At the end of 2017, I sounded a bullish tone on fast-food operator Yum! Brands, Inc. (NYSE:YUM). The parent company of fast-food staples KFC, Pizza Hut and Taco Bell appeared to be on a winning track with its re-franchising efforts and global growth strategy.
YUM stock also appeared undervalued given forthcoming tax reform and consistently positive comparable sales growth.
But that was all before Chipotle Mexican Grill, Inc. (NYSE:CMG) stole Taco Bell’s Chief Executive Officer Brian Niccol.
Believe it or not, that is a game changer. Niccol is largely credited with turning around the Taco Bell business and making it a trendy dining option popular among millennials, and with good reason. He had been at Taco Bell since 2011, and with him at the company, Taco Bell went from a business with negative comps to a business with consistently positive comps.
That is why YUM stock has failed to rally despite a broader market rebound. The S&P 500 is 5% off its recent highs. YUM stock is nearly 10% off recent highs.
But does one man really make or break a company? Normally, no. Especially a company coming up on its 56th birthday.
So is this dip an opportunity to load up on YUM stock? Perhaps. But I’m exercising caution until I see that Taco Bell can comp positive this year without Niccol at the helm. Taco Bell slipping into negative comps territory could send a somewhat richly valued YUM stock down even farther.
Near-Term Concerns Have Appeared for YUM Stock
The broad growth narrative at YUM remains intact.
This is a company that is re-franchising essentially all of its locations and turning into an asset-light, hugely profitable, money-making machine. This re-franchising does kill revenues, but the revenue slicing is like getting rid of all the unwanted fat.
Store costs are coming out of the system, capital investment needs are going down, and lease obligations are falling. Meanwhile, margins, profits and cash flows are booming.
This process is already happening, but there is still more to be done. The G&A expense rate was 2.5% in 2015. That fell to 2% this year and is expected to keep falling all the way to 1.7% by 2019.
Meanwhile, capital expenditures totaled $427 million two years ago. Last year, that fell to $318 million. This year, CapEx is expected to fall to $225 million. By 2019, it’s expected to fall to $100 million.
All together, we are talking about a free cash flow boost in excess of hundreds of millions of dollars. All those extra dollars will be allocated back to shareholders, via dividends and buybacks. Overall, you’re looking at YUM in 2019 having higher levels of profitability, more cash flow, bigger buybacks and a hiked dividend.
Nothing has changed about this long-term growth outlook. Consequently, in a multiyear window, YUM stock should trend markedly higher.
But there is a ton of uncertainty surrounding this name in the near term.
For multiple quarters, YUM’s biggest growth segment has been Taco Bell. As stated earlier, a lot of Taco Bell’s success is due to Niccol, who leveraged targeted advertising and menu additions to make Taco Bell a trendy fast-casual dining destination. But now he’s gone, and no one really knows how Taco Bell will do over the next several quarters without his lead.
Plus, Niccol’s arrival at CMG immediately bumps up Taco Bell’s competition, especially if CMG goes after the same core millennial demographic.
If comparable sales growth at Taco Bell does go neutral or flips into negative territory, then YUM stock will be adversely affected. This is a stock trading at nearly 24 times forward earnings for a long-term earnings growth rate of 14%, which equates to a price-to-earnings/growth (PEG) ratio of 1.7. That is sharply above the market’s 1.1 PEG ratio.
Bottom Line on YUM Stock
Long term, I’m bullish on YUM’s ability to unlock tremendous shareholder value via re-franchising and global expansion.
Near term, however, I’m more cautious on YUM stock given what could be operational hiccups at Taco Bell against the backdrop of a somewhat rich valuation.
As of this writing, Luke Lango was long YUM and CMG.
