YUM remains on the Best Ideas list as a long.
YUM reported 4Q14 adjusted EPS of $0.61 (-29% y/y), well short of the $0.66 consensus estimate. Despite this, strong relative topline trends appear to have saved the day. China delivered a better than feared comp of -16% (-19% est), while Taco Bell (+6%) and KFC (+4%) also exceeded consensus estimates. Pizza Hut (0%) fell short of feeble estimates, which is particularly disappointing considering the new menu and “flavor of now” launch. Needless to say, this quarter did nothing to dismiss our view that the Pizza Hut business should be sold
China's Woes Persist
The majority of the earnings call was spent talking about the pace of the recovery in the China business. Management hinted that things are progressing slower than they originally imagined and voiced at the December analyst day in NYC. In our view, setbacks like this are what will push an activist to get involved in the name. To be honest, management deserves a lot of credit for building a strong business in China that has proven to be very profitable in the past. But it’s been two painful years and misjudging the pace of a recovery is not encouraging. The perception that they don’t have a handle on this business, to whatever extent it may be, simply adds fuel to the activist fire.
Clearly, the top priority is getting China KFC back to 2012 form which, management estimates, would add $1.7 billion in incremental revenue. KFC’s average unit volumes in 2014 were 20% off their peak levels, thanks in large part to back-to-back supplier incidents. But consumer scores appear to be improving in the region, which should lead an acceleration in comps. The team also has two menu revamps scheduled in 2015 and the rollout of premium coffee which will be in 2,000 restaurants by year-end. Pizza Hut is much less of a concern and is trending in the right direction.
Estimates Need to Come Down
Despite a slower than projected recovery in the China business, management reiterated its FY15 EPS growth goal of “at least 10%.” This, in and of itself, looks like a tough hurdle and is dependent on a strong second half recovery in China. The street, modeling 15% growth, will need to bring their estimates down.
We expect the stock to be range bound for the first half of 2015, until we see a material uptick in the business. It won’t be smooth, but we continue to like the long setup here given limited downside and the potential for significant upside. There are a number of levers management can pull to immediately create value, the easiest of which would consist of undergoing a leveraged recapitalization to bring its debt ratio in-line with peers. Management may be getting the benefit of doubt for now, but if the anticipated second half snapback doesn’t materialize, they will face serious pressure to make a transformational transaction.