Yum! Brands, Inc. (NYSE:YUM) has been one of the better performers in the restaurant sector for years now. The YUM stock price gained 30% in 2017 and 57% over the past three years, excluding the additional value created from upside in spin-off Yum China Holdings Inc (NYSE:YUMC).
But YUM stock hasn’t been alone in performing well. Many of its QSR (quick-service restaurant) peers have posted solid performances as well. McDonald’s Corporation (NYSE:MCD) stock has gained 40% in 2017. Burger King owner Restaurant Brands International Inc (NYSE:QSR) has risen 29%, and roughly matched YUM’s performance since 2014.
What’s interesting about these gains is that they’ve come in a fast-food business that really hasn’t performed all that well –particularly lately. Data from industry analyst Trinity Capital shows that average same-restaurant sales growth in the QSR category has slowed to basically flat through the first half of 2017, after growing under 2% a year ago.
That’s better performance than seen elsewhere in the restaurant industry, admittedly. Both “fast casual” and “casual dining” have seen comps turn negative. But 1%+ same-store sales restaurant growth over the past six quarters — which implies likely declining traffic — doesn’t seem like it should be enough to drive share prices higher.
And so the key question facing not only YUM but its rivals is: How are the stock prices of fast-food restaurant concepts rising at the same time that fewer customers are visiting those restaurants?
Franchise Versus Franchisee Model
One clear reason is that brand-owners like YUM operate a franchise model. And that model has become a favorite of investors. The big run in McDonald’s stock has been driven in large part by its efforts to “refranchise” company-owned restaurants.
McDonald’s goal has been to get to 95% franchise ownership. For Yum! Brands, per the 10-K, the target is 98%. And the attraction from an investment standpoint is clear. Franchisors like Yum! make their money solely off a percentage of sales (4-6% for YUM concepts, though Yum China pays only 3%), along with fees for new franchises.
That model creates a simplified organizational process, with less need for corporate expense. It insulates franchisors from store-level expenses like labor and commodities. Profit margins, as a result, are extremely high.
Being a franchisor is a good business — and that’s not just in fast food. Domino’s Pizza, Inc. (NYSE:DPZ) and Dunkin Brands Group Inc (NASDAQ:DNKN) both have performed well and receive high earnings and cash flow multiples — with similar business models.
But in fast food, in particular, the franchise model has been a godsend lately. Labor pressures are rising, due in large part to state-level minimum wage hikes. Costs have risen for key inputs like beef after two beneficial years. And pricing pressure is intense, with McDonald’s bringing back the Dollar Menu five years after moving away from it.
The wonderful thing for a franchisor like Yum! Brands is that it doesn’t have to worry about those problems. At least, not yet.
The Key Question for the YUM Stock Price
So the reason YUM stock has gained is twofold. One, its earnings have risen, since even decelerating sales growth leads revenue and margins higher. Yum! Brands is guiding for “mid-single-digit” adjusted operating income growth this year, which thanks to financial leverage and share repurchases, should drive low double-digit earnings-per-share growth. Two, its earnings multiple has expanded, with forward price-earnings ratio rising from about 22x a year ago to about 26x at the moment.
And it’s on the latter point that I’d worry about the YUM stock price. Clearly, investors like the margins and consistency of the franchise model, which is why franchisor stocks are rising, despite cost and pricing pressure on franchisees. But when do those franchisees fight back?
After all, the pressure is only getting worse. Wages are climbing. Promotions are getting more and more aggressive, with Yum! Brands’ Taco Bell adding 20 more items to its dollar offering. At the corporate level, the promotions work well enough, as they drive sales. For franchisees, however, the combination of lower pricing and higher expenses is cutting into profits.
At some point, Yum! Brands is going to have to keep those franchisees happy — or the 2-3% annual contribution from new franchises is going to slow. Meanwhile, the optimism toward refranchising stalls out next year, when the company should hit its 98% company-wide franchise target. And it’s hard not to wonder what happens then — particularly if sales growth remains anemic.
The broad point here is that Yum! Brands is a good business — but I’m not sure it’s that good. Global expansion, which Dana Blankenhorn highlighted this week, and a turnaround at Pizza Hut can help. But investors are paying 26x earnings for single-digit net income growth — and a business that so far has been able to pawn its risks off onto franchisees. That’s worked so far and is one reason YUM shares have gained. But if and when that stops working, Yum! Brands will see some challenges.
As of this writing, Vince Martin has no positions in any securities mentioned.