Section I: Management Presentation
Good morning. My name is Angela and I will be your conference operator today. At this time, I would like to welcome everyone to the Yum! Brands third quarter 2013 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions) Thank you.
I would now like to turn the call over to Mr. Steve Schmitt, VP of Investor Relations. Sir, you may begin.
Steve Schmitt – VP, IR
Thanks, Angela. 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. Following remarks from David and Pat, we will 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 on 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’re 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 any future use of the recording.
Finally, we would like you to be aware of a couple of upcoming Yum! investor events. First, our 2013 New York investor and analyst conference will be Wednesday, December 4 in Midtown Manhattan. Second, our 2013 fourth quarter earnings release will be Monday, February 3.
With that, I would like to now turn the call over to Mr. David Novak.
David Novak – Chairman and CEO
All right. Steve, thank you very much and good morning to everyone. There are three key messages I want you to take away from our call this morning. Number one, we are very disappointed with our overall third-quarter results and the fact we now believe China same-store sales will unlikely be positive for the fourth quarter. Frankly, these results were well below the high expectations we have for our business.
Number two, there were some bright spots in the quarter and we are pleased with Pizza Hut Casual Dining in China, overall China restaurant margin, international development momentum and Taco Bell. And number three, despite current challenges, we remain as confident as ever in our ability to deliver strong sustainable growth in the years to come.
For the third quarter, earnings per share, excluding special items, declined 15% versus prior year. This included a 10 point adverse impact from a higher tax rate, driven by an increase in our tax reserves. Additionally, based on KFC China sales for September, which is part of China division’s fourth quarter and a less than expected sales lift from the launch of our new beef burger, it’s now unlikely that China division’s same-store sales will be positive for Q4, although we do expect to show improvement. Obviously, we are falling short of our Q4 guidance of positive same-store sales growth. We are now estimating a high single to low-double-digit percentage decline in full year EPS, excluding special items.
We also recorded a significant non-cash special item charge in the third quarter for the write-down of Little Sheep intangibles. While we are deeply disappointed with our Little Sheep results so far, the team is taking steps to strengthen the concept and improve operations. And we remain confident that we will create a significant value over the long term through new unit development in China’s large and extremely popular hot pot restaurant category.
If you followed us over the years, you know that our target has always been consistent dynasty-like performance growing at least 10% year after year. And in fact, the business accomplishment we’re most proud of is that prior to this year we delivered double-digit EPS growth for 11 consecutive years. This places Yum! Brands among an elite group of companies to deliver this track record of performance.
Now we’ve certainly been humbled by this year’s performance. But I want you to know that we are confident and determined to reestablish our track record of sustainable growth in the years to come. I also want to assure you that we’re working very hard right now to recover from the one-two punch of China poultry supply incident in December and the unexpected bout of avian flu in the spring.
Let me share with you some of the actions we’re taking over the next few months to continue to rebuild consumer trust at KFC China and gain more sales and profit momentum as we enter 2014, which we expect will be a bounce-back year for Yum! Brands.
Our number one priority at KFC China is to build and reinforce positive consumer perceptions around the safety of our food. And while our key brand attributes have improved significantly from where they were in the first few months following the December incident, the fact is, is that they remain below 2012 levels. The KFC brand is showing its resilience and we are confident that a full recovery is in store but more time and effort are required.
So in November, our plans are to launch what we are calling our [I Commit] campaign. We expect this to be a powerful new quality assurance campaign featuring actual representatives of our over 300,000 KFC employees, suppliers and poultry farmers in China. Our quality assurance message will be delivered in an authentic manner and will be centered on the theme that KFC is safe for my family, friends and me and hence, safe for you.
We are also leveraging our massive network of employees and suppliers through social media. The goal is to leverage the fact that KFC brand is part of the of fabric of China and of course, all of this is on top of the Operation Thunder actions we initiated earlier this year to strengthen our poultry supply chain.
On the marketing calendar front, we’ll be following up the recent new product introduction of our beef burger with promotions featuring chicken on the bone, wings and beverages. At the same time, our China team will remain very focused on operating efficiency. We were really pleased to see a nearly 20% restaurant margin despite the decline in sales. I want to recognize the team for really buffing down at the store level. Pat will share more details on this in his remarks.
In short, I’m confident we’re doing the right things to rebuild consumer trust at KFC China and we expect to have momentum heading into 2014. The good news is we’ll begin overlapping very weak same-store sales in December and we’ll have this unfortunate benefit across most of next year. And we plan a number of major menu and value innovations to ignite the sales growth in 2014. Sam Su will share more details of our initiatives during our December meeting in New York.
Now the obvious question is why do you think sales momentum stalled in China? I’ve always said that no two crises are the same. And we always said that we would need to get to time and that it would take at least nine to 12 months. So far, it’s nine months and counting and not happening as fast as we had hoped.
Now, as I just mentioned trust scores are improving significantly, but still below 2012 levels. We believe this is because KFC’s leadership in size has grown exponentially over the years, and our customers’ expectations of the KFC brand have grown along with it. Social media has also exacerbated the issue and kept the dialogue alive. And macros haven’t helped.
While we’ve announced process improvements, communicated a trust message, and we’ve had value promotions, frankly, we haven’t had the kind of major innovation that could turn the tide. And like I said, we are working hard to get back on track, and we are confident that we will.
On the China development front, we continue to expect at least 700 new units in 2013. This means we will have opened around 1,600 new units in a two-year period, and we expect another strong year of development in 2014, all of which will provide substantial momentum for our China division as sales continue to recover at KFC.
Whether it was Sudan Red, avian flu, or SARS, we experienced temporary setbacks to sales and profits, but we stayed the course and kept building units, and I’m glad we did. KFC is a power brand in China today and will be for many, many years to come. In fact, even with our recent challenges at KFCs, we wouldn’t trade places with anyone else in China.
Today, we have nearly 4,500 KFC restaurants in over 900 cities in China. That’s more than twice the size of our nearest competitor in the QSR category. Additionally, we serve about 60 million customers at KFC every week or so, which is almost the entire population of the UK. That may be one reason why the BBC recently published a report naming KFC as the number one foreign brand in China. Any way you look at it, our KFC brand is deeply ingrained in the hearts, minds, and lives of the Chinese customer.
Additionally, China is undeniably the number one retail opportunity in the world. The country continues to experience the fastest pace of urbanization the world has ever seen, and the macro trend we remain most enthusiastic about is the growing consuming class, which is expected to increase from 300 million people today to over 600 million people by 2020.
So, with the number one brand in the restaurant category situated in what will soon be the largest consumer economy in the world, and supported by the people capabilities that are the envy of our industry, we believe KFC is undoubtedly in a very powerful position to bounce back strongly. Clearly, we still have work to do, but we know we’re doing the right things to regain consumer trust, and we remain confident that our best days for KFC in China are yet to come.
Moving to our second brand in China, Pizza Hut Casual Dining clearly has momentum, delivering solid same-store sales growth in the quarter, up 5% on top of 8% in the third quarter of last year. So far this year, we’ve grown same-store sales at Pizza Hut Casual Dining by 4% and unit growth of 29%. That’s pretty good performance by any standard.
Pizza Hut Casual Dining goes well beyond pizza and is unquestionably the leading western casual dining concept in China. Pizza Hut continues to lead with menu innovation and everyday affordable value. 20% of Pizza Hut’s menu is revamped twice a year, and we recently launched a major new product with Stone Pan Sizzling Steak that we know our customers love.
We’re also continuing to leverage our assets by expanding our breakfast menu into more and more cities. With this new sales layer, our long-term goal is to create and own the mid-scale casual dining breakfast occasion in China on a scale that matches what exists in the United States today. This is a huge opportunity, and we’re very well-positioned to capture it.
In the third quarter, we opened 38 new Pizza Hut Casual Dining units and now have over 950 units in 242 cities, compared to the over 900 cities where KFC currently operates. Importantly, we have a strong economic model, leading to less than three-year cash paybacks on new units. With the terrific performance we’re seeing, we’re continuing to accelerate our new unit development and are aggressively expanding into lower-tier cities. We expect to have around 1,000 units by the end of the year, which would be up from about 500 units only three years ago. And we’re just getting started.
We’re also continuing to invest behind the development of our emerging brands. Pizza Hut Home Service, which is in the home delivery category, has 185 units in 22 cities. We have strong unit economics driven by best-in-class technology and everyday affordable value, and we’ll ultimately scale this brand across the country. We’re already a leader in ecommerce with over 60% of our Pizza Hut delivery sales now sourced through online channels. So with the strong foundation already in place, and with the enormous consumer demand for home meal replacement in China that will only grow, we expect our Pizza Hut Home Service business will contribute more meaningfully in the years ahead.
We also continue to make slow but steady progress with East Dawning, our Chinese fast food concept, but still have work to do before we have a scalable business model. And as I said before on Little Sheep, we’re committed to making this the number one casual dining restaurant chain in China and showing the true potential of the brand. We’ve had a clear setback, but our belief in what we can ultimately do with this brand remains intact.
So let me wrap up the China business. I’ve always said that our China business will have its ups and downs, and this year is clearly proving to be one of those downs. At the same time, I’ve also said there’s no market we’d rather lead in and invest in. Make no mistake, we love our overall position in China. We have complete confidence in a full recovery and long-term impressive growth at KFC. Pizza Hut Casual Dining is a growing powerhouse, and we have future growth engines with Pizza Hut Home Service and ultimately with Little Sheep and East Dawning.
Outside of China, we expect generally on-target performance for Yum! Brands this year, and we’re well-positioned to deliver against our ongoing operating profit targets in 2014 and beyond.
At Yum! Restaurants International, 2013 is basically on track. We have an outstanding business portfolio with nearly 15,000 restaurants in over 120 countries and territories. We have tremendous development opportunities in emerging markets, and over 90% of our restaurants at YRI are franchised. This combination creates a steady stream of franchise fees and strong growth.
Now as you probably know, Yum! is a clear restaurant leader in emerging markets, and we expect to build upon this position in the years to come. Importantly, the bulk of our emerging market business will continue to be led by franchisees. The reasons our franchisees continue to accelerate development and invest their own capital behind our iconic brands is pretty clear. Payback periods for franchisees in many of these emerging markets are around three years, and we’re attacking our cost structure across the board to improve our overall investment model so that the pace of development will increase over time.
On the subject of international development, I’m pleased to report that we remain on track to open at least 1,000 new units in YRI this year, which is above the 950 units we were expecting at the beginning of the year and represents a new record for the division. Additionally, our development pipeline for new units in 2014 is very robust.
In summary, our international franchise base of about 1,000 franchisees has proven to be a high growth and extremely reliable source, and we expect growth will accelerate over time as more and more of our development occurs in emerging markets which benefit from faster growing local economies and more favorable cost structures.
Additionally, we expect our relatively new equity base in select emerging markets, such as Russia, South Africa, and most recently Turkey, will begin to deliver more profit growth in the future. We initially invested ahead of the growth curve in these markets, but are now positioned to leverage our early investments to achieve higher growth and higher returns in the years to come.
In the United States, we’re having another solid year. With the completion of our refranchising program this year, and the second consecutive year of net new unit growth, we expect to continue consistent 5% profit growth in the years ahead.
Taco Bell, which represents about 60% of our U.S. profit, is set up for another solid year. In recognition of the extraordinary success of the Doritos Locos Tacos and Cantina Bell product platforms introduced in 2012, as well as leading the way with social media along with the launch of the much talked about LIVE MÁS advertising campaign earlier this year, Taco Bell was recently named by Advertising Age as Marketer of the Year for the entire consumer goods industry. The brand definitely has mojo, and congratulations to Greg Creed and the team.
Building on this brand strength, we now know we have a winning proposition with our breakfast platform. We have three destination products, great value, and an attractive investment proposition for our franchisees. And the good news is that based upon our extensive market test, 90% of the breakfast sales are incremental. And it looks like the breakfast advertising is also driving total brand sales.
I was in Orlando on Monday for the Taco Bell annual franchise convention, and I was pleased that the franchise leadership stood up on stage and enthusiastically endorsed the national breakfast launch. And it’s clear to me we have a unity of purpose across the entire franchise system to win.
The franchisees are also excited about the significant innovation we have planned for our core business. We know that for the U.S. to have a successful year, it’s important for our most profitable U.S. brand to do well, and we certainly have a lot going in our favor at Taco Bell.
We also expect 2014 to be a better year at Pizza Hut with the most significant news being our plan to nationally advertise WingStreet for the first time, which includes chicken strips and our award-winning wings. Virtually all the stores in our system are putting in the chicken operating platform so we can use network television next year to feature home delivery chicken products.
The industry-leading pizza innovation, consistent everyday value, and the chicken sales layer will be our focus throughout 2014. We’ve also changed advertising agencies to help us break through more aggressively in the category and leverage the power of our leading brand.
And finally, while the country macros and our recent results haven’t been as strong as we’d like, we’re continuing to invest in and develop a great business in India. We currently have 613 restaurants and we are full steam ahead with development as we expect to open up 150 new units this year. Although it’s still early days, we expect our India division will drive substantial growth for Yum! in the years ahead, and we are making the required investments to build a powerhouse there.
So, to sum things up, in spite of our short-term sales issue with KFC in China, the fundamentals of the Yum! growth model remain extremely compelling. As you know better than I, there are three keys to driving shareholder value in retail: New unit development, same-store sales growth, and high returns.
In terms of development, our new unit opportunity in emerging markets, including China, remains the best in the retail, and our opportunity to expand is huge. We have three iconic brands, and while we have 58 restaurants per million people in the United States today, we only have two restaurants per million in the emerging markets. That’s a long runway for growth and gives us tremendous confidence in our ability to continue our aggressive expansion for many years to come.
Furthermore, we have nearly 40,000 restaurants around the world that have all kinds of capacity to grow. This represents a huge opportunity for same-store sales growth. In addition to our ongoing efforts to drive sales through improved product innovation, marketing, and operations, we’re developing major new sales layers, broadening our menu variety, expanding our day-parts, and opening new channels with digital.
I’ve mentioned our breakfast rollouts at Pizza Hut Casual Dining in China and at Taco Bell, but we’re also doing this at KFC in many of our emerging markets. Pizza Hut WingStreet in the U.S. is another example of what we’re doing to leverage our home delivery capabilities and drive higher levels of asset utilization.
Meanwhile, our returns on invested capital have consistently been among the best in the retail industry. We love the virtually capital free franchise model, which will generate over $1.8 billion in franchise fees this year. These franchise fees provide us with a large, reliable, and growing stream of cash which, combined with the profit from our equity stores, enables us to invest in high-return growth opportunities and return meaningful cash to our shareholders.
Speaking of shareholder cash payouts, I’m pleased to note that we recently increased our dividend by 10%, marking our ninth consecutive annual double-digit percentage increase. Since 2004, the year we instituted a dividend payment, we’ve returned over $11 billion to shareholders in the form of dividends and share repurchases, all while also continuing to invest in future growth. The mere fact that we’ve increased our dividend in a down year demonstrates the power of our operating cash flow and the confidence we have that our investment model will deliver strong shareholder returns for many years to come.
In summary, after over a decade of growth, 2013 is clearly proving to be a setback. However, we are confident we will restore our track record of double-digit EPS growth in 2014 and well into the future. We have an established track record. In fact, our compound annual growth rate in EPS is above 10% over the past 12 years, and that includes this year. I want to emphasize that we know these results are yesterday’s news, but we firmly believe that Yum! is a company on the ground floor of global growth, and recognize that it’s “show me” not “tell me” going forward.
Having said this, we have every belief and enormous intentionality that we’ll begin to get back on track in 2014. We expect to have a strong bounce-back year, driving EPS growth of at least 20%, which is admittedly now off a lower base than we had hoped for. And as always, if we can do better, we will.