This is from the AMM Dividend Letter released February 11, 2016. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
We like to think we do a decent job of writing these letters; however we’re realists and we do not hold illusions of grandeur that we are the Hemingway of financial writing. One investor that may be vying for this title is Howard Marks. Mr. Marks is the Chairman of Oaktree Capital and has been writing his memos for Oaktree investors since the early 90s. Howard’s memos have become a must-read within the finance industry. Warren Buffet says it’s the first thing he reads whenever a new memo is released.
The latest memo talks about “The Market”. We commonly look at the broad equity market and assign an intelligence to it especially during times of stress. We think the market “knows” something that we don’t. It doesn’t.
So, what does the market know? First it’s important to understand for this purpose that there really isn’t such a thing as “the market.” There’s just a bunch of people who participate in a market. The market isn’t more than the sum of the participants, and it doesn’t “know” any more than their collective knowledge.
This is a very important point. If you believe the market has some special insight that exceeds the collective insight of its participants, then you and I have a fundamental disagreement. The thinking of the crowd isn’t synergistic. In my view, the investment IQ of the market isn’t any higher than the average IQ of the participants. And everyone who transacts gets a volume-weighted vote in setting an asset’s price at a given point in time.
People of all different levels of ability act together to set the price. They vary all over the lot in terms of knowledge, experience, insight and emotionalism. The market doesn’t give the ones who are superior in these regards any more influence than the others, especially in the short run. My bottom line on this subject is that the market price merely reflects the average insight of the market participants. That’s point number one.
If anything, I think it’s emotion that’s synergistic. It builds into herd behavior or mass hysteria. When 10,000 people panic, the emotion seems to snowball. People influence each other, and their emotions compound, so that the overall level of panic in the market can be higher than the panic of any participant in isolation. That’s something I’ll return to later.
Now let’s think about the first goal of investing: to buy low. We want to buy things whose price underestimates the value of the underlying assets or earnings (value investing) or the future potential (growth investing). In either case, we’re looking for instances when the market is wrong. If we thought the market was always right – the efficient market hypothesis – we wouldn’t spend our lives as active investors. Since we do, we’d better believe we know more than the consensus. So by definition we must not think the market – that is, the sum of all other investors – knows everything, or knows more than we do, or is always right. That’s point number two.
And that leads logically to point number three: why take instruction from a group of people who know less than you do? In “On the Couch,” I wrote that it all seems obvious: investors rarely maintain objective, rational, neutral and stable positions. Do you agree with that or not? Is the market a clinical and rational fundamental analyst, or a barometer of investor sentiment? Does the market’s behavior these days look like something a mature adult should emulate?
It seems clear to me: the market does not have above average insight, but it often is above average in emotionality. Thus we shouldn’t follow its dictates. In fact, contrarianism is built on the premise that we generally should do the opposite of what the crowd is doing, especially at the extremes, and I prefer it.
Large price swings in assets do not indicate a market intelligence. What it does show is the current state of investor psychology.
Fundamentals – the outlook for an economy, company or asset – don’t change much from day to day. As a result, daily price changes are mostly about (a) changes in market psychology and thus (b) changes in who wants to own something or un-own something. These two statements become increasingly valid the more daily prices fluctuate. Big fluctuations show that psychology is changing radically.
And, I said on page two, emotional fluctuations – swings in market sentiment or psychology – do seem to be synergistic. That is, in crowd psychology, 2 + 2 = 5. While I don’t think the price of an asset reflects more wisdom than is possessed by the average of its market’s members, I do believe mass psychology will make a group swing to reach greater emotional extremes than its members would separately. In short, people make each other crazy. And when times are bad – like now – they depress each other. That was a factor in the edge enjoyed by our distressed debt team in 2008: they were able to buy at the market’s lows because they weren’t in New York, where everyone was trading scary stories and getting each other down.
Again, we can gain insight through logic. We all know we want to buy (not sell) at the lows, and sell (not buy) at the highs. So then how can it be right to sell because of a decline or buy because of a rise? Advocates of this latter approach must think (a) declines and rises tend to continue more than they reverse and/or (b) they can tell which declines mean “buy” and which mean “sell.” Some savants may have that latter ability, but not many. In general, I think it’s ridiculous to sell something because it’s down (just as it is to buy because it’s up).
We shouldn’t be basing our decisions on what the market is doing.
So the bottom-line question is simple: does the market reflect what people know, or should people base their actions on what the market knows? And if the latter, where does “the market” get its information, other than from people? For me it’s simple: if people follow the market’s dictates, they’re taking advice from . . . themselves!
Read the whole memo, it’s worth it.
Dividend Stock in Focus
Yum! Brands (YUM): $65.24*
*price as of the close February 11, 2016
When we developed the AMM Dividend Strategy we decided to focus on dividend growth over high current dividend yield investing. We focus on three core types of dividend payers as the building blocks of our dividend strategy portfolios.
1) Dividend Stalwarts: Companies that have strong dependable market positions, that pay a reasonable dividend (~2-3%), and have shown an ability to grow their dividends over a long period of time at a pace far faster than inflation. While the current yield is modest, we expect the growth in the dividend payout to provide a more robust yield (on original cost) in the future.
2) Restructuring/Special Situations: Companies undergoing a restructuring, spin-off, or other special situation. If we see value in the restructuring and the parent company pays a reasonable dividend we will invest. Our initial time frame for these investments is one year but if, after the restructuring, one of the companies’ appears to offer good odds of becoming a dividend stalwart we may hold our investment for a longer time frame.
3) New Dividend Payers: Companies that have recently initiated a dividend policy. While these companies do not have the long history of paying and growing their dividend like the stalwarts, they do have a strong market position and the cash flow to become a stalwart in the future.
Yum! Brands could easily fit into the dividend stalwart category but we’ve started a position in Yum! because it is undergoing a corporate restructuring. Yum! Brands is splitting into two companies. One company will focus solely on the Chinese market, Yum! China. The other company will retain all other markets with North America being the biggest one. Each new company will have a different growth and operational profile and the upcoming restructuring should unlock the value of each business.
Yum! Brands is known for owning and operating KFC, Taco Bell, and Pizza Hut. Yum! Brands itself is the result of a corporate restructuring, a spin-off, from Pepsi Co. in 1997.
Dividend History:
Yum! Brands started paying a quarterly dividend in 2004. Over the last 9 years, Yum! has grown their dividend at a compound annual rate of 21%.
From S&P Capital IQ. Click image to enlarge.
Yum! also recently raised its dividend another 17%. The upcoming corporate restructuring should boost Yum! Brands’ dividend further and potentially provide a one-time special dividend too. Yum! Brands’ current payout ratio looks high at 78% but this is because of special one-time write-downs tied to recent food scandals. Yum! Brands’ dividend is well covered by Free Cash Flow when we add back the one-time non-cash write-downs.
Catalysts for Dividend Growth and Price Appreciation:
Spin-Off
Yum! Brands is essentially two restaurant business models combined as one. The first model is an asset-light model that relies heavily on franchising its stores and collecting royalties from the franchisees. This first model represents Yum! Brands’ U.S business. The asset-light model produces lower revenue per store but generates higher margins and profitability per store.
The second model is an asset-heavy model that relies on owning and operating its stores. Yum! generates more revenue per store but controlling and operating the store is less profitable than franchising it. This model represents Yum! Brands’ Chinese division. Yum! Brands has a total of 6,867 stores in China and Yum! operates 5,521 of them. Currently Yum! Brands’ China division generates pre-tax operating profit margins of 10.28% while the US franchised focus division generates pre-tax operating profit margins of 23.76%.
Yum! Brands is also a combination of two different growth prospects. Yum! Brands’ US division is a mature business focused on slower growth and incremental operational efficiencies. Yum! China is still an emerging business and a play on the growth of the Chinese middle class. Management believes they can build out 20,000 stores in China.
Yum! China has the potential to grow to 20,000 restaurants or more in the future from approximately 6,900 restaurants today. The business also has significant sales and profit growth potential in its existing restaurants, which the Company plans to capture over time by growing its core offerings and expanding further into new initiatives such as home delivery. – From 8K released 10-20-2015
Separating the two business models and two growth prospects from each other should unlock the hidden value of the two businesses.
YUM! China
The table below highlights a few US Companies that we think are comparable companies to Yum! China. While we think of KFC and Pizza Hut as traditional fast-food companies in the U.S., in China these brands are viewed more like traditional casual restaurants. U.S. casual restaurant companies like Brinker (EAT), DineEquity (DIN), and Darden Restaurants (DRI) own and operate their restaurants like Yum! China.
Once Yum! China is spun-off from Yum! Brands it will trade on US exchanges. We will use these companies as comparables to estimate a range of potential values for Yum! China.
Data from S&P Capital IQ. Click image to enlarge.
Yum! China added 448 net new stores for the period ending September 5, 2015, for a total unit count of 6,867.
Image from Yum! Brands 10Q for the period ending 9-5-2015. Click image to enlarge.
Over the trailing 12 months Yum! China generated revenues of $6.867 Billion which equals $1 million in sales per store. Over the same trailing 12 months Yum! China generated $693 million in operating profits. This is a 10.09% operating profit margin.
Using the highlighted companies and their multiples of 12-14x operating income, we come up with a value range of Yum! China of $8.32-9.7 Billion. This is Yum! China’s estimated value today if it were trading on its own. We also want to estimate a reasonable value for Yum! China 5 years from now.
Let’s say Yum! China continues to add 448 net new stores for at least the next 5 years. By 2021 Yum! China will have 9,107 stores opened. If they too can generate $1 million in sales then 2021 revenues will be $9.11 billion. At a 10% operating margin, Yum! China will generate $910.7 million in operating profit. Using the same multiples from above this produces a 5-year value range of $10.92-12.75 Billion.
Yum! China’s current operating margin is under-representative of its underlying earnings power. In 2014 Yum! Brands had issues with a Chinese food supplier who was relabeling and selling meat that passed its expiration date. Expectedly Yum! Brands lowered expectations and estimates as its Chinese KFC sales fell.
Before the food scandal Yum! China had an operating margin of 14%. If Yum! China can recover from the food scare and regain operating efficiency than Yum! China is worth a lot more in 5 years. 9,107 stores producing $9.11 billion in revenue with 14% operating margins produces $1.28 billion in operating profits. Using the same 12-14x multiples produces a value range of $15.3-17.6 billion.
The multiples we’re using may prove to be too conservative given Yum! China’s growth prospects and potential margin expansion. The companies we used as comparables have lower growth rates and consistently produce sub 10% Operating Margins except for DineEquity (DIN).
At 10 percent operating margins we reasonably estimate that Yum! China could be worth 31% more in 5 years. If operating margins can get back to pre-scandal levels, then we estimate the company could be worth 83% more in 5 years.
It looks like Yum! China is on the right track. According to the 10Q ending September 5, 2015, Yum! China grew revenues 7 percent year-over-year and operating margins were 16% versus 11% in the period a year ago.
YUM! U.S.
The table below includes a handful of companies that are comparable to Yum! Brands post spin-off. Outside of China & India, 91% of Yum! Brands stores are franchised. Yum! brands’ goal post spin-off is to reach 95% franchised stores. The comparable companies below also have over 80% of their stores operating as franchises.
Data from S&P Capital IQ. Click image to enlarge.
The higher the franchise mix, the higher the trading multiple. A post spin-off Yum! Brands with a franchise mix over 91% should trade in-line with McDonald’s. For the trailing twelve months Yum! Brands generated $1.26 billion in operating profits. Applying an 18x multiple values Yum! Brands ex China at $22.7 Billion.
Yum! Brands pre-restructuring trades at a market capitalization of $31.52 Billion. At this price, we are paying a fair price for both the US and China businesses as is. However, we think Yum China! priced as it is today drastically undervalues its growth potential and its ability to rebound from its food scandal. We also think Yum! Brands’ current trading price is undervaluing its US operations.
Pizza Hut
Started out as a casual dine-in pizza restaurant. The majority of pizza ordering and consumption in the U.S. has switched to delivery. Pizza Hut does deliver pizza but it still operates its casual dine-in restaurants. Pizza Hut’s larger store footprint compared to delivery only options like Domino’s Pizza (DPZ) leads to lower sales per square foot and lower operating margins per store. Shifting its store mix from more dine-in locations to delivery only locations will increase speed and convenience for customers and improve its operating metrics.
KFC
Compared to other chicken-focused quick service restaurants like Bojangles (BOJA) and Popeye’s Louisiana Kitchen (PLKI), KFC is operating below its potential. Domestic KFC stores are profitable and growing but operations could improve. One step is modernizing their menu and increasing their exposure to chicken sandwiches, one of the fastest growing segments in fast food. Another option is expanding their hours of operation and staying open later at night. Improving the speed and quality of service is the last step.
Taco Bell
Taco Bell is Yum! Brands’ best-performing segment. While it is not a fast growing segment it generates high margins and lots of free cash flow. Taco Bell’s recent push into breakfast continues to drive year over year same-store-sales growth. A Taco Bell spin-off is possible. If KFC and Pizza Hut obscure the value of the Taco Bell division, we wouldn’t be surprised to see activists push for a spin-off.
Recapitalization
Before the completion of the spin-off, Yum! Brands will take on more debt that will stay with Yum! Brands after the Chinese spin-off. The increased leverage is to buy back more shares and issue a special dividend before completion of the spin-off. Management plans to return about $6.2 billion to shareholders before the spin-off of Yum! China is complete.
Pre-Mortem (Potential Risks to our Thesis):
Can’t Overcome Food Scandal & Operational Ineffeciencies
The big question for Yum! China is if it can bounce back from its food scandal. So far we’ve seen positive signs. However, if the Chinese consumer is anything like the U.S. consumer it will take time to earn their trust back. It took Jack In The Box (JACK) almost 4 years to recover from its E. Coli scare.
When Yum! Brands first started operating in China it had no real local competition. Operational inefficiencies were easy to overlook as customer volume made up for it. Yum! Brands now faces more local competition and its food scandal may have pushed its former loyal customers into the arms of its competitors. The reduced customer traffic also exposed its operational inefficiencies. Not only does Yum! China need to win the trust of its customers back it also needs to improve upon its service quality and speed to keep customers happy and coming back for more.
China
China provides a great opportunity for growth but exposure here comes with commensurate risk. The biggest issue is the government itself. One day it’s business friendly, and then an enemy the next. Part of the idea behind the Yum! China spin-off is to have a Chinese company that can better handle Chinese issues. I don’t know how Chinese the new company will look when it will initially trade on the NYSE exclusively. A Hong Kong listing has been discussed but a timetable has not been announced. While Yum! China will be a Chinese-focused company it doesn’t mean the Chinese government will recognize Yum! China as Chinese.
Another reason for the Yum! China spin-off is to create a direct play on the rise of the Chinese middle class and the country’s ongoing shift to a more consumption based economy. Chinese growth has slowed in recent years, which was to be expected as the economy became larger. The question is whether or not the economy is growing much slower than officially released numbers and what this might mean for the spending habits of its burgeoning consumers. Eating out is a small luxury and an easily cut one if consumers perceive or are experiencing any economic hardship. In our opinion, a Chinese recession would be a short-term problem. However, if China’s economy slowed dramatically within the next year it would be bad timing for a stand-alone Chinese focused consumer discretionary company to start trading.
Changing U.S. Consumer Tastes
The trend in quick service restaurants has been towards fast casual, “healthier” fare that tends to be locally sourced and sustainable. KFC, Taco Bell, and Pizza Hut are clearly not in this category. So far fast casual food concepts and traditional fast food outlets have coexisted and grown as more and more people eat out than make food at home. If the fast casual trend persists it will pressure sales at KFC, Taco Bell, and Pizza Hut.
Yum! Brands is well aware of the potential threat fast casual presents. Yum! launched U.S. Taco Co. as a fast casual concept restaurant, but recently shuddered the business. While Yum! is expected to launch other fast casual restaurants, the better move may be to buy an existing, emerging, and already successful brand. Given Yum! Brands increased debt load from the upcoming spin-off, any major purchase will likely require either stock issuance, which would be dilutive to current shareholders, or more debt.
Conclusion:
Yum! Brands is a high-quality company that has generated high returns on equity, tangible assets, and capital for a long period of time. We’ve been watching it and waiting for its price to come down to a level we’d be willing to pay for the company. The Chinese food scandal created that opportunity. Food scandals are resolved quickly but the customers’ perceptions persist dragging sales, earnings, and stock prices down over the short-run.
All previous letters are archived here.
