Yum Brands Inc. (YUM) has been one of the American companies to benefit the most from the growth of China. KFC is the most popular fast food franchise in China, and Yum's growth in the region has driven the success of the company. Other fast food franchises Yum operates include Pizza Hut, Taco Bell, Long John Silver's, A&W, and Pasta Bravo, among others, in over 110 countries.
However, gains in China have been offset by losses in the US market. As a result, the stock is overvalued due to changing consumer trends in developed markets, increasing commodity prices, cutting margins, and market saturation of weaker franchises.
Yum has been successful in bringing Pizza Hut and KFC to China, but at the same time has lost sales in the US, which still makes up 59% of revenues and 50% of the company's profits. The reason for this is not just because of a weakened US economy. Average Americans have grown more health-conscious over the past five to 10 years. KFC and Taco Bell have a reputation for being some of the least healthy and most artificially derived food of any restaurant. Even though the Taco Bell lawsuit has been dropped, the perception (and reality) of its low quality food drives away customers. As a result, Yum's restaurants have to use low prices as their selling points, keeping margins down. This change towards healthier eating, along with a potential slowdown in China, will derail Yum Foods.
The inherent problem with Yum foods lies in the fact that increasing input costs for beef, chicken, corn, and other food products -- along with oil and paper -- will erode margins. Yum cannot pass these costs to its consumers because the fast food industry is highly competitive and utilizes low prices as its selling point. This makes the demand for its food highly elastic, and price increases will cause significant drops in sales. It does not help that poorer and lower middle class Americans also tend to consume the most fast food and are the most affected by food price increases. Accelerating and limited pricing power is a bad recipe for Yum.
Looking into Yum's financial situation further indicates its overvaluation. The stock currently has a debt to equity ratio of two -- high for a company that franchises most of its capital. Yum also has a high P/E of 21.89 and a price to book ratio of 14. On a discounted cash flow basis, the company's intrinsic value is $44.51 (assuming current earnings growth does not slow), well below its current price of $52.30 ... and I believe the stock will decline to some point between $43-47 per share in the next six months.
However, Yum may not hold on to the pace of its expected growth rate of 12.28%. The fast food market in the US and other first world nations has been saturated, leaving limited growth beyond same store sales, while emerging markets' expansion profits are split by local companies in joint ventures.
Overall, Yum Brands Inc. is on the wrong side of rising commodities prices and American dieting trends. These competitive pressures will bring its stock down as its restaurants begin to saturate emerging markets. With further economic development, emerging market consumers may also shift away from fast food when they can afford to care about health concerns.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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