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A recent article on YUM, published on an online Franchise News website called Blue Mau Mau, put forth some interesting perspectives on the company’s franchise business in the United States.  YUM has been facing mounting problems in the U.S. for some time and the evidence this article presents suggests that these issues may prove difficult to resolve. 

Last year, at YUM annual investor conference in NY, the company centered its message to the investment community on “three pillars of growth”: China, YRI, and Taco Bell.  The critical component here is Taco Bell, because it represents the life of the U.S. business, with over 60% of the operating profit for the division.  The U.S. Division accounts for 35% of total operating profit, as of December 2010.

In the most recent quarter, the US business underperformed as Taco Bell had a very disappointing quarter with SSS flat in the quarter but seeing a negative reversal in trends following a lawsuit that made allegations regarding the ingredients of Taco Bell’s beef.  From the initiation of the lawsuit through the end of the quarter, SSS slumped 2% versus +4% during the first period of the quarter.  The plaintiff’s law firm subsequently dropped the case but there is significant damage to the brand’s public image. 

The company now has to continue to strive to repair that image while also mend relations with the franchisee community.  The beef lawsuit has proven to be a tipping point, of sorts, for franchisees.  According to the article on bluemaumau.org, Taco Bell’s Franchise Management Advisory Council (FRANMAC) sent an email to franchisees with 14 bullet points that the Board had taken up on the franchisees behalf on topics such as the lack of transactions being driven by value propositions and the need for a reduction in the costs of new buildings.  The letter also implored the franchisees to partake in a “Town Hall Call” to have their voices heard. 

The body of the article raises several questions regarding the malaise that Taco Bell faces in the U.S. and the root cause(s) of it.  The most interesting questions posed by the author are: “Is YUM advancing its growth in China at the expense of its struggling domestic fast food restaurants?  Has Yum lost touch with the American consumer? Is it so wedded to old ideas that the marketplace has moved beyond them?”

These are all relevant questions not only for Taco Bell, but KFC and Pizza Hut too.  Until this quarter, Taco Bell has not faced the same degree of commercial adversity that has become so familiar to KFC and Pizza Hut.  Now, thinking about it, the investment community has been hearing for several years about the innovations or iterations that are going to fix these ailing brands.  Alas, nothing seems to work. 

On the one hand, it is understandable that the company is focusing on international operations and, some might say, YUM have been ahead of the game in this respect.  Emerging Markets offer significant growth opportunity for the company and the infrastructure that has been built up in China is highly impressive.  Nonetheless, it is important for investors to note that the malaise in YUM’s domestic business only amplifies the leverage of the stock to China and emerging markets.  To the extent that there is volatility in those geographies for any reason and YUM suffers, do not expect the domestic market to offer much stability. 

Drawing from a book I recently read, and applied to a thought-piece on Starbucks, YUM’s brands in the USA have a long-term secular problem that will require significant time and capital to fix.  I’m once again referring to the book The New Rules of Retail, by Robin Lewis and Michael Dart, an impactful book that offers a comprehensive account of the history and future of retail with in depth accounts of the key macro trends that impacted the retail industry and the executive decisions that impacted companies. 

While I encourage anyone interested in retail to read the book, I can attempt to sum it up the key consumer shifts that Lewis and Dart outline pertaining to “Wave III” (post 2000):

  • From needing “stuff” to wanting experiences
  • From conformity to customization
  • From plutocracy to democracy
  • From wanting new to demanding new and demanding now
  • From self to community

The shift from ubiquitous brands such as GAP and Levi’s to niche brands, from large chains to small brands, and from (perceived-to-be) socially irresponsible firms to (perceived-to-be) socially responsible firms certainly corroborates with The New Rules of Retail thesis.  I see the first bullet as being most crucial here; the chains that offer an experience, and the anticipation of such, are thriving while those standing still in this regard are faltering.  In my view, KFC, Taco Bell, and Pizza Hut are standing still.

As FRANMAC sees it, there are some key steps that Taco Bell could take to address its issues.   I’ve outlined a few of the fourteen below.  For the rest, please see the image at the end of this note or visit www.bluemaumau.org:

INEFFECTIVE ADVERTISING: A core responsibility of our advertising agency is to produce creative that effectively promotes our menu.  Ads in the past 12 to 18 months have been largely ineffective and we believe that an agency review should take place.  Taco Bell Corporate, in conjunction with FRANMAC should immediately undertake an agency review.  Without a doubt, we will learn new things, obtain fresh ideas, and be further ahead, even if we decide to stay with the incumbent agency.

TRYING TO DO TOO MUCH AT ONE TIME (not focusing on the core)We have either a real or perceived quality problem at Taco Bell.  Until such time that we reinvigorate our base business, we should redeploy the resources that are utilized on HMR, Oasis, and Breakfast to focus on our quality perception and fixing our core.

DRIVING VALUE CAN BE DIFFICULT (I wonder how the MCD franchisees are feeling as transactions slow?): The value proposition as currently being executed is not driving transactions, and squeezing margins beyond a reasonable tolerance.

SALES ARE NOT GETTING ANY BETTER: We do not understand the unwillingness to allow DMA's to run the Beef Quality spot while senior management says we just have to wait until we start running value again.  The business will turn around then.  Well, it didn't.  Now what?

GIVEN YUM FOCUS ON ROI THIS WAS VERY SURPRISING: All mandates must have an adequate return on investment.

A PERCEIVED LACK OF DIRECTION: There continues to be an ongoing lack of alignment around the Refresh program.

QUESTIONS ABOUT HOW SOON TACO BELL WILL REALLY BE GROWING UNITS AGAIN:  We believe there is a need to cut 20-25% out of the cost of a new building to make the economic model work.

I understand that franchisees can get emotional when sales and profitability are down.  The article even describes one Pizza Hut franchisee’s view that YUM’s “hardball tactics” in counteracting pushback from Pizza Hut franchisees have reached “Syrian” proportions.  Whether or not franchisees are categorically correct on every gripe they have at the moment, they are on the front lines dealing with real issues.  On the other side of the equation, any franchisor at any company will tell you that franchise relationships are not perfect, but strong.  As always, the truth lies somewhere in the middle.

YUM - FRANCHISEES PUSHING BACK - franmac

Howard Penney

Managing Director