Yum! Brands, Inc. (NYSE:YUM) is one of the few names combining above-average EPS growth and room for multiple expansion into 2014. YUM's story is also supported by steady franchise royalty income, and the franchise model generates about two-thirds of YUM's profits.
Above all, the company's China woes appear to be subsiding with the region posting positive same store sales growth in November. Yum has clearly had a tough 12 months in China as the "triple whammy" of slowing macro trends, a poultry supplier issue, and Avian flu has hammered sales and earnings.
There have also been signs of more heated competition, especially in larger cities, alongside rising labor costs. All of this has added up to a big reset on China earnings expectations for the company.
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However, the situation is improving in China from where Yum! Brands gets more than 50 percent of its overall sales and operating profit. It operates about 6,000 restaurants in China mostly under KFC brand. The company has over 40,000 restaurants in more than 130 countries.
November same-store sales increased an estimated 1 percent for the China Division. This estimate included even sales at KFC and 7 percent growth at Pizza Hut Casual Dining.
On the cyclical front, Deutsche Bank analyst Jason West is seeing some early signs of improvement in China macro trends, including improving consumer confidence, CPI, exports, and PMI, along with stabilization in retail sales trends.
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For 2014, Yum! expects to deliver at least 20 percent EPS growth, with China Division operating profit growth of at least 40 percent. The company plans at least 1,850 new international units, including 700 new units in China For full-year 2013, EPS is expected at high-single to low double-digit decline versus the prior year.
YUM's recent announcement to combine Yum! Restaurants Internat! ional (YRI) and U.S.individual divisions for KFC, Pizza Hut and Taco Bell, effective January 1, 2014, makes it well positioned to more aggressively accelerate growth in the years ahead.
Meanwhile, the backdrop of steady cash flow provides downside support. YUM's global business consists of China, the US (31 percent of profits), YRI (35 percent of profits) and India (breakeven). The US and YRI businesses are each 91 percent franchised while China is 19 percent franchised and India 74 percent franchised. So, globally, about 80 percent of YUM's restaurants are franchised, which provides for a steady cash flow stream, even in down years.
YUM is on-track to generate $1.2 billion in free cash flow in 2013, similar to the prior two years, despite the earnings shortfall in China. YUM also has a relatively clean balance sheet, with debt/EBITDA of just 1.1 times.
West estimates about $1.2 billion to $1.3 billion in cash flow in 2014, which implies about 3.5 percent free cash flow yield. Given the likelihood of some recovery in China in the coming years, and franchise-heavy businesses for the balance of the portfolio, he does not see much downside risk to the free cash flow story, which suggests limited downside risk for the stock.
While YUM shares have gained recently, they have underperformed the market by 13 percent this year. YUM trades at 21 times its forward earnings, which is an 11 percent discount to the restaurant industry. Though YUM's earnings might not fully recover in the next 1-2 years, the market expects above-average growth off the lows seen in 2013.
West sees about 20 percent EPS CAGR over the next two years. As this recovery plays out, he believes YUM should be able to at least hold the current multiple, with some expansion possible if the overall market remains strong.
As a result, risk-reward is heavily skewed to the upside, particularly if investors are willing to look out a year. There are only few companies in the restaurant sector with room for multiple ! expansion! . While some might argue that many companies look inexpensive on 2015 earnings, few companies have such a clear path to accelerated EPS growth over the next couple years.
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