Yum! Brands, Inc. (YUM) Q2 2013 Earnings Report, Transcript and Summary

At this time, I would like to welcome everyone to the Yum! Brands second quarter 2013 earnings conference call. [Operator instructions.] Thank you, Mr. Schmitt, Vice President of Investor Relations. You may begin your conference.

Thanks, operator. Good morning everyone, and thank you for joining us. On our call today are David Novak, Chairman and CEO; Rick Carucci, President; and Pat Grismer, our CFO. Before we get started, I would also like to remind you that this conference call includes forward-looking statements. Forward-looking statements are subject to future events and uncertainties that could cause our actual results to differ materially from these statements. All forward-looking statements should be considered in conjunction with the cautionary statements in our earnings release and the risk factors included in our filings with the SEC. In addition, please refer to the Investors section of the Yum! Brands’ website, www.yum.com, to find disclosures and reconciliations of non-GAAP financial measures that may be used on today's call. We are broadcasting the conference call via our website. This call is also being recorded, and will be available for playback. Please be advised that if you ask a question, it will be included in both our live conference and in the future use of the recording. Finally, we would like you to be aware of the following Yum! investor events occurring in the next three months. Our Yum! Restaurants International investor and analyst conference will be on August 21, in Plano, Texas. Our Yum! China investor and analyst conference will be on September 9 and 10 in Shanghai, China. And our third quarter earnings release will be Tuesday, October 8. I would now like to turn the call over to David Novak.

Thank you, Steve, and good morning everyone. The second quarter was extremely challenging for Yum! Brands, but sales and profits were generally in line with what we had previously communicated. Earnings per share, excluding special items, declined 16% versus prior year, as our China division operating profit fell 63% prior to foreign currency translation. Operating profit increased 12% at Yum! Restaurants International, and 4% in our U.S. business. Now, there’s obviously been a lot going on with our KFC business in China, so let me give you an update on our progress. Beginning in April, KFC sales in China were significantly impacted by the intense media surrounding avian flu. The quarter was also impacted by the residual effect of the poultry supply incident, which occurred in late December. Fortunately, the extensive media surrounding avian flu in China has subsided, and same-store sales at KFC are on the road to recovery. In fact, our KFC same-store sales decline in June was 13% versus the 26% decline we just reported for the second quarter. This is clearly another improvement in our trend, and further evidence the brand is continuing to recover from both avian flu and the poultry supply incident. I was just recently with our China team and I can assure you they are weathering the adversity and executing with a great sense of urgency. So even though we believe the gift of time will be the most important contributor to our ongoing KFC sales recovery, the team remains extremely focused and are taking the necessary steps to get sales back on track as soon as possible. For example, we launched a quality assurance advertising campaign in mid-April reminding consumers of our commitment to quality in China and that properly cooked chicken is perfectly safe to eat. Our quality assurance message…

Thank you, David. Good morning. Today, in addition to talking about our results at Yum! Restaurants International in the U.S., I will also describe the diversity of our franchise business at YRI. I will then show how portfolio actions and new unit development are improving results, margins, and our growth proposition in the U.S. At Yum! Restaurants International, our strategy is to drive aggressive international expansion and build strong brands everywhere. On our last earnings call, I mentioned that the YRI franchise revenue stream is large, growing, global, and diversified. In the 10-year period from 2002 to 2012, our franchise units almost doubled, from 7,000 to 13,000. YRI’s franchisees have tripled over the same timeframe, from almost $300 million to about $900 million. This year, franchise fees will reach nearly $1 billion. So clearly, this revenue stream is large and growing. Let me now spend a minute talking about how diversified this global portfolio is. Let’s first look at the regional balance. We have a large and growing presence in Asia, which accounts for 28% of our franchise fees. The Americas account for 22% of our fees. Europe also accounts for 22% of YRI fees. To round out the world, 16% of our franchise fees come from the Middle East and Africa, and 12% from Australia and New Zealand. In addition to having strong regional balance, our franchise fees reflect our dominant presence in high-growth emerging markets. Emerging markets currently account for about 45% of our revenue stream, but make up a higher percentage of our growth. As an example, in our most recent quarter, 63% of our new units were opened in emerging markets. We also continue to enter new emerging markets. In the past 12 months alone, KFC has entered Argentina, the Ukraine, Malawi, Angola, and just last…

Thank you, Rick. Our second quarter earnings per share were obviously very weak, due to the temporary sharp decline in our KFC business in China, but we expected these results as previously communicated. The important thing to focus on is that our KFC China business is clearly recovering, demonstrating solid improvement in same-store sales. Additionally, our other key businesses, including Pizza Hut in China, are delivering results that are generally in line with our growth targets. Over the next few minutes, I’ll provide some additional perspective on our second quarter results, our EPS expectations for the full year, and our preliminary thoughts on 2014. For the second quarter, we recorded a 16% decline in EPS before special items, due to the significant challenges we faced in China, partially offset by growth in our YRI and U.S. divisions and a lower tax rate. In China, operating profit declined 63% in Q2, prior to foreign currency translation, driven by a 20% decline in same-store sales. This decline in same-store sales included a 26% decline at KFC and 7% growth at Pizza Hut casual dining. Similar to what we experienced in the first quarter, China restaurant margins decreased significantly in the second quarter, down 5 percentage points versus prior year, driven by the operating deleverage you’d expect with a double digit decline in same-store sales. In addition, because Q2 is a seasonally low sales period in China, the deleverage impact on division operating profit, when viewed on a percentage basis, was even more pronounced due to the relatively fixed nature of G&A expenses. Bear in mind these P&L dynamics work in both directions, so as same-store sales rebound at KFC, we expect both margin and profit to benefit significantly from operating leverage. On the development front in China, we opened 100 new units…

[Operator instructions.] Your first question comes from John Ivankoe with JPMorgan.

Obviously when we talk about China, we talk a lot about the Yum-specific issues that have affected the first half of ’13. But I was hoping we could maybe talk about the China macro. And to the best of your ability and your knowledge, can you separate what’s happened specifically to you guys in chicken and talk about how the China macro may have potentially affected your rate of development and the development opportunities this year, pricing, and perhaps even overall traffic to western QSR. If there’s any comments that you can make from a bigger picture perspective?

I think when we step back and we look at what’s going on in China, and as I mentioned in my remarks earlier, I think the biggest thing we see going on in China continues to go on, and that’s that the consuming class continues to grow. You know, it’s 300 million today, it’s expected to be 600 million people by 2020. And this is backed up from a number of different sources. And as Pat just mentioned, we also see disposable income growing as well. The economy itself is growing 7%, which still makes it the fastest-growing economy in the world. So those are things that I think bode well for brands that are consumer-oriented. When you look at just the infrastructure, what’s going on in China, it continues to expand at a rapid rate. I think China’s building over 90 airports, six of which will be at least as big as O’Hare airport. Train stations are expanding, subway lines. All these really represent fantastic opportunities for our brand. And you know, I think what’s happening in China today is still unprecedented. It’s the largest urbanization effort in the history of the world. And I think that Yum! Brands, and our position competitively, is stronger than any restaurant company in this world. And I think what we’re seeing, and Pizza Hut’s great evidence of this, is that if you have innovation and you have value, and an economy like China has today, you can have very strong same-store sales growth and you can open up new units very profitably and move into lower-tier cities and expand very aggressively. And that’s what we’re seeing with Pizza Hut casual dining in spite of all the, I guess you could say, headwinds that might exist in the market. So at the end of the day, we continue to be very bullish on China. And when you look at the long term, we wouldn’t trade places with anyone. And I think that this country is going to continue to grow very rapidly, and we’re seeing it today. There’s a bit of a slowdown, but their slowdown is, I think, a pretty rapid rate when you compare it to what’s going on everywhere else in the world. So, again, you know, we find this to be true everywhere in the world. When you have powerful brands, you innovate, you provide everyday affordable value, you operate your business well with good service, you can win. So what we’re focused on doing in China is continuing to innovate, continuing to work on our value equation, continue to upgrade our assets, continue to open into the new trade areas, because we think it’s a winning proposition over the long term.

Your next question comes from Keith Siegner with Credit Suisse.

Just to follow up on John’s question a little bit, and maybe try to get a little bit more specific, when you think about, even if we’re decelerating to what’s still in absolute terms a great pace of growth for the economy, what could this do to that mid-teens wage inflation outlook you talked about? This quarter came in a little bit lighter. Is it still a mid-teens wage growth inflation outlook that you’re looking for? Or could we end up seeing something slightly slower?

Keith, you’re right. We did see the inflation on labor moderate a bit in the quarter. But that was more due to some productivity initiatives that helped to mitigate what would have otherwise been a rate of inflation consistent with the guidance we provided, which over the long term is driven by what the government’s policies are around driving an increase in disposable incomes, which continues to be in the mid-teens range.

So then one follow up question. As we think about pricing and how fiscal ‘12’s price increases kind of roll off mid third quarter, how do you think about your ability to raise pricing? In an environment, we just talked about that has fairly meaningful cost inflation, how do you think about - is it the macro factors that most influence this? Do you need to see traffic back to a certain level? Do you plan to take pricing? Anything around those plans for the back half and into next year would be very helpful.

At present we have no new pricing actions planned. Our number one goal is to regain the traffic that we’ve lost over the last few months, and we’re confident we can do that based on the trends we’ve seen to date. We know that it’s important to provide consumers with innovation and compelling value, and so it’s not our expectation that we would be taking more pricing later this year. Now, obviously the situation is very different at Pizza Hut, where we remain in a position of significant strength with our brand. And we have taken some pricing this year, and consistent with our growth model for that business, we may take pricing later this year. But in the case of KFC, given where we’re at today with the brand and our goal to rebuild the brand for the long term, we’re not expecting to take additional pricing.

Your next question comes from Brian Bittner with Oppenheimer.

When I look at the store level margins for China, your labor cost deleverage was a lot less severe this quarter than Q1. So it looks like the cost control has obviously tightened. And I know you just talked about some labor productivity, but your same-store labor costs look like they were actually down over 8%. So when we think about sales reramping, how important is it going to be for you guys to stress maybe some of the newfound cost controls you’ve found, or some of the productivity initiatives you’ve found, so that you can allow the operating leverage to really flex itself as those sales come back? And you talked about operating leverage a little bit. Maybe other than the labor line, maybe you could point out some other sources of operating leverage as sales come back, and how we should think about the China margins.

The operating leverage actually has a greater impact on our occupancy and other costs. We have a much higher component of fixed cost. We do get the operating leverage benefit on the labor line, though, that’s true. But we do expect that the productivity initiatives that we’ve put in place will sustain and will contribute to an improving margin over time. The single biggest lever as it relates to our path back to higher margins is first regaining the transactions that we’ve lost, and beyond that to continue to build new sales layers. Because that’s ultimately what allows us to leverage the fixed costs in our business.

And just a quick follow up. If you can talk about possibly the food cost dynamics in China right now and how your food cost outlook is shaping up.

You may recall in New York what we had estimated for the China division for the full year was about 3% food cost inflation. Thankfully, due to favorable trends, primarily in chicken and cheese, we’re now expecting food inflation to be about flat on the year. What we’ve seen year to date is deflation. So we saw about 5% deflation in Q1, 3% deflation in Q2. We don’t expect that deflationary trend to continue balance of year. We expect to land on roughly flat for the full year.

Your next question comes from John Glass with JPMorgan.

From Morgan Stanley. Could I ask, just following up on the, I understand about the labor productivity savings. That makes sense. But occupancy only grew 5% in U.S. dollars. And unit growth was 3X that rate. So is there a substantial variable piece to occupancy, and that’s why that’s occurring? What else would cause that line to decelerate so much from a growth perspective?

Included in that line is rent and about half of our leases in China have a variable component. Also included in that line is advertising expense, which also tends to be variable.

And was that particularly variable this quarter? In other words, did you reduce advertising spend this quarter?

John, we did take the advertising rate up just a bit in the quarter.

So not down, up?

That’s correct.

And then can you talk about G&A globally? There were some reductions that looked like, from a dollar perspective, some of it came from the U.S., year ago period comparison, but it feels like there was also maybe some reductions, both maybe at corporate and certainly in China. What were those? How sustainable are those? Are those just tied to compensation, or were they in other areas?

Definitely there were some overlap issues I think we called out, but in terms of anything one time, I don’t think there was really anything unusual in the quarter.

And how material is Little Sheep? I understand there’s maybe an impairment risk, but is there a risk that if these trends continue to be poor, that there’s going to be some risk to the China margin that’s material enough to call out, or there’s some risk to earnings in the back half because of it?

No, consistent with what we’ve disclosed in the past, the operating results of Little Sheep are not material to the China division results today.

Your next question comes from Michael Kelter with Goldman Sachs.

On the labor line in China, expenses grew 9% in the quarter, which is less than unit growth, despite some inflation. So obviously you were able to reduce hours, which I think you guys were calling productivity initiatives. Can you maybe be more specific? Where were you able to cut back on labor at the store level in China? And then how do we think about 2014? Are these efficiencies you’ll be able to carry with you that you found in the business? Or are you going to have to flex labor hours back up when sales recover?

There were actually two things going on with China labor in the quarter. The first is that because the adverse sales impact of the avian flu, publicity was more pronounced in Shanghai than in other parts of the country. And in Shanghai, as you know, we have some of the higher labor rates. The mix of our labor across the division benefited from that, and that contributed a bit to the labor favorability we saw in the quarter. And then the second piece is around the team’s ability to implement tighter controls around labor utilization and a more optimal mix of part time and full time employees.

And then you guys talked about some catalysts for KFC China later this year, including new news on chicken. Can you give us just anything on what to expect there? I mean, are we talking step change type innovation? Anything you could share would be helpful.

I don’t think I’d characterize it as step change, but we think it’s very solid. That’s how we characterize it. And we really wouldn’t want to go into detail on that in the call.

And then maybe one last clarification. June same-store sales improved to minus 10, can you tell us anything about the compares so we understand the context of that figure, meaning was June last year weak disproportionately for any reason? Or is the improvement to minus 10 in June a clean, sequential improvement and indicative of the trajectory of their recovery?

We’ve made the judgment not to break out the quarters. We reported the quarterly comps last year, and we’re going to continue to report the monthly numbers.

Your next question comes from Mitch Speiser with Buckingham Research.

David, you mentioned the opportunity around transportation areas. I believe maybe some data was given at the analyst day in December. Could you just give us a sense of how many stores are near transportation hubs, and where you see that unit growth opportunity? It seems like that type of unit development might be a little less vulnerable to food safety related issues and perhaps macro-related shocks.

I’d have to go back and get the exact number on that, but we can get back to you on that.

And while I’m on the line, if I could separate ask about YRI, in the emerging markets you had a very strong comps growth. Can you maybe give us a sense of where the strength was? Was it broad-based? Were there any areas of weakness? And within emerging markets, Africa has been talked about a lot, and maybe just long term, can you give us a sense of when you think Africa could start being a profit contributor?

We highlighted on the call Russia and South Africa were the big drivers. If you talk about the impact of South Africa, you have to think of it as two pieces. South Africa right now has the lion’s share of the business, so that’s what’s going to impact the current year’s results. And so South Africa has been performing very well. Over time, the cumulative impact of it, as we enter these new African countries, will come into play, but it’s probably not going to have a material impact on YRI’s results for the next two or three years.

Your next question comes from Jeff Omohundro with Davenport Securities.

My question is regarding Taco Bell and the DLT rollout of Cool Ranch. Just wondering about the pacing of product, compared with nacho cheese. And when looking at the Flamas that’s coming, what’s your sense about the potential of this product versus Cool Ranch? And then lastly, on this same topic, this seems to me relatively rapid pacing of new flavors in this new sales layer. Just wondering how sustainable this model might be going forward in the longer term.

Well, you know, I think consumers maybe wouldn’t call it fast-paced. As soon as we launch nacho cheese Doritos, people got the joke and they were almost asking for Cool Ranch Doritos Locos Tacos. So we actually had to wait a little longer than we would have liked to, just because the demand was so great on the nacho cheese. We couldn’t get the supply we needed to launch the Cool Ranch. , : But when we advertised it, we also used the slogan “Collect all two”. We wanted to reinforce we still had the nacho cheese piece. So we look at that as a portfolio and we’re looking at adding to that portfolio. We originally thought that would be early next year. We’re still evaluating the timing of that. We could right now forward possibly a little bit into this year. So we’re excited about it, and I think that those will be the main three brands in terms of flavors. I think after that you’ll probably see some more flavors, but they may be either in and out type of ideas. We’re obviously very excited about the results we’ve got as well as the future potential to add other flavors.

I think the only thing to add on that is that no one else has this. It’s pretty nice when you have products that nobody will ever have but us. So it’s a platform that is totally unique to Taco Bell, and so every time we advertise it, whether we have product news or not, we’re advertising something that no one else has. And, you know, as Rick said, we’ve started out with two biggies. The two biggest Doritos flavors are nacho cheese and Cool Ranch. We’ve hit on them. Flamas is obviously a much smaller segment. But it does give us an opportunity to come back and [pulse news]. I think the big thing about Doritos Locos Tacos is no one else has it.

Your next question comes from David Tarantino with Robert W. Baird.

I have a question on the longer term vision for the China margins and the type of recovery you’re expecting. I think you’ve talked about 20% margins longer term. I’m just wondering what type of average unit volume you might need to see over the next couple of years to get back to that level. Is it just a matter of recapturing the sales that you’ve lost over the last year or so? Or do you need to go beyond that to get back into the really high teens or close to 20%?

You’ll recall that prior to the onset of the poultry supplier incident in late December, we were at about 18%. So step one is to regain the traffic that we lost. And we therefore have a high degree of confidence that as that happens, we will return to that level. In terms of getting back to 20%, we still consider that an appropriate target for our business, because nothing structural has occurred to prevent that. And so as we think about the drivers that are going to get us back to the 20% target, beyond regaining the transactions that we lost, and also benefitting from the recovery in average check, I would say there are three factors. The first is continuing to build sales layers. We’ve been very successful at this over the years, introducing new day parts and new occasions that put us in a position to leverage our fixed costs. The second is to continue to evolve our new unit development strategy. As we’ve indicated before, we are shifting our new unit openings increasingly to lower-tier cities for KFC and more broadly to Pizza Hut casual dining, which is comfortably, today, above 20%. And so with those changes to our development program, we’ll see a benefit that will get us closer to that target of 20%. And the final piece is given the strength of our competitive position over time to take pricing where it makes sense. You probably recall that our ongoing earnings growth model for China requires mid single digit same-store sales growth in order to offset inflation and maintain our margins. Based on the inflation that we’ve experienced maybe over the last year and our decision not to take pricing, there will be a point in time where we may need to leverage the strength of our competitive position to take a bit more to get to the 20. I think it’s fair to say that that is an appropriate target, but it will be very challenging to get to 20% in 2014. But you know, make no mistake, we will have a high-margin business in China. It’s difficult to say when we’re going to hit that 20%, but you have to remember that we manage our brands for the long term. We’re not chasing a 20% margin. We’re not focused on getting there next year, for example. We love our competitive position, and even with the 18% margins we had going into the supplier issue, we had three-year cash paybacks because we have such an exceptional asset turnover ratio. It’s a powerful investment model for our shareholders, and we see extraordinary returns continuing at Pizza Hut. So we think the 20% is an appropriate target, and we have a path to get there over time.

And just one quick follow up on the step one of getting back towards that 18% figure. And given you’ve absorbed some inflation this year, and you’re likely to see some inflation next year, what type of rebound in the comps might you need to see next year to get back to that 18%? Or is that an unrealistic target for next year?

Well, given where we’re at in our recovery, and we are seeing those improving trends, it’s premature to have such a detailed conversation around 2014. We continue to believe that we will see the strong bounce back. We’ll provide a more detailed perspective, as we typically do, at our analyst conference in December. And at that time we can provide you more insight into the extent to which same-store sales and pricing and inflation will play into our margin recovery over the course of 2014. The last thing I will say is that based on our past experience with these things, the recovery curve, or the recovery trend, is rarely linear. So, you know, it’s just important to keep that in mind. We’re giving you our best estimate. We reaffirmed that we expect the fourth quarter to be positive for China. And that will provide us the momentum that we need going into 2014 to see the strong bounce back next year.

Your next question comes from Andy Barish with Jefferies.

Just a couple of quick ones. On the promotional side of things, was wings something that you kind of brought on? Or was it in the plan to kind of go back to value? And then just secondly, on the overall China development, can you frame it with just kind of a broader perspective on the percentage of openings in kind of tiers three through six going forward versus sort of what it has been historically, I guess?

Well, on the development front, we are continuing to shift. It’s not something that changes dramatically overnight. But I can assure you that there are two key shifts occurring in our new unit development program. For KFC, moving increasingly to tier three and below cities and increasing significantly the number of Pizza Hut casual dining openings.

And as far as wings go, wings are very popular in China. And we promote them generally in the summer period. And so I don’t think it’s extraordinary, out of the realm of what we typically do.

Your next question comes from Joe Buckley with Bank of America.

Just a couple of questions focused on this year if I could. The tax rate is coming in a little lower than what you guided to. Do you think that will be the case for the full year? Or are you thinking something less than 27% for the full year now?

It’s not uncommon for us to see some unevenness or volatility, if you will, from one quarter to the next. I think it’s early at this stage to provide guidance that was different from what we provided in December, which was about 27% for the full year.

And then the wage rate inflation, what did it run this quarter? And you mentioned a mid-teen rate, but hasn’t it been well below that so far this year? And would you expect it to remain below that?

So we’re talking specifically about China labor inflation. Q1 was in the mid teens range. Q2 was high single digits. In terms of where we’re going to land on a full year basis, it could be in the high single digits to low double digit range. As I said before, when we look longer term, we continue to expense something in the mid teens range.

And your final question comes from Jeffrey Bernstein with Barclays Capital.

Just two questions. One just a follow up on the China side. It seems like the recovery is going along the expected trajectory, but I’m curious about the approach going forward. Pat, you mentioned the outlook for ’14 is somewhat heavily dependent on the sales and margin recovery in ’13. I’m just wondering if you could talk a little bit about value and the promotions you might be thinking about. Better still, if you want to talk specifically on that, is margin a focus at all? Or is it all about achieving the desired full sales recovery at all costs? And then I had a Taco Bell follow up.

Well, it is premature to talk in any detail around 2014. We wanted to give you a sense for what we expect next year, which is the strong bounce back. Certainly value is an important element of any brand strategy, along with breakthrough innovation, and our plan is to continue to offer both.

We never go after a recovery at any cost. We run a business. We’ve got a business to run, and we want to have a long term, sustainable business model and brand proposition. So we’re basically running the business the way we think it ought to be run, so that we’re relevant to customers on a continual basis. And we’re not doing anything that’s overly dramatic.

And just a follow up on the Taco Bell. I know in your prepared remarks you mentioned the breakfast rollout. I guess it’s on track for ’14. Any color you can give in terms of the sales lift you were getting in test, or the potential impact of the comp, or any impact that might have had on the core lunch and dinner business? Any color around breakfast relative to lunch and dinner and what contribution that could make?

Not really at this stage. We may know a little bit more. We’re sort of dialing up some of our product ideas and advertising for later this year, and at that point we may have a better read for what exactly could happen.

But in test is there any color around the sales mix or the profit contribution or anything like that?

The sales mix has been around the 4% range, but this is before we’ve now dialed it up. So like I said we have plans to dial it up in the fall, and once we dial it up, both advertising and adjusting our product line, we may have a better read.

Okay, since there aren’t any more questions, let me wrap this up by just saying that this was a slug it out quarter for Yum! Brands on our way to recovery in China. While our second quarter EPS declined 16%, it was generally in line with our expectations. The good news is that KFC China sales are recovering as expected. At Yum! Restaurants International in our India division we expect record unit development this year, and our new unit pipeline has never been stronger. Our estimated mid single digit full year EPS decline versus prior year remains unchanged. And importantly, we expect a strong bounce back year in 2014 as we continue to aggressively invest behind our core strategies and capitalize on the enormous growth opportunities we see around the world. We continually say we’re on the ground floor of global growth, and that continues to be the case.

Thank you very much. Appreciate it.