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Yum! Brands’ Fourth-Quarter Earnings Preview

publication date: Feb 4, 2015
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author/source: Valuentum Analysts

Yum! Brands reports after the bell today. Watch Valuentum’s President Brian Nelson on CNBCAsia at 5:40CT.

If 16%+ comparable-store sales growth during any given period can ever be described as such, Chipotle (CMG) dropped the ball during its calendar fourth quarter. The fast-casual burrito maker’s shares are facing pressure as a result of management’s overly conservative comp guidance of low-to-mid-single digit growth for 2015, as if we haven’t seen this before. Chipotle sets the bar low and then hurdles over it like an Olympic high-jumper. McDonald’s (MCD), on the other hand, is in a world of hurt, and with CEO Don Thompson’s retirement, the brand has been shaken to the core as it struggles to connect with millennials. Investors in the Golden Arches are still in the denial stage, and shares aren’t cheap.

Will Chipotle’s ongoing strength hurt Yum! Brands’ (YUM) Taco Bell? Is McDonald’s performance foretelling of difficult times at KFC and Pizza Hut in the US? What about China (FXI) and its 7.4% pace of economic expansion in 2014, the slowest pace in a quarter-century? Will $2-per-gallon gas be a huge catalyst?

Auto makers including Ford (F) and GM (GM) are literally firing on all cylinders thanks to plummeting prices at the gas pump, but frankly the impact from lower gas prices has been mixed across our coverage. At the high end of consumer spending, Tiffany (TIF) reported that holiday comparable store-sales fell 4%, and on February 4, Polo Ralph Lauren (RL) missed top and bottom-line expectations. The results of both firms were impacted by currency headwinds, and while we don’t view currency shifts as material to the calculation of long-term intrinsic value, we’re paying close attention to them. We wouldn’t expect the high-end ultra-luxury and aspirational players to see much of a benefit from plunging prices at the pump because their core customer demographic is already quite well-off from a financial standpoint, and any bump from a lower gas bill is largely negligible. This is why we don’t view falling gas prices as a catalyst for high-end, non-durable, status-reinforcing consumer goods.

However, the bill at the pump will have a big impact on the dollar stores and Walmart (WMT), where a customer’s budget is extremely sensitive to what they pay to get from point A to point B. Fred’s (FRED) January same-store sales improved 4%+, for example. If it now costs $20 less to fill up the tank every week, that’s an incremental $20 that will fall into the hands of the dollar-store operations, which serve customers primarily in the low- and middle-income brackets. In fact, more than a third of the discount-retailer industry’s customers live in households that earn less than $20,000 a year. The percentage jump in their discretionary income due to plunging energy costs is significantly larger than that of the rich and ultra-rich, which fuel the brand portfolios of Richemont (CFRUY) and Louis Vuitton (LVMH), for example. 

But what about fast food? If McDonald’s is any indication, Yum! Brands is in for a very difficult fourth-quarter report and 2015, though even a poor showing may be improvement over a 2014 that was mired in meat sourcing scandals and sub-par results in its China division. Global comparable sales fell ~1% at McDonald’s in its fourth quarter, and $2 gas did little to help. In the US, comparable sales dropped almost 2%, and its Asia sales continue to be hurt from supplier issues in China and Japan. McDonald’s is working hard to reinvent itself, and the executive suite is doing all that it can to reconnect with millennials to offset the growing pressure from upscale fast-casual establishments from Chipotle and Panera (PNRA) to up-and-coming burger joints such as Habit (HABT) and Shake Shack (SHAK). McDonald’s is trying a Create Your Taste sandwich-customization platform, but this may just add complexity. Clearly, the Golden Arches is running out of ideas.

The fast food market has never been more competitive, and millennials are opting for fast-casual items. The success of companies such as Noodles (NDLS) and one of the greatest growth stories-to-be Zoe’s Kitchen (ZOES) epitomizes the trend toward this segment. Pricing pressure from the likes of Burger King (QSR), which is selling 10 nuggets for just a $1.49 is hurting everyone, especially McDonald’s. Yum! Brands’ KFC is losing the battle to Chik-fil-A in the US, and its efforts to right the ship in China have yet to completely pan out.

We’re also not sure of the conviction of Yum! Brands’ management in new concepts from Bahn Shop (Vietnamese) and Super Chix (chicken sandwich concept) to US Taco Co and Urban Taproom (fast-casual tacos). Why it isn’t also pursuing a fast-casual pizza operation to capitalize on its industry experience with Pizza Hut we do not know. Fast-casual pizza will be a huge theme in 2015 and beyond, with hundreds of operators entering the fray. Buffalo Wild Wings’ (BWLD) Pizza Rev may end up as the winner, though there appears to be room for quite a few players. Pizza is a good business, especially for the franchisers.

According to Black Box Intelligence, restaurant same-store sales in the fourth-quarter rose at the fastest pace in six years. However, the latest read on Yum! Brands, as recently as December 9, was that China same-store sales aren’t recovering as fast as had hoped. 2014 earnings-per-share growth is now expected to be in the mid-single-digits, and 2015 expansion is targeted at 10%+. In 2014, management had been looking for earnings per share expansion of at least 20% growth, revealing how the Shanghai Husi scandal stopped the recovery in its tracks (earnings per share fell 13% in 2013 due primarily to avian flu concerns). In the fourth-quarter report, we wouldn’t expect the executive suite to tweak 2015 targets so early in the year. Unfortunately, there’s still a lot that can go wrong.

As with its global peer McDonald’s, Yum! Brands has a fantastic and recognizable brand name and tremendous free cash flow generation to fund the sustainability of its dividend (Yum’s Dividend Cushion ratio is close to 2). The firm’s top priority is the turnaround in China, and the largest delta to profit growth will come from a recovery in that region. Though its reputation has been tarnished to a degree, customers still trust the big 3: KFC, Pizza Hut and Taco Bell. “If KFC food is not safe, then nothing is safe in China.” – Focus Group Consensus (December 11, 2014, Yum! Brands’ Analyst Meeting Presentation).

Yum! Brands is one of the best, if not the best, restaurant growth story in China. There are 57 Yum! restaurants per million people in the US and only 2 Yum! restaurants per million people in the largest 10 emerging markets. In China, it has the opportunity to triple the number of KFC and Pizza Hut units from 4,800+ and 1,300+, respectively. Taco Bell’s breakfast initiatives are off to a great start, and the company is looking to double sales at Taco Bell by 2022. Digital initiatives at Pizza Hut are also helping sustain the brand in the face of competition from Domino’s (DPZ) and Papa John’s (PZZA). Clearly, the runway for expansion and reinvention is long. It’s up to management to execute.

The challenge for investors is that Yum! Brands’ growth story is well-documented. The bar is set high. We value the company’s shares at $68 each. The restaurant reports after the bell today.


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