Yum!'s Growth Opportunity

In this article, let's take a look at Yum! Brands Inc. (YUM, Financial), a $31.85 billion market cap company, which operates, franchises, or licenses the largest number of fast food restaurants in the world, with more than 40,000 units in over 125 countries, including the KFC, Pizza Hut and Taco Bell chains.

Growth opportunity

The company has over 6,400 restaurants in China and about 40% of the firm's operating income comes from this country. This country has solid drivers like the well-established distribution infrastructure and local site development teams.

Trying to predict the future growth in emerging markets, we think about favorable disposable income trends, urbanization, and young populations are all drivers for growth.

The most important risk in this industry is the rivalry among restaurants, which is particularly increasing in the past years. As the industry is quite mature, companies must fight each other for maintaining or increasing market share.

Dividend and share repurchase

Yum! has an attractive dividend policy showing its commitment to return cash to investors in the form of dividends as it generates healthy cash flow on a regular basis. Both programs have returned over $2.1 billion and $6.7 billion, respectively, to shareholders since 2004.

The current dividend yield is 2.1%, which is quite good to protect the purchasing power, especially considering the consistency of track-record dividends payments and favorable expectations regarding dividend growth and share repurchases for the next years.

Revenues, margins and profitability

Looking at profitability, revenue declined by 3.24% but earnings per share increased in the most recent quarter compared to the same quarter a year ago ($0.89 vs $0.33). During the past fiscal year, the company reported lower earnings of $2.36 versus $3.37 in the previous year. This year, Wall Street expects an improvement in earnings ($3.22 versus $2.36)

Finally, let´s compare the best measure of performance for a firm's management: the return on equity. The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

The company has a current ROE of 63.92% which is higher than the one exhibit by Darden Restaurantes (DRI, Financial). In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment. So for investors looking those levels or more, Brinker International (EAT, Financial) could be the option. It is very important to understand this metric before investing and it is important to look at the trend in ROE over time.

Relative Valuation

In terms of valuation, the stock sells at a trailing P/E of 22.8x, trading at a discount compared to an average of 31.8x for the industry. To use another metric, its price-to-book ratio of 12.7x indicates a premium versus the industry average of 3.57x while the price-to-sales ratio of 2.5x is above the industry average of 1.27x.

As we can see in the next chart, the stock price has an upward trend in the five-year period. If you had invested $10,000 five years ago, today you could have $22,523, which represents a 17.7% compound annual growth rate (CAGR).

Final comment

The profitability of the companies is driven by the ability to reach new markets and meet customer needs. We believe operations in China are a key driver for growth with an established distribution infrastructure. We all know that rivalry among quick-service restaurants is fierce, but we believe in the firm's ability to continue growing.

Further, the PE relative valuation and the return on equity that significantly exceeds the industry average make me feel bullish on this stock. I think the stock is trading below its intrinsic value, but in a next article we can calculate it.

Hedge fund gurus like John Burbank (Trades, Portfolio) and Jeremy Grantham (Trades, Portfolio) added this stock to their portfolios in the second quarter of 2014.

Disclosure: Omar Venerio holds no position in any stocks mentioned