One critical argument in David Einhorn’s short recommendation of Chipotle Mexican Grill, Inc. (NYSE:CMG) at this month’s Value Investing Congress was that the trendy restaurant would soon start to lose market share to Taco Bell, one of the “concepts” at Yum! Brands, Inc. (NYSE:YUM). Despite offering a consumer survey conducted by Greenlight Capital in support, Einhorn was mocked for this point- did the billionaire not understand that Taco Bell and Chipotle were completely different restaurants? Had he ever visited one?
Shortly afterward, Yum! Brands, Inc. issued its 10-Q for the quarter ending in August. Revenues were up 9% from the same period last year, roughly even with the growth rate from earlier in the year despite concerns about Chinese macro. Net income rose sharply, at a 23% rate. Revenues were down in the U.S.- China, responsible for over half of sales, drove overall growth- but operating profits rose 13%. To some degree these changes were due to refranchising initiatives. According to the 10-Q, U.S. Taco Bell operations, China, and the International division (which excludes the U.S., China, and India) are responsible for 90% of operating profits. Given the strong increase in U.S. operating profits, it seems logical to conclude that Taco Bell is making significant contributions.
It’s good to see profits growth, but Einhorn had noted in his presentation that he was not long Yum! Brands, Inc. and it’s possible that the reason for that is the company’s valuation. At 21 times trailing earnings and 19 times forward earnings estimates, the market seems to be expecting growth to pick up. While it’s possible that good U.S. consumer numbers will continue to power domestic operations higher and also contribute to a stronger Chinese economy, the valuation does seem aggressive to us.
Yum took the #2 slot on our list of the ten most popular restaurant stocks among hedge funds in the second quarter, as more funds and other notable investors- likely worried at the time about Chinese exposure- sold out of the stock than of McDonald’s Corporation (NYSE:MCD). Billionaire Steve Cohen’s SAC Capital Advisors diverged from this trend, as the fund added shares and had about 940,000 shares in its 13F portfolio at the end of June (see more stock picks from SAC Capital Advisors). Legg Mason Capital Management, managed by Bill Miller, slightly reduced its stake but still owned 1.3 million shares at the end of the second quarter (find more stocks that Legg Mason owned).
Yum’s peers include Chipotle, quick service restaurants McDonald’s and Burger King Worldwide Inc (NYSE:BKW), and pizza restaurant Domino’s Pizza, Inc. (NYSE:DPZ). Domino’s recently reported strong third quarter earnings, with earnings per share coming in at 43 cents versus 35 cents a year earlier. Much smaller than Yum at a $2.3 billion market cap, Domino’s trades at a forward P/E of 18. Even with its good growth, that does not seem like an attractive valuation, including relative to Yum. Chipotle has an impressive growth history behind it, but Einhorn’s action and other short activity (shortly before his presentation, about 12% of the shares outstanding were held short) reflect skepticism that the company can preserve its market share. Trading at trailing and forward P/Es of 35 and 27, respectively, it is highly sensitive to a lower trajectory of earnings.
McDonald’s, somewhat surprisingly, is the cheapest of these peers on a forward basis. The $94 billion market cap quick service restaurant trades at 15 times estimates of 2013 earnings, and also offers a 3.1% dividend yield. Its recent growth may not be particularly high, but is still respectable and despite Yum’s expansion opportunities we see McDonald’s as a better value. Burger King, fresh off its IPO in June, carries a forward P/E of 22- higher than what we see at McDonald’s or Yum. The investment thesis is that Burger King will be able to expand its business, but we are skeptical that it should get this kind of an earnings premium.
Yum does seem to have the potential to chip away at Chipotle. However, there’s no reason that both companies can’t be overpriced, and we think that McDonald’s is a better value in the restaurant industry.