The share price chart of Yum! Brands is shown above.
The writing was on the wall. We warned about the impending collapse in Yum! Brands’ (YUM) shares in our highly-selective July 14 note, “Warning! 5 Heavily-Followed Dividend-Paying Stocks to Avoid:”
“The owner of KFC, Pizza Hut and Taco Bell has a solid franchise, but its share price has rocketed too far too fast, perhaps on renewed speculation that it will spin off its Yum! China division into a separate entity, which may never happen. But while speculation fuels the share price advance, there are a few things we do know for certain. The fast-food environment in the US is cutthroat, and the trend toward fast-casual is a long-term secular dynamic, meaning recent progress by KFC and Taco Bell in the US market, albeit noteworthy, may not hold permanently. The firm’s KFC brand is perhaps the best restaurant growth story in China and India, and its growth ambitions may pan out as planned, but such a dynamic is certainly not unknown, and from our perspective, it has been more-than-factored into the stock price. At more than 25 times present-year earnings, Yum! Brands is certainly not connected to its fundamental dynamics. With Chinese equity markets collapsing, the implications on consumer spending in the country, the most valuable one for Yum! Brands, cannot be ignored. We don’t like the risk-reward.”
On October 7, the restaurant giant surprised the market with its third-quarter results for the period ended September 5. Though sales in the company’s China Division sales advanced 8% in the period, the meager pace of same-store sales (2%) in the country was far worse than expected, especially for a company that should be bouncing back from recurring problems associated with bird flu scares and sourcing scandals in the country. Noting that same-store sales in China would come in at a mid-single-digit pace during the fourth quarter, with unusual but material weakness coming from Pizza Hut Casual Dining in the country, management now expects full-year earnings per share to advance at a low-single-digit pace, below previous expectations calling for a double-digit ramp. We had thought if faced with operational adversity, management could use share buybacks as a way to stem the earnings-per-share decline, but it now seems that things may be far worse operationally than even management can reasonably forecast.
Multinationals leveraged to consumer spending in China are only starting to feel the residual impact from the collapse in China’s equity market, in our view. Nu Skin (NUS), which develops and distributes personal care items and nutritional supplements, noted it is experiencing a direct impact from “economic conditions in China,” to explain why the company experienced “lower-than-expected sales” of its new cosmetic oils in the country during August and September. We now believe that Nike’s (NKE) fantastic performance in China for an overlapping period, ending August 31, may now mean that the firm is just weathering the macroeconomic storm far better. The shoe giant’s ‘futures’ orders had capped some concerns about consumer spending in the country when it reported a couple weeks ago, but Yum! Brands’ and Nu Skin’s quarterly updates have put those concerns right back on the table for investors.
What to do about Yum! Brands?
For starters, shares are no longer as “bubbly” as they once were, but they aren’t necessarily cheap either. Our fair value estimate had been in the low-$70s prior to the quarterly release and with the company’s equity now dropping to the high-$60s, there’s still not much of a margin of safety. Second, the collapse in the share price suggests an immediate snap-back may not be in the cards, even if we see some buying tomorrow and into the following weeks. Portfolio managers are moving out of shares.
To put it bluntly, our fundamental and valuation thesis on Yum! Brands has played out, and we wouldn’t be interested in shares until an adequate margin of safety presents itself on strengthening market conviction in the business (strong pricing momentum). That Yum! Brands may break apart its business is only a catalyst for the headlines. Our intrinsic value process already captures the free cash flow generation from each aspect of its business. We think the speculative euphoria regarding a potential split-up is what got investors in trouble in the first place.
A slowdown in consumer spending in China across the restaurant universe will have implications on McDonald’s (MCD) and Starbucks (SBUX) as well, even as the former seeks to cushion the blow with all-day breakfast initiatives and the latter masks any impact with pure unit growth. At nearly 20 times and 30+ times fiscal 2016 earnings, respectively, the risk to their share prices is to the downside. Any upside surprise may be met with selling pressure on valuation concerns, even as shares of McDonald’s seek to break to new highs.
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