Management highlighted that U.S. commodity inflation is having a more negative impact than they initially forecasted (now expecting inflation of over $100 million versus their original forecast of $55 million). Although the company will take pricing actions to offset some of these incremental costs, this $45 million of additional expenses represents about a 6% hit to YUM’s U.S. operating profit growth relative to management’s initial guidance. Management, however, took guidance down by 8% while raising top-line expectations, which leads me to believe that the company’s Why Pay More value initiatives at Taco Bell and new pasta products at Pizza Hut are driving traffic at the expense of margins. Management alluded to the margin tradeoff between its new pasta products versus pizza, but called it “minimal” and said that “you can have a little margin degradation as long as you’re making more cash.”
- I understand the motivation for using value to drive traffic, but think the risk to margins, particularly relative to the current commodity cost environment, is a real concern.
- YUM also raised its operating profit targets for China and YRI. The company now expects at least 27% growth in China (versus initial guidance of 20%) and at least 11% growth at YRI (from 10%). YUM has consistently posted solid operating profit results from both of these segments on a reported and currency-neutral basis.
- I think it is worth noting, however, that the currency benefit has grown over time for both China and YRI and helped by 12% and 9%, respectively, in 2Q08. Investors have become accustomed to these high, double-digit reported operating profit growth results and this favorable currency impact may not be around forever.
- As an aside, yesterday the Yuan had its biggest down day since May 26