5 Things To Watch When Yum! Brands Reports Earnings On Wednesday

YUM! Brands,which owns Pizza Hut, Taco Bell and KFC, is expected to report revenue of $3.4 billion for the quarter, on EPS of $1.1. During last year's Q3, the company reported revenue of $3.4 billion, on EPS of $0.97. Wall Street is therefore expecting flat sales growth but a 13% rise in profitability. Yum's three fast food chains, along with its operations in China, each report individually, so here's what to look for per segment.

The Pizza Hut division has over 14,000 units, of which 55% are located in the U.S. and 95% are franchised and operated by a third party. Over the past two quarters, Pizza Hut brought in $511 million in revenue, or about 9% of YUM! Brands' total revenue. Sales have declined by about 5% because of refranchising efforts, meaning the company franchised some of its wholly owned restaurants to third parties. Operating profit grew by over 6% and operating margins grew 3.3% to 25.8%, thanks to lower pension costs in the U.S. Same-store growth on the other hand, is flat for the quarter...for the second year in a row.

The KFC division of YUM! is made up of just over 15,000 units, of which 70% are located outside the U.S., and 90% are operated through franchise agreements. With $1.3 billion in revenue since the beginning of the year, KFC represents about 23% of YUM! Brands' annual revenue. KFC, the largest segment of YUM! outside of China is still growing, and has posted same-store sales growth of 2% during the last quarter, in line with last year's growth. Revenue has declined 2% due to unfavorable changes in currency values, something KFC is especially vulnerable to because of the large amount of units it operates outside the U.S.

With about 6,500 units, nearly all of them based in the U.S., and 85% of its restaurants franchised, Taco Bell is the smallest of YUM! Brands three fast food chains by physical presence. Its sales however—with $889 million over the last 6 months—surpassed those of Pizza Hut. Taco Bell has largely cooled down from an extraordinary 2015, when same-store growth reached 6%. Today, growth is flat on the year. As with YUM!'s two other restaurant chain divisions, lower costs have brought improved margins. At 29%, Taco Bell's are higher than the norm.

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China is the most exciting part of YUM! Brands' portfolio. The China division includes all three fast food chains within China, which amazingly, represent 51% of all of YUM!'s sales today. More important, a spin-off of the China business will take effect on October 31. Beginning November 1, all YUM's operations in China will begin to trade on the NYSE as Yum China Holdings under a new symbol: YUMC.

The Chinese business is inherently different from the rest of YUM's international segments, because almost all restaurants are company owned, not franchised. Over the past two years, foreign exchange has been hurting the company's business in China, but lower costs of sales due to changes in tax structures have offset this, resulting in higher operating profit. China still has room to grow both in margins and in sales.

Conclusion

Everywhere but in China, YUM! Brands is continuing the move to franchise operations, which is improving operating margins. That's good news.

Its P/E ratio of 27 is average, if a bit high. For comparison sake, McDonald's (NYSE:MCD) 2015 P/E was 23 and its full 2016 P/E is estimated to be 21. While defensive investors might shy away from YUM because of the relatively high P/E ratio and possible recession risks, at $90.29 per share at yesterday's close, the company isn't grossly overpriced.

However, the growth potential for the China spin-off is stronger than that of the parent company, and YUMC should trade at a higher earnings multiple. It should be noted that higher volatility is expected, especially during the early months after YUMC's IPO, when prices of new offerings are generally more sensitive than those of more established, older companies.

That being said, opportunities should arise to buy into the China spin-off at a lower than average P/E, which would make it a safer position and obviously more beneficial over the longer term. Buy on low volatility and hang on to reap the rewards from China's growing middle class.

Written By: Investing.com