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Shares of Yum Brands (NYSE: YUM) are now down 23% for the last three months.
It’s a heck of a move for any stock, but especially for a fast-food joint. Yet, Yum isn’t just any fast-food stock: It generates a lot of income from China.
About 40% of Yum’s operating income is derived from China. So when the market catches wind of potential macroeconomic headwinds in China, it’s bad news for Yum.
The decline in China took the market by surprise, although it shouldn’t have. In early September I noted that Yum Brands stock was one of five stocks to avoid during China’s economic slowdown. The currency devaluation and slowing economy has been weighing on Chinese consumers, with many cutting expenditures on dining out.
With that, third-quarter earnings were a big issue for Yum. Comparable-store sales growth in China was 2% – well below Wall Street’s expectations of 10% growth.
Nonetheless, were the third-quarter results really all that bad?
The standout issue was slower than expected growth for Pizza Hut in China. Same-store sales are still growing and China restaurant margins expanded by 470 basis points to 19.6% in the third quarter. Taco Bell had a standout quarter and KFC posted positive comps across the majority of its markets.
Yum? Or Yuck?
The likes of McDonald’s (NYSE: MCD) and Wendy’s (NYSE: WEN) are both up more than 15% for the last year, outperforming Yum.
And with a price-earnings ratio of 33, Yum doesn’t appear all that cheap. The key is you’re paying for growth. Yum still has an industry tops return on invested capital of 20%, while also offering a 2.3% dividend yield.
On a forward earnings basis, Yum actually trades at a cheaper valuation than McDonald’s or Wendy’s. Its forward P/E (based on next year’s earnings estimates) is 19, compared to McDonald’s mark of 20 and Wendy’s 26.
So, while China was weak, things aren’t all that bad for Yum Brands. The average annual sales volume for KFC China is $1.4 million, and it’s still better than you’ll find at other restaurants in the region.
The Catalysts to Push Yum Higher
Yum isn’t facing the same issues as McDonald’s. While McDonald’s is a great dividend stock, it appears that McDonald’s has issues with its brand image and lacks a fundamental catalyst to push shares higher.
There are a couple catalysts for Yum. First is its plan to boost its franchisee ownership outside of India and China to 95%. This will boost its income and margins with little capital outlay.
The China restaurant market is still heavily fragmented and has a growing middle class. But one key is that Yum’s China restaurants are primarily company-owned. As the market stabilizes, there’s the opportunity to franchise those stores and increase the margins and cash flow there.
Beyond China, Yum is also an emerging-markets play which will benefit from increased urbanization and spending on dining out.
Yum also recently restructured its operations outside of India and China, consolidating the KFC, Pizza Hut and Taco Bell brands to help develop a focus on growing its presence in developed markets – regardless of the brand.
The Spinoff Thesis Is Back in Focus
As I noted back in May, there are a couple of activist investors trying to push the company to split itself up. With China weighing on the company and its stock underperforming peers, a renewed push to get the company to split could be coming.
(Stock spinoffs like this can be hugely lucrative opportunities for investors. Click here to see why.)
Separating the China division from the rest of the business would allow for two management teams that focus on their respective markets and businesses.
The non-China business would be an asset-light business that relies heavily on franchising. That means the non-China business could also lever up its balance sheet, given that it would no longer have to support store growth in China. It could then use that money to buy back stock.
A spinoff would also allow investors to either invest in the slower-growth, high-returns, high-cash-flow franchise business; or the higher-growth, higher-risk China business. In that scenario, both businesses should see reduced stock volatility and higher multiples.
Given the recent restructuring mentioned above and the fact that Yum China has its own processes for marketing, supply chain and site selection, a split would not be disruptive.
Much of the market misunderstands Yum, given that it’s a bit more complicated story than the likes of Wendy’s or McDonald’s. Yum runs a company-owned store model in high-growth markets and uses a franchising model in developed markets.
But the market treats Yum as if it were a volatile Chinese company, overlooking its global brand presence and potential changes to its business that could push shares higher. If you have a time frame that’s longer than a year, this could be a chance to buy.