2023-12-05 04:35:29 ET
Summary
- KFC's international operations and Taco Bell continue to lead Yum Brands in a positive overall direction, notwithstanding domestic weakness in KFC and Pizza Hut.
- Q3 sales growth was solid, while net unit count growth appears unaffected by the weakening macro environment.
- These shares still offer attractive total returns potential despite a nominally rich 24x EPS multiple.
Yum Brands ( YUM ) stock has lagged since I first covered it back in mid-2022, with a circa 9.5% total return representing underperformance versus the S&P 500 as well as peers McDonald's ( MCD ) and Restaurant Brands International ( QSR ). Despite trailing recently, Yum's prospects remain largely unchanged from last time out, with Taco Bell looking strong at home and banner brand KFC continuing to report healthy growth abroad. While Yum has its chronic weak links in domestic KFC and Pizza Hut, long-term growth prospects are still attractive overall and management remains capable of aggressively returning cash to shareholders. As a result, I remain bullish despite recent underperformance.
Like recently covered Restaurant Brands, Yum is a somewhat mixed bag in terms of brand strength. KFC is the company's largest contributor to group earnings, generating around $975 million of the firm's $2.1 billion year-to-date operating profit before corporate expenses. However, the KFC brand itself is not especially strong domestically. Restaurant-level operating margin was 13.6% for the company-operated units through Q3, which after a 4-5% royalty rate roughly maps to around 9% or so for franchised outlets. US KFC system sales represent around 15% of the brand's global tally, so call it around $5.2 billion annualized in total. Given 3,900 U.S. restaurants as of Q3, implied average unit volumes are somewhere in the $1.3 million region. That would mean U.S. franchisees are probably earning around $120,000 in EBITDA per unit on average on a 9% post-royalty margin. Given the cost to open up a new restaurant, which includes land acquisition, building costs and so on, is in the seven-figure area, it is unlikely that annual cash-on-cash returns exceed a low-teens level. As a result, franchisees have little reason to expand. That is why the domestic unit count has actually been falling, with U.S. KFC units down 0.7% year-to-date and by around 5% over the past five years.
Pizza Hut is the other big weak spot in the company's portfolio. Pizza Hut's domestic AUV is only around $0.8 million, which given the inherent fixed cost leverage in restaurants points to very poor unit economics. Unsurprisingly, Pizza Hut's domestic unit count has fallen by around 12% over the past five years, albeit 0.3% year-to-date growth points to signs of stabilization. Poor domestic performance has at least been offset by growth outside the U.S., with global unit count up around 15% on 2018 levels and 9M'23 global system sales 10% higher on the same basis.
Taco Bell and KFC ex-U.S. are the company's strongest assets. In terms of the latter, chicken-themed concepts in general are highly portable and KFC has emerged as the global leader. The ex-U.S. unit count has been expanding at a circa 7% annualized clip in recent years, with positive same-store sales growth leading to an even higher rate of system sales growth. As a result, Q3 KFC system sales now stand at circa $8.6 billion, up around 30% over the past five years.
KFC Global System Sales
Data Source: Yum Brands Quarterly Earnings Supplements
Turning to Taco Bell ($660 million in year-to-date operating profit), restaurant-level margins clocked in at a very healthy 23.8% in Q3, indicating strong economics for franchisees even after subtracting the usual mid-single-digit royalty rate. Unsurprisingly given that, Taco Bell's domestic unit tally is actually still increasing at a fair clip, with the 7,279 U.S. unit count up around 4% since my initial piece in mid-2022.
Now, one thing worth noting is that Mexican-themed concepts typically don't travel as well as chicken, burger, and pizza ones do outside of the U.S. That means the global ceiling for Taco Bell is probably considerably below that of, say, KFC or Pizza Hut. Even so, management's long-term ambition of 2,500 international Taco Bell units would be good for around 30% total unit growth, with the firm reporting 8,385 units globally as of Q3. Remember Taco Bell is still reporting positive net openings in the U.S., too, with the company opening 81 net units year-to-date in the country.
Those two brands continue to drive good overall growth for the company. System sales were up 11% year-on-year through Q3 in currency neutral terms, with KFC up 14% and Taco Bell up 10%. Encouragingly, same-store sales growth remains resilient despite a toughening outlook for consumer finances. KFC's same-store sales growth was 6% in Q3, decreasing sequentially but still resilient, albeit flat performance in the U.S. looks pretty weak. Taco Bell's Q3 performance looks even better, with 8% year-on-year same-store sales growth actually representing an acceleration in Q1 and Q2.
One other positive thing to note about Yum is that net unit growth continues to come in strong. I commented in pieces covering Restaurant Brands (see earlier link) and Papa John's ( PZZA ) that unit growth had decelerated below their respective longer-term targets. Now, given the backdrop of higher interest rates and deteriorating consumer finances, I am happy to give these firms a pass. The fact is that with funding costs sharply higher and consumers potentially cutting back on discretionary spending, now might not be the best time to open a new restaurant. Despite this, Yum reported a total unit count of 57,274 at the end of Q3, which was 6.1% higher than the year-ago period and comfortably above its 5% long-term growth target.
Yum Brands Global Unit Count
Data Source: Yum Brands Quarterly Earnings Supplements
On the subject of long-term growth, management contends that two-thirds of the world's KFCs have yet to be built. That would imply a doubling of the total Yum estate just from KFC alone. I expect a more modest contribution from Taco Bell and Pizza Hut, but the fact remains the company has many years of its 5% annualized target growth ahead of it. Along with a low single-digit contribution from same-store sales growth, that should be good for around 7-8% annualized system sales growth.
Most of Yum's estate is franchised and associated revenue typically comes with very high margins. The company reported $1.3 billion in franchise and property revenues through Q3, with only $57 million in franchise and property expenses. As that revenue grows with system sales, group-wide profit margins should expand, so earnings growth will probably run at an even higher rate than system sales growth.
Given that, a 24x EPS multiple doesn't look aggressive to me. With limited CapEx requirements, Yum can distribute most of the implied earnings yield straight to shareholders, which partly explains how the company has aggressively reduced its share count over the years:
What will constrain things a little is leverage, with net debt standing at roughly 5x EBITDA. That is quite high, though I would note that over 80% of its debt is fixed rate and the company's cash flows are more stable than your 'average' firm. The majority of its debt isn't due in the next five years either, so refinancing risk is not really something I would be concerned about.
Yum stock trades for $124.67 at time of writing. With the company in a position to grow earnings at a double-digit CAGR and return most of those earnings via dividends and buybacks, this stock still has solid double-digit annualized returns potential, and I would be a buyer of these shares up to around the $140-145 mark.
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Yum Brands: KFC International And Taco Bell Continue To Impress