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YUM reported 2Q14 earnings AMC yesterday, missing top line estimates by 110 bps while beating bottom line estimates by 19 bps.  Strength in China and KFC were largely offset by weakness at Pizza Hut and Taco Bell.  In aggregate, system-wide restaurant margin increased 300 bps to 15.5%.  We cautioned coming out of 1Q that we believed a China recovery was baked-in and that the Street was looking to Taco Bell for any incremental upside.  Unfortunately, Taco Bell delivered another disappointing performance in 2Q in which it failed to meet high expectations surrounding its national breakfast launch.

Management reiterated guidance for 20%+ adjusted EPS growth and 40% operating profit growth in China, but indicated full-year China SSS would come in at the low end of its initial guidance range or in the high-single digits.  All told, there remains a lack of quarter-to-quarter visibility in the China segment and we believe management guided cautiously with this in mind.  With that being said, we believe investors can finally put any China fears behind them - the recovery is well underway.  Management also indicated that full-year results for the Pizza Hut Division will fall far below initial expectations.

While the stock has reacted negatively to the print and subsequent earnings call, we continue to believe YUM is a strong long-term investment with limited downside over the intermediate-term.  We believe YUM is best positioned to capitalize upon a material emerging market opportunity.  As noted on the call, YUM currently has two restaurants per million people in emerging markets compared to 58 restaurant per million people in the U.S.  In addition to its enormous growth potential, YUM is a largely franchised business (~90% of stores outside of China are franchised) that generates more than $2 billion in franchise fees.  With this diversified revenue stream, YUM is able to strategically invest in its growth and enhance its earnings growth by returning all excess cash (after investments, ~2% dividend payout) to shareholders through share repurchases.

Below, we provide brief updates on each operating Division.

China Division system-wide sales increased 21%, including same-store sales growth of 15%.  Restaurant margin increased 620 bps to 16.8%.  New unit returns are outstanding and the company is well-positioned to capitalize upon China's growing consumer class, particularly in higher return tier 3-6 cities.  KFC same-store sales grew 21%, benefitting from an easy comp as well as its Brand Relaunch which included 15 new products, redesigned packaging, new uniforms, new menu boards and a new marketing plan that leveraged four local popular celebrities.  Value scores improved despite average check rising.  The company remains focused on premium innovation and superior customer service.  With that in mind, it has begun rolling out free Wi-Fi and is working on a new mobile app with payment capabilities.  Pizza Hut same-store sales were flat in the quarter, after lapping 7% growth in 2Q13.  The business model is as strong as ever, with two-year cash paybacks on new Pizza Hut casual dining restaurants.  They continue to aggressively expand into lower tier cities, with plans to have over 1,200 units by year-end.  Pizza Hut home service continues to be an exciting opportunity with room for substantial upside.

KFC Division delivered 2% same-store sales growth, led by international strength and offset by a struggling U.S. business.  Restaurant margin and operating margin increased 30 and 10 bps, respectively.  While the domestic KFC business was weak, 90% of the division's operating profits come from outside the U.S.  KFC is well-positioned to capitalize on emerging markets, with plans to build 650 new units outside of the U.S. this year.

Pizza Hut Division same-store sales declined 3%, in part due to flat same-store sales in emerging markets and a 4% decline in the U.S.  Restaurant margin and operating margin decreased 640 bps apiece.  Full-year operating profit is expected to fall well short of prior expectations.  Management plans to launch a number of initiatives to reignite sales in 4Q, aimed at developing a stronger value proposition (more competitive offers).  They also appeared excited about the digital opportunity here and set the goal of surpassing competitors in this space in 2015.  YUM expects to build 450 new international units this year.

Taco Bell Division same-store sales increased 2%, falling well short of 6% estimates.  Although restaurant margin decreased 270 bps due to incremental food and labor costs, operating margin increased 10 bps.  The comp was particularly disappointing, considering 2Q14 marked the launch of Taco Bell's national breakfast.  We believe the marketing aimed solely at breakfast in the first two months of the year, along with a disappointing product launch, negatively affected the lunch and dinner dayparts.  Breakfast comprised 7% of sales in the quarter and added approximately $70,000 to $120,000 in sales per unit.  Management, and franchisees, appear genuinely excited about the breakfast daypart (plan to broaden the offerings) and intend to leverage innovation across all dayparts in the coming quarters.  YUM reiterated its long-term goal of having 8,000 Taco Bell restaurants in the U.S.

India Division same-store sales decreased 2%.  Management is committed to moving ahead of the growth curve and is targeting 2,000 units by 2020 (up from ~700 today).

YUM: EARNINGS RECAP - 1

YUM: EARNINGS RECAP - 2

Call with questions.

Howard Penney

Managing Director

Fred Masotta

Analyst