YUM – Lower 2H08 Expectations, Less than 10% EPS growth

YUM is scheduled to report 3Q earnings on Tuesday after the close. Although the company raised its full-year 2008 EPS growth guidance to up 12% following its 2Q results, this reflects a significant slowdown in YOY growth in the back half of the year as 1Q and 2Q EPS grew 18% and 16%, respectively, excluding one-time items. It is important to remember that YUM’s FY08 EPS growth is being helped by the company’s expected share buy backs, which will reduce shares outstanding by 8% (down 8.5% in 1Q and down 9% in 2Q). As I have said before, YUM management’s compensation is tied to EPS growth so I do not doubt management will find a way to achieve its long-term full-year EPS target of at least 10%.
  • This slower 2H08 earnings growth can be partly attributed to tougher revenue and operating profit comparisons, particularly in 3Q, on top of an already tough operating environment (increasing commodity costs in each of YUM geographic segments). On a consolidated basis, YUM is facing its toughest top-line comparison in 3Q (3Q07 revenues grew 12.6%). YRI and China both had strong quarters from a revenue standpoint in 3Q07 while the U.S. experienced a 5.8% revenue decline. Unfortunately, easy comparisons no longer provide much cushion for YUM’s U.S. segment as 1Q07 and 2Q07 YOY declines were worse than 3Q07 and results continued to be soft in 1H08. These recent declines stem primarily from declining trends at KFC, which the company does not expect to see any material improvement from until 2009 (also partly attributable to company refranchising).
  • Increasing commodity costs will continue to hurt profits in all three of YUM’s divisions with management guiding to a one point contraction in restaurant margins for FY08 in China, YRI and the U.S. I would not be surprised to see U.S. restaurant margins decline slightly more than the one point the company is guiding. Management stated that operating profit comparisons get more difficult for YRI and China in 3Q, saying, “In the third quarter, we expect YRI will be below our first half profit growth rate as they lap strong year-ago performance.” Regarding China, management stated, “We cannot expect mid-teens same-store sales growth and 30% to 40% profit growth to continue.”

  • An additional headwind for YUM stems from the currency benefit the company has been booking at both its China and YRI segments since early 2005. I think it is worth noting that the currency benefit has grown over time for both China and YRI and helped by 12% and 9%, respectively, in 2Q08. Investors have become accustomed to high, double-digit reported operating profit growth results and this favorable currency impact may not be around forever.

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