Better Buy: McDonald's Corp. or Yum! Brands Inc?

By Markets Fool.com

McDonald's (NYSE: MCD) and Yum Brands (NYSE: YUM) -- the parent company of Pizza Hut, KFC, and Taco Bell -- are two of the biggest fast food chains in the world. While both stocks might seem like solid and stable "big brand" investments, one is clearly better than the other. Let's examine both companies' business models, growth rates, and valuations to see which is the better long-term play.

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How do McDonald's and Yum make money?

Most of McDonald's and Yum's stores are franchised, which keeps overhead costs low but revenue limited to franchisee fees, royalties, and rent from each location. Over 80% ofMcDonald's locations and over 90% of Yum's locations outside of China are franchised.

Image source: McDonald's.

But within China, only about 15% of McDonald's stores and 7% of Yum's stores were franchised last year. This was mainly due to food safety concerns, potential intellectual property risks, and a lack of large franchising partners.

Both companies plan to aggressively reduce their number of company-owned stores. McDonald's wants95% of its global stores to be franchised over the long term. To hit that target, it's been selling thousands of company stores to franchisees inChina, South Korea, Japan, and Taiwan. Yum plans to spin offits Chinese unit, Yum China, as a separate publicly traded company in October. The company plans for Yum China to run on a fully franchised model.

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McDonald's and Yum both face tough competition from smaller fast food challengers like Chick-fil-A and "fast casual" chains like Panera Bread. Both companies are also vulnerable to demands for higher wages, rising food costs, currency headwinds, and uneven growth in overseas markets.

How fast are McDonald's and Yum growing?

McDonald's and Yum have both posted lackluster top line growth over the past year. Yum missed analyst estimates for six consecutive quarters, but McDonald's beat expectations for five straight quarters.

Company

Q2 2015

Q3 2015

Q4 2015

Q1 2016

Q2 2016

McDonald's

(9.6%)

(5.3%)

(3.5%)

(1%)

(3.5%)

Yum Brands

(2.8%)

2.4%

(1.2%)

0%

(3.2%)

YOY revenue growth. Source: Quarterly reports.

That's partly because expectations for McDonald's were pretty low when Steve Easterbrook took over as CEO last March. But Easterbrook's strategies -- which included all-day breakfast, McPick 2, table-side service, and cooked-to-order burgers -- seemingly halted McDonald's decline.

Yum, however, posted uneven growth as its massive Chinese unit weakened, KFC lost ground to Chick-fil-A (which reportedly generates triple the amount ofrevenue per store), and Pizza Hut faces lots of pressure from the increasinglytech-savvyDomino's Pizza (NYSE: DPZ).

Image source: Pixabay.

McDonald's total sales declined last quarter due to the strong dollar, but its global comparable store sales improved 3.1% on a constant currency basis with positive growth across all regions. Yum, however, posted flat worldwide comps growth on the same basis, with flat growth in China and Pizza Hut divisions, a 1% decline at Taco Bell, and 2% growth at KFC. These numbers indicate that McDonald's should post stronger top line growth than Yum if the dollar weakens.

Profitability and valuations

McDonald's adjusted earnings dipped 1% to $1.25 per share last quarter, missing estimates by $0.13. The company attributed that miss to a $0.20 hit from "strategic charges" from refranchising and other initiatives. Yum's adjusted earnings rose 9% to $0.75 per share last quarter, beating expectations by a penny.

Both companies use debt-financed buybacks to boost their earnings. McDonald's spent $11.6 billion on buybacks over the past 12 months, while Yum spent $2.5 billion. That's why analysts expect McDonald's revenue to fall 4% this year but for its earnings to improve 12%. Yum's revenue and earnings are expected to respectively rise 1% and 16% this year (excluding the impacts of spinning off Yum China).

Yum's growth estimates look better, but the stock is also pricier at 27 times trailing earnings with a forward P/E of 22. McDonald's trades at 22 times earnings with a a forward P/E of 19. However, both companies trade at discounts to the restaurant industry's average multiple of 39. McDonald's forward dividend yield of 3% is also notably higher than Yum's 2.1% yield.

The winner: McDonald's

McDonald's four straight quarters of positive global comps growth, lower valuations, and higher dividend make it a better long-term investment than Yum. Yum's bottom line growth looks better for now, but that could change after the restructuring expenses required for spinning off Yum China are factored in. McDonald's expenses are weighing down its bottom line, but its refranchising plans should eventually reduce its overhead burden in wobbly overseas markets like China.

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Leo Sun has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.