YUM - Not Making Any Real Changes, Despite Slower Sales

Earlier today, I highlighted the fact that YUM was trading down despite it having beat 2Q EPS expectations and how this marked a change in pattern to how the restaurant names have been trading following quarterly earnings. For the most part, restaurant companies have been posting better than expected bottom line numbers by cutting costs to offset soft revenue trends, and their stocks have been rewarded. I think a couple of things are at play here:

1.) Investors have become accustomed to revenue misses from the casual dining operators and other restaurants in this more challenging environment, but this was the first significant same-store sales miss for YUM's China and YRI businesses, forcing YUM to take down FY comparable sales guidance.

2.) Financial engineering helped YUM to offset its weaker than expected top-line results (a lower tax rate and lower share count).

Relative to how other restaurant names have traded, I think the second point is the more important one as we have seen a lot of companies offset soft sales trends with significant cost cutting. These reduced cost structures, however, have created more operating leverage and stemmed from increased labor efficiencies and G&A savings. These companies have made real changes to how they operate their businesses and the benefit of the savings will continue to be realized going forward. A significant portion of the cost reductions have resulted from slowing new unit growth.

YUM, on the other hand, is maintaining its full-year 10% EPS growth guidance despite lowering its same-store targets as a result of a lower tax rate, a less negative foreign currency impact and improved restaurant margins in China and the U.S., largely as a result of more commodity deflation than initially anticipated. None of these earnings drivers is sustainable. YUM is not offsetting its top-line weakness by making significant changes to its operating model.

YUM is targeting $60 million in G&A savings in the U.S. but even with these cost savings, YUM had to take down its U.S. operating profit growth target to up high single digits from about 15%. In the U.S., YUM is taking real costs out of the business, primarily as a result of its refranchising strategy, but these cost reductions are not enough to offset the same-store sales shortfall. This is a big difference relative to what we have been hearing from other restaurant companies.

I have been saying for a couple of quarters now that YUM is growing too fast, particularly in China and YRI. This rapid growth will make it difficult for YUM to reduce costs and could prove a challenge to margins should sales deteriorate further.

YUM's CEO David Novak closed the call by saying that he is fixated on 3 shareholder value drivers: first, driving new unit growth; second, improving same-store sales and third, being the industry leader in return on invested capital. He highlighted the fact that the company has the most work to do around growing same-store sales. I would argue that YUM's sustainability and returns would improve dramatically if the company focused on fixing same-store sales first and growing new units second.

YUM - Not Making Any Real Changes, Despite Slower Sales - YUM 2Q09 EBIT

YUM - Not Making Any Real Changes, Despite Slower Sales - YUM 2Q09 CFFO



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