Stock of the Week: Yum! Brands

If you knew that the KFC, Pizza Hut, and Taco Bell fast-food chains -- pardon me, quick-service restaurants (QSRs) -- were all owned by the same company, give yourself a brownie point. And if you also know that they're owned not by PepsiCo (NYSE: PEP  ) , but rather Yum! Brands (NYSE: YUM  ) , you might be up for the coveted Floppy Chicken Award.

Just about everyone is familiar with Colonel Sanders and the big red Pizza Hut roof. But not everyone realizes that KFC and Taco Bell, with three other chains, are controlled by a company spun off from Pepsi 11 years ago. Originally called Tricon Global Restaurants (memorable, huh?), the company gave itself its yummy current moniker in 2002.

A taste of the fast-food business
The fast food industry is saturated, and the competition is fierce. Counting the total number of units, Yum! Brands is the largest QSR company, with more than 35,000 locations at the end of 2007. For comparison, McDonald's (NYSE: MCD  ) had 31,000-plus restaurants, and Burger King (NYSE: BKC  ) had a bit more than 11,000. With a market cap in the neighborhood of $17 billion, though, Yum! is only about one-quarter the size of McDonald's.

The crowded competition for customers' dining-out dollars requires Yum! and its rivals to advertise heavily in order to keep their brands fresh in diners' minds. Ultimately, Yum! strives to get consumers who crave fried chicken thinking of KFC first and foremost, rather than a rival like AFC Enterprises' (Nasdaq: AFCE  ) Popeye's Chicken & Biscuits. Yum! may have accomplished that mission, since two of its brands -- KFC and Pizza Hut -- are ranked No. 2 and No. 3 for restaurants on Interbrand's list of most valuable brands. (McDonald's holds top honors.)

Yum! has a two-pronged business model. First, it operates its own restaurants, bringing in sales and paying for food costs and other expenses. Second, it licenses its brands, letting franchisees operate the stores in exchange for a portion of those locations' sales.

While license fees and royalties aren't QSRs' largest revenue source, they're definitely the most profitable element on the top line, sending most of the revenue they generate down to the bottom line. Yum! had $1.3 billion in 2007 revenue from 26,406 franchises. Those franchises generated a whopping 97% gross margin, compared to a mere 21% on company-owned stores.

A scrumptious investing opportunity
Yum! Brands' investing story is centered around growth, primarily internationally, and especially in China, which grew revenue 31% in 2007. Though China hosts just 10% of the company's total stores, the country's revenue provided 20.5% of Yum!'s 2007 sales and more than 27% of its operating income. Meanwhile, the 18,000 stores in the U.S. contributed half of Yum!'s revenue and operating income. With more than half a billion people in China, it's easy to see the possible growth the company can tap there.

But Yum!'s not just banking on Chinese opportunities; the company is also aggressively returning money to shareholders. Yum!'s buybacks reduced share count by 5% in the last quarter alone, and by nearly 20% over the past five years. While its recently announced plan to buy back another $4 billion worth of shares will pile on more debt, those repurchases will certainly help the company easily meet CEO David Novak's goal of annualized 10% growth. Beyond trimming its share count, the company also pays a growing dividend that currently rewards shareholders with $0.60 per share (a 1.7% yield).

Unappetizing risks
I see three major pitfalls for Yum! Brands:

  1. Political perils. In 2007, Yum! opened a net of 455 stores in China, for 17% growth, and 463 elsewhere internationally, for 4% growth; domestically, the company closed a net 143 locations. With the company placing so much emphasis on foreign locations, a change in China's laws could badly hurt Yum!'s fortunes. Except for lobbying, this is mostly out of the company's control.
  2. The rising cost of food. As more corn is diverted to produce ethanol, the corn used to make food, and to feed chickens, cattle, and cows becomes more expensive, raising the prices of chicken, beef, and cheese. The company must either pass those costs on to the customer or shrink its margins.
  3. Food safety and general cleanliness. At the end of 2006, an E. coli outbreak grievously harmed Taco Bell's sales, and an attack of rats caught on film at a New York City location in early 2007 further tarnished the chain's reputation. Such incidents had short-term negative effects on sales, since it takes time for people to trust the food again. Besides using reliable suppliers and high internal standards, this factor is also mostly out of Yum!'s control.

Delicious cash flow growth
Yum! has generated mouthwatering 20.3% growth in annualized free cash flow over the past five years. While analysts anticipate a much slower 11.6% earnings growth rate for the next five years, the company has historically grown free cash flow more quickly than net income. Applying Yum!'s historical 20% growth rate in a three-stage model for five years, discounted at 12%, offers a little more than 20% upside potential.

Like Starbucks, I think Yum! Brands might be undervalued -- poised to grow more quickly than the assumed rates that Wall Street's already baked into its share price. But when I reduce my estimated free cash flow growth rate to analysts' expected earnings growth rate of 12%, I get an intrinsic value of roughly $30, which would make the stock more than 20% overvalued. Yum!'s current price of nearly $37 implies that investors expect 15% growth.

Growth potential is always tough to predict, and as you can see, various growth expectations create wide swings in Yum!'s intrinsic value. Still, given the enormous potential in China, and the rejuvenation of Yum!'s domestic brands, I'd be willing to order up a small position in this company near its current prices, and add further on any weakness in the shares.

Further yummy Foolishness:


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