• It's Coming...

    MARKET EDGES

    Identify global risks and opportunities with essential macro intel using Hedgeye’s Market Edges.

Conclusion:  China carried the third quarter relative to expectations, but commodity and labor inflation should take a toll on margins in 4Q10.  Top-line trends in the U.S. and YRI were positive, but continued to decline on a two-year average basis.  It will be difficult for the company to sustain its reported restaurant-level margin growth if trends do not improve in both the U.S. and YRI.


YUM 3Q10 earnings came in relatively in line at $0.73 per share versus the street’s $0.72 per share estimate, and management raised its FY10 EPS guidance to $2.48 from $2.43, matching the street’s full-year estimate.

Relative to expectations, China was the bright spot during the quarter with same-store sales growing 6% versus the street’s 4.0% estimate.  This 6.0% comp growth implies a 300 bp acceleration in two-year average trends from the prior quarter.  Restaurant margin grew 90 bps YOY, which was better than I was anticipating, as a result of both the better-than-expected comp growth and the fact that the company guided to both commodity and labor inflation in the back half of the year, which did not fully materialize in 3Q10.  Although the company did experience higher labor costs during the quarter, it benefited from another quarter of YOY commodity deflation.  That being said, management expects commodity and labor inflation to negatively impact margins in the fourth quarter.  To that end, I would expect restaurant-level margin to decline during 4Q10; though given the company’s strong year-to-date restaurant margin gains, YUM should easily achieve its full-year goal of growing restaurant-level margin in China.

Same-store sales growth came in below expectations in both the U.S. and YRI.  U.S. comparable sales growth was up 1% during the quarter relative to the +2.2% consensus estimate.  Pizza Hut posted another quarter of 8% comp growth, which at first glance, looked very impressive, but it is important to remember that the concept was lapping a -13% number from last year.  Positive comps are impressive in this environment, nonetheless, but two-year average trends decelerated 250 bps from the prior quarter.  This slowdown points to share losses within the casual dining segment given the improvement in two-year average Knapp trends in July and August (and rumored for September).  Please refer to my “KNAPP TRACK: SEPTEMBER (RUMORED) TRENDS” post for more details.

Taco Bell same-store sales came in +3%, which points to better trends on a one-year basis but slowing trends on a two-year average basis relative to 2Q10.  And, KFC just continues to be horrible.  Comps declined 8.0%, implying a 300 bp sequential deceleration in two-year average trends.  Management said that trends at KFC would be soft in the back half of the year as “there is no quick fix.”  YUM has been in the process of a turnaround at KFC for some time now and although the concept sees an occasional quarterly uptick in sales, we are yet to any sustained improvement in trends.  U.S. restaurant margin improved 30 bps YOY despite the sales shortfall, which management attributed primarily to refranchising. 

Comparable sales growth at YRI grew 1% in the quarter, in line with the prior quarter on a one-year basis, but implying a 50 bp slowdown on a two-year average basis. 

On the second quarter earnings call, management guided to stronger sales growth for the balance of the year at YRI, largely as a result of easier comps in the back half of the year, so this sequential slowdown in two-year average trends was disappointing.  The street was looking for 2.3% growth during the quarter.  That being said, restaurant level margin improved 160 bps, which the company again attributed to the impact of refranchising.