In a difficult demand environment, YUM’s 3Q EPS numbers look like they are immune to reality. Yesterday, YUM reported 3Q EPS of $0.70 (excluding special items) versus the street at $0.58. In short, when demand for your core products is declining at the pace YUM saw in 3Q, the only way you can beat numbers to this degree is by pulling the goalie (financial engineering and reducing G&A aggressively).
I actually had a client say to me (who had no ax to grind on the stock), do you think they did this just to “rub it in” to those that are negative on the company – of which I am one. When you dig deep into the trends of the quarter, it’s hard not to come to that conclusion.
YUM reported a 3Q EPS that was over the top, given the magnitude of the miss in top line sales. US same-store sales declined 6% versus a consensus decline of 1.9%, but restaurant levels margins rose 3.2% (given the fixed cost nature of this business, this is nearly impossible to do). China same-store sales were flat (implying a 250 bp sequential decline in 2-year average trends) and YRI same-store sales were flat relative to consensus expectations of a 2.3% increase. YRI’s 2-year same-store sales trends declined 50bps from last quarter. Despite the top line miss in same-store sales, on a consolidated basis, restaurant level margins rose 3%.
Every restaurant operator on the planet is looking at these numbers in amazement or with a healthy degree of skepticism. I understand the company benefited from a decline in food costs, but discounting and the negative leverage on declining same-store sales should mitigate some of the benefit. Helping margins has been the 10 consecutive quarters of declining payroll and benefit expense as a percent of sales (6 quarters in the US). This consistent decline in payroll as a percent of sales in the US is unheard of, particularly when sales are declining. This is not a sustainable trend.
More to the point, despite beating the street by $0.12 this quarter, they only raised guidance by $0.04. That alone speaks volumes to the real trends that YUM is seeing. The company’s new guidance implies YUM will earn $0.46 per share in the fourth quarter, $0.10 below the street’s estimate going into the quarter. The strength of Q3 is offset by the weakness in Q4. If 3Q was such a great quarter, why is there no follow through into Q4? Unfortunately, we now know that the company’s “quarterly” guidance must be taken with a grain of salt. Should we read into this that Q4 is going to be another blockbuster quarter?
Over the past two years, YUM has been unable to sustain any sales momentum at any of its brands in the USA. In the current quarter, Pizza Hut’s 13% decline in same-store sales is disturbing (blame-the-ad-agency once again). While YUM did not disclose the performance of KFC and Taco Bell, we can only take from that to mean that those concepts are not meeting expectations either. I am interested in learning on the earnings call if there is any follow through on the trends at KFC given all of the hype over the new grilled chicken product introduced earlier this year.
Using the company guidance of just three months ago, we were modeling a 27% tax rate for the quarter (to get to the guided full-year 25% tax rate). They came in at 20%! I know this number can be very fluid, but again the magnitude of the divergence is massive (added at least $0.05 to 3Q EPS relative to my estimated 27% tax rate). This is definitely financial engineering at its best. Lower taxes make it easier for management to raise guidance for the year and safely beat the 10% EPS target needed to get paid bonuses.
Lastly, in Q2, the company lowered its full-year US operating profit growth guidance from 15% (including G&A savings of about 9%) to high single digit growth, which implies all of the growth is expected to come from cost saving initiatives. If management maintains this guidance, YUM’s U.S. operating profit growth will be down to up slightly (I am currently forecasting -5% given the positive comparison from 4Q08), which again points to no follow through in the coming quarter off of this 18% growth.