Description

In light of the restaurant selloff in March, I conducted an analysis of the publicly traded QSR concepts in which I stress-tested each model under various downside scenarios to identify top franchises with sustainable free cash flow, low owned-store exposure, long-term unit growth potential and high relative exposure to countries already recovering from the COVID crisis and lower exposure to Europe where more restaurants are fully closed. Yum! Brands quickly emerged as my favorite name as a result of the quality of its assets, low operating leverage, valuation, potential for long-term unit growth and its ability to weather the current economic storm.

Yum is the franchisor of three businesses: KFC and Taco Bell, which dominate their categories, and Pizza Hut, the #2 global pizza chain. The portfolio offers a unique mix of high unit growth and favorable geographic exposure. With a large store base in China, where economic activity is already starting to recover, and with lower exposure to Europe (relative to MCD) where more stores are fully closed, Yum should generate relatively favorable cash flow through the economic pause and lead the space in returning to unit and EPS growth. While Yum’s 4.3% unit growth is lower than QSR’s 5.2% growth and DPZ’s 6.9% growth, I am wary of Tim Horton’s weak performance as such a large earnings driver for QSR and DPZ is significantly more expensive. Additionally, as a franchisor with relatively few company-owned stores, Yum commands higher margins and has lower capital requirements than many of its peers (MCD has a higher owned-store base, particularly in Europe where more locations are closed right now).

My channel checks also suggest Pizza Hut may emerge from this crisis with improved margins and streamlined takeout and delivery operations. In a limited number of markets where franchisees have been allowed to use multiple third-party delivery sources, sales have improved and outsourcing delivery staff has driven high-single-digit restaurant margin improvements. The combination of higher comps and improved margins as well as a recent tailwind from increased pizza demand will support earnings for the U.S. Pizza Hut system through the downturn. Furthermore, Yum has recently appointed Kevin Hochman as interim president of the brand and I believe he will allow franchisees greater flexibility to adjust local operations and marketing to improve sales. Kevin was successful turning around KFC and his presence and vision for the brand is encouraging to franchisees. Finally, the U.S. Pizza Hut system only generates about 10% of Yum'sEBITDA so the outsized fixation on the segment is unwarranted. The system will be a healthy cash generator for Yum for many years to come.

Though Yum and its franchisees are not immune to the current economic environment, we think they have the staying power to come through this ordeal. In our analysis, franchisees should be cash flow breakeven with comps down 35%-40% and many will qualify for CARES Act loans providing a short-term liquidity buffer. At the corporate level, Yum’s low operating leverage and relatively low mix of owned-store sales means cash flow will remain positive even in an environment in which same-store sales are down 40%. That we are contemplating such stark declines in revenue is a testament to the unusual times in which we find ourselves. But, at some point life will normalize, and when it does, Yum! will be positioned to grow earnings in the low-teens for years to come. Even after the recent rally, Yum! trades at 14x normalized EBITDA and a 6% free cash flow yield, a significant discount to historical multiples. At recent multiples closer to 18x EBITDA and <5% free cash flow yield, the stock will be worth $110-$120 for 30%-40% upside, excluding the 2.2% dividend yield.

Catalyst

- Strong free cash flow generation through the economic downturn.

- Growth in units and earnings recover in 2021.

- Near-term demand for pizza and expanded delivery options support Pizza Hut sales.

- Multiples rebound to recent averages above prevailing levels.