I have not written about sustainability in a very long time. Two years ago, nearly my entire investment thesis for the restaurant industry was centered on the sustainability of a company’s growth model. Needless to say, back then, many restaurant companies were growing well beyond their means. There is now clear evidence that YUM has pushed the growth model too hard and the strain of that growth is starting to emerge.
YUM is growing too fast, especially in China!
For YUM, 40% of senior management compensation is keyed off of growth in system wide sales and new units, which are effectively one in the same. Another 50% of their compensation is driven off of EPS growth. I believe, therefore, that they have a compromised disposition toward growth. If you don’t grow, you don’t get paid! As a result capital spending needs to go up every year in order to hit growth targets. Since 2005, YUM capital spending has grown by nearly 60%.
YUM’s 2007 proxy was the first proxy in which the company laid out a table that showed the performance targets and the weightings used to determine management compensation. This implies that the philosophy was in place for 2006. So guess what happened in 2007? You got it – there was a dramatic increase in capital spending (up 21% in 2007 from up nearly 1% in 2006) and new unit development. In 2005 and 2006 YUM’s international system (China and YRI) built 1,189 and 1,181 units respectively. In 2007, (year 2 of the new compensation structure) the YUM built 1,358 new stores in China and YRI. In 2008, YUM grew its international restaurant base by nearly 1,500 stores and total capital spending grew by 26%.
YUM’s capital spending reflected as a percentage of revenues was 8.3% for fiscal 2008, up from 7.1% and 6.4% in 2007 and 2006, respectively. I know that there will be more than a handful of people who will disagree with me, especially the company, but there is a direct correlation between management’s compensation structure and the company’s growth trajectory. Importantly, this is going to end badly for the company.
People outside the U.S. use QSR restaurants differently than they do in the U.S. In most countries around the world, especially less developed countries, QSR restaurants are used more like a casual dining and special occasion restaurant. Global economies around the world are slowing at the same time YUM has elevated its level of unit development.
At first glance, YUM’s 4Q results looked strong with revenues up 8% for the full year and earnings growing nearly 14%. This growth continues to be fueled, however, largely by unit growth (up nearly 3% for the full year) and share repurchases. The company spent $1.6 billion to purchase 47 million shares, reducing its full-year diluted share count by 9%. This continued aggressive spending does not come without cost as the company outspent its cash generated from operations on capital spending needs in the fourth quarter, which is not a sustainable trend. This is the first quarter that YUM’s net CFFO/net income turned negative since 4Q05. With the company’s capital spending increasing 26% year-over-year, the company had to increase its borrowings to fund its share repurchases.
The company has said that it will suspend its share repurchase program at least in the first half of 2009 in order to build liquidity, which is encouraging, but it expects to maintain a similar level of capital spending of about $900 million. At its analyst meeting on December 10, 2008, YUM management said that it expected to spend $900 million in FY08 and that number ended up being $935 million so I would not be surprised to see the FY09 number move higher as well as YUM has become addicted to spending with capital spending growth exceeding sales growth by nearly 18% in FY08 and 12% in 2007 (again, not sustainable).
Same-store sales trends in China slowed considerably in December as YUM had reported that quarter-to-date comparable sales were up 4% through November 30, but closed out the quarter only up 1% (a timing shift in December hurt by 1%). YUM was lapping a difficult 17% comparison in the fourth quarter but this slowdown was worse than expectations. EBIT margins declined again in China in the fourth quarter (down 190 basis points) as a result of continued commodity and labor inflation. YUM expects to face similar challenges in 1Q09 as YOY commodity pressures will be more severe in 1H09 and the company is lapping 13% same-store sales growth and 35% operating profit growth in the first half of the year. Despite these challenges, YUM is maintaining its FY09 unit growth targets in China. Management did acknowledge that the pace of new unit openings has inevitably led to some sales transfer between units and cannibalization, but that the overall sales lift warrants the openings. New unit growth at the expense of sales cannibalization is typically a sign of bad things to come.
One bright spot in the quarter was the 7.7% operating profit growth in the U.S. The U.S. results were helped by the company’s refranchising efforts. Although U.S. operating profit still declined 6% for the full year, this sequential improvement and positive YOY U.S. restaurant and EBIT margins in the quarter was encouraging as the U.S. continues to be the largest contributor to total company operating profit representing about 40% of segment operating profit. These positive results, however, are expected to reverse in the first quarter. The first quarter will be made more difficult by the fact that the company does not expect to fully realize the financial benefits of its G&A restructuring until 2Q. Additionally, YUM is expecting to turnaround its KFC business in FY09 but this turnaround relies on the success of its Kentucky Grilled Chicken launch, which is also a 2Q event. Management said that U.S. sales trends have started the year below its initial expectations and that there is now more downside risk to its estimate of a mid-single digit decline in U.S. operating profit in 1Q.