is not the right choice. It is a stable company and has a current dividend yield of 3.40%, which it should grow further as it has done consistently over the past.

The valuation

Yum! Brands trades at a P/E ratio of 19 and Chipotle Mexican Grill (NYSE: CMG) currently has a P/E of over 36. It has a dividend yield of 2.1%, while Chipotle pays no dividend. Yum! Brands' current forward 2013 EV/EBITDA is 11 and is P/E ratio is over 18, while its historical averages for both these statistics have been 9.5 times and 17 times, respectively.

Yum! Brands' current valuations also show that it is trading at a premium, and with increased competition and a contracting foot hold in China that growth may further decline.

Chipotle, on the other hand, is a growth company and it looks to be fairly priced at an EV/EBITDA of 17 times and a forward P/E ratio of over 30 times. Its margins have been reduced recently because of the rising costs of production and expansion policy. The company has opened 123 new stores in the first three quarters this year and has more stores in the pipeline. Chipotle’s high prices on the menu card, which it plans to increase further, and its customer loyalty should widen its margins again.  Furthermore, its catering business has a potential to add more than $200 million to the company’s revenue.

Final words

Yum! Brands has an amazing track record of success, but its current situation has forced the company to lower its guidance for 2013. The top line will remain affected in the next few quarters as the company will take time to rebuild its image in China again. The company is saturated in the U.S. market too, which is evident from the fact it is closing stores in that region. I believe that the company does not have the required growth to support its valuation, and I would be wary in creating long-position in this stock.


tarunbachhawat has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill and McDonald's. The Motley Fool owns shares of Chipotle Mexican Grill and 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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