2023-03-23 16:17:27 ET
Summary
- Yum! Brands is a global QSR company that operates and franchises restaurants. The company is divided into four segments: KFC, Taco Bell, Pizza Hut, and The Habit Burger Grill.
- Yum! is facing some headwinds from healthy eating trends and greater consumer choice through delivery apps but has not seen this impact growth.
- Yum!'s financial performance has been impressive, driven by technological improvements and de-risking through re-franchising.
- Yum!'s capital position suggests dividend/BB will be cut at some point in the next 24-36 months.
- At Yum!'s current valuation, we cannot see any upside.
Investment thesis
Yum! owns some of the most recognizable brands in any industry. As a franchise-led business, the company looks to be a low-risk bet on the status quo. Yum! is able to take a share of the profits and even recharge its admin spend, without taking any of the capital risk. This is highly attractive for investors.
Our objective is to assess how things are changing in the restaurant industry and how Yum! has developed as a company in the last few years. We will conclude with a view on whether the company's premium valuation is justified.
Company description
Yum! Brands, Inc. ( YUM ) is a global quick-service restaurant company that operates and franchises various restaurants worldwide. The company is divided into four segments: KFC, Taco Bell, Pizza Hut, and The Habit Burger Grill. Yum!'s brands primarily target the fast-food segment of the market.
Yum! brands do not operate the large majority of its locations, with 98% of its global footprint being franchised ( Source: Yum! Investor Day report ). For this reason, investors should not look at this business as an asset-heavy operation but rather as a services business that takes a slice of each location's success.
Yum! boasts an impressive cohort of brands, which allows the business to be the largest restaurant company in the world.
Share price
Yum!'s share price has trended positively over the last decade, gaining over 150%. This has been driven by attractive shareholder distributions and strong profitability. Like many others in the sector, the company experienced a sharp decline during COVID-19 but saw a quick bounce back into 2021 as post-lockdown demand soured.
Shift toward healthy eating
Consumers are becoming more health-conscious and are seeking healthier diets as part of a cleaner way of living, particularly in the West. This looks to be beyond a trend, with Governments and social movements looking to change the way people think about food. This has contributed to a softening in demand for unhealthy fast food. Yum!'s brands are very much in this space, with its two largest companies being KFC and Pizza Hut. Brands that have done well in response to this are those who have been able to introduce healthier options into their menu. Nevertheless, it is difficult to shake the unhealthy image many of these brands come with. Take KFC for example, if I had to guess they would have nothing remotely healthy on their menu as they are known famously for fried chicken. Looking at the menu, the following can be found at the bottom. With little social media advertising to promote this, it feels like a low-effort way of having a healthier option.
KFC healthier options (KFC)
Our view is that this shift in consumer spending will continue, pressuring Yum!'s brands to innovate beyond just having a healthier option.
Delivery and takeout
The COVID-19 pandemic has accelerated the development of the delivery industry as consumers appreciate the optionality of receiving food at home which they would otherwise have to dine in for. This trend is expected to continue as these delivery apps continue their marketing push, and we see the rise of Ghost Kitchens. Our view is that this is damaging for Yum!. The reason is that the historical consumer behavior was to buy from a handful of options of which they were aware. For this reason, the large players such as KFC and McDonald's ( MCD ) were highly successful, with marketing being incredibly important, as well as geographical reach. Things have begun to change, with the delivery apps controlling consumers' behavior. This is because consumers can now scroll through hundreds of restaurants, giving them greater choices and the ability to compare. Many brands, such as Chipotle ( CMG ) and Wingstop ( WING ) have seen rapid growth driven by this model. This has contributed to fewer individuals defaulting to Pizza Hut for a Pizza for example, when they can now look at 10s of options, allowing for pricing among other things to be compared.
We should appreciate that Yum! has not stood still during these technological developments, investing heavily in its digital customer offering. This has been driving growth for Yum!'s brands despite the greater competition. The following illustrates the transition from in-store sales to digital sales.
One thing we should also factor in is that many of these delivery companies are loss-making and heading into weaker economic conditions. This could contribute to the hiking of fees on the platform, encouraging consumers to once again go directly to brands. As the above illustrates, Yum! has done a fantastic job of investing in their digital offering, such as the click & collect segment.
Our view is that the net impact on the company long-term is inconclusive currently. They are certainly facing greater competition but so far, the company has been able to drive growth nonetheless.
Digital investment
As a mature business, expecting substantial growth through customer acquisition is optimistic. What we have seen is that many large food businesses are investing in technological capabilities, to make operational gains and improve ticket prices. The following illustrates Yum!'s initiatives.
Yum! technological capabilities (Yum!)
This is a necessity for brands, as it is driving accretive gains to existing sales. Looking long-term, this will become more greatly beneficial as more of the purchasing process becomes automated, reducing the need for human input.
A simple example of this is digital marketing, which has contributed to greater customer conversion compared to historically successful channels.
Pizza Hut UK gains (Yum! Brands)
We can see this contributing gradually to improving margins over the next few years, with other businesses in this space seeing similar gains.
Financial analysis
YUM! Financials (TIKR Terminal)
Presented above is Yum!'s financial performance following the spin-off of its Chinese operations.
Revenue has grown at a rate of less than 1%, driven primarily by the reduction of company-owned locations and the offsetting increase in franchised locations. Following the spin-off of their Chinese operations, the decision was made to reduce their company-owned locations until they reached <2%. This is observed between FY14 and FY19. Our view is that the franchise growth is quite attractive, remaining very consistent across the period.
In addition to this, the company has achieved improving margins across the period, although they have seen a dip below Yum!'s peak FY19 level. This has been driven by greater administrative costs, likely driven by the current inflationary pressures we are currently experiencing. Margins have been able to improve consistently as Yum! reduces its ownership activities in exchange for greater franchises. This will likely stabilize at a slightly higher level, as the company has reached its 2%/98% target.
In combination with an FCF margin of 16%, the company's profitability profile is highly attractive.
Moving onto the balance sheet, the transition toward 98% franchises can be seen in the company's ROA, which has increased from 11% to 23%. Although we did not question the strategic choice, it was certainly the correct one.
Our only issue with the business is its capital allocation. Management has aggressively rewarded shareholders through dividends and buybacks, funding much of this through debt. Yum!'s net debt balance has increased at a rate of 20%, leaving its ND/EBITDA ratio at 5x. For most businesses, this would be crippling. The nature of franchising allows it to be bearable. S&P's credit rating for Yum! is a BB+, reflecting a degree of speculation. The problem for prospective investors is that the company cannot sustain much more debt with an EBIT/Interest ratio of 4x, meaning we could see a reduction in distributions. Seeking Alpha's dividend grades have all been noticeably downgraded following the most recent annual results. From a financial perspective, this looks like a ship that's sailed.
Seeking Alpha's credit rating (SA)
Outlook
Wall St. outlook (TIKR Terminal)
Presented above is the Wall St. consensus view of the business.
Analysts are seemingly very bullish on the coming 5 years, suggesting revenue can grow at a greater rate than historically achieved. We find it difficult to justify a level beyond 5%, especially if economic slowing contributes to softening sales initially. This looks to be based on aggressive assumptions around improving ticket prices, the evidence for which is lacking.
Further, analysts are of the belief that margins will continue to improve slightly in the coming years. We concur with this view, as technological advancements have already shown the ability to make noticeable improvements in margins.
Valuation
Yum! valuation (Seeking Alpha)
Yum!'s valuation reflects its current position in the market. The company is trading at a sharp premium to its peers, with an over 100% premium to the average sector EBITDA multiple. To an extent, investors are receiving what they are paying for. Yum! is the leading company in sales and can generate significant amounts of cash to distribute to shareholders. On the other hand, the company is seeing its debt position deteriorate to an extent that it must rain in distributions. To justify such a premium, our view is that the company should not be facing any material issues.
Final thoughts
Yum! is a market-leading business that is facing some headwinds but from a position of strength. Said position has allowed the business to achieve continued growth alongside the current market trends while de-risking the business and achieving greater profits. Realistically, the company will be able to maintain healthy growth long-term, although competition will stop this from reaching >5% in our view. Despite this and the improving profitability, we struggle to see value for investors at the current share price. When the day comes that dividends/BBs need to be reduced, the share price will likely quickly adjust to the news, representing what could be a buy opportunity. Until then, we consider this quality business a hold.
For further details see:
Yum!: Too Expensive From Attractive Financials