Friday, 9 October 2015

It is time to buy Yum! Brands

My conclusion from my last major Yum! Brands write-up just under three months ago (link here) was that:

'Despite the activist chat noted above the reality is that a China split-out is not going to happen shortly. Given this - and the positive longer-term dynamics - holding on is fine but at least a return to the US$70s is going to be required to get more excited about the stock.  Frankly the risk of a bit of sluggishness associated with the Chinese bounceback could also be apparent. So for new money no need to rush today'

As an observation this has kind of worked well as the share did fade into the US$70s / early US$80s inthe couple of month immediately after the call...but in recent days the Yum! Brands stock has plunged to around 52 week lows:

So what went wrong?  As Seeking Alpha noted the big challenges were in China where the company makes well over a third of their current overall profitability: 

'Following its FQ3 miss, YUM expects FY15 (ends in early December) EPS growth to be in the low-single digits, below prior guidance of "at least" 10%. Consensus is for EPS to rise 14% to $3.51."[T]he pace of recovery in our China Division is below our expectations," says CEO Greg Creed. Pizza Hut Casual Dining was particularly weak. Yum now expects low-single digit negative FY15 Chinese same-store sales growth, with mid-single digit positive FQ4 growth.China division sales rose 8% Y/Y in FQ3 (year-ago sales were weak on account of the OSI scandal), with units rising 7% and same-store sales 2%...Globally, system sales rose 6%, and restaurant margin 330 bps to 18.2%. KFC Division sales +6% (3% same-store growth); Pizza Hut +2% (1% same-store growth); Taco Bell +7% (4% same-store growth)'

So much then for the hopes of a remunerative China spin-off centred on not only a recovery from historic hygiene scandals but also (as noted here) the structural positive of ongoing convenience and dietary trends in the country: 

Average daily calorie intake in China jumped to 3,074 from 1,863 between 1971 and 2011, as meat consumption increased, says PwC. By 2011, Chinese citizens were on average consuming only 340 calories a day fewer than Britons (who were munching their way through 3,414 calories a day, on average.)

What was fascinating from the conference call comments made by the company that the poor trading was not particularly lacklustre hygiene issues bounceback or structural dietary change centred...but more macro / wrong choice of product oriented: 

China – ‘clearly a macro softening going on…economy still growing, no reason why it should not perform better’

Pizza Hut – less entertaining hitting weekday business.  Said 5* products at 3* prices, think recently 6* for both
’25 points below in September…something we did not see…negative through the end of the year…low single digit negative for the end of the year (for the whole of China)’

‘in today’s volatile environment…it continues to be difficult to forecast sales in China’ 

The Yum! Brands story remains all about China at the margin. New management should help iron out some of the recent mistakes (e.g. pricing) but clearly there is still uncertainty.  The better news is that hopes are now suitably lowered.  As before with China/Yum! anticipating that the theme will eventually kick back in should be the correct view.  In the meantime the observation during the conference call that on new restaurant builds in China have...

 ‘cash paybacks 3-4 years…attractive use of capital…assumes current conditions are temporary’

...provides some support. 
Outside of China KFC remains a solid performer...

...whilst Pizza Hut remains dull in the developed markets...

...and Taco Bell as noted in the above Seeking Alpha extract is continuing to perform strongly.  

To put some numbers on the overall group for FY15 the company should generate operating profits of c. US$2bn and free cash flow of around US$1.6bn putting the company on an EV/ebit multiple of around x19 and a free cash flow yield of around 5.5%.  Clearly there is some recovery element in the numbers and tentatively/prospectively the stock next year (assuming some element of a China rebound) is trading around a x15 EV/ebit multiple.  

Such a valuation is about right given the above strategic profile but tactical challenges/disappointments - and the above mentioned free cash flow (including a 2%+ dividend yield) provides some additional floor support.  

Of course the additional retained optionality is in a formal break-up of the company.  Management were pushed hard on this on the conference call but rebutted all questions in favour of further clarity/comments at the time of the December capital markets day.  A pure China unit and a cash flow generative heavy ex-China part would highlight sum-of-the-part scope. In short the current c. 10% premium to an ideal forward x14 EV/ebit multiple is offset by the potential optionality about the company's capital structure.  This puts the share  in 'buy' territory today.

Buying Yum! Brands today in the mid US$60s with a target of US$80+ on a China turnaround/positive potential structuring of the business feels the right conclusion to me.  Fortunately or unfortunately fast food and related remains a growth area with good cashflows attached to it. 

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