Trade War Aside, Yum China Stock Is Ready to Fall Right Here and Now

Yum China stock looks pretty overvalued above $35

yum china stock

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In 2016, global fast food giant Yum! Brands, Inc. (NYSE:YUM) split its business into two: Yum China Holdings Inc (NYSE:YUMC) and Yum operations everywhere else. Since then, Yum China stock has been the big out-performer.

Tailwinds in China consumption coupled with surging popularity in the KFC brand in China has caused the numbers at YUMC to look quite good. As a result, since the split, Yum China stock is up more than 40%, versus just a 25% gain for YUM stock.

Can this continue? Will Yum China continue to outperform YUM stock?

I’m not so sure about that. There isn’t really anything wrong with the growth narrative at Yum China. The company is doing just fine. KFC is red-hot. Pizza Hut will bounce back. Margins should stabilize. The unit growth narrative is promising. Overall, the narrative is just fine.

But at present levels, it just seems like too much optimism and not enough risk is priced into YUMC stock. As a result, I wouldn’t be surprised to see YUMC stock pull back in a meaningful way in the foreseeable future on any operational hiccups.

Here’s a deeper look.

Yum China Has a Good, but Not Great, Narrative

The story at Yum China presently is as follows.

KFC is red-hot, and has been red-hot for a long time. Pizza Hut has recently hit a rough patch, partly due to unit performance saturation, partly due to competition, and partly due to management being behind the curve on some important updates to the business (like store remodels and delivery).

Margins are strong at KFC, but struggling at Pizza Hut due to negative comparable sales growth, causing the overall margin profile to be rather flattish on a year-over-year basis. The store base is consistently growing at a mid-single rate. Earnings are growing at a healthy pace.

Overall, that is a pretty solid growth narrative. It isn’t great. But it is sold.

Going forward, it will be more of the same.

KFC should remain red-hot. KFC has become the fast food brand in China, and recent numbers show that this won’t change anytime soon. Meanwhile, Pizza Hut will bounce back because Pizza Hut is the pizza brand in China.

Eventually, management’s new initiatives surrounding store remodels, marketing, and delivery will bring growth at Pizza Hut back into the picture.

That will cause margins to improve again. But not at an absurd rate. Delivery and in-store investments will continue to keep margins from growing by all that much.

On the flip-side, overall growth should get a big boost from the promising long-term unit growth narrative (management believes the Yum China store count can triple over the next several years). It should also get a big boost from continued robust growth in China consumption, as China per capita household expenditures remain significantly lower than U.S. per capita household expenditures.

In grand total, then, this is a company with reliable comparable sales growth in its two chains, strong unit growth drivers, healthy margin drivers, and some macroeconomic tailwinds. That comes together to create a good, but not great, narrative supporting YUMC stock.

Yum China Stock Looks Overvalued Above $35

The problem with Yum China stock above $35 is that it isn’t priced for a good growth narrative. It is priced for a great growth narrative.

Comparable sales growth at KFC will cool. Meanwhile, comparable sales growth at Pizza Hut should bounce-back. That will lead to overall comparable sales growth in the 0-5% range.

Unit growth should continue to run around 5-7% per year. Therefore, that combination implies overall revenue growth in the 5-12% range, which at the midpoint equates to 8.5% revenue growth.

Margins should head higher once comparable sales growth turns positive at Pizza Hut. Thus, operating margins should expand slightly over the next several years.

This combination of 8.5% revenue growth and slight margin expansion leads me to believe that YUMC can do about $2.50 in earnings per share in 5 years. A market-average 16-times forward multiple on that implies a four-year forward price target of $40. Discounted back by 10% per year, that equates to a present-day value of just over $27.

Yum China currently trades above $35. Thus, the disconnect between intrinsic value and current market value makes me believe that a meaningful pullback is on the horizon.

Bottom Line on Yum China Stock

Yum China has a good growth narrative. But a not great one. Unfortunately, Yum China stock is priced for a great growth narrative, and that means that eventually, this stock will be forced to pull back to more a reasonable level.

As of this writing, Luke Lango was long YUM. 


Article printed from InvestorPlace Media, https://investorplace.com/2018/07/yum-china-stock-fall-now/.

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