YUM! Brands (YUM) Stock Analysis

OVERVIEW

About YUM!

YUM is the largest quick service restaurant company (QSR) based on the number of locations.  YUM! has over 37,000 locations in 110 countries and territories.  These locations are split through five primary brands: Kentucky Fried Chicken (KFC), Pizza Hut, Taco Bell, Long John Silver’s (LJS), and A&W.

KFC, Pizza Hut, Taco Bell, and Long John Silver’s have the highest market share in their respective categories.  KFC has the largest relative portion of market share with slightly over 40%, which is 3x larger than the next nearest competitor.  Pizza Hut is the market leader in ready-to-eat pizzas with 14% market share.  Taco Bell operates in 20 countries and has 52% market share in its respective category.

In the mid-2000’s, YUM tried to adopt a dual branded approach with many of its stores.  This approach meant combining brands like Taco Bell and Long John Silver’s together in one location.  Since then, the company has abandoned this strategy due to operational issues and a negative response from consumers.

Of YUM’s five brands, the two lowest performing brands are Long John Silver’s and A&W.  Of total locations, these two brands account for slightly more than 4% of the total locations combined.  It was just recently announced that YUM intends to sell these two brands to focus on the other three brands to increase brand perception in the United States and grow these franchises abroad. 

Growth strategy

In its reports to shareholders, YUM management highlights four key strategy objectives:

1.       Build leading brands in China in every signifcant category

2.       Drive aggressive international expansion and build strong brands everywhere

3.       Dramatically improve U.S. brand positions, consistency, and returns

4.       Drive industry leading long-term shareholder and franchisee value

Each of these key tenets relates well to YUM’s future, as YUM sees the key growth opportunities not in the United States, but in emerging market economies like China, India, and Africa.  In my opinion, this is how YUM views itself at the current time.  YUM accepts that the McDonald’s brand is too powerful of a brand in the United States and will accept being number two.  But, China, India, and Africa all have economies with rising incomes, but low per capita QSR’s.  Management intends to challenge McDonald’s in these countries by becoming the McDonald’s of emerging economies, with emphasis on the KFC, Pizza Hut, and Taco Bell brands.

Over the past few years, the perception of the YUM brands in the United States has slipped.  Management has realized this and is working to rebuild the images of these brands.  By shedding lower margin and performing LJS and A&W, management should be able to put more emphasis on these brands in the United States.

Increasing emphasis on these emerging economies is good for shareholders.  These economies will grow at a faster rate than the United States.  In addition, the currencies of these economies should strengthen against the USD making those earnings and cash flow worth more in USD.  This will allow YUM to distribute more to shareholders through either dividends or share buybacks.

Risks to the growth strategy

I identify the following as risks to the growth strategy:

1.       Commodity inflation

2.       Local preferences for core products

3.       Repatriation of cash for “U.S. cash needs”

First, commodity prices have a major impact on gross margins for YUM.  In 2009, YUM saw slight margin expansion as food inflation was down from 2008.  In 2010, there was a general increase in agricultural commodities.  To maintain margins if there is inflation, YUM will need to increase prices and it will be interesting to see how consumers react.

Second, local preferences will be key as the company will face competition from strong U.S. brands like McDonald’s and Starbucks.  The firm will need to continue to build quality franchises overseas that attract local consumers to continue building the brand.

Third, over 60% of cash is generated in internationally for YUM.  YUM will need to pay dividends and fund stock buybacks with USD.  It will be important to see if YUM can continue repatriating cash at local tax rates to fund these programs.  If not, YUM will be forced to either reduce these programs or increase USD borrowings.

Refranchising

Although not explicitly part of the four key strategy objectives, YUM management seems focused on reducing the number of company owned franchises in the United States.  In its 2009 annual report, the firm intends to reduce company owned franchises in the United States from 16% in 2009 to less than 10% by 2011.  Doing this has both advantages and disadvantages for shareholders.

Advantages include more cash for the firm.  First, by refranchising, the firm will receive cash from the sale.  Second, because the firm is no longer responsible for the upkeep of these stores, it will require less cash for capital improvements.  This will have a positive impact on free cash flow.

Disadvantages include franchisees obtaining the proper capital to effectively run the franchises and running the franchises in a matter that YUM would like for them to run them.  Currently, YUM brands have a negative perception in the United States as being dirty stores.  Part of the firm’s strategy is to rebuild brand image in the United States.  Selecting the appropriate franchise owners will be critical.

TOTAL SHAREHOLDER RETURN

From 2005 to 2009, management returned a total of $6.3 billion to shareholders with net income of $4.5 billion.  The $1.8 billion shortfall was made up with increased borrowings.  From 2005 to 2009, total debt increased from $1.9 billion to $3.3 billion.

From a dividend perspective, the management is currently committed to paying out between 35-40% of net income annually each year in dividends.  Management appears committed to having a sustainable dividend policy that includes increases each year.  From 2005 to 2009, the dividend payout ratio increased from 16.1% to 33.8%.  From 2007 to 2009, the ratio has never quite hit the 35% minimum target of management.

From 2005 to 2009, the total yearly dividend increased from $0.22 per share to $0.88 per share.  Compounded annually, this is a 38% increase each year. 

From a stock repurchase perspective, management spent a total of $5.1 billion from 2005 to 2009.  An area of concern is the leverage used to employ this program.  From 2005 to 2008 (no stock repurchased in 2009), the stock buyback ratio exceeded 100% of net income each year ranging from 119% to 169% of net income.  This program has reduced the number of basic shares outstanding from 572 million to 471 million. 

Has the stock repurchase program increased shareholder value?  Based on 2005 basic shares outstanding, the firm spent a total of $8.88 per share to repurchase stock increasing earnings per share by $0.40, thus a yield of 4.5%.  Although this does not appear high, the market has rewarded YUM with a higher stock price.  Based on the TTM earnings multiple of 15.1 in 2009, the stock repurchase program increased YUM’s per share price by $6.05 (15.1 x 0.40 = $6.05). 

INCOME STATEMENT

Sales growth

From 2005 to 2009, YUM experienced top line sales growth from $9.3 billion to $10.8 billion.  Compounded annually, this is a 3.8% increase each year.

Margins

Although not as high as initially expected, YUM has consistent margins.  From 2004 to 2005, gross margin ranges from 24.4% to 26.8%.  Of the five years, 2009 was the highest year as food costs went down from the previous year.

In addition, both operating and net margin has shown consistency.  Operating margin had a range of 12.3% to 14.7%.  Each year margins increased indicating management is effective in keeping fixed costs flat, so margins can expand on higher sales.  Net margin ranged from 8.15% to 9.88%, with 9.88% margin in 2009.  The increase in net margin is most likely due to more sales being generated overseas.  Since each of these countries has a lower effective tax rate than the United States, each additional dollar earned is taxed at a lower rate.  If YUM has issues repatriating cash and needs to, this number may go down as it will need to pay increased taxes to repatriate the cash.

Total net income vs. net income per share

From 2005 to 2009, net income per share (i.e. basic EPS) increased from $1.33 per share to $2.27 per share.  Compounded annually, this is a 14.3% gain each year.  Total net income increased from $0.8 billion to $1.1 billion.  Compounded annually, this is a 8.9% gain each year.  In other words, 8.9% growth each year is due to higher net income and 5.4% is due to stock repurchase.  For shareholders, it is important to see if this driven by earnings growth or share repurchase. 

BALANCE SHEET

As previously noted, YUM has increased leverage due to help finance stock repurchase.  The $1.8 billion shortfall against net income was made up with increased borrowings.  From 2005 to 2009, total debt increased from $1.9 billion to $3.3 billion.

In addition, the firm remains committed to maintaining its investment grade credit rating.  Currently, YUM has a BBB- equivalent rating from both agencies.  For example, in 2010, YUM issued the lowest “non-financial” bond ever by a BBB- issuer.  Bond investors do not seem concerned by YUM high leverage or large stock repurchase program.

Equity base and return on common equity

Beginning in 2005, YUM began an aggressive stock repurchase program.  Removing AOCI from common equity, the equity base for YUM fluctuated between $0.3 billion and $1.6 billion.  In fact, if AOCI is included, YUM had negative equity in 2008 of (-$0.1) billion. 

Because of this small equity base, return on common equity is higher than average for YUM.  Excluding OCI, return on common equity averaged over 75% for YUM from 2005 to 2009.  In other words, YUM management is extremely effective at allocating capital.

Traditional capital structure ratios

If one were to look at total debt to total assets, this number increased by almost half from 2005 to 2009.  During that time period, total debt to total assets increased from 32.6% to 45.7%.  In 2008, this number peaked at 55%.

Coverage

Based on traditional accounting rules, most investors would fear the large increase in a ratio like total debt to total assets.  The problem with solely looking at traditional metrics is it does not take into account better coverage of debt and interest by free cash flow.  Free cash flow is defined as (operating cash – capital spending).  In other words, it is the amount of cash management has to pay down debt or return to shareholders.

Like the traditional ratios, the coverage ratios have also worsened.  From 2005 to 2009, debt payoff from free cash flow increased from 3.0 to 5.4.  In other words, with the amount of cash flow generated in each of those years, it will take an additional 2.4 years to pay off outstanding debt based on that year’s free cash flow.

In addition, free cash flow interest coverage worsened from.  From 2005 to 2009, free cash flow interest coverage decreased from 4.9 to 3.1.  In other words, in 2005, YUM generated $4.90 in free cash flow for every $1 in interest expense.  In 2009, YUM generated $3.10 in free cash flow for every $1 in interest expense.

Relatively, the coverage metric that worsened the least was the EBIT coverage ratio.  This ratio decreased from 9.1 to 8.2.  In other words, in 2005, YUM generated $9.1 in EBIT for every $1 in interest expense.  In 2009, YUM generated $8.30 in EBIT for every $1 in interest expense. 

RECOMMENDATION

In this analysis, I did not get into valuation of YUM.  After looking at key income statement and balance sheet metrics, I do have some issues with YUM.  First, I believe gross margins should be higher.  I intend to perform further analysis when the 2010 10-K is release to obtain a full year number.  With food inflation starting, I would like to see management’s comments regarding this and what impact, if any, food inflation has had on margins.  Also, I would like to analyze gross margins of competitors like McDonald’s.  Second, I believe the leveraged balance sheet could be an issue for growth.  By issuing a large amount of debt for stock repurchase, YUM is limiting itself to borrow to finance for expansion.  It further increases the need to YUM to have a successful refranchising program.

Expect further analysis and a recommendation at a later date.

I do not own YUM or plan on making an investment in the next 72 hours.  This information is the best information I could obtain or analyze on YUM.