Yum! Brands, Inc.: “Magic Numbers” Leads to Record Profits for Investors
What Yum! Brands, Inc. Can Teach Us About Investing
If you want to make a lot of money in investing, then you need to understand these two magic numbers: 80/20.
The Pareto principle, also known as the “80/20 rule,” states that 80% of the results come from 20% of the causes. In business, the most successful companies zero in on the smallest, most profitable part of their industry. They make their shareholders fortunes by focusing on the most lucrative 20% of activities and leave the grunt work to partners.
You can see the 80/20 rule at work in the world’s most successful businesses. Nike Inc (NYSE:NKE) focuses on designing and branding athletic apparel, contracting out the low-return, capital-intensive activities like manufacturing and retailing. The Coca-Cola Co (NYSE:KO) makes most of its money selling syrup, leaving the take of bottling, distributions, and retail to bottlers. Microsoft Corporation (NASDAQ:MSFT) works only in the most lucrative part in the computer industry, designing software and operating systems.
Here’s another example: Yum! Brands, Inc. (NYSE:YUM), the owner of “Taco Bell,” “KFC,” “Pizza Hut,” and “WingStreet.” Historically, the fast food giant owned and operated most of its restaurants. But in 2016, management revealed plans to franchise almost all of its locations.
At first glance, the strategy might not make much sense. By partnering with franchises, Yum! Brands has to give a new stakeholder a cut of the profits. And you can see that right away in the company’s financial results; since 2016, revenues have actually dropped 10% to $5.7 billion.
So why did executives go down this route? It all comes back to the 80/20 rule. By refranchising locations, Yum! Brands, Inc. outsourced the hardest, least-profitable part of the fast food business: running and operating restaurants. Now franchisees, not shareholders, have to front the cost of building new stores. Franchisees also have to perform the difficult job of hiring workers, training staff, dealing with customers, and negotiating with local regulators. Yum! Brands, meanwhile, can kick up its feet, collecting a royalty on each sale.
That strategy has paid off. By refranchising locations, the company has reduced the total amount of capital (debt and equity) invested into the business by more than half. Profits, however, have barely dipped. Yum! Brands generated $1.54 billion in 2018, down only six percent from 2016.
This initiative has turned the company into a money-making machine. In the business lingo, we call this “making the equity sweat.” In 2016, Yum! Brands, Inc. generated $0.28 in profit on every dollar invested into the business. Last year, this return figure jumped to $0.60. More impressively, diluted earnings per share jumped 80% to $4.49 a piece.
And shareholders have cashed in. Since 2016, Yum! Brands has spent $9.8 billion on stock buybacks. Over that same period, management has boosted the quarterly distribution 40% to $0.40 per share.
“The third and final year of our transformation is underway and I’m thrilled with the progress towards our commitment to becoming a more focused, more franchised, and more efficient growth company.” said Chief Executive Officer Greg Creed. “Through the lens of our four growth drivers, we continue to leverage our unprecedented scale and expand our capabilities with the goal of improving franchise economics and accelerating growth. We remain confident in our enviable business model and our commitment to lasting growth that maximizes shareholder value.” (Source: “Yum! Brands Reports Solid First-Quarter System Sales Growth of 8%; Same-Store Sales Growth of 4%; GAAP Operating Profit Decline of (22)%; Core Operating Profit Growth of 12%,” Yum! Brands, Inc., May 1, 2019.)
Wall Street, it seems, has taken notice. Since Yum! Brands announced its new refranchising strategy in late-2016, shares have delivered a total return, including dividends, of 76%. That has crushed the return from the broader S&P 500 and wider restaurant industry over the same period.
Chart courtesy of StockCharts.com
The Bottom Line on YUM Stock
The Pareto principle can make you a more successful investor. Great companies don’t need to provide every product and every activity. Instead, they cherry-pick. Smart managers select the parts of the value chain—from conception in research through design, development, branding, manufacturing, selling, and physical distribution—that generate 80% of the profits but require only 20% of the capital and effort.
By adopting the 80/20 rule, Yum! Brands, Inc. has taken an already wonderful business to another level. Let others handle the thankless job of building and running restaurants. By focusing on the most profitable activities of the fast food business, branding and marketing, the company can earn unprecedented returns for shareholders.
Investors should give and YUM stock a second look.