Mixed 3Q for Yum!, China Excels - Analyst Blog

Yum! Brands Inc. (YUM) reported third quarter 2010 adjusted earnings of 73 cents per share, which inched past the Zacks Consensus Estimate by a penny. Earnings increased 5% year over year mainly on the back of strong performances in its China division. On a reported basis, Yum! Brands’ quarterly earnings were 74 cents per share, up 7% year over year.

The company reported a 3% year-over-year increase in total revenue to $2,862 million during the quarter, which fell short of the Zacks Consensus Estimate of $2,870 million. Sales growth stemmed from a 20% increase in the China division, partly offset by a respective 8% and 4% drop in the U.S. and YRI divisions.

Behind The Headline Numbers

Comparable-restaurant sales improved 6% in mainland China. However, comparable-restaurant sales nudged up 1% in the U.S. attributable to an 8% increase in Pizza Hut and a 3% rise at Taco Bell, but offset by an 8% decline at KFC as well as in the YRI division.

In the quarter under review, Yum! Brands saw a spike in its overall cost structure arising from its China division as was expected. Both company restaurant costs and general and administrative (G&A) expenses rose in China by 18% and 24%, respectively. However, these were partially mitigated by a respective 8% and 10% decline in company restaurant costs in YRI and U.S. divisions. In the YRI division, G&A expense fell 5% while in the U.S., it remained flat year over year.

Consolidated operating profit grew 16% year over year mainly in China (up 24%; and up 23% excluding foreign currency translation) and the YRI (up 18%; and up 16% excluding foreign currency translation) divisions, somewhat offset by a 2% decline in the U.S.

Restaurant margin spiked 0.9 percentage points in China, attributable to strong same-store sales growth and commodity deflation, partially offset by labor inflation. Restaurant margin at YRI and the U.S. were up 1.6 and 0.3 percentage points, respectively, driven primarily by the impact of refranchising.

Unit Growth

Robust performance in the China division during the quarter was primarily driven by 12% new unit growth. The company has strengthened its position in China by adding 90 new restaurants during the third quarter. Further, Yum! Brands solidified its footprint internationally by opening 184 new units in the quarter, with the majority being across 34 emerging markets.

Financials

At the quarter end, Yum! Brands had cash and cash equivalents of $1,274 million with long-term debt of $2,905 million, and shareholder equity of $1,643 million.

Guidance

Management raised its fiscal 2010 adjusted earnings to the range of $2.43 to $2.48 per share from 2.39 to $2.43 on solid ongoing performance. This implies 14% annualized earnings growth as against the previous annual target of 12% growth. However, management expects commodity cost and labor inflation to scale up in the fourth quarter.

Yum! Brands is slated to open about 1,400 international units, mostly in China and YRI divisions, in fiscal 2010. This will make it the industry’s leading international new unit developer.

Going forward, Yum! Brands will continue to refranchise significant portions of its U.S. operations and expects to complete this initiative by year-end 2011.

Our Take

The Chinese division of Yum! offers significant growth opportunity with its two leading brands KFC and Pizza Hut. Moreover, its adoption of a refranchising strategy mainly in the U.S. is expected to reduce its capital requirement. Yum! Brand’s close competitor McDonald’s Corp. (MCD) has accelerated its unit growth in the Chinese market, but it still lags Yum!. Recently, the company also hiked its dividend by 4 cents to 25 cents. However, stiff competition from other quick-service restaurant operators, cost escalation as well as wage inflation in China, and macroeconomic factors influencing consumer spending patterns still remain concerns. Consequently, we have a Zacks Rank #3 (short-term Hold recommendation) on the shares. We also reiterate our long-term Neutral rating.