YUM - EXPECTATIONS ARE LOW FOR A REASON

YUM will likely make the numbers and maintain its FY09 10% EPS growth target.  YUM typically makes the numbers and consistently beats earnings expectations.  With YUM, it is the earnings quality that deserves more attention.  As we saw in 2Q, management optimism about the top line sales will be reined in. 

In 2Q, despite softer than expected sales trends, the company beat street expectations, helped by a significantly lower than expected tax rate.  Management highlighted that although this lower tax rate resulted in the company decreasing its full-year tax rate guidance to 25% from 27%, on a YOY basis, the forecasted tax rate should provide a slight EPS headwind in 2H09.  Additionally, during the 2Q earnings call, management had said it was not anticipating any share repurchases in the back half of the year and that the company’s share count could actually increase in 4Q09, which would have marked the first time the company’s share count had not declined on a YOY basis since 1Q05.  After that earnings call, I was interested to see how YUM would make the numbers with fewer strings to pull.  To that end, YUM announced this week that it would resume buying back stock following the Board’s authorization of a $300 million share repurchase program. 

Unit growth and lower YOY commodity, G&A and interest expenses will all play a factor in making numbers in 3Q09 (and now a lower share count will help to make full-year numbers).  Not all of these earnings drivers fall in the financial engineering category, but along with a lower share count, I would argue (as I always do) that YUM is pushing too hard on unit growth, particularly in China and YRI, as it helps drive earnings growth.  In 3Q09, YUM will continue to push unit development to offset slowing same-store sales growth. 

Like its peers, YUM will benefit from commodity cost favorability in the back half of the year in both the U.S. and China, though the YOY benefit will be of a greater magnitude in the third quarter.  G&A expenses will continue to come down as the company is working to reduce its G&A cost structure by $60 million in the U.S. in FY09 (already achieved $20M in Q1 and $18M in Q2).  YUM’s goal to refranchise 500 units in the U.S. will also help the G&A line going forward.  Commodity costs will not come down forever.  The YOY favorability combined with reduced G&A is working to offset continued sales weakness.  This trend is no different from any other restaurant company right now.  Like we saw earlier this week, DRI beat EPS estimates despite sales weakness, but investors seemed most focused on what the company had to say about sales going forward and that was not good.  I think the same story will play out for YUM. 

YUM already significantly reduced its full-year sales guidance following 2Q results.  Flat same-store sales growth in China for the year is achievable and represents a significant deceleration in 2-year average trends.  The company’s 3% comparable sales growth guidance for YRI assumes the company maintains its 2-year average trends for the balance of the year, which could be at risk.  In the U.S., YUM’s guidance stated that same-store sales will be down slightly.  I am convinced that full-year same-store sales will be down as well, but I would be interested to get some clarity around that “down slightly” guidance and that could prove to be one of the real telling points of the quarter as it relates to YUM’s stock performance following the earnings release. 

In my opinion, investors could be expecting too much out of KFC this quarter.  Yes, the Kentucky Grilled Chicken launch during the second quarter boosted KFC same-store sales to +3% from -7% in Q1 and consistently negative performance prior to that.  Management highlighted that following the initial launch that sales flattened.  As everyone knows, we are in an extremely difficult operating environment and those post-launch results are likely more relevant relative to 3Q performance.  KFC is lapping a -4% comparison but easy comparison no longer matter.  Pizza Hut’s underlying trends will most likely be little changed from 2Q when same-store sales declined 8%.  And Taco Bell, which was up 1% in 2Q, will continue to be pressured by the increased discounting of its peers.  For reference, both Pizza Hut and Taco Bell are facing difficult comparisons from 3Q08 when same-store sales growth was up 8% and 6%, respectively.  Even with these difficult sales trends, U.S. operating profit should continue to improve during the third quarter.  I would expect this operating profit growth and improved margin performance to reverse in the fourth quarter as the company will be lapping its first quarter of growth since 3Q08. 

Management already lowered its full-year U.S. operating profit growth target following 2Q to high single digit growth from up 15%.  I would not be surprised to see this number come in even below the revised guidance.  It would not be the first time YUM’s U.S. operating profit guidance was too optimistic.

YUM - EXPECTATIONS ARE LOW FOR A REASON - YUM 3Q09E ebit margin