Yum!'s China Story Is About Urbanization; Not GDP

We believe the market is improperly valuing share of Yum! Brands. The company’s high exposure to China (~50% of revenue) coupled with the economic slowdown in that country has spooked investors. However, we believe the Chinese exposure and dynamics are misunderstood, as YUM’s growth is not as tied to China’s GDP, but instead to the urbanization of its population. In addition, we expect YUM to benefit from emerging markets growth as both unit growth and greater ownership of superior unit economics should drive margins.

We use sum-of-the-parts and DCF as our primary valuation frameworks to better capture the true economics of the business segments. Our base case results in value of ~$85 per share, representing upside of 20%+ from current levels.

Misunderstood Risk in Key Chinese Market
YUM’s China segment is becoming less correlated to Chinese exports and more aligned with disposable income trends. With the Chinese government's mandate to continue urbanizing its rural population, YUM's Chinese customer base grows and has higher disposable income.

Less than 50% of China’s population is urbanized compared to 80% plus for countries like the US and Germany. Therefore, even if export driven GDP slows in China, we believe YUM will sill grow as China’s population continues to urbanize and enjoy improved purchasing power.

Emerging Market Growth Plans
YUM’s exposure to emerging markets has and is expected to fuel its growth over the next five years. Management estimates >10% annual unit growth in China over the next five years. As well, management estimates 100+ net new units in India off a current base of ~450. Other key YUM growth geographies include Russia and Brazil.

As YUM continues to grow units in emerging markets, it is also taking greater equity ownership in these emerging markets. Higher equity ownership in emerging markets units enables YUM to capture the strong economics for its shareholders. Cash margins for new units (KFC or Pizza Hut) are 25% and above compare to current company average of ~20%.

Valuation
We based our valuation on sum-of-the-parts and DCF as we believe this is the “best” way to assess true economics of each segment. Our base case value per share of ~$85 implies ~20%+ upside from current levels.

Our sum-of-the-parts assigns mature market QSR adjusted EV / EBITDA multiple to the US segment. For the Chinese segment we use peer Chinese restaurant and other high growth concept adjusted EV / EBITDA multiple.

Finally, for the YRI segment we use a blend of the US segment and Chinese segment multiples at this segment is a mix of both mature and high growth markets. Our EV / EBITDA multiples analysis is adjusted for off-balance sheet operating leases, which we capitalize for each company with a commensurate adjustment for rent expense from EBITDA. Our base case sum-of-the-parts results in $84 per share with a minimum of $74 and maximum of $91.

In the DCF analysis we model unit and SSS growth well below management’s expectations and at the lower-end of sell-side estimates. As well, we have margins only increasing by ~100bps and staying flat thereafter despite the superior cash margins of new units in emerging markets, which are 500bps+ better than the company’s overall current margins.

Furthermore, we assumed no benefits from net working capital investment even though this has been a source of cash for YUM historically. Our base case DCF results in $85 per share value, with a min of $70 and maximum of $98.