Recent Sell (2)

Whenever I purchase a stake in a company my plan going in is always to hold for the long term.  Essentially I want to treat my positions as if I owned the whole business and avoid the temptation to trade in and out of positions depending on Mr. Market's moods.

However, sometimes it seems right to make some sales.  The reason for this sale, well position trim really, was three-fold.  (1) I wanted to have some cash on the sidelines, (2) the valuation seems quite rich at the current price level and (3) I have concerns regarding some decisions made by management.  Add those 3 together and you get a position that's ripe to be trimmed back a bit.

I first started purchasing shares of YUM Brands (YUM) back in 2014.  Since then the position has done remarkably well for me with a 20.1% IRR.  I'll detail my concerns later, but first let's look at the numbers.  After 2 rounds of purchases and one dividend reinvestment I owned 42.099 shares of YUM Brands at an average cost basis of $2,163.15.

On July 22nd I sold 11 shares of YUM Brands for $113.1634 per share.  After commissions the net proceeds came to $1,239.85.  That's a pretty solid return if you ask me since the cost basis on those shares was $580.59.  From capital appreciation alone these shares delivered a 133% gain.

Overall I can't complain about YUM Brands and the returns that it's generated.  A 20% IRR over roughly 5.5 years is pretty good.  Keep in mind that doesn't include the spinoff of YUM China either which boosts the returns even more.

This position trim reduced my forward 12-month dividends by $18.48 and represents roughly a 1/4 position trim.  I still own 32.099 shares of YUM brands that should provide $52.25 in annual dividends barring any future increases.




Reasons for the Trim

YUM Brands wasn't a major part of my portfolio so there wasn't a whole lot of "risk" should things turn south.  However, as I mentioned earlier I wanted to raise some cash and YUM was a potential candidate due to what I believe is a pretty rich valuation.

Currently, YUM's price is around $112.50 which puts the TTM P/E ratio at ~26.5x.  Based on the estimates for FY 2019 and FY 2020, YUM's P/E ratios sit at 29.4x and 26.5x, respectively.  That in conjunction with a dividend yield of roughly 1.50% leaves a lot to be desired.  YUM's operating earnings yield, EBIT/EV, is a paltry 3.9%, largely due to the massive amount of debt on the balance sheet.  Analysts still expect some hefty growth with forecasts of 15.1% annual growth over the next 5 years which is great; however, given my concerns regarding operations and some decisions by management YUM seemed ripe to at least be trimmed.

For starters management has been very aggressive with it's spending.  While free cash flow and free cash flow after the dividend have been positive every year starting in 2009, the FCFaDB is a whole other story.  For 7 consecutive years YUM has seen negative FCFaDB and even worse they've had larger negative FCFaDB than FCF that was generated by the business since FY 2014.

That massive overspending of free cash flow has led to a serious deterioration in YUM's balance sheet.  YUM Brands was already a heavily indebted company from FY 2009 through FY 2015 and since the spinoff of YUM China during FY 2016 things have just gotten worse.

As of the end of FY 2018 YUM's balance sheet showed $10.1 B of debt compared to -$7.9 B of equity.  In other words a net worth of -$2.1 B.  

Over the TTM things don't look any better as debt has continued to climb although free cash flow has seen an improvement.  The free cash flow interest coverage sits at 2.0x and it would take 9.9 years of the TTM free cash flow to pay down the debt entirely and 17.4 years of the TTM FCFaD to do the same.

In other words, the debt is likely here to stay barring a drastic increase to YUM's operations.  In addition the risk to the business as well as the dividend has increased significantly.  With the amount of leverage that YUM Brands now has they are very sensitive to the direction of interest rates.  Should interest rates rise that's going to be a further drag on cash flow.

Plus going forward I don't expect share buybacks to be as big of a tailwind as they have in the past.  At least not without further deterioration of the balance sheet.

Conclusion

When you put together the fact that shares seems relatively expensive in conjunction with the massive overspending of cash flow to repurchase shares that has led to a severe deterioration in the balance sheet, I think YUM is a much riskier investment than it used to be.  I'm considering closing the remainder of the position, but have not yet decided on whether I should or not.  The yield isn't exactly enticing, although the growth has been thus far, but giving the change to the business I am very much considering doing so.  Notwithstanding the fact that I would prefer to have some more cash on the sidelines at this time.

What do you think about my trim of YUM Brands?  Do you own shares in the business?  Do you have any concerns about the overspending of cash flow and balance sheet deterioration?  

Let me know in the comments below.