YUM! Brands, Inc. YUM is steadfast in its brand transformative efforts, under which the company is focusing on the development of its three iconic global brands, increasing its franchise ownership, and creating a leaner and more efficient cost structure. It is also focusing on restaurant development to drive continued growth. However, high costs and tricky nature of consumer discretionary spending pose concerns for Yum! Brands.
In second-quarter 2018, the company reported better-than-expected results for the seventh straight quarter. Adjusted earnings of 82 cents increased 20% on a year-over-year basis. The shift to refranchising substantially bolstered the company’s operating margin and earnings per share.
Refranchising Strategy to Boost Earnings
Yum! Brands has adopted a de-risking strategy by reducing its ownership of restaurants through refranchising. In fact, the China division’s spin-off has largely made Yum! Brands a more asset-light company, as many company-owned restaurants have been in the Chinese market. In second-quarter 2018, the company had franchise ownership of 97%. It is committed to become at least 98% franchised and possess less than 1,000 company-owned restaurants by the end of 2018.
We note that refranchising a large portion of the system reduces the company’s capital requirements and facilitates earnings per share growth. Furthermore, free cash flow will continue to grow, facilitating reinvestments to increase brand recognition and shareholder return. Remarkably, this shift to refranchising has substantially benefited the company’s operating margin over the years. Thus, Yum! Brands expects to become a "pure play" franchisor, with more stable earnings, higher profit margins, lower capital requirements and stronger cash flow conversion. Moreover, since a major portion of its business is refranchised, Yum! Brands is likely to be less affected by food inflation than most of its peers.
Efficiency in Maintaining Cost and Financial Position Bodes Well
Yum! Brands aims to revamp its financial profile and thereby, improve the efficiency of its organization and cost structure globally. It believes that a “slimmer Yum Brands” would lead to efficiency gains. Management expects to cut capex to about $100 million by 2019, increase free cash flow conversion to 100%, and reduce General and Administrative (G&A) expenditure by approximately $300 million (or 1.7% of system sales). In addition, the company aims to maintain an optimized capital structure with the leverage of five times EBITDA. Over the next three years, it is committed to return an additional $6.5-$7 billion to its shareholders through share repurchases and dividends. Resultantly, the company expects EPS of at least $3.75 in 2019.
High Costs Amid Competitive Environment to Hurt Profits
Yum Brands operates in the retail restaurant space, which is highly dependent on consumer discretionary spending. The industry is also highly competitive, with bigwigs like McDonald’s MCD, Domino’s DPZ and Starbucks SBUX making pragmatic use of advanced technologies to innovate across value chains. Amid such stiff competition, Yum! Brands is continuously facing pressure to innovate and strategize its menu offerings.
Resultantly the company faces high cost of operations from brand growth initiatives. An increase in the cost of employee wages, benefits and insurance, as well as other operating costs from sales building efforts, have led to significant pressure on the company’s margins. Moreover, with relentless expansion, the company is prone to face profit margin pressure.
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