Takeaway: YUM has been one of the best performers in the restaurant space over the past 6 months (+6.1%) and is a name we continue to prefer on the long side. Look for strength in China to dispel any remaining fears and the company to solidify its runway for +20% EPS growth in 2014.
Investment Thesis Overview
Despite being a strong performer to-date in 2014, YUM shares have room to run. We see fair value between $90-100/share.
YUM continues to be one of our favorite longs in the big cap QSR landscape as we believe the company is well positioned to capitalize on a substantial long-term growth opportunity in China and other emerging markets. Looking near term, we expect easy comps, notable margin expansion and positive earnings momentum to drive performance throughout 2014. As we’ve stated before, the magnitude of this performance will depend heavily upon the trajectory of the recovery in China. While management’s guidance of 40% operating profit growth in China may be aggressive, we believe they have multiple levers at their disposal to reach greater than +20% EPS growth in 2014.
Domestically, Taco Bell continues to take share from competitors and drive incremental sales through innovation. The chain recently launched its national breakfast rollout, supported by a strong advertising campaign. Early signs indicate that breakfast has been selling well and franchisees are supportive of the move. We believe breakfast represents a material opportunity for Taco Bell, even if they are only able to capture a small piece of the market. Taco Bell has significant brand momentum and continues to carry the domestic business. We expect to see a renewed level of focus at both the KFC and Pizza Hut brands throughout the year, but don’t expect to see any material improvement as they continue to lose share to competitors.
In addition to its strong positioning in emerging markets, YUM has three main levers (growth investments, growing dividend, share repurchases) to continually support the stock and drive shareholder value.
For 2Q14, the street expects revenues of $3.23 billion (+11% YoY), adjusted EPS of $0.72 (+29% YoY), and system-wide same-store sales of +3.3% (led by +11.2% growth in China). We see upside to earnings driven by strong same-store sales and operating leverage in China as productivity initiatives continue to materialize.
Same-Store Sales Trends
System-wide two-year same-store sales look to have bottomed in 1Q14 and we anticipate a recovery from these lows. A recovery in China and momentum at Taco Bell following its breakfast rollout should support meaningful system-wide comp growth throughout the year.
Strong comp growth and other efficiency initiatives in China should enable the company to improve restaurant level margins and operating margins in the quarter to an extent comparable to 1Q14.
YUM is currently trading at 22.00x P/E and 12.03 EV/EBITDA on a NTM basis.
The quarter, and really the year, relies heavily upon the performance of the China segment. Therefore, the main risk to our thesis is any setback or weakness in this market which would likely be driven by disappointing same-store sales. Over 90% of stores outside China are franchised. As such, the domestic KFC and Pizza Hut businesses are largely irrelevant when looking at the grand scheme of things. A continuation of the underperformance we saw at the Taco Bell brand in 1Q14 would be concerning, though to a much lesser extent than any underperformance in China.
Takeaway: We are riding out our long position in Lorillard.
The big news last Friday was that all parties that may be involved in a deal to acquire Lorillard (LO)—directly or not—acknowledged through press releases that in fact, the parties are underway in discussions (yet noted that there is “no certainty that any deal will take place”).
This not-so-new-news (rumors have persisted since March of a deal between Reynolds American (RAI) and LO), bolted LO shares on Friday as high as 5%+ intraday to well over $66.
Shares are showing continued strength today and are up 1.3% to just shy of $67.
Hedgeye Consumer Staples analyst Matt Hedrick writes that “we are riding out our long position in LO, which we initiated as a Best Idea Long on 2/26/14 at $47.74, to a price target of $80.”
Hedrick expects to see RAI and LO work closely to get this deal done, and attaches an 85% probability that a deal in fact gets done. Assuming Thursday’s (7/10) closing price of $63.09, he assumes there’s an additional 26% upside to our target, and around 8% of downside to $58 should a deal not get done.
Takeaway: How about some new shirts and shorts with those new shoes?
Editor's note: This is a brief excerpt from Hedgeye retail sector research. Related tickers are Foot Locker (FL), Finish Line (FINL) and Dick's Sporting Goods (DKS). For more information on our product offerings click here.
Ed Griffin-Co-owner, Fleet Feet Sports, Syracuse, N.Y.
“'We are putting a ton of focus on apparel sales — and women’s in particular. We have hired apparel specialists...spread the footwear try-on areas throughout the store to better integrate apparel and accessories to create a more even flow of traffic.'"
Lee Silverman-President, JackRabbit Sports, New York
“'We’re putting a lot of effort into apparel. If we’re going to grow, it needs to be through apparel. We’re adjusting our store merchandising, replenishing, buying and sales techniques — there’s a lot to learn.'"
Hedgeye Takeaway: No surprise that running specialty stores are looking to apparel to help fuel the next leg of growth. The running category hasn't exactly been knocking the cover off the ball over the past 12 quarters. On the other hand, athletic apparel has shown no signs of cooling off and would help some of these smaller concepts diversify at higher margins. But, it won't be easy with Dick's Sporting Goods and Finish Line pushing in the same direction.
Takeaway: Brazil is setting up as a short in 2H. Lots of capital has flowed into the country this year on a catalyst that is unlikely to materialize.
On JUN 3 we closed out a long recommendation in Brazilian equities and the BRL, citing a marked deterioration in Brazil’s high-frequency growth data that was likely to perpetuate incremental Policies To Inflate out of the Rousseff administration. While the initial recommendation did generate a substantial degree of alpha, our decision to “book” the gain was clearly the wrong one given that the iShares MSCI Brazil Index Fund (EWZ) and the BRL/USD cross have appreciated +7.2% and +2.9%, respectively, since then.
Nothing worse than leaving money on the table…
Since JUN 3, we’ve seen signs of economic stabilization, with PMI, Industrial Production, Consumer Confidence and Credit Quality data more-or-less flattening out relative to their recent trends, while Retail Sales and Consumer Credit growth have shown material improvement.
This economic stabilization comes in the wake of a slew of fiscal easing measures out of the Rousseff camp that is likely perpetuating what we’re identifying as renewed confidence in her failed economic policies. In fact, in her initial volley to start the campaign season, she proclaimed that Brazil had very little space to adjust fiscal policy. Moreover, her platform of increased spending on social welfare, health care and education represents little change to the inflationary fiscal and monetary policy she has promoted throughout her administration.
Looking at Brazil from a top-down perspective, we see that headline consumer price inflation has run above the mid-point of BCB’s target band of +4.5% YoY +/- 200bps for the entirety of her presidency. Again, this is largely due to an ever-expansionary fiscal policy mix that has weighed on Brazil’s fiscal and current account balances.
It’s worth noting that our predictive tracking algorithm has Brazilian inflation readings accelerating throughout 2H14. In the context of a OK-at-best outlook for growth, we think that will likely continue to erode expectations for real interest rates in Brazil over the intermediate term (e.g. Brazil's 1Y OIS spread has compressed -48bps over the past 3M). That should reduce (but not completely quash) the country’s allure in the context of our 3Q macro theme “#DollarDevaluation”.
No surprise here, but various readings of confidence – be it Consumer or Business – in the Brazilian government and/or Brazil’s economic situation are at/near cycle-lows – which is one of the factors that got us to believe back in FEB that the OCT presidential election will be tighter than what was priced into the markets at the time.
Fast-forward to today, however, it’s very clear that investors are well aware of this setup given the outperformance of Brazilian capital and currency markets since then. As we initially outlined, international investors took a page out of the Japan (2012-13) and India (2013-14) playbooks speculate on political change in Brazil.
What if the political change never comes? What if, after all is said and done in OCT, we have another four years of pro-inflation, pro-BoP deterioration policies in Brazil? What if the “Brazil discount” is reapplied to the prices of Brazilian financial assets?
That’s a key risk(s) for investors to consider going forward from today’s prices.
We’ve already seen Rousseff’s support in the polls stabilize in recent weeks amid positive developments on the political front (e.g. the PMDB – Brazil’s 2nd largest political party – backed her election bid while officially nominating PMDB lawmaker Michel Temer as her running mate).
Per the JUL 1 Datafolha survey, Rousseff rebounded to 38% from a trough of 34% last month. While the poll was conducted ~1W prior to Germany handing Brazil its worst-ever World Cup defeat (on home soil nonetheless), history would seem to suggest that the World Cup has little-to-nothing to do with the outcomes of Brazilian presidential elections (e.g. Henrique Cardoso won re-election in 1998 in spite of Brazil losing to France in the final and Lula da Silva defeated the incumbent to claim victory in 2002 despite Brazil beating Germany for the title that year).
We’ll get more polling data this week (i.e. Sensus JUL 15, Datafolha JUL 16 and Ibope JUL 18), which will help us begin to cement our views on the upcoming election and the prospect for meaningful political and economic reform in Brazil.
To the extent Rousseff starts to gain momentum, we’ll likely begin to recommend investors trade Brazil with a short bias going forward.
Best of luck out there!
Associate: Macro Team
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