Yum! Brands’ (YUM) second annual earnings-per-share guidance revision for 2015 in a matter of a couple weeks–as late in the year as the month of October–must be a new record for an executive suite. Credibility now shot, management is pulling out all the stops and going full-steam ahead with separating its China operations from the rest of its business. Yum! Brands is simply shell-shocked, in our view, and is acquiescing to activist investor demands that may not be beneficial to the interest of long-term shareholders. We think the move by the executive suite is being pursued solely to preserve their jobs.
Though some estimates suggest that a separation of Yum! Brands’ China Division from the rest of its operations could generate as much as $16 per share in incremental value, we’re not buying it. The company’s China business has been its bread-and-butter (or chicken-and-biscuits) for years, and we doubt that management hasn’t been laser-focused on the most important part of its operations. That a miracle can be worked to right the ship in the country simply through a separation is wishful thinking at best and faulty thinking at worst. The separation may offer investors the opportunity to invest in China directly or its US operations (namely the blossoming Taco Bell), but by no means do we think Yum! Brands is suffering from a massive “conglomerate” discount.
We expect excitement surrounding the announcement to pave the way for sell-side shops to facilitate trading across their desks, but we think the break-up increases fixed costs across back-office functions as it delinks the sharing of best practices across international boundaries. Though Yum! China will essentially be debt-free, we’re awaiting more robust disclosure regarding the newly-formed entity’s cash flow profile, and we suspect that its operations won’t be as “substantially” free cash flow positive as management says they will be, particularly as the new company pursues unit growth initiatives. Yum! Brands will migrate to a pure-play franchisor over time, but management’s plan to transition to a non-investment grade credit is playing into the hands of short-term activist thinking. We’re not sure the break-up is in the best interest of long-term holders.
Yum! Brands’ aggressive move to distract investors from weakening earnings growth is only half the story. Between McDonald’s (MCD) all-day breakfast initiatives, news of the restructuring of its real estate, and rumors that Monster (MNST) has been found in some of its restaurants, investors’ heads are spinning. The Golden Arches has called the all-day breakfast roll-out a success, but franchise owners seem to disagree. For one, it has been an operational nightmare as hash browns taste like fries (at least at some locations we’ve visited recently), but many franchisees are saying the initiative was rushed. Breakfast has given customers yet another option to trade down to squeeze margins, and most operators are calling it nothing short of a “nightmare.”
Franchise owners have a right to be upset, but it may not be a problem that can be solved. McDonald’s no longer resonates with the younger crowd like it once did with today’s 30- and 40 year-old somethings when they were growing up. The company is shunned by health-conscious parents, and the very mentioning of McDonald’s comes with such a social stigma that even noble health initiatives by the company are met with skepticism by parents. With operations facing tremendous pressure, the executive team at McDonald’s is considering spinning off its real estate operations into a “McREIT,” another financial initiative hoping to squeeze the last bit of return out of a tired quick-service story. Though we think the “McREIT” initiative holds more promise than the Yum! separation, McDonald’s investors may not be lovin’ it come later this decade. Monster may not provide a “big enough” shot-in-the-arm for the restaurant, even if it’s a big deal for the energy-drink giant.
The secular trend toward fast-casual continues, though the leader of this segment, Chipotle (CMG), hit a speed bump during third-quarter results, released October 20. Comparable store sales growth for the burrito joint priding itself on the concept of “Food With Integrity” came in at 2.6% during the third quarter, roughly in-line with reported consensus, but investors were expecting an upside surprise that didn’t happen. Revenue advanced 12% in the quarter, but restaurant level margin pressure hindered the pace of net income expansion, which trailed the rate of top-line growth marginally. Labor costs ate into profits as avocado and dairy prices eased a bit. The restaurant is on a hiring spree, and minimum wage hikes may come back to bite such initiatives, a dynamic that may prove to be the most ominous long-term headwind across the restaurant space.
Yum! Brands and McDonald’s will get a lot of headlines in the coming months, but operationally, both entities have seen better days. A break-up at Yum! and a real estate restructuring at Mickey D’s could offer a short-term boost to shares, but we think the odds are against the long-term investor at current levels. Fast casual companies like Chipotle are literally eating their lunch, and we think the fast-casual concept revolution is in the early innings. Only time will tell which new concepts will come to market to take share away from Yum! and McDonald’s. Chipotle’s shares are too pricey for our taste, even as we say the company’s plans for as many as 235 new restaurants in 2016 look achievable. We continue to monitor the restaurant space closely.