YUM: China Leads The Way

SUMMARY

YUM reported 1Q14 earnings AMC yesterday, missing top line estimates by 241 bps while beating bottom line estimates by 392 bps.  As expected, China led the way in 1Q delivering 9% same-store sales growth and an 80% improvement in operating profit.  These results prove that the supply chain debacle is largely beginning to fade and consumers have regained trust in the KFC brand.  Despite strong performance in China, KFC Division, Pizza Hut Division and Taco Bell Division results were less than desirable, weighing down earlier optimism over impressive China numbers.  The stock traded down intraday, suggesting a China recovery is baked in.  As such, we believe the street is looking to Taco Bell to be the source of incremental upside in 2014, but a disappointing 1Q14 has raised concerns. 

DETAILS

China Division delivered 9% same-store sales growth including 11% growth at KFC and 8% growth at Pizza Hut Casual Dining.  Restaurant margins grew 6.8% over the prior year.  However, lapping last year’s productivity measures and additional labor and food costs pressure will likely slow the rate of margin improvement moving forward.  Management guided to a full-year restaurant margin of 17%, in the middle of its prior 16-18% guide.  KFC appears to have regained consumer trust and plans to capitalize on its current sales momentum by bringing more innovation and excitement to the brand.  A new menu was rolled out to 4,600 restaurants in late March should help achieve this.  KFC plans to revamp the menu once a year.  Better sales forecasting, labor scheduling, optimizing operating hours and other initiatives have helped improve restaurant margins.  New advertising, packaging, staff uniforms and menu boards are all additive to the brand restage.  The team has plans for a new mobile app which will allow for preordering/electronic payment and expects free Wi-Fi to be available in over 2,000 restaurants by year-end.  Pizza Hut casual dining generated strong same-store sales in the quarter and continues to resonate with customers as it offers compelling value and a flexible menu (refresh 20% of the menu twice a year) which is increasingly including breakfast.  A strong economic model will allow the team to continue aggressively expanding into lower tiered cities.  Home service continues to be a strong, local brand as 40% of what they deliver is Chinese food.  There are approximately 200 home delivery units with room for substantial upside.

India Division same-store sales declined 1%.  India continues to be a long-term opportunity for YUM, but is largely immaterial to the current business.  KFC plans to launch a new vegetarian line of products and management remains focused on developing a stronger economic model for expansion into lower-tiered cities.  Pizza Hut delivery grew same-store sales at a faster clip than its largest delivery competitor while Taco Bell continues to be a potential source of growth in India.

KFC Division delivered 1% same-store sales growth, led by international strength and offset by a struggling U.S. business.  Restaurant margin and operating margin declined 30 bps and 60 bps, respectively.  We remind you that 90% of KFC profits are generated outside the U.S.  With only 2 stores per 1 million people, KFC is well positioned to capitalize on a growing consumer class in emerging markets.  Australia and the U.K. continue to be pockets of strength for the developed markets segment, while the U.S. and Canada continue to woefully underperform.  The team plans to apply overseas best practices to these two regions in 2014.

Pizza Hut Division same-store sales declined 2%, due in large part to a struggling U.S. business and marginally offset by international strength.  Restaurant margin and operating margin declined 420 bps and 580 bps, respectively.  The U.S. business continues to lose share to competitors offering more compelling value.  WingStreet and new Garlic Parmesan Pizzas could provide a bit of a short-term boost, but the brand’s issues go well beyond a lack of innovative offerings.  Management is moving quickly to find ways to fix their value proposition and engage the digital consumer, but noted that the brand could trail prior estimates in FY14.  Outside the U.S., we expect the pace of global development to accelerate in 2014.

Taco Bell Division same-store sales declined 1%.  Restaurant margin and operating margin declined 260 and 140 bps, respectively, as operating profit fell 16%.  Restaurant margin was hurt by a mix of labor intensive promotional products and higher than expected commodity inflation.  Management also cautioned that commodity pressure could mitigate 2Q profits.  Taco Bell rolled out breakfast at the end of 1Q and, according to management, is off to a good start.  The team plans to introduce mobile ordering soon, in addition to a major new product launch in 2H14.  Net new unit growth should accelerate from 78 to 100 in FY14.  Though 97% of profits currently come from the U.S., management has plans to make Taco Bell YUM’s third major global brand.

ANALYSIS

YUM is a largely franchised business, with over 90% of stores outside China franchised and will generate approximately $2 billion in franchise fees in FY14.  As such, it is a very high return business.  It is also positioned exceptionally well to capitalize on a long-term growth opportunity in emerging markets.  This quarter wasn’t the best, but the turnaround in China is the number one thing we wanted to see.  The domestic Taco Bell business will stabilize and, in our view, accelerate meaningfully from here as breakfast, new product innovation, digital initiatives and additional pricing will drive incremental sales.  When all is said and done, we believe YUM will be able to generate greater than 20% EPS growth in FY14.  China looks strong, emerging markets have positive momentum and the Taco Bell business is poised to bounce back after a quarter in which most restaurants struggled.

In addition to strong growth prospects, YUM offers an attractive and growing dividend yield and has three main levers (growth investments, growing dividend, share repurchases) to continually support the stock and drive shareholder value.  Barring an unexpected upheaval of issues in China, we view YUM as a sound investment that offers attractive upside in both the near and short term.

YUM: China Leads The Way - YUMN

Howard Penney

Managing Director

Fred Masotta

Analyst