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Using our cash flow returns on investments based tool, Yum Brands (NYSE:YUM) appears prominently on our list as a high-quality, investment-grade company. Using a conventional valuation matrix as well as our DCF-based valuation tools, it could be undervalued by as much as 24%. It is a stable value compounder moderately outpacing the S&P 500 over 10 years. We initiate with a buy rating.
The Company
YUM is the world’s largest restaurant chain with over 57,000 outlets across 155 countries. Its main brands include KFC, Pizza Hut, Taco Bell, and The Habit Burger Grill. As of the year ending Dec 2022, from total revenue of $6.8bn, KFC contributed $2.8bn, with Taco Bell $2.4bn, Pizza Hut $1.0bn, and Habit Burger $0.6bn.
The Q3 results released on 1 Nov saw revenue increase by 4% to $1.71bn but missed its predicted target of $1.77bn. Revenues excluding foreign currency translation, grew 10%. EPS, however, beat targets and came in at $1.44 compared to analyst expectations of $1.27. This is an increase of 32% over the same period last year.
David Gibbs, CEO & Director said in the Q3 earnings call:
…our industry has softened a little bit, but the industry is doing better than most industries….
Also, Gibbs expects to meet and exceed long-term growth targets:
Our twin growth engines, KFC International and Taco Bell U.S., led the way, with KFC showing broad-based strength across both developed and emerging markets. With our strong year-to-date performance, we continue to expect that our full-year 2023 results will outperform all aspects of our long-term growth algorithm.
YUM is well-positioned in its segment and is an excellent defensive company.
Consensus estimates EPS for FY23 to be $5.34, and FY24 $5.83, an increase of 18% & 9%. Revenues are expected to increase a little slower at 4.5% and 7.9% for FY23 and FY24.
This equates to a net income margin of 21% for both FY23 & FY24.
This is an improvement from the 5-year net income margin average of 19.6%.
Yum Brands Profitability (ROCGA Research)
On all measures, we see the company has made improvements in profitability. The improvements can be seen in the momentum where the short-term averages are greater than the longer-term averages, especially since the spinoff of Yum China (YUMC) in 2016. Asset turnover is a measure of efficiency and is calculated by dividing the revenues by average assets. Simply put, it measures the amount of assets used to generate revenue. Since the spinoff, YUM has also improved its asset turnover from 0.8x to 1.2x. Another very similar ratio we like to use is the gross asset turnover. This uses an adjusted and comparable measure of assets employed instead of the book value. These have also improved from 0.69x in 2016 to 1.01x in 2022.
Below we will use our associate’s returns on cash-generating assets (ROCGA), a methodology based on cash flow returns on investments. It is a measure of economic performance. More information on how ROCGA is calculated including gross assets, gross cash, and cash flow returns on investments can be found in Bartley Madden’s paper “The CFROI Life Cycle“. Bartley Madden has been a significant contributor to the Cash Flow Returns on Investment methodology.
YUM is highly cash-generative and is also growing modestly. It has been diligent and has returned excess cash to its shareholders. As much as $9bn has been paid out as dividends and share repurchases over the past 5 years and $22.3bn over 10 years. Shares outstanding have gone down from 452m in 2013 to the current 280m, down 38%. With modest growth and share buybacks, revenue per share has increased steadily at over 7% CAGR over 7 years.
So far we have seen modest growth, improving margins, and better asset turnover, all pointing to improving returns.
Yum Brands Returns On Cash-Generating Assets (ROCGA Research)
Since the spin-off of Yum China in 2016, we have seen returns on cash-generating assets improve. For the forecast years, we use consensus EPS.
YUM also has a strong balance sheet with an interest cover of 4.2x and net debt to EBITDA of 4.9x. Dividend yields have been approximately 2%, not forgetting the share repurchases.
Risks
Inflation is receding, but an uptick would in turn put pressure on costs of goods sold and wage inflation. A macroeconomic slowdown will have a mixed effect on the restaurant industry with more people deciding to cook and eat at home and some moving down to the more cost-effective food chains. YUM faces foreign exchange risk, but we think this can only be transitory, can go both ways and should not affect the long-term prospects.
Conventional Valuation
YUM is also trading at a slight discount in comparison to McDonald’s (MCD) which is trading at a PE of 22.6x (FY24) and Chipotle Mexican Grill (CMG) 41.7x (FY24). CMG’s higher growth can partially explain the higher valuation ratio.
For FY24, YUM is trading at 21.9x. This is the lowest since 2012 when the PE was 20.1x. The 5-year average historic PE ratio was 25.9x and FY24’s 21.9x presents a significant discount to historical averages.
Yum Brands & S&P 500 10-year Performance (ROCGA Research)
Looking at the 10-year performance, the company has kept pace with and slightly outperformed the S&P 500.
Cash Flow Returns On Investments Valuation
To value a company, we use our affiliate ROCGA Research’s quantitative and systematic cash flow returns on investments based DCF valuation tools. The first step involves modeling the company, back-testing the valuation for correlation with the historical share prices, and using that same model to forecast forward.
Value is a function of returns and growth in cash-generating assets. The total value of the company is the present value of existing assets and the present value of growth assets.
Yum Brands Default ROCGA Valuation (Chart created by the author using ROCGA Research platform)
The blue band above represents the share price highs and lows for the year and the orange line is the DCF model-driven historic valuation. The green line is the forecast warranted value derived using the same model along with consensus earnings and default self-sustainable organic growth. Self-sustainable organic growth is a ratio of investable free cash as a ratio of invested capital. Investment can be via acquisitions, organic, or self-investments via share buybacks.
The valuation model above is highly correlated to the share price range and we use the same model to project forward with consensus EPS. The share price range and the model-driven valuation did not correlate well during the transitory spin-off period of 2015-2016.
Yum Brands has constantly generated value, as evident in the share price performance and the consistent increase in ROCGA value per share. Our model predicts this will continue and for FY24, YUM could be undervalued by as much as 24%.
Conclusion
Yum Brands is a high-quality, value-generative investment-grade company. It is trading at a discount to its historic PE averages and from a cash flow returns on investments based DCF analysis. We initiate with a buy rating.
