Yum Brands , the way to invest in China
Some people may argue that China's economy is overheating and its growth could be affected by higher food and wage inflation plus a real estate bubble waiting to burst. I think that could happen someday in the future but China is a secular growth story, driven by a huge consumer population growth. The key is finding how to invest in that trend the most intelligent way.
I think that one of the most conservative ways to play the China trend comes from YUM. Yum is exposed not only to the growth of China but also to other emerging countries such as India, Russia, South Africa and Brazil. In addition, Yum has a solid presence in the US, wich means that a recovery there could impact positively to the bottom line. I will detail some bullets I have been finding in my research:
Superb management team: Yum! CEO David Novak has proven results and great leadership, showing a great track record of both yearly EPS and ROIC growth of 20%+ since assumption in 2001. It is a truly shareholder oriented management team, increasing diviend almost every year and announcing considerable share buybacks. For example, Yum authorized a record share buyback of 750m until Jul 2012 (that will reduce the shares outstanding from 469M to 453M assuming $50 stock cost). By these measures, Yum is positioned in the top 15% of SP&500 companies for shareholder payout.
Predictable Business: Yum! has a consistent and predictable business that generated nine consecutive years of double digit EPS growth. Its revenue and net profit volatility is minimal (for example, sales decreased only 3% in 2008-2009 global crisis and EPS grew 10% in that period). I do not know many emerging market businesses that have the quality of earnings and track record of Yum. If there is an inflationary scenario margins could erase some basis points down (Management told in the last earnings release that they won't come below 20%) but powerful brands and big established businesses will defend better.
Competitive moat in China: Yum has been operating in China from 1987, it has a local management team (lead by Sam Su, who is a legend in China) and the most recognizable food brand and stores. Yum also owns and operates a food distribution system in China that is truly unique. No restaurant company has the tenured executive team, operational excellence and country-wide distribution system that Yum already has. In other words, Yum can provide a similar service as competitors but at the same time outperform them in margins due to economies of scale and the power and scalability of Yum Brands. That is what Warren Buffett calls "competitive moat".
Exposition to high growth markets: China is the fastest economy in the world with a consuming class population of 450 millions that is expected to triple by 2020. Emerging markets seems to be on the ground floor of growth, with a consuming class population of 1.1B in 2010 and a projection to be around 2.0B by 2020.
Big projected business growth: Yum plans to grow from 3.054 KFC stores in China to 15.000, the same number Mc Donald's has in the US. Also it plans to grow its number of Pizza Hut stores from 479 to 2.000 and Pizza Hut delivery services from 106 units to 5.000. In addition, Yum is starting to build three powerful brands in India, a market that could become as big as China in the future. For example, Yum has 2.7 stores per million population in China, 1.7 in the rest of emerging markets and just 0.2 in India. If that rate is incresed to 1, the incremental growth could be huge.
Also, Yum is getting scale in Europe, where it lags Mc Donads in units. For example, Yum just started to make business in France and Germany, countries where Mc Donalds has 2.521 units and Yum has just 160. So the business potential is there.
Also it is expanding in Russia, Brazil and Africa. Yum has a total of 438 units between India, Vietnam, Russia, Pakistan and Africa ex South Africa. They target to grow to 3.750 in the next 10 years.
Taco Bell opportunity in the US: This brand generates 60% of profits in the US division and is a category leader in value with the strongest margins among Pizza Hut and KFC. Yum is starting to leverage assets in Taco bell by offering breakfast and new beverages. Also, Yum has an ambitious goal of getting close to 8.000 Taco Bells in the US from 5.200. For example, Burger King in the US has 7.300 stores. Management plans to get near that number.
Valuation: I run a DCF model assuming 10% sales growth for the next 5 years and then gradually slowing down to a perpetual growth of 2%. I also reduced slightly the net profit margin and assumed it stays around 10-11% in the future. Using a WACC of 9% I got to a equity valuation of $54, which is similar to the current price.
I also divided the business by three areas: China, which generates EBITDA of 700M and assigned a multiple of 20x. Franshise and Licensee fees business that generate EBITDA of 1B and assigend a multiple of 12x and company stores, a low growth business that generates EBITDA of 700M with a multiple of 6x. That number brought me to a $60 valuation.
Also, if we take the current EPS of 2.34 and assume that it grows 10% in the next 5 years to 3.76 using a P/E multiple of 16x (average in restaurants), YUM could have a price of $60. Using the current P/E of 20x (which was the average P/E in the last 5 years) the price could be from $70-75
Conculsion: Yum is not trading with a superb margin of safety valuation but has many positives and is currently the stock I find most comfortable to play the emerging China theme. The stock is not expensive and could be very interesting for a long term investor.