Yum! Brands reported strong EPS growth last night on the back of blockbuster China comps and a lower-than-usual tax rate.
Depending on what you assume for a “normalized” tax rate, the 16.7% tax rate YUM reported for the second quarter helped EPS by $0.07-$0.08.
Needless to say, such a tax impact calls into question the quality of the company’s earnings but the strong growth in China cannot be discounted. That said, there are serious issues to be addressed in the U.S. and those issues took up a significant proportion of the discussion during the earnings call this morning.
Earlier this year, management highlighted four goals as its “2011 Focus”:
- Build Leading Brands in China in Every Significant Category.
- Drive Aggressive International Expansion and Build Strong Brands Everywhere.
- Dramatically Improve U.S. Brand Positions, Consistency and Returns.
- Drive Industry-Leading Long-Term Shareholder and Franchisee Value.
On points 1 and 2, YUM is powering ahead as usual. Point 3 is completely missing and the situation seems increasingly dire. Point 4 is intact, for now, but they will need to show more solid operating profits (not lower tax rates) in the back half of the year to convince investors that long-term shareholder value is secure. If the back half of the year produces better quality earnings, it would go a long way toward reassuring investors. The stock is up today following incredible comps out of China, albeit with down margins.
Below we run through management’s commentary on each of the three business divisions and provide our own thoughts on how things are likely to transpire over the intermediate term.
YUM China
China remains the jewel in the crown for YUM, providing 18% same-store sales versus 4% growth in 2Q10 and 13% growth in the first quarter. On a sequential basis, two-year average trends accelerated by 250 basis points in 2Q. Management highlighted several key initiatives that are attracting traffic to its China stores. 24-hour operations, delivery service, and a growing breakfast business are all helping to increase AUVs. Breakfast is available in almost all of the KFCs in China (3,378 as of June 11, 2011) and accounted for 13% of transactions versus ~10% beforehand. 24-hour operations are now the norm for over 1,300 units and delivery service is available for 1,600 restaurants. During the second quarter, KFC China continued to offer a 6 RMB Breakfast promotion and began offering a 15 RMB weekday lunch promotion also. These promotions helped drive transactions, which gained +21% during 2Q.
While it is tough to imagine for U.S.-based investors, Pizza Hut is a very popular brand in China and continued to perform strongly in 2Q. Continued expansion of Pizza Hut into new cities should provide strong returns for YUM China.
Inflation is an issue in China and management is likely to take price as the company’s full-year inflation guidance is now +9% for commodities and mid-to-high teens for labor. Despite this, management anticipates full-year margins to remain above 20%
Hedgeye: YUM faces markedly easier margin compares over the next three quarters. While same-store sales compares also increase in difficulty, I would expect momentum to continue (obviously not at the same rate at 2Q). Management is guiding to double-digit same-store sales growth in the third quarter.
YRI
YRI continues to represent a bright spot for YUM as the company positions itself to grow in emerging markets. YRI continues to see positive same-restaurant sales growth and margin expansion, despite the impact of inflation. The company set out its stall regarding YRI at the Analyst Meeting in NYC earlier this year when management explained that the expected growth in “consuming class population” between 2010 and 2020 in “YRI Emerging Markets” is expected to far outstrip the impressive forecasted growth in China over the sale period. Nevertheless, there are clearly opportunities in developed nations also. France, for instance, was highlighted today by management as being a significant opportunity. As of year-end 2010, YUM had 117 Pizza Hut restaurants and 117 KFC restaurants in France. McDonald’s, YUM management pointed out today, has almost 1,200 restaurants in France and makes more money from them than YUM does from the entire YRI division. Clearly there is plenty of white space, even aside from the obvious emerging market targets, for YUM to grow.
Hedgeye: YUM has shown itself to be an anomalous restaurant company in its ability to build the infrastructure necessary to manage multiple brands over multiple geographies. We wouldn’t bet against the company succeeding in other international markets as well. We were critical, after the Analyst Meeting, of claims by the company that Africa offers the next big source of growth for YUM, and will continue to monitor the returns the company sees on its investments, but for now the accelerating comps and expanding margins bode well for the division’s profitability.
YUM U.S.
Last, and by almost every metric least, the U.S. division is a disaster and, as good a management team as YUM has, I’m not sure they are going to come up with the answers any time soon. The company’s frustration came across during the earnings call and prior statements that 2011 would be a “transition” year for YUM U.S. are clearly euphemisms in retrospect. Same-store sales for the U.S. division declined -4% and Operating Profit declined by 28% year-over-year. During the conference calls, participants and listeners were informed of a relaunch of last year’s disastrous Kentucky Grilled Chicken product but it was clear that no real solution is forthcoming. During the Analyst Meeting earlier this year, in NYC, management distributed materials that showed YUM’s path to becoming a truly global company. In 1998, 78% of YUM’s profits were from the US and management stated that, by 2015, the goal was to reach a 25% U.S./75% international split in operating profit source. It seems they have gotten there much faster than they had wished, due to the U.S. profit declining so much. We expect the U.S. to become more and more insignificant as YUM’s international store count continues to grow.
Hedgeye: One has to wonder if they would be better off taking drastic measures with their domestic business, KFC in particular. Taco Bell may have been hurt by the bogus lawsuit and time will likely fix that issue, but KFC and Pizza Hut are two brands in indisputable decline and I believe something bold has to be done to change their fortunes. Even with an infrastructure as vast as YUM’s, however, there are only so many tasks that a management team can execute on and the international markets are simply more important.
Howard Penney
Managing Director
Rory Green
Analyst
