Why You Shouldn’t Bite Into Yum! Brands Just Yet

Source: Thinkstock

Source: Thinkstock

Yum! Brands (NYSE:YUM) is trading very close to its all time high of $83.43/share. The company has been executing on all fronts after suffering a setback in its Chinese business. After struggling in China after a health concern, the company has been able to rebuilt its image, and as a result its Chinese operating profit nearly doubled last quarter on a year-over-year basis.

This is undoubtedly great news. However, we need to realize a couple of things. First, Yum’s nearly 20 percent year-over-year growth in operating income last quarter was almost all due to its Chinese business. If we exclude the company’s Chinese business Yum is still growing, but at a relatively modest rate that doesn’t justify the stock’s lofty 33 trailing price-to-earnings multiple. Second, this incredible Chinese growth comes after a period of weakness and it follows that, more likely than not, it is unsustainable. Even if we assume a relatively constructive growth figure of 20 percent for the company’s Chinese operating profits this subtracts meaningfully from the company’s overall growth.

Nevertheless, if you look at analyst assessments for the company we see relatively robust profit growth estimates going forward. For instance, next year’s profits are supposed to exceed this year’s profits by 20 percent. In addition to Chinese growth, the company has also shown margin expansion, which has been a difficult achievement for companies in the restaurant space given rising food prices. While we have seen prices of grains fall somewhat over the past few weeks, we have continued to see strength in livestock futures, and meat is a significant expense for fast food companies, especially Yum! Brands given that its top restaurant chain is Kentucky Fried Chicken.

Now the aforementioned growth isn’t impossible, but I think it will be a difficult goal to reach. Furthermore, the price target attached to this scenario is just $87/share, which isn’t really much higher than the current stock price. It follows that there really isn’t much upside even if the company continues to execute. But what is the downside?