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Takeaway: 3Q was fairly ugly & the recovery in China is taking longer than expected. But, it is recovering nonetheless. We remain bullish on YUM.

If you are long YUM, or looking to go long YUM, you are likely asking yourself one question: Is China melting down?

YUM reported a quarter that is fairly consistent with what you would expect from a company that is struggling in its core market, which, in this particular case, happens to be China.  That being said, there are some positives coming from last night’s release.

USA – Better Than Bad

The U.S. reported flat same-store sales, which was below the consensus estimate of +1.5%.  However, same-store sales at YUM’s most important U.S. brand, Taco Bell, grew +2%.  KFC and Pizza Hut same-store sales, on the other hand, declined -4% and -1%, respectively.  Restaurant margins in the U.S. declined 70 bps to 16.0%, due to commodity inflation and increased promotional activity.


YRI – Very Respectable

On balance, YRI is performing reasonably well, despite slowing on the margin.  YRI same-store sales increased +1%, below the consensus estimate of +2.4%.  The slowing sales trends can be partially explained by an earlier Ramadan, which negatively impacted YRI comps by -1%.  YUM reported emerging market same-store sales growth of +4%, but developed markets saw a -1% decline.  YRI restaurant level margins declined 60 bps to 12.7%, as the benefit from refranchising Pizza Hut UK was offset by softer than expected KFC UK and Turkey margins.

CHINA – Disappointing

YUM reported and -11% decline in same-store sales in September (first month of 4Q).  The real issue here, however, is that the stock (and me) has been under the assumption that comps would continue to recover and achieve management’s targeted return to positive growth in 4Q.

Unfortunately, sales trends appear to have actually eroded coming out of the quarter.  China’s September same-store sales for YUM’s two main brands in the region, KFC and Pizza Hut, are estimated to be -13% and +6% in September, respectively.  While YUM’s Pizza Hut business appears to be on track, the same cannot be said for KFC.  The company’s efforts to lift KFC’s brand image and, ultimately, recover traffic, do not appear to be working.

China restaurant level margins were down 190 bps year-over-year, which was actually better than expected.  In our view, this is remarkably impressive given an overall -11% decline in same-store sales.  Food costs were down 70 bps, but this benefit was partially offset by an 80 bps increase in labor costs.  What really caught our eye was the performance of the core assets, which looks even better when considering that YUM attributed 100 bps of the China margin decline to a negative impact from its write-down on the Little Sheep business.  YUM acquired the business in February 2012 and, needless to say, it has been a major disappointment, perhaps most signified by impairment charges of $0.55 included in 3Q results.




Is China Melting Down?

We are about to find out if YUM’s easy same-store sale comparisons are truly “easy” or if there is something else going on here:

  • Are the issues one-time in nature?
  • What is the extent to which secular headwinds – such as weaker spending or increased competition – may be impacting performance on top of the ongoing chicken quality concerns?
  • Is KFC overbuilt in tier 1 cities?
  • Can same-store sales recover in tier 1 cities?  13% of YUM’s new unit growth are going into tier 1’s.
  • How promotional will the company be in order to get traffic back?
  • Do they have pricing flexibility?
  • Can traffic improve simultaneously with lower labor costs?

There are many unanswered questions emanating from YUM’s 3Q earnings release.  For the time being, we are sticking with our bullish thesis on YUM.  The next big event for YUM will be the December 4th Investor & Analyst meeting.  We still have reason to believe that China same-store sales will turn positive in October.  Stay tuned.

Howard Penney

Managing Director