Time to Buy This Restaurant Chain

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

Poultry issues in China, a horse-meat scandal in Europe, and an avian flu outbreak have been the core reasons behind a lackluster year (2013) for Yum! Brands (NYSE: YUM). However, the recent earnings release by Yum! depicts that the worst is behind the company. Yum! reported a June sales decline of 12.2% less than the analysts’ estimates, showing that the fast-food giant is slowly and steadily heading in the right direction. But the big question remains the same: When will the company start to mint significant profits once again?

Yum! Brands earnings

In the second quarter, Yum! posted a 10% decline in its June sales – a far smaller drop than in May. The company’s most important unit, China, would report its June sales in the third quarter. In the month of May, Yum!’s sales in China fell by 19%. KFC's same store sales in China were down 13% in June versus 25% in May and 36% in April.

According to CEO David Novak, “China sales are recovering as expected. The extensive media surrounding avian flu in China has subsided and same-store sales at KFC are clearly improving”. He further added, “As KFC sales continue to recover, we expect to have solid momentum in China heading into 2014”.

In the second quarter, Yum! posted earnings of $281 million, or 61 cents a share, compared to $331 million, or 69 cents a share, last year.

Going forward

As the Chinese poultry issue (small quantities of antibiotics were found in KFC chicken) and the horse meat scandal have almost ended, things start to look better for the food giant. In the third quarter of 2013, analysts expect Yum! to earn 95 cents per share on sales of $3.60 billion. For the full year, analysts’ estimates stand at $3.08 a share on $13.50 billion sales.

Valuation

Yum! is trading at a forward P/E (1yr) of 18.9 and has a PEG of 2.15. It’s yielding a dividend of 1.80% and a PEGY of 1.84. Using the food industry’s forward P/E (1yr) of 21.5, I would value Yum! Brands as follows:

Using 2014 consensus estimates, I value Yum! at $81. This reflects that it’s an undervalued stock, having an upside potential of more than 14%, making it a great buy at this stage.

Food industry’s major players

Sales at the world's biggest hamburger chain, McDonald's (NYSE: MCD), grew 2.6% during the month of May. The company's new value-priced meals and late night-breakfasts were the chief contributors behind this sales increase. Sales were up 2.4% in the U.S, 2% in Europe and 0.9% in Middle East and Africa (APMEA) region. May turned out to be a far better month for the company as same-store sales had dipped 0.6% in April.

McDonald’s is trading at a forward P/E (1yr) of 16.30 and is yielding a dividend of 3.10%. It has a PEG of 2.10 and a PEGY of 1.56. This low PEGY makes McDonald's slightly more undervalued than Yum! Brands. Using 2014 earnings estimates, I value McDonald’s at $117, which shows it’s undervalued by almost 15%. Adding its dividend yield into this gives us a total return of more than 18%, making McDonald’s one of the best buys in the food industry.

On the other hand, Burger King’s (NYSE: BKW) new special menus and variety deals have shown a lot of promise during the last couple of months. In an effort to compete in a much more competitive food industry, the company has plans of expanding its home delivery services in the U.S. Though Burger King is doing pretty well in the market, its stock doesn't seem that attractive at this stage. A high forward P/E (1yr) of 21.66 makes it an expensive buy in the industry. A meager dividend of 1.20%, plus, a mean recommendation of 2.8 on the sell side shows that this may not be as attractive as McDonald’s or Yum! Brands. Hence, I remain neutral on Burger King.

Conclusion

As China comprises more than half of Yum!’s business, the Chinese market is of foremost importance to the company. With Chinese same-store sales improving consistently over the last three months, the next quarter should show a significant improvement of earnings. Having said this, small traces of the avian flu still remain in China, which means that the food industry needs more time before people start consuming chicken like they did before. Therefore, Yum!’s sales aren't expected to turn into positive figures until the last quarter.

On the July 12, 2013, Yum!’s shares closed at $70.64. This low price makes Yum! a great buy at this stage. As Yum!’s profits can’t go lower than they did in the first half of 2013, it’s the best time to buy it and cash in on substantial returns. In short, buy Yum! Brands for an upside of 14%.

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Waqar Saif 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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