With their strong brands, Yum remains a well-diversified player in the global fast service restaurant industry. Almost all of the company’s brands, which include KFC, Pizza Hut, and Taco Bell occupies the leading market position in their respective territories. In addition, these brands have huge international appeal, which should help the company expand its leadership in China and several other emerging markets. Analysts remain optimistic about Yum’s ability to generate positive economic returns despite competitions globally.
Yum Brands have been a longtime favorite of the investment groups since the company increased EPS by 10%+ per year for the past decade experiencing tremendous growth in emerging markets, where a rapid growth of middle class seems poised to continue to drive sales far into the future. Yum’s strong brands allowed the company to gain distinction globally and are embraced well. In the end of 2011 alone, KFC had 4,708 units in the U.S., and 8,920 units in YRI, including 3,701 units in mainland China. Approximately 79% of the China units, 11% of the YRI units, and 10% of the U.S. units, which are company owned. Another strong brand grew at the end of 2011; Pizza Hut had 764 units in China, 5,383 units in YRI and 7,600 units in the U.S. All of the China units and approximately 11% of the YRI units and 6% of the U.S. units all of which are company owned. The Taco Bell had 5,670 units in the U.S. and 275 units in YRI by the end of 2011. In an estimate, about 21% of the U.S. units and 1% of the YRI units are all company owned and not franchises. Yum Brands sold off two of its brands including Long John Silver’s and A&W All American Food Restaurants to key franchise leaders and strategic investors in separate transactions, in December of 2011.
Overseas Expansion and Asia
Yum’s strong brands fueled its overseas expansion and had remained the key growth driver, specifically in emerging economies. The company willingly accommodated the middle-class growth in China. The company acquired the Chinese chain of hot pot restaurants, Little Sheep Group Limited on February 1, 2012 to combine with its very own Pizza Hut and to become a leading casual dining concept in China, to further boost its market. The Little Sheep venture is positive to generate nearly 5% to the company’s revenue base in China for 2012. The company raised its target of unit openings from 600 to 700 in China this 2012. Yum expects nearly 75% of its operating profit to come from China and YRI by 2015. The growing economic success in China is anticipated to favor Yum since people are capable to purchase branded food. Yum also projects consumer base for branded food will double from 300 million by 2020 as population in the metropolis increase. Yum currently have 4:1M, meaning 4 restaurants per million people in China versus around 60 in the United States. This is a good sign for the company that seeks to gain from high growth and high return opportunities in China. Yum decided to reduce its marks in saturated markets and add them in level 3 through level 6 Chinese cities.
The emerging middle class of nearly 450 million individuals, which grows 4%-5% annually, could triple the national GDP within the next decade. The highly fragmented restaurant industry with chains controlling just 3% of total restaurant expenditures means tremendous growth opportunities in China. The expansions target also could be pushed higher through nontraditional-format openings, including restaurants at public transportation areas. Currently, 5,000 unit openings are already under its belt, the company prides their unrivaled personnel and site development capabilities, and a company owned distribution system. Yum has the ability for complete access on lower-level Chinese cities at a time when most competitors are limited to major urban centers.
China gets much of the attention being the company’s largest operating profit contributor, but analysts expect emerging economies such as India, Indonesia, Malaysia, Vietnam, the Philippines, including African markets to become vital drivers of long-term free cash flow. Yum continuous to be un-penetrable in several Eurasian markets, including France, Germany, and Russia, where it faces only limited competition from several restaurant concepts. Sufficient consumer demand and discretionary income among these markets could support another 5,000 net new locations over the next decade, putting the Yum Restaurants International (YRI) segment in all markets outside the U.S., China, and India, around 19,500 units by the end of 2021, with another 2,000 units in India. More importantly, strong unit-level productivity metrics and a flexible approach to ownership structures should drive excellent cash flow growth as Yum further penetrates high-growth emerging markets. David Novak announced that Yum was separating its India segment into its own standalone segment for reporting purposes, at the end of 2011, which I see as a positive signal for investors looking for visibility to ongoing growth in the country. Although the company does not anticipate India to contribute to EPS like of China for another 10 years, Yum expects the India business unit to be a billion dollar business by 2015.
Company owned and Franchise Position
Yum’s company owned and franchise position is really admirable, in 2001, 84% of company-owned units operated in developed markets and 16% operated in emerging markets. By 2011, the company reported that 53% of company-owned units operated in emerging markets and that by 2014 that number is expected at approximately 70%. Currently, Yum is actively refranchising units in developed, low-growth markets in the U.S and in Western Europe, and plowing capital into high growth international markets, making it possible to capitalize to a greater degree from emerging market growth.
Yum adopted a less risky strategy by reducing its ownership of restaurants through its refranchising program. The company announced its U.S. refranchising initiative during the end of 2007. Refranchising provided Yum a low-risk opportunity to boost returns; this expects to retain only 5% ownership in Pizza Hut and KFC by the end of 2012 and plans to reduce Taco Bell ownership from 22% to 16% by the end of 2013. These streamlining efforts will benefit the company’s general and administrative expenses. In third-quarter 2011, Yum announced its decision to refranchise its entire Pizza Hut UK segment.
The organization also plans to open up restaurants in about 20 fast growing African countries by the end of 2012 mainly through franchising. Yum acquired 70 restaurants in South Africa in 2011 taking full control of that region. They also find room for growth in Western European countries where Yum is still un-penetrable and facing competition from Mcdonald’s. Management views massive retailing potential and seeks opportunities to expand in other emerging markets like India, Russia and Africa as well. With a 2:1M ratio, meaning two restaurants per million people in the world’s 10 largest emerging markets provides Yum the opportunity to grow in the future. Russia delivered stupendous performance in second-quarter 2012 with 44% system sales growth and 32% same-store sales growth.
The current financial position and sustainability strategies of Yum are focused on these aspects;
- Supplier Relationship: Being the leading restaurant operator in China and the U.S., Yum has developed a narrow economic moat through its considerable advantage over suppliers and scale advantages. Suppliers are eager to collaborate with Yum and its significant growth potential, ensuring the best purchasing terms possible for raw materials. With incredible advertising resources and convenient, high-traffic locations, Yum’s brands are among the most recognized in the world.
- Investor Satisfaction: Yum consistently enhances investors return. Yum targets an annual dividend payout ratio of 35% to 40% of net income, which increases its dividend every year. According to management, Yum’s strong balance sheet and cash generation allowed the company to return more than $1 billion to shareholders in 2011. The company accelerated its buyback program. It repurchased $733 million of stock in 2011. Management recently stated that it planned the repurchase about $800 million in 2012 after a relatively low share repurchase activity of $371 million in 2010. The share buyback activities will likely favor 2012 EPS growth by 2 points. The company reiterated its target to deliver EPS growth for 2012 to at least 12%. In fact, around 97% of outlets in China are company operated. Currently, the company has also started accelerating its franchising activities there.
- Better Pricing: Regardless of the depressed margins in second-quarter 2012, The company expects modest margin improvement in the latter half of 2012 and double-digit profit growth mainly backed by strong top-line growth. Further, moderating inflation and the imposition of pricing action will aid margin expansion. During the second-quarter 2012, Yum implemented pricing action in the range of 3-4% in China leading to 7% effective pricing in the third quarter.
- Store Hours and Menu Variations: KFC and Pizza Hut did a tremendous job in international markets of leveraging assets throughout the day by offering a localized, robust, high-value menu of food and beverage products for breakfast, lunch, dinner, and everything in between. In China, KFC sells congee and PH Dine In draws customers for afternoon tea. Yum is also expanding delivery in China with Pizza Hut Home Service (135 units), and KFC is currently in the early stages of expanding delivery and 24-hour service. Their Delivery and Drive Thru’s are not that important in emerging markets than in developed markets. However, it is expected to gain traction in the coming years.
- Manpower Development: During the December 2011 investor conference three presentations were given by Yum China executives. The first, by President and COO Mark Chu, concentrate fully on how the company is developing local leaders to keep pace with the rapid speed of new unit development. He said that every store in China is a training store and that developing capable Restaurant General Managers (RGMs) is his number one goal; Chu boasts 4,000+ RGMs and counting. Focus on people’s growth and development is a competitive advantage that will gain dividends.
Fair value estimate represents a fiscal 2013 price/earnings 18x, enterprise value/EBITDA 11x, and a free cash flow yield of 5%.