RealMoney Silver - Yum! Puts Value and Growth on the Menu

Yum! Puts Value and Growth on the Menu
By Bill Trent
RealMoney.com Contributor
6/24/2008 12:48 PM EDT

Jim Cramer says Yum! Brands (YUM) is the best way to play China's growing appetite for protein. Yum! management has called China its number-one growth strategy, and expects to have 3,000 stores in the country by year-end.

To my mind, the fundamentals look tasty enough to take a bite of, regardless of whether it is the "best" play on China or simply a good one. The company has three other growth prongs as well: aggressive international expansion outside China; improving U.S. brand positions, consistency and returns; and driving industry-leading long-term shareholder and franchisee value.

Yum! seems to be executing on all fronts. International sales were up 15% in the first quarter, with 18% growth in operating profits. U.S. brands posted 3% same-store sales growth, reversing the negative comps experienced last year, and returns on invested capital are 18%.

Expansions of the Pizza Hut menu, including pasta and wings, could help that brand attract cost-conscious casual diners, while Taco Bell is already positioned as the fast-food value leader. All in all, I think Yum! is well positioned to weather tough economic conditions.

Against that backdrop, shares have fallen more than 10% in the last month in this tough market environment. Yum! is set to report earnings in the middle of July.

Modest Concerns

I'd usually be concerned by the stock's recent drop through the 200-day moving average. However, given that this has happened several times over the last year, and the previous examples were followed by 25%-30% gains in the months that followed, I'm not treating the signal as bearish in this case.

As Scott Rothbort notes, the greater concern is the potential for rising commodity prices and slower consumer spending to take a bite out of profits for a few quarters. So far, though, the consensus on Wall Street is for the opposite to happen. Over the last 90 days, earnings estimates for both 2008 and 2009 have increased by $0.02-$0.03 per share.

I think the fundamentals offer an attractive entry for longer-term investors, though those with a shorter time horizon may want to wait a bit longer or use a put-write strategy to effect a cheaper entry point.

Margin of Safety

Against these fairly modest concerns, I think the company's strong cash generation provides a significant margin of safety.

Free cash flow, measured as cash flow from operations less capital expenditures, has exceeded $800 million over the last 12 months. The resulting 4.7% free-cash-flow yield offers more than a 100-basis-point risk premium over 5-year Treasuries, even before considering the company's impressive growth.

As to the growth, analysts are expecting annual earnings growth of 12% over the next five years. That estimate seems reasonable to me, as it is below the 14% growth rate experienced over the last five years, and well below the company's sustainable growth rate based on its return on equity.

At 19 times this year's earnings, Yum!'s valuation is right in line with its five-year average. With no change in valuation, the stock could reach $41 per share simply by meeting analysts' estimates over the next year. Combined with the 2.1% dividend yield, that implies a total return of 15%.

In the current market environment, I'm willing to trade a little bit of upside for stocks with a high margin of safety. Yum looks like it has just the right menu.