In one of my last articles of McDonalds, I mentioned how the fast food giant got into trouble in China over a meat safety issue. Well, it seems like the woes of fast food makers is yet to see the daylight as another colossal giant in this space i.e Yum! Brands (YUM, Financial) is facing an investigation on a similar issue. A juggernaut in the quick-service restaurant space with popular brands like KFC and Taco Bell under its belt, Yum! Brands represents an interesting investment story.
Before we go into an analysis of different aspects of Yum!’s investment hypothesis, it is important to discuss its current crisis in China as it is one of the biggest markets for the company hosting over 4,500 KFC stores of its total 14,000, and 1,200 Pizza Hut stores. China and other emerging markets offer major opportunities for the company as there are only an average of two restaurants per million people in the top ten emerging markets, compared to a whopping fifty-eight restaurants per million in the United States. Additionally, disposable income and discretionary spending are both increasing in line with economic growth in these emerging economies. In the second quarter, KFC earned more than 90% of its profits from its international operations in which China was a major contributor. Restaurant margins showed a healthy increase of 6.2% to 16.8%, and operating profits jumped dramatically by 188% to $194 million.
What’s brewing in China?
So it is not difficult to understand the impact of the Chinese markets on Yum!’s revenue but the recent onslaught of negative publicity definitely poses a reasonable challenge. However, it is also to be noted that this is not the first time that the company has entered the troubled waters in China over fresh meat issue. In 2012 and 2013, the fast food giant reeled from one PR disaster to another in China but successfully regained its customer base in a quick span of time as evidenced by the abovementioned numbers.
While the company is facing a crisis in China, the good news for its stakeholders is the increasing importance of Taco Bell in its overall operations. Taco bell has fuelled great innovation in its menu not just by making favourable additions but also with an adept pricing strategy. Few menu additions have been as game-changing as 2012's rollout of Doritos Locos Tacos at Taco Bell. The chain sold 825 million of the tacos served in Doritos-dusted shells through its first two years of availability. The spike in traffic has resulted in positive comps in nine of the past 10 quarters.
Taco Bell’s growing significance
One prominent example of how Taco Bell is serving the tastiest food at affordable prices can be found in the new Taco Bell Dollar Cravings menu which offers over 10 items for $1 each. This is expected to regain some traffic within the age group of 18 to 24 years which had shifted to other options such as Chipotle.
Taco Bell raised the stakes in late March by rolling out a national breakfast menu. The publicity generated by its head-turning Waffle Taco helped Yum! Brands bounce back from the chain's first quarter of negative comps in more than two years during this year's first quarter. Same-store sales in the U.S. inched 2% higher during the second quarter, the first full period of breakfast availability. That may not be much of an uptick for a period given Taco Bell extending its operating hours earlier in the day to grab breakfast traffic, but now the key is to see momentum build as there is definitely a lucrative market to be had in morning commuters.
Valuation and takeaway
Yum! Brands is currently trading at a forward multiple of around 17.7 as compared to an industry average of 20.7 and also, the company’s PEG ratio stands at a low 1.82 in comparison with industry’s average of 2.86. This implies that the company is trading cheap for now and for the opportunities that lie ahead, it is a justified price. Wall Street still expects EPS to come in around $3.56 per share for the full fiscal year, marking year-over-year growth of 20%. For fiscal year 2015, a further growth of 15% to $4.09 per share is expected.
For a company that operates on a scale like Yum! Brands, it is not a cause of worry to face some hurdles in a particular geography. This is because Yum! is eyeing a long-term opportunity in China and a slight aberration in its plans is therefore not a reason to worry. Yum! is also focused on enhancing the customer experience by way of a complete makeover of its restaurants. In addition to design changes at its outlets, KFC has redesigned packaging, included a new menu board, and has improved staff uniforms. Pizza Hut is also doing well, and Yum! plans to expand Pizza Hut to lower-tier cities across the globe, establishing more than 1,200 units in the current fiscal year.
All in all, Yum! Brands represents a lucrative buying opportunity in the long-run and its current valuation provides a good entry point for prospective investors.
