Yum Brands Inc (YUM) — Q3 2015 Earnings Call Transcript

Thanks Suzanne. Good morning everyone and thank you for joining us. On our call today are Greg Creed, our CEO; and Pat Grismer, our CFO. Following remarks from Greg and Pat, we’ll take your questions. Before we get started, I would 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 to find disclosures and reconciliations of non-GAAP financial measures that may be used on today’s call. We are broadcasting this 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 future use of the recording. Finally, we would like to make you aware of the following upcoming Yum! Investor Events; our 2015 Investor and Analyst conference will be on December 10th in Dallas, Texas and our fourth quarter earnings release will be on Wednesday February 3rd. And with that, I’d now like to turn the call over to Mr. Greg Creed.

Thank you, Steve, and good morning everyone. Delivering 14% EPS growth in today’s environment would normally be considered a very good result. But these are not normal times and our performance is anything but satisfactory. I know that you all want to hear about China today and have many questions that we are going to answer for you. But before I spend most of my time today on China, I do want to talk about the performance of our three global brands. Taco Bell, as you have rightfully come to expect, had another great quarter. Same store sales growth of 4% rolled over plus 3% from a year ago and with another 3% sales growth from new units. Year-to-date, this has doubled the number of new units from last year and margins are now over 21%. This brand is doing all the right things in all the right places. KFC had another solid quarter. Same store sales growth of plus 3% with another 3% from new units. We saw notable standout performance in Australia, Russia, and Japan and some underperformance versus trend for South Africa and the UK. While KFC in the U.S. is still a small component of the global brand, it continued a steady progress with transactions plus 4% to the category as the innovation pipeline is now starting to be a force. Pizza Hut was relatively flat, which we could argue was pretty much in line with expectations. But let’s be honest; we’re still significantly lagging the performance of our nearest competitors and we clearly have much urgent work to do for this brand to fulfill its potential, which brings me on to what we all want to talk about which is China. Let me start by being really clear. We all and I personally take full accountability for our results in China. And while there is clearly a macro softening going on including headwinds from unexpected foreign exchange pressures and yes, the online ordering aggregators who are delivering for mom and pops are in a death battle for supremacy with heavy discounting and the malls look more like fancy food courts than shopping centers, the simple facts are that the economy there is still growing and there is every reason and no excuses to why we should not perform better. I also want you to know that our new China CEO Micky Pant and his team also get it and as I’ll detail are taking significant measures to get sales, traffic, and profits back to historic levels. If I step back and look at our own research and independent research, they both show that KFC and Pizza Hut have very strong positions. KFC is the undisputed leader in QSR and Pizza Hut owns western casual dining. And both own the hearts and minds of the Chinese customer. And as I’ve said before and I’ll say again, we wouldn’t trade places with anyone. So the obvious question is what is going on; why is this taking way too long to recover and in particular, what happened over the past six to seven weeks? Let me start with KFC, which did see sequential improvement and is on trend to continue that improvement into the fourth quarter and beyond. With Micky Pant now at the helm, we have a fresh set of eyes and we are taking the following immediate actions. First, we are sharpening our brand positioning and we will position and market KFC as the unequivocal Chinese favorite; always original, always Chinese. Second, we are rejuvenating the product pipeline and dramatically improving our discipline and effectiveness around products testing. We have also begun to test new simplified menu boards that will speed up the ordering process and importantly return and celebrate our core chicken products. Third, we will introduce more disruptive value innovation. We will drive transactions, which we know we can do profitably with box meals and day of the week specials, like we have done in the rest of the world. And fourth, we will take our proven pipeline of successful chicken innovation from around the world and adapt it to Chinese taste. Both Micky and I are confident that these actions will reinvigorate the KFC brand and help us fully recover and more over time. So, this leads me to Pizza Hut casual dining in China. Historically we have delivered amazing growth by revamping 25% of our menu every six months. However, it’s clear to all that recent promotions have not performed at historical levels and let me give you a couple of examples. In mid-August, we launched a premium-priced steak product, in hindsight, just as the macro started to weaken. Furthermore, in recent weeks, we’ve seen companies cut back on parties, dinners, and entertaining. So, while our weekend business is going okay, this has impacted our weekday dinner results significantly. So what are we doing about it? We are adding a weekday value dinner promotion on top of the scheduled menu revamp that starts October 19th. And if I look back at our previous success, it’s when we’ve offered five-star service at three-star prices. The calendar this year has had things that are more like six-star products such as fajitas and premium steak at six-star pricing at a time when consumers are seeking value. So, we are going to get back to what made us great five-star pizza, pasta, and wings at three-star pricing. I know that we are rightly in show me time versus tell me time. But I’m confident that our current performance is no indication of our future potential and that our best days are still ahead across China, India, and the three global brands. So, in conclusion for Yum!, this is proving to be a more challenging second half driven by a slower recovery in China and the foreign exchange headwinds. However, we believe in the long-term strength of our company. As further evidence of this, we announced a 12% increase in our quarterly dividend last night. This marks the 11th consecutive year we’ve increased our dividend at a double-digit rate. In summary, we are in a unique position at Yum! with three category leading brands that we will strengthen and grow into three iconic global brands that people trust and champion. We remain focused on the three keys to driving shareholder value: New unit development, same-store sales growth, and generating high returns on invested capital. We believe this combination of efforts will enable us to generate consistent shareholder value in the years ahead.

Thank you, Greg, and good morning everyone. Today I’ll discuss our third quarter results and share some details behind our current full year outlook. As Greg mentioned, Taco Bell continues to be strong, KFC is solid, and Pizza Hut remains in turnaround mode. The big story is our China Division, which is recovering but at a much slower pace than we previously expected. Recent sales in China have significantly affected our outlook for the rest of the year, especially at Pizza Hut Casual Dining. I’ll focus on China, but let me quickly recap the financial results for the third quarter: earnings per share excluding special items grew by 14%, a marked improvement from the 7% decline we reported in the first half of the year. Same-store sales not only turned positive in China but were also positive across all three of our global brand divisions. Worldwide restaurant margins at company-owned stores reached 18%, up 3 percentage points from the prior year. However, foreign currency translation negatively impacted our earnings per share growth by nearly 6 percentage points in the quarter, influenced by an unexpected devaluation of the RMB in mid-August. Here are the highlights from each division’s results and their implications for our full year performance. Operating profit in the China Division increased by 64% before foreign currency translation, with restaurant margins nearing 20%, an improvement of nearly 5 percentage points from last year. The China team has done a great job managing costs, and I believe their sustained productivity improvements will lead to meaningful profit growth as sales recover over the long term. Sales turned significantly positive as we moved past last year’s supplier incident that occurred in late July. Specifically, in the first seven weeks of the third quarter before this incident, same-store sales for the division averaged a decline of 11%, but in the following four weeks, they averaged a growth of 31%, resulting in a 42-point swing to the positive, which gives us optimism about the ongoing recovery. For the entire quarter, same-store sales increased by 2% for the division, which included 3% growth at KFC and a 1% decline at Pizza Hut Casual Dining. Now looking forward, specifically in the fifth week of China’s fourth quarter, how are sales trending and what does it mean for our full year results? And similarly, how did we misjudge our previous forecast? I’ll address both. Encouragingly, KFC same-store sales in China are continuing to recover, as shown by our latest sales data. In September, KFC China’s same-store sales rose by 9%, marking the first month of the fourth quarter. Based on current information, we anticipate Q4 will show another quarter of improvement for KFC in China. However, it’s important to note that this recovery is happening more slowly than we had initially anticipated, which is affecting our prior outlook for fourth quarter results. The situation at Pizza Hut Casual Dining is much more challenging. In late August and into September, we saw significant deceleration in same-store sales compared to our forecast. The loss of sales momentum is leading to notable negative effects in our Pizza Hut Casual Dining business, which accounts for about a third of China Division profits. We believe three main factors are driving this: First, extraordinary volatility in financial markets, the unexpected currency devaluation, and generally softer economic conditions are impacting the casual dining sector more severely. Second, we’re facing what we think is a short-term but significant impact from online ordering aggregators entering the casual dining space. Third, and most crucial, our marketing promotions underperformed our expectations, causing us to lose significant momentum in the business, which we are now actively working to regain. This confluence of events took us by surprise, especially as business trends changed unexpectedly at the end of August. For reference, same-store sales at Pizza Hut Casual Dining fell by 3% in September, indicating a rapid downturn and falling 25 points short of our earlier expectations. Based on current trends, we anticipate that Pizza Hut Casual Dining sales in China may remain negative for the rest of the year, potentially reaching the low double digits. Therefore, we now forecast mid-single-digit positive same-store sales for the fourth quarter and low-single-digit negative for the full year in the China Division. This disappointing result is well below our previous expectations, even while the China team is working urgently to regain momentum at both KFC and Pizza Hut. Our outlook has changed, and the reasons we’ve missed our initial forecast are tied to the sudden decline in China sales, predominantly led by Pizza Hut, with the underlying causes surfacing quickly and unexpectedly. In this volatile environment, forecasting sales in China for both brands remains challenging. We use the best judgment we can based on available information. We plan to provide another update on China sales at our investor meeting in December. Shifting to our KFC Global Division, we recorded another quarter of growth in sales, margin, and profit before foreign currency translation. Sales were particularly robust in Australia, Japan, and Russia, and we achieved a same-store sales growth of 2% in the U.S., bolstered by a 3% growth in same-store transactions, indicating continued improvement. These gains were offset somewhat by weaker sales in South Africa, Thailand, and the UK. Despite increased sales leverage, division operating margin decreased by 20 basis points, primarily due to heightened advertising expenses tied to our U.S. turnaround program, which also impacted profit growth by 2 percentage points during the quarter. Additionally, division operating margins faced a 1 percentage point reduction from strategic investments in general and administrative expenses and increased pension costs. Overall, KFC’s operating profit grew by 3% when excluding foreign exchange impacts. Notably, KFC’s new unit development remains strong, with 335 new international restaurants opened this year, totaling over 40% more new locations in the first three quarters of 2015 compared to 2014. This reinforces our confidence in the strength of the KFC brand and its growth-oriented franchisees.

Thanks, good morning. I realized you’re going to be reticent to talk about structure changes with the business but I mean one fundamental observation about Yum! today is that the last three years have been one where the company is no longer hitting the 10% plus EPS growth, the combination of growth rate and consistency is broken down. Thinking about Yum! going forward, obviously structure change could be part of the solution there but if the company doesn’t make a structure change as you’re observing the business today, what can you do to restore the consistency in growth?

So David, let me just start, I think as you know, over the last three years particularly in China, we had two food safety incidents and obviously we’ve had marketing missteps. So clearly, what we got to do is primarily turn around China. I think where we do perform well, we’ve got the following in place; we’ve got very clear brand positioning, we have insight-driven product innovation, we have disruptive value, we have upgraded assets, we have social, mobile, and digital at the cutting edge and we deliver a superior experience. So we know those are the things that when we deliver, we deliver outstanding results. So, I think the thing we have to do in all the divisions is to get back and execute against those basics. So that’s what I got the organization absolutely focused on. So my number one priority is to turn around China using all of those tools and directions that I’ve just articulated.

David, that math actually isn’t right. We’re expecting mid-single-digit same-store sales positive for the division in the fourth quarter. So with negative same-store sales for Pizza Hut, they could be in the low double-digits. The KFC number could be in the range of high single-digits to low double-digits.

Looking at the unit growth in China instead of the comp growth, we’ve seen another tick up in unit closures at KFC. Can we just get a little bit more color on where those are coming from? Is it more higher tier cities or you might be coming up against lease renewals, lower tier cities that might have some more macro issues? The rates doubled sort of since last quarter and more than doubled year-over-year. So what’s driving that step function?

Definitely there has been an uptick in China unit closures relative to our original expectations. Part of that is Little Sheep; there continue to be closures in Little Sheep and that is placing a drag on net unit growth; we do expect about 60 closures there this year. But every year we have a base of store closures including forced closures, relocation opportunities, and lease expirations. So even if we had no underperforming stores, we would go for closures. But at KFC, it is true that performance-driven closures have been higher than we anticipated coming into the year and that’s really the cumulative effect of three years of softer than expected sales. We do look at these on an individual basis and there are unique circumstances supporting each one of those decisions.

I have a question about China, specifically regarding online delivery, which has been extremely competitive this year and perhaps the source of significant disruption. I've heard media rumors about a major merger between one of the big O2O platforms and a restaurant review app, which might reduce competition. However, how can investors feel confident that conditions will improve in 2016? The competition seems intense. Looking at your Pizza Hut operations in China, what specific strategies are you implementing to enhance your delivery services or capture a larger market share? It appears that O2O players are creating challenges for small restaurants, putting you at a competitive disadvantage. Could you share your plans to tackle these competitive pressures in the delivery sector?

Let me provide a comprehensive response. Firstly, in terms of delivery, we operate about 300 delivery units, which is a small fraction of our overall business compared to Pizza Hut in China. However, as you mentioned, there is indeed a fierce competition for dominance among the aggregators, who are heavily discounting their services. We are cautiously entering this area, but it remains a minor component of our business. Therefore, we believe that the current economics cannot support all the players in the market offering such low prices. From our observations of these aggregators in other regions, they typically compete for market share by lowering prices, but eventually, they must raise them again. Furthermore, we maintain that the delivery experience provided by these aggregators does not match the quality of the delivery experience from Pizza Hut. In summary, there is intense competition for market share, but we do not think that they will be able to maintain these discounts in the long term.

I have two questions, both related to China. The first is about communication. Back in late August, about ten days before the end of the quarter in China, you issued a filing that highlighted a significant recovery. Many of us were surprised that the third-quarter number came in much lower than we expected, especially since the message seemed to indicate that things were on track. Did we misinterpret the filing, or did something change in the last week and a half? I'm trying to understand the discrepancy between the positive commentary toward the end of the quarter and the third-quarter results. I will ask my second question afterward.

Well, I can’t speak to how you or others interpreted what we said. But as I said in my remarks earlier, the facts are that in the seven weeks leading up to the lap, the average same-store sales for the division were minus 11 and then for the next four weeks swung 42 points to the positive to plus 31. So in fact, same-store sales had turned significantly as we lapped last year’s supplier incident.

I acknowledge that China has fit historically into the long-term growth plan and as everyone has been talking about, it has been hurting the model and the valuation of your stock for three years now. But the problem here is the visibility looking forward is no better today than it was last year or the year before. And Greg, you started the call talking about everything but China, because you really wanted to highlight the strength in that business. But the way Yum! is structured today, China is all that matters and we all know that. And at some point, I wonder when the board and the management team believes that the China turnaround story no longer makes sense to completely dominate the investment conversation for Yum! Brands and at some point, when they would believe a separation is a more realistic option for the sake of what appears to be an undeniable opportunity for value enhancement.

I think what I can say is we’re always going to believe in China and we’re always going to participate in its growth. Let me be really clear. I think we’ve also got a new leader on the ground in China and with the new leader comes fresh ideas and a fresh perspective. And there is no doubt that he is taking a lot of the ideas that we know have proven and worked around the world and we’re putting those into test aggressively whether it’s KFC or Pizza Hut in China. So that’s what I believe is the best answer which is we continue to believe in China, we all like to participate in China’s growth; we’ve got a new leader, he is bringing massive action to bear, which is great because he ran the Global KFC and Pizza Hut businesses in his prior job. He knows what’s worth; he knows what’s resonating with customers; he knows how to adapt certain taste to local taste. And that guy is doing everything he can do. He is being incredibly well received by the China team. People are saying he is incredibly smart. He is incredibly experienced. He is incredibly humble. He is incredibly collaborative. And he has an action agenda.

Just I guess going back to the competitive issues, particularly on the order aggregators and I guess if there is anything else that’s really surprised you. But that seems to be one of the bigger surprises that’s emerged more recently. And you talked about the impact on sort of delivery at Pizza Hut but you also mentioned the Pizza Hut Casual Dining was impacted by this. But are you saying that the order aggregator sort of delivery model would impact Pizza Hut Casual Dining specifically or is this also not going to be an issue for KFC?

No, I think it’s clear that right now with the massive discounting just going on, you can get a meal that you would traditionally go out for, delivered to your house at very low price. But as I said, we know these economics are not sustainable. We know they are burning through all this cash. That’s why on the Pizza Hut delivery side, we are experimenting with it. But I think that we feel and we have seen as we have practiced in other markets around the world, eventually these prices go up; when these prices go up, demand wanes. It’s the fact of life.

What is the right timeframe to look at this recovery? You’ve got a new CEO in place. Are we going to hear next quarter that look it’s going to take some time to rebuild the product pipeline and how much of this will be revolved or resolved with pricing? How much of this is maybe resetting pricing?

No John, as I speak to Micky, and I’m talking to Micky quite a bit. The discussion we've had is that there are some clearly proven ideas that we've had success with globally, whether it’s box meals for lunch, day of the week specials, or product innovation, and he is currently working on testing all of that in China as quickly as possible. So I think that in December, we’ll be able to provide a clearer update on the successful strategies from around the world that we’ve implemented in KFC or Pizza Hut in China. We hope to have some preliminary numbers, even if they are just from early test markets.

I know you don’t want to give too much color on the outlook for '16, but my question is how lasting should we think about what your implied fourth quarter combined China margins could be? And I guess Pat, your full year China profit growth guidance of high to mid-single-digit implies a fourth quarter profit number that might be slightly above $100 million which represents a 65% drop in profits from your actual third quarter performance that’s about double what it normally is historically.

You’ll have to remember that the fourth quarter is one of the lowest seasonal times of the year. So absolute profits historically for China have been very low, whereas the third quarter is the peak summer season when profits are relatively high. So, it’s not fair to draw those sorts of comparisons between Q3 and Q4 on an absolute basis. But the outlook we’ve given for China Division profit performance for the full year takes full effect of what we’ve guided by way of same-store sales growth for both KFC and for Pizza Hut Casual Dining in China and the corresponding impacts to their levels of profitability bearing in mind that it’s a low seasonal period for the business.

First, Pat, could you give us some perspective on what KFC was cycling in the month of September, so we have a good understanding of how to frame up the plus 9% comp? And then I have a follow-up.

We didn’t provide monthly comps last year. And I don’t know that it would be necessarily helpful to do that at this stage.

We have leading brands in the world’s largest growing economy and we are on the ground floor of growth.

I want to talk about the competitive issues, particularly on the order aggregators and I guess if there is anything else that’s really surprised you.

We’ve got to have very clear brand positioning. We have got to have innovation that is driven from insights. We’ve got to have disruptive value and we’ve got to be strong and great in the whole social mobile digital space.

And this concludes today’s conference call. You may now disconnect.