Despite negative quarterly year-over-year growth reported last quarter, investors have stuck with the company on the premise that management would turn the ship around in the second half of the year, evidenced by numerous company statements promising this growth. Management has made these growth claims very boldly, using China as the main focus of its efforts. Management has been very reluctant to report any bad news from China, since Yum! Brands entire long term strategy revolves around it. Investors have also been willing to stay put with the company because of Yum! Brands 2% dividend yield, which represents over 75% of net income. This payout ratio, as it is referred to in the industry, has been steadily rising over the past year. Higher payout ratios demonstrate an inability of companies to raise dividends in the future and will negatively affect a company's retained earnings, which are earnings the company keeps after paying interest, taxes, and dividends.
If net income declines, Yum! Brands may be forced to cut its dividend as the company already has the worst liquidity metrics in the industry. Earnings, reported on October 6, could make or break investor sentiment and, in turn, share price.
Some 52% of Yum! Brands revenue comes from China, and while other companies with high exposure to the Chinese market have been revising estimates downwards due to the slowing Chinese economy, Yum! Brands management has yet to do so, fearing an investor backlash and stock selloff. In the last earnings call, when China fears were beginning to take shape, CEO Greg Creed told investors not to worry. On the other hand, it seems senior management has been worrying, as senior management has been busy selling off stock ahead of earnings. Since last quarter, over 40,000 shares have been sold by management, with no insider buying. Insider ownership of the company is now under 0.3%, which should leave investors wondering if management has enough incentive to do well.
Without even taking into account the fact that slower growth means less spending on fast food, currency adjustments from China will hurt Yum! Brands revenue and operating profit.
Since the end of last quarter, the yuan has declined 2.5% against the dollar, which means whatever profit Yum! Brands earns from China will be adjusted down 2.5%. This certainly does not bode well for Yum! Brands revenue, and this has not been reflected in Yum! Brands earnings estimates from management. Thus, investors are presented with an extraordinary arbitrage opportunity. Furthermore, there is overwhelming evidence that the dollar could continue to gain strength against the Yuan as Chinese GDP slows and China continues to move toward valuing its currency in a free market, in contrast to the dollar pegging it uses now.
On top of the threat to earnings growth, Yum! Brands is also facing serious liquidity issues, with a current ratio of .64, the worst in the industry, and less than half the industry average of 1.29. Current ratio represents all the companies current assets divided by its liabilities due within a year.
Yum! Brands will have only two options: take out more debt, or cut the dividend. The recent Federal Reserve decision to keep interest rates steady may help Yum! Brands make a decision, but with a debt-to-equity ratio of over 200%, Yum! Brands may be forced to cut its dividend. This quarterly earnings publication could be when we see the company make its decision publicly. A dividend cut could be the difference between Yum! Brands trading at a price-to-earnings of 40 or trading at the industry average of 25.
The bottom line: this earnings report could be ugly. For investors interested in a more in depth analysis of Yum! Brands long term viability, check out this research.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.