The fast-casual food industry has had some trouble over the past couple of years due to systemic factors (mostly) and self-inflicted wounds.
The systemic challenges are showing up across names such as Chipotle, McDonald’s, Burger King, Starbucks, and Yum Brands. The number one systemic challenge is inflation. This drove up the price of both labor and raw materials. We all see the raw material effect in the grocery store, where food prices have risen sharply. The second systemic challenge is regulation. States like California have jacked up their minimum wage, which has made running some stores unprofitable and led to closures. The second effect is to reduce staffing and replace employees with kiosks where people order their meals. Finally, there may be some consumer fatigue, with people wanting something different. Some problems are probably self-inflicted. A Big Mac, fries, and Coke can cost as much as $16. So feeding a family of 4 can cost close to $60. We see this cost driven more by the home office than by local restaurants. We think the franchise operators need to find a way to help the local restaurants and franchisees offer consistent, high-quality products without continuous price increases.
Yum Brands seems to have found a way to keep growing revenue and profits even while the industry has struggled. The chart above shows that the company has grown its revenue by 8.6% CAGR since 2017. EPS has grown just as fast, and free cash flow has grown a little faster. We take these as respectable numbers and attribute them to the company competing in a more affordable space. That said, the woes of the broader space have hit the company’s share price. The share price hit a peak in July at about $170 a share and closed trading on Friday at $138.63. That is a drop of about 18.5%. We see this selloff as a buying opportunity.
Technically, the share price is sitting on intermediate-term support, which suggests it is an opportune time to buy the stock. Further, the company just sold its struggling US Pizza Hut operation, and it has no answer to pizza chains like Domino’s, independent Italian restaurants, and rest stops like Casey’s. This was a good strategic move, and the company can now concentrate on what is working. While Habit is not yet big or well-known, we think people will like the value proposition.
Valuation is very reasonable, and if growth continues at 10% of so, the stock will turn out to be cheap at the current price. The PE is 17 based on trailing earings and analysts are looking for profits to fall over the next 12 months, creating the opportunity for upside surprise. The company employs an asset-light strategy, with franchisees responsible for building and maintaining stores. This has enabled the company to have a very high Return on Invested Capital of 40.1%.
Given our bullish view, we think it makes sense to sell a cash-covered put on the stock. With YUM trading at $138.63, consider the following option.
In this trade, the investor collects $408 upfront, which they get to keep. Since this structure is a cash-covered put, an additional $13,092 in cash will be required to support the trade. The investors will have to put this money to work if the share price trades at or below $135.00 at expiration. The breakeven level is $130.92, $7.71, or 5.6% below the current price. Since it is a bit out of the money on a low volatility stock, there is a 68% chance of making money on the trade. If the stock trades down and the put is exercised, that is not a horrible outcome, as one will buy the stock at 7.0 times earnings and collect a dividend. The investor can then write a call against the stock and collect an additional premium.
This may seem like a minor trade. But the potential ROE is attractive. If it works, the investor will earn $200 by risking $ 4,050, yielding a 4.94% return over 80 days. That is an annual rate of return of about 22.5%.
