Yum Brands: Is There a Future in Fast Food?

The fast food industry has been completely disrupted in recent years by the troubles at McDonalds (NYSE: MCD), growing income inequality and the rise of aggressive next generation retailers like Chipotle Mexican Grill (NYSE: CMG). Naturally, many investors will be wondering what this portends for Yum! Brands (NYSE: YUM).

Yum is definitely vulnerable to disruption. It owns three American fast food icons: KFC, Pizza Hut, and Taco Bell. To make matters worse, the company is heavily exposed to the Chinese market.

Despite that, Yum is also something of a value and contrarian investor’s favorite, and it is easy to see why. The company did reward shareholders with a return on equity of 54.91% and a dividend yield of 2.52% on September 30, 2015.

The Case against Yum Brands

The case against Yum is very easy to lay out: Its brands are old-fashioned, low priced and definitely working class in an industry that is increasingly dominated by eateries that cater to more sophisticated and affluent diners.

Taco Bell in particular has a reputation for low quality and low prices. It even has the nickname “Taco Hell” in some circles. Pizza Hut has long been decried and dismissed by pizza connoisseurs, and KFC has had to fend off an aggressive challenge from Popeye’s Louisiana Kitchen (NASDAQ: PLKI), which emphasizes quality. Popeye’s is one of the few fast food brands that appeals to both working-class diners and affluent foodies.

Despite that, Yum’s Achilles’ heel could be its Chinese exposure. The company has over 6,900 restaurants in the Middle Kingdom. Much of its success has been propelled by Chinese growth even as its core market in the United States has fallen off. Now that China’s economy is slowing, Yum may no longer have that income of growth.

Are Yum Brands’ Customers Disappearing?

In the United States, Yum is threatened by growing income inequality. Pew Social Trends reported that the average income of middle-class families in 2014 was 4% lower than it was in 2000. To make matters worse, the median wealth of middle-class families fell by 28% during the same period. That means Yum’s major group of customers in the United States, the middle class, has less disposable income. Fast food is an industry dependent on the existence of a large middle class with high levels of disposable income.

During the same period, the percentage of aggregate income in the hands of upper-class Americans grew to 49%. That means the affluent have more disposable income than ever, which partially explains the success of chains of higher priced, high-quality chains like Chipotle and Shake Shack (NYSE: SHAK).

The Case for Yum Brands

The value and contrarian case for Yum Brands is a pretty simple one: Yum is a rather simple company in a business that is not sexy or glamorous. Peddling cheap tacos, fried chicken and simple pizzas to the working class is not exciting, but it is profitable.

A case can be made that Yum is one of those companies that an idiot can run. After all, most of the work at any KFC or Taco Bell can be done by any high school dropout. Yum’s core customers are nowhere near as picky as Chipotle’s; all it needs to do is provide reasonably tasty pizzas and tacos and sell them at a low price.

However, recent developments at McDonald’s show us that it is easy to mess up even such a simple business model. McDonald’s sudden drop in sales also demonstrates that even working-class customers can dramatically and suddenly change their dining habits.

Yet financial numbers show us that Yum seems to have avoided the kind of sales and revenue collapse that brought McDonald’s to its knees. Yum’s revenues in September 2015 were slightly lower than in September 2014. Yum reported a TTM revenue of $13.46 billion in September 2014 that fell to $13.15 billion in September 2015. So it is struggling to maintain position, yet some of the other financial numbers are good.

Yum reported a profit margin of 12.28%, a free cash flow of $632 million and a net income of $932 million for the third quarter of 2015. Yet it struggled in some of those areas too. Yum’s net income was down significantly in 2015; it reported a figure of $1.458 billion for third quarter 2014.

Fast Food Is No Longer a Value Investment

Although cash from operations was slightly improved, Yum reported $2.254 billion in cash from operations in September 2015, up from $2.199 billion in 2014. Yum’s cash from operations should scare investors though; it fell to a low of $1.995 billion in March 2015 before making a sudden improvement.

This seems to indicate that the fast food business is highly unstable, which makes a sudden collapse or even into the death spiral very possible. One reason for that is the high operating expenses and low margin of profit in fast food. Yum’s resources are also very limited; it had just $861 million in cash and short-term investments during the third quarter of 2015 and $6.481 billion in liabilities.

Yum’s financial numbers show us that fast food is no longer a value investment. Its chains are no longer generating the steady stream of cash necessary to cover their liabilities. To make matters worse, the cash cow known as China may no longer be paying off for Yum.

Investors should be very leery of this stock. At $68.58 a share, Yum seems overpriced, particularly since it no longer seems capable of growth. To make matters worse, it looks as if Yum is struggling to maintain revenue and market share. Therefore both fast food and Yum brands could be simply too unstable to be value investments.