YUM – GROWING IN CHINA ‘UNTIL THE COWS COME HOME’

YUM used its annual analyst meeting to focus the investment community on where the growth is.  Pizza Hut and KFC in the US – forget-about-it. 

Last week, Yum Brands hosted its annual analyst meeting in New York City.  Prior to the meeting, the company put forth its 2010 EPS growth goal of at least 10%.  So, the focus of the meeting was on the company’s ability to get to 10%.

At the analyst meeting, YUM quantified its same-store sales assumptions underlying the earnings target.  In 2010, YUM sees 2% same-store sales growth world-wide.  Given the current environment and the pickle the US business is in, this target is aggressive.  To management’s credit, they even stated that they have no clue when comps will turn positive…

Looking at the three key business units, management’s outlook assumes 2% comparable sales growth in China, 3% at YRI and 2% for the US.  Let’s just say management is counting on a consumer recovery in 2H10 and the benefits of easy comparisons.  The current trends and outlook suggest that this will be very difficult to attain.

Global unit growth is the key driver to incremental profitability at YUM, especially in China.  In 2010, YUM expects at least 475 new restaurant openings in mainland China, or 13-14% growth.  Guidance is for 15% operating profit growth.  Currently, China generates about 33% of the company’s operating profits. 

Not to be to myopic but I was very interested to see how management handled the issue over sales trends in China.  I would note that they don’t talk about cannibalization anymore.  That being said, they have not changed their stance – it’s an economic issue.  As management sees it, the Chinese consumers have not recovered from two specific economic shocks.  The first one came in the middle of 2008 after the earthquake struck.  Prior to the earthquake, the company was posting double-digit same-store sales growth and 20% unit growth.

The second one came at the end of 2008 when the financial crisis struck and the consumer got even more cautious.  Same-store sales growth in China slowed rather significantly in 4Q08 on a 1-year basis and has remained weak for all of 2009.  The company was lapping difficult comparisons in the first half of 2009, but same-store sales were flat in Q3 and are expected to be -3% in Q4, despite the relatively easier comparisons in the back half of the year.   

Regardless of comparisons, 2-year average trends more accurately show where trends are headed.  Last year on YUM’s 4Q08 earnings call, CEO David Novak highlighted this fact when he said, “Given the strong results we were lapping in the second half of 2007, it makes sense to look at two-year growth rates to gain a greater understanding of China trends. When examining two-year trends for the China Division’s system-sales growth you will find that fourth quarter growth was 49%, just three points below the first half’s strong results, an improvement of four points over the third quarter.”  It is important to remember that Mr. Novak pointed us to look at 2-year trends when comparable sales growth in China came in at 1% in 4Q08 following 12% growth in 1Q08, 14% in 2Q08 and 5% in 3Q08.  On a 2-year basis, same-store sales trends improved in 4Q08 on a sequential basis from 3Q08 so Mr. Novak highlighted this improvement to justify the slowdown in 1-year numbers.  To that end, two-year average trends have gotten sequentially worse every quarter since then and will turn negative in 4Q09, assuming management’s outlook for -3% is correct. 

YUM – GROWING IN CHINA ‘UNTIL THE COWS COME HOME’ - YUM China SSS

At its meeting last week, management said the continued softness is just a function of “lapping what we were running against.”  To that, I would respond that YUM is already lapping easier comparisons in 2H09 and more importantly, two-year average trends continue to come down.

Management also said the real test of current trends will come when they start to lap “the bad bad economy.”  We are already there.  As management stated in its presentation, the second “economic shock” came at the end of 2008.  Same-store sales in China were -1% in December 2008 so we are lapping the beginning of that impact in Q4 and comparable sales are expected to come in -3%. 

Importantly, management said “we still feel that there's no basic fundamental change in China,” which I viewed as justification for continued unit growth.  The extent at which management is bound and determined to keep the unit growth machine going was summed up when Mr. Novak said “We could drop our sales 20%-25% and open restaurants until the cows come home - So that's what we plan on doing.”    

My biggest take away from the meeting was that YUM management will do its best going forward to keep the investment community focused on China, YRI and Taco Bell.  Yum’s U.S. business accounts for 40% of the company’s global operating profits and Taco Bell accounts for 60% of the US.  With the US KFC and Pizza Hut businesses in secular decline, I would not be surprised if these businesses combined account for less than 20% of US operating profits in the coming years.  If it were not for the overseas potential of these brands, I see no need for the company to keep either brand.  For now, however, these businesses still matter.  Management may want to divert our attention to other areas of growth, but current trends at KFC and Pizza Hut are extremely concerning and need to be addressed.

Yum expects to focus much of its domestic efforts on refranchising KFC and Pizza Hut and expanding business at Taco Bell.  Thus, higher scrutiny on where Taco Bell is going is important.  According to management, Taco Bell’s success relies largely on its “branded value” perception and new products offering multiple proteins, a launch of balanced options (drive-thru diet) and day part expansion (breakfast).

I have a hard time believing that the latter two – the drive-thru diet and breakfast - will have any impact on sales any time soon.  Breakfast is so competitive and the real estate strategy for Taco Bell over the years did not contemplate offering breakfast (locations not conducive to morning rush hour traffic).  Therefore, the company will have a very difficult time building that day part.    The idea that YUM will be able to shift consumers’ mindsets to believe that they can lose weight at Taco Bell seems crazy to me and will not “change the category.” 

The Drive-Thru Diet will launch December 27 in order to take advantage of consumers making New Year's resolutions.  On January 1st Christine Dougherty will be to Taco Bell what Jared is to Subway.  According to YUM, Christine has lost 54 pounds over the last two years eating off the Drive-Thru Diet!  She has apparently been eating fast food between 12 to 15 times a month.  Some of those occasions were at Taco Bell, while others were at other brands.   

YUM is calling it the Drive-Thru Diet because they are trying to take on Subway directly while highlighting that Subway does not have drive-thrus.  The two key attributes of QSR are convenience and value.  With Taco Bell being the value leader in the category, management is trying to capture some “better for you” food customers.  Good luck with this one!

What will have in impact will be the new value product offering and new proteins being introduced in 2010.  Taco Bell will be generating a significant amount of new product news and three new proteins – (1) the Beefy 5-Layer Burrito (which could sell for 89 cents each), (2) Pacific Shrimp Tacos ($2.79 each), its new seafood entry and (3) Grilled Cantina Tacos (includes pork).  All of the new products will shift the concept away from the typical “spicy” Mexican flavor. 

All in all the investment community was very bullish on YUM and they do communicate a positive story.  The “growth till the cows come home” strategy is China will one day be a problem for YUM -- timing on this issue is critical.  Same-store sales trends in China are weak in 4Q09 despite easy comparisons. 

The trends in the US have put incremental pressure on management to keeping the China operations without issues.  For now management is getting a free pass on sales trends in China, but for how much longer?