Why Yum! Brands Looks Set For A Good Run In 2016

  • Yum! Brands' China division's Q4 2015 performance showed signs of recovery.
  • This recovery is in time for Yum! Brands' planned China spin-off by the end of this year.
  • The China division spin-off, revenue recovery and Yum's financial engineering among other things will help Yum! stock in the short-term.

On 3 February 2016, Yum! Brands reported an increase in adjusted earnings which topped analyst expectations but the company missed on its top-line estimates. Yum Brands (NYSE:YUM) reported $3.95 billion in revenue compared to analyst expectations of $4.02 billion in revenues. But China was the main highlight of the quarter. This is because, apart from showing strong signs of recovery, Yum! Brands' China division offers a lucrative opportunity due to the potential arbitrage opportunity from its spin-off at the end of 2016. That's the reason I am advocating not to bet against Yum! Brands in 2016. The company has a few tricks up its sleeve, one of which is the Yum! China spin-off. Further, there's a $6.2 billion shareholder repurchase program.

Q4 2015 China Highlights

  • Yum! Brands' China division continued being the company's key growth area: 83% of international expansion occurred in emerging markets. New global restaurants totaled to 1,160, including 384 stores or ~33% of Yum's new global restaurants in China.
  • Yum! Brands' China division started showing signs of a recovery: China system sales increased 7%, driven by 7% unit growth and 2% same-store sales growth. Restaurant margins increased 4.3% to 11.4%. Operating profit margins increased 207%.

Full Year China Highlights

  • Emerging markets are Yum! Brands' strength: At the end of 2015 new global restaurants totaled to 2,365, including 743 in China, with 351 KFC stores and 355 Pizza Hut stores. 80% of international expansion occurred in emerging markets.
  • Yum! Brands' China Division system sales increased 2%, driven by 7% unit growth and partially offset by a 4% same-store sales decline. Restaurant margins increased 1.1 percentage points to 15.9%. Operating profits increased 8%.

Historically, a spin-off has been a great strategy to undertake for companies that have grown too big. The signs of recovery in Yum! Brands' China division is a great indication that the spin-off might attract more attention, as well as a better price. China has been a great growth opportunity and this trend is likely going to continue.

The Yum! Brands story is similar to that of McDonald's between 1999-2003. McDonald's kept seeing its stock price decline in spite of pursuing accretive acquisitions such as Chipotle and Boston Market.

Source: Nasdaq - McDonald's Stock Price Between 1989-2016

mcdonalds

When McDonald's acquired Chipotle, Donato, and Boston Market from 1998 to 2000, its stock price continued to move sideways. It was not until the company streamlined its operations by spinning off new ventures that the stock price began to surge again. McDonald's began selling its acquisitions in 2003: a divestiture of Donato's Pizza in 2003, an IPO of Chipotle in 2006, the sale of Boston Market in 2007, and Pret A Manger in 2008.

History can repeat itself with Yum! Brands because once it streamlines its operations, the market will be able to recognize the company's underlying value. Investors are unable to do so now because Yum! is too big. For instance, as of Q4 2015, Yum! Brands had a total of 42,692 stores worldwide. That is ~15% higher than McDonald's 36,258 restaurants worldwide or ~217 stores for each of the 196 countries in the world. The spin-off will be advantageous because it would allow separate corporate focus on the China division and on the parent company. This focus would subsequently lead to greater freedom for the management's to pursue new ventures.

The potential arbitrage spin-off opportunities will likely bolster investor confidence in the stock. I expect increased bullish sentiments as the spin-off deal nears completion. The idea that spin-offs create long-term shareholder value dates back to more than 50 years of research. According to research papers samples by Spin-off research: "Over the two-year period prior to the spin-off, the stock price of the average parent company outperforms the stock market by 35% on average

"Over the two-year period prior to the spin-off, the stock price of the average parent company outperforms the stock market by 35% on average. After the spin-offs, stock returns of both the parent and the spin-off outperform the market...over the entire three-year period, assuming portfolio re-balancing, we find a compounded raw return of 106.6%." The spin-off type of arbitrage opportunity detailed in books like chapter three of "You can be a stock market genius" is the kind of research that often drives momentum in these transactions. The caveat here is that most people tend to buy the momentum and sell on the news. This is because Yum's parent company will likely see a lot of volatility after the announcements as the market tries to price in the news.

The Franchise model will reduce a lot of the headline risk. Yum's China division has faced significant headwinds over the last few years. For instance, in 2012, a state media agency accused KFC suppliers of cramming extra antibiotics into their chickens. Two years later, Yum was also found to be selling tainted meat at KFC. Also, Yum! Brands rushed to settle these accusations as fast and as possible, but its actions offered very little consolation to consumers. These headwinds have had detrimental effects on the company's brand image and also on its margins. They also created an opportunity for competitors to penetrate the market.

Lastly, we have a strong upside growth momentum being created by Yum! Brands' financial engineering. The company is in the midst of returning $6.2 billion to shareholders through a share buyback program. Since the announcement of the program, Yum has bought 23 million shares and as of February 2nd, 2016, the company's share count is at 411 million. The overall plan in the beginning (23+411=434 million shares) was to buy ($74/share) ~84 million shares or approximately 19% of all the 434 outstanding shares at the time. Yum! has bought 23 million shares and have ~61 million shares remaining to be bought or ~15% of all outstanding shares. I believe this is going to have a strong impact on EPS and short-term volatility. Although I do not believe in financial engineering as it does not create long-term shareholder value and it can mask the real reasons for earnings declines, as people focus too much on EPS. However, it has the potential to influence investor sentiment towards the stock. This influence could lift the Yum! stock price in the short term, especially in the midst of the long-awaited spin-off.

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  • I do not have any business relationship with the companies mentioned in this post.
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