Yum! Brands, Inc. (YUM) a Good Stock to Buy?

Earlier in July, Yum! Brands, Inc. (NYSE:YUM) released its results for the second quarter of its fiscal year (the quarter which ended June 15th of 2013). As the restaurant company (whose concepts include Pizza Hut, Taco Bell, and KFC) shifted its store composition more towards franchises, lower costs did not successfully offset reduced revenues and as a result earnings decreased by 15% versus a year earlier. This resulted in profits being over 20% lower in the first six months of the current fiscal year compared to the prior year period.

While operating profits actually ticked up outside of China, a variety of factors including food safety concerns in that country (which should prove temporary) caused operating income to be less than half of what it had been in last year’s fiscal Q2. Since China is Yum! Brands, Inc. (NYSE:YUM)’s largest geography, making up about half of revenue, the company is highly dependent on conditions there. Cash flow from operations was also down, though Yum! Brands, Inc. (NYSE:YUM) dipped into its cash reserves in order to fund its dividend and roughly $330 million in buyback activity. The stock currently trades at 23 times trailing earnings, which is actually not that out of line for a quick service restaurant company. In addition, Wall Street analysts believe that Yum! Brands, Inc. (NYSE:YUM)’s troubles in China will work themselves out next year and so earnings per share will rebound somewhat; their forecasts imply a forward P/E of 19.

We’ve found in our research on hedge funds’ quarterly 13F filings that the most popular small cap stocks among hedge funds outperform the S&P 500 by 18 percentage points per year on average (learn more about our small cap strategy) and track these filings in our database as a result. This also allows us to track interest in individual stocks over time; for example, we can see that billionaire Richard Chilton’s Chilton Investment Company owned about 740,000 shares of Yum! Brands, Inc. (NYSE:YUM) at the end of the first quarter of 2013 (see Chilton’s stock picks). Emerging Sovereign Group, managed by J. Kevin Kenny, initiated a position of about 2 million shares between January and March (find Emerging Sovereign’s favorite stocks).

Other budget quick service restaurants include McDonalds Corporation (NYSE:MCD), Burger King Worldwide Inc (NYSE:BKW), The Wendy’s Co (NASDAQ:WEN), and Jack in the Box Inc. (NASDAQ:JACK). McDonalds Corporation (NYSE:MCD), at a trailing P/E of 19, is the cheapest of this peer group. However, it too has been struggling with little change in either revenue or earnings compared to a year ago. It might be of interest to defensive investors with a beta of 0.3 and a dividend yield of 3%, but even in that case we’d be concerned about its valuation. Jack in the Box Inc. (NASDAQ:JACK) has been having problems as well: in its most recent quarter revenue slipped 3% compared to the same period in the previous fiscal year, with net margins shrinking as well. The sell-side is forecasting an improvement in earnings per share next year, but even if Jack in the Box hit analyst targets the forward P/E would be 19 and so the company would need decent growth from that point on.