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?

Let us suppose that the company’s profit growth falls to, say 10 percent. Assuming that there is continued strength in livestock prices, and assuming that there is a deceleration in the growth of the company’s Chinese business makes, this is a reasonable assumption. With 10 percent growth, the company cannot sustain a forward price-to-earnings multiple of 30. If the company were to trade at a market multiple of 22, then the stock has more than 25 percent downside. If we begin to see pessimism, enter the stock market it isn’t inconceivable to see a lower forward multiple of, say, 17, and this means the stock has around 40 percent downside!

Ultimately, Yum! Brands is a solid company, and given its growing Chinese business and its strong profit margins, it has set itself apart in the restaurant industry. But as a result, the company could become a victim of its own success, and the stock is simply trading too high. With that in mind, I think this is a company that investors should keep on their radars, but they need to be careful at current levels. Analysts and investors are pricing in a stellar future for the company and even one slip-up could mean a lot of downside. Since you aren’t being rewarded very much if the bullish scenario plays out, it follows that there is no reason to own the stock.

Disclosure: Ben Kramer-Miller has no position in Yum! Brands.

More From Wall St. Cheat Sheet: