Yum! Brands (NYSE:YUM) has shed 18% this year, in tandem with the S&P 500. As a result, the stock is currently trading around its 52-week lows, at a nearly 8-year low price-to-earnings ratio. The main reason behind the decline of the stock is the surge of inflation to a 40-year high, which exerts great pressure on the margins of the restaurant chain as well as on the valuation of the stock. In addition, the company is facing some operational headwinds, such as the lockdowns in China and its exit from Russia. However, as all these headwinds are likely to prove temporary, those who purchase the stock around its current price and keep a long-term perspective are likely to be highly rewarded.
Due to the unprecedented fiscal stimulus packages offered by most governments in response to the pandemic and the ongoing war in Ukraine, inflation has surged to a 40-year high this year. Such high inflation is a strong headwind for most companies for multiple reasons.
First of all, inflation has significantly increased many costs of restaurant chains, such as food and packaging costs as well as labor expenses. Yum! Brands is not immune to the effect of inflation. In the second quarter, its operating margin shrank from 35.4% in the prior year’s quarter to 33.9%. As long as inflation does not subside, the company is unlikely to match the margins it enjoyed last year.
In addition, the surge of inflation has led consumers to tighten their wallets. Many companies, especially retailers, have mentioned that they have observed reduced consumer spending this year, as inflation has made consumers more conservative. However, Yum! Brands is well known for its affordable menu offerings and thus it is relatively immune to this effect of inflation. It has incurred some business deceleration but it still managed to grow its revenue 3% in the latest quarter. Revenue growth would have been even higher if the company had not exited Russia and had not been hurt be the lockdowns imposed in China. To cut a long story short, Yum! Brands is essentially immune to the effect of inflation on consumer spending but it is not immune to the effect of cost inflation on its margins.
Moreover, high inflation has another effect on most stocks, i.e., it reduces the present value of their future cash flows. Consequently, it exerts pressure on their valuation. This is especially true for stocks with a high growth profile, as the future cash flows of these stocks had a much greater present value before the arrival of inflation.
Yum! Brands has somewhat disappointed investors with its business performance this year. Its earnings per share have incurred downward revisions of 6.6% in total in the last six months and thus the company is expected to grow its bottom line by only 2% this year. This is a disappointing growth rate for this stalwart.
However, it is critical to realize that Yum! Brands is facing an especially tough comparison base this year. To be sure, it grew its earnings per share 23% last year, from $3.62 to a new all-time high of $4.46. In addition, the restaurant chain is facing some non-recurring headwinds this year, namely almost record inflation, the exit of its operations from Russia, where the company had 1,165 stores (out of ~54,000 stores in total), and lockdowns in China. All these headwinds are likely to prove temporary and hence the long-term growth prospects of this high-quality stock remain bright.
Yum! Brands is doing its best to enhance its digital sales and it has proved exemplary in this aspect. Its resilience throughout the coronavirus crisis is undoubtedly a testament to its successful transformation towards an off-premise business environment. While McDonald’s (MCD) and Restaurant Brands International (QSR) incurred an approximate 20% decrease in their earnings per share in 2020 due to the pandemic, Yum! Brands managed to grow its earnings per share 2% in that year. That was an outstanding performance during one of the fiercest global recessions in history.
Moreover, Yum! Brands has multiple growth drivers in place. First of all, the company has stated that it intends to grow its store count by 4%-5% per year on average for the foreseeable future. In addition, the company has proven its ability to grow its same-store sales for several years in a row, apart from the obvious exception of 2020 due to the pandemic. As sales grow, margins expand thanks to some economies of scale. Furthermore, the company has reduced its share count consistently, at an average annual rate of 5% over the last nine years.
To cut a long story short, Yum! Brands has promising growth prospects ahead thanks to a series of growth drivers, namely the opening of new stores, growth of same-store sales, margin expansion and share repurchases. Analysts seem to agree on this view, as they expect the company to grow its earnings per share by 15% next year and by another 13% in 2024.
Yum! Brands is currently trading at 24.7 times its expected earnings this year. This price-to-earnings ratio may seem too high to some investors but it can be justified by the somewhat low earnings, which have resulted from the aforementioned headwinds this year. Indeed, the stock is trading at only 19.0 times its expected earnings in 2024. This price-to-earnings ratio is 21% lower than the historical 10-year average price-to-earnings ratio of 24.2 of the stock and hence it reflects an opportune valuation level.
Investors should be aware that Yum! Brands has almost always traded with a premium valuation thanks to its consistent growth trajectory and the popularity of its brands. Therefore, they should not expect to purchase this high-quality stock at earnings multiples below 20. In fact, the current price-to-earnings ratio of 24.7 is a nearly 8-year low level for this stock. Those who can wait patiently for the aforementioned headwinds to subside are likely to be highly rewarded in the long run.
Yum! Brands has decelerated this year due to the multiple headwinds facing its business. However, all these headwinds are likely to prove short-lived. The Fed is doing its best to lead inflation back to its long-term target range and hence inflation is likely to begin to normalize next year. As Yum! Brands has promising growth potential and is trading at a nearly 8-year low price-to-earnings ratio, it is likely to highly reward those who purchase it around its current price.