YUM: LONG-TERM DRIVERS IN PLACE

YUM continues to be our favorite LONG in the big cap QSR landscape as we believe the company is positioned to capitalize on a substantial long-term growth opportunity in China and other emerging markets.  We expect easy comps, notable margin expansion, and positive earnings momentum to drive performance throughout 2014.  The magnitude of this performance will depend heavily upon the trajectory of the recovery in China.  Management’s guidance of 40% operating profit growth in China may be aggressive, but we believe they have multiple levers at their disposal to reach at least 20% earnings growth in 2014.

China Concerns Are Overdone

Analysts sounded cautious on the 4Q13 earnings call and somewhat hesitant to believe YUM is positioned for a strong recovery in China in 2014.  Avian Flu and competitive concerns (local pressures facing the Pizza Hut business) have been weighing down expectations.  We believe these concerns are largely overdone. 

While it is difficult to gauge consumer psyche regarding recent Avian Flu episodes, management has not seen a notable negative impact in January.  The company has strengthened its supply chain and, through the recent I Commit initiative, made significant progress in rebuilding the trust of consumers in the KFC brand.  YUM will also continue to benefit from improved sales forecasting at KFC, labor scheduling, and service optimization in the region.  Given strong brand attribute stores and a strong start to January, we have little reason to believe comps will not accelerate meaningfully from 2013 levels.

After posting a weak comp in December, Pizza Hut casual dining has been a point of contention as fears of local, competitive pressures have mounted.  However, the brand still posted a +5% comp in 4Q and sales have rebounded thus far in 2014.  Pizza Hut casual dining continues to be a tremendous growth vehicle (strong economic model, two-year cash payback) for YUM as they look to accelerate unit growth in lower tier (better return) cities.  Pizza Hut home business (55% of the menu is Chinese food) represents another strong growth opportunity.

We believe the trends in sales and margins in China suggest the company has made significant progress restructuring the business, setting the stage for improved profitability in 2014.  Longer term, we believe China represents a material opportunity for YUM to capitalize on a growing consumer class that is expected to double from 300mm+ in 2012 to 600mm+ by 2020.

Taco Bell Is Underappreciated

While Pizza Hut and KFC delivered less than desirable comps in the U.S. in 4Q, the Taco Bell business (2/3 of U.S. operating profits) continues to be strong, posting a +1% comp in a sluggish sales environment.  This represents its 8th consecutive quarter of comp growth.  We expect this brand to continue taking share from competitors in 2014 and to drive incremental sales through product innovation and the rollout of the breakfast platform.  Restaurant level margins are approaching 20% and development is set to accelerate to 86 net new units in 2014, with the potential for 2,200 more units domestically.  Taco Bell is currently carrying the U.S. business but with the refranchising program nearly complete, we’d expect to see a stronger emphasis on turning around the domestic Pizza Hut and KFC businesses.

YRI is a Longer-Term Play

A lot of the recent sell-off can be attributed to emerging market concerns.  The overall performance of YUM’s YRI business, however, was encouraging.  Russia, Southeast Asia, Africa and Latin America continue to be pockets of strength and the company successfully entered four new emerging markets in 2013 (Tanzania, Ukraine, Argentina, Mongolia).  The YRI business (which will be consolidated with the U.S.) will be somewhat volatile – but that is to be expected.  YUM’s expansion into emerging markets is a material long-term growth opportunity, as the company positions itself to capitalize on a rapidly expanding consumer class.

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Howard Penney

Managing Director