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Market Overlooking Yum's Long-Term Potential

Current headwinds aside, wide-moat Yum remains a compelling long-term cash flow story, says Morningstar's R.J. Hottovy.

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We believe that these pressures are largely macroeconomic in nature, as other consumer-facing companies in the region have also noted a sentiment-driven reduction in spending following August's equity-market volatility and yuan devaluation. However, before finalizing our comp estimates, we await management's conference call comments regarding the competitive environment and its plan to "get sales, traffic, and profits back to historic levels."

Based on a more cautionary spending environment, we now view China comp growth in the low single digits over the next 12-18 months as more realistic (versus earlier expectations in the mid single digits). This will likely result in a 5%-10% reduction in our $100 fair value estimate. However, we didn't find anything in today's results that would lead us to reconsider our wide moat rating, as the China comps overshadowed several positives from the quarter (including a 470-basis-point increase in China restaurant margins to 19.6%, positive comps across most markets for KFC, and another stand-out quarter from Taco Bell).

Certainly, investors will have to exercise patience, as China trends are unlikely to turn around overnight. However, with Yum trading at around $70 per share, we believe the market is overlooking the company's long-term free cash flow potential and possible activist-led moves like a leveraged recapitalization or spin-off of Yum China.

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About the Author

RJ Hottovy

Sector Strategist
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R.J. Hottovy, CFA, is a consumer strategist for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He is responsible for consumer discretionary and staples research. He has covered the consumer sector as an analyst and director of global consumer equity research for Morningstar since joining the company in 2008, and specializes in a broad range of consumer categories including restaurants, footwear and apparel retailers, consumer electronics retailers, fitness clubs, home improvement and furnishing retailers, and consumer product manufacturers.

Before joining Morningstar, Hottovy was a director and senior stock analyst for Next Generation Equity and an analyst for William Blair & Co., specializing in a wide range of retail and consumer product companies. He also spent two years at Deutsche Bank, covering waste management, water utilities, and equipment rental stocks.

Hottovy holds a bachelor’s degree in finance and a second degree in computer applications from the University of Notre Dame, where he graduated magna cum laude. He also holds the Chartered Financial Analyst® designation and is a member of the CFA Institute and the CFA Society of Chicago.

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