Yum! Brands’ (YUM) CEO David Novak on Q3 2014 Results – Earnings Call Transcript

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 to make you aware of the following upcoming Yum! Investor event. Our 2014 New York Investor and Analysts Conference will be on Thursday, December 11, in Midtown, Manhattan. And our fourth quarter earnings release will be on Wednesday, February 4.

With this, I would now like to turn the call over to Mr. David Novak.

David Novak

Okay. Thanks, Steve. And good morning, everyone. Despite the recent supplier incident in China which has impacted China sales and reduced our full year EPS outlook, I am absolutely confident in Yum! Brands’ ability to deliver strong, sustainable growth in the years ahead. And here is what, we fully expect China to fully recover. KFC Global is having a strong year and building momentum. Taco Bell has successfully and profitably introduced breakfast and is now expanding in the United States with new unit growth. And Pizza Hut Global should have a strong 2015 led by an expected US turnaround, which is in its early stages.

For the third quarter, earning per share increased 3% excluding special items. We clearly had unexpected negative sales in China and continued soft performance at our Pizza Hut Division. On the positive side, we delivered solid results at our KFC and Taco Bell Divisions, and have the benefit of overlapping a higher tax rate in the prior year. Importantly, our China sales are on the path to recovery and we expect a strong bounce back in 2015.

Now while it is clearly yesterday’s newspaper, let me remind everyone that through the first half of the year, we are well on our way delivering on our objective of at least 20% full year EPS growth excluding special items. First half EPS growth of 27% was driven by particularly strong results in China, where system sales were 19% and we delivered restaurant margins of nearly 20%. However, our strong first half results have been offset by an unexpected and highly publicized food supplier incident in China, which significantly impacted sales at both KFC and Pizza Hut. As a result, we are now estimating full year EPS growth of 6% to 10% prior to special items.

Now I am sure you have a lot of questions about China. So let me get right to it. First here is what happened. On July 20, an undercover investigation was televised in China depicting alleged illegal actions by employees of Chinese food service supplier, Shanghai Husi, a division of OSI, which is a large and global food service supplier to many in the restaurant industry. To be clear, OSI was not a major supplier to Yum!, and represented only a small percentage of our sales at KFC and Pizza Hut in China. However, given our size and category leading positions in China, our sales were disproportionately impacted because we were mentioned with the same media weight as our major competitor, who was a large customer of OSI in China.

Also the fact that this followed the December, 2012, poultry incident at KFC clearly didn’t help. Upon learning of the televised report, we terminated our relationship with OSI not only in China, but globally. We also began taking unprecedented measures to further strengthen our supply chain practices in China to prevent and identify fraudulent and deceptive behavior by suppliers going forward. For example, we are now requiring standards for suppliers in China to install closed-circuit televisions and implementation is underway. We are also establishing a whistleblower system to encourage suppliers’ employees to report any potential food safety violations.

Unfortunately, no matter how many controls we have in place, it’s extremely difficult to prevent a company from deceiving us if they resort to illegal activities. Nevertheless, we will learn from this incident and are committed to developing even better quality assurance processes as we move ahead.

Let me be clear, we expect all of our suppliers to follow the law and we are absolutely appalled with the alleged outrageous behavior of OSI. In fact, their actions are under investigation by the Chinese government, six employees have been arrested, and OSI has publicly admitted to wrong doing. We are waiting the final outcome of this government investigation, and I assure you we will pursue every legal recourse available to recover damages from this incident.

While we are doing everything we can to turn the situation around, what we need most right now is to get to time. As we’ve said before, experience tells us it take six to nine months to fully recover from this type of events, and this will most likely be the case with this situation as well. But make no mistake, KFC and Pizza are beloved brands in China and around the globe, and are proven to be absolutely resilient. We have complete confidence in a full sales recovery and expect our bounce back to be strong.

Now this is the quarter when we typically share some perspective on the upcoming year. So as we look towards 2015, China is obviously the key variable. I am sure you can imagine it’s difficult to predict the exact shape of our bounce back in sales at this stage of the recovery process. However, sales are on the path to recovery and we expect a strong bounce back in 2015. Equally important, we firmly believe we are building momentum behind major initiatives around the world that would drive strong, sustainable growth in 2015 and beyond.

Let me give you a little color on each of our divisions starting with China. As I said, obviously we have a short-term issue and we are weathering the storm. While primarily staying the course with our marketing plans, we supplemented this with the short quality assurance advertisement in August and communicated our action plan via social network.

Our consumer trust scores clearly dropped but our research indicates that we are on our way to rebuilding trust. At KFC China, we have over 4,600 restaurants in nearly 1,000 cities across the country, which is more than twice our nearest competitor. Going forward, we are continuing the roll out of our new restaurant design and introducing new digital technologies to contemporize the customer experience. Additionally, we expect to build up the most successful learnings of our KFC menu revamp and we are launching new group of products in the first half of 2015. Our goal is to present even better KFC our customers will appreciate and restore the stronger business model we had in the first half of the year.

Even with our short-term sales issues, we still have the underlying economics that gives us confidence to keep investing in aggressive new unit expansion. Turning to Pizza Casual Dining, which is by far in a way the number one restaurant casual dining chain in China, and it has no major competitor. Pizza Hut continues to lead with menu innovation and everyday affordable value. In fact, 20% of Pizza Hut’s menu is revamped twice a year with the most recent update occurring on September 29.

We are also continuing to leverage our assets by expanding our breakfast offering into more and more cities. With this new sales layer, our long-term goal is to create and own a 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 are well positioned to capture it.

Today, we have nearly 1,200 restaurants in over 300 cities in China for Pizza Hut. We have a powerful economic model that generates fantastic new unit returns. So with strong underlying economics even in a temporary downturn, we continue to accelerate our new unit development of Pizza Casual Dining and plan to open over 250 units this year, further strengthening our category leading position. In fact, no other major casual dining chain in the world that we are aware of is growing units at such a rapid pace. Pizza Casual Dining is clearly a power brand with a great future.

Taking a step back, let me put KFC and Pizza brands in China into perspective. Basically today at KFC, we have restaurant margins of about 15% on depressed average unit volumes of $1.4 million. While these unit economics are strong, this compares to restaurant margins of 20% in average unit volumes of $1.7 million in 2011. There is no question in our minds; KFC will eventually get back to these sales and margin levels. Remember, McDonald’s has average unit volumes of $2.5 million in the United States. We firmly believe we are still early on in our journey to leverage our asset base in KFC in China.

Looking at Pizza Casual Dining, our average unit volumes have dipped slightly below $1.6 million, and we have restaurant margins of about 19%. This compares to average unit volumes of over $1.6 million and restaurant margins in excess of 20% just last year. Again, with breakfast, late night, continued innovation, a strong economic model and accelerating new unit development, we fully expect to get back to previous sales levels and more in the years ahead.

In addition to our opportunity to grow same -store sales and margin, the biggest opportunity we have in China is to penetrate the country with new stores. Yum! Currently has five restaurants per million people in China with a consuming class is expected to grow from 300 million people in 2012 to over 600 million people by 2020. This compares to or about 60 restaurants per million people in the United States where the consuming class is about 300 million people today. We continue to believe we’ll openly have well over 20,000 restaurants across all of our concepts in China.

So in 2014, our new unit development target of at least 700 new unit stores remains unchanged. This means we will open over 1,400 new units in a two year period and we expect another strong year of development in 2015. All of which will provide substantial momentum for China Division as sales continue to recover.

Now let me share some perspective on our three global brands divisions starting with KFC. Our KFC Division which is our second largest profit contributor behind China continues to deliver solid sales and profit growth led by strong international performance. Importantly, our international new unit pipeline remains extremely robust. We expect to open at least 650 new KFC units outside of United States this year, and grow operating profit in this division consist with our full year guidance of more than 10%.

As you may know, we have nearly 40,000 restaurants in over a 110 countries around the world, 91% of which are franchised. We are especially pleased with our continue strength in emerging market led by high growth countries such as South Africa and Russia. Looking ahead, our new unit opportunities in emerging market are arguably the best in retail. With about two KFC restaurants per million people in emerging market, we know we have a long runway for growth.

Moving to our more developed KFC market, we have very solid businesses in Australia and UK and we are also pleased with the progress we are making in the United States. KFC is in strong shape and well positioned for 2015.

At Pizza Hut, while we are disappointing with the full year operating profit and it will fall well short of our initial expectations, we are pleased with the progress we are making and expect us to continue in to next year. We sharpened our focus on value in the United States and have leveraged more competitive offers to drive digital activations. And consumers are responding. In fact, sales turned positive during the last few months of the quarter and our digital mix is now over 40% on our delivery in carryout business which represents more than five percentage point increase over second quarter. Our system is now fully aligned around competing more effectively and winning into digital and social world. You will see more evidence of this going forward.

Looking ahead, we expect to build up this momentum with a launch of further initiatives to drive same-store sales growth beginning in the fourth quarter. Our plan is to launch new advertising positioning, design to better connect with millennials. We’ve recently had good success with our Hershey’s dessert cookie and bacon and cheese stuffed crust pizza. We plan to reinforce Pizza Hut’s leadership, quality, innovation and superior value as we continue to implement a comprehensive turnaround plan.

Globally, we are sharing best practices to drive sales growth and we are making focus to investments to accelerate our pace of new unit development, especially across the delivery and express channel. We expect to open a record 450 new international units this year for Pizza Hut and are counting on this number to grow significantly in the years ahead.

Turning to Taco Bell. We are definitely well positioned to deliver on our expectation for a strong second half. During the quarter, we delivered same store sales growth of 3%, clearly outpacing the QSR category. Importantly, breakfast sales are sustaining with the 6% day part mix without the benefit of high launched level media weight. I would go so far as to say we are one of the very few companies in the history of the QSR industry to launch breakfast successfully and profitably in year one. Not only our breakfast sales largely incremental, but we are making money and sustaining it with margins of nearly 21% in the quarter. Without question, we now have a great platform to grow from. Remember, McDonald’s breakfast day part is 25%. So this gives us an opportunity to grow on that day part for many years ahead.

Going forward, we will introduce mobile ordering and payments in the fourth quarter and we have significant innovation plan in our core business to drive growth, balance of the year and beyond. With strong unit level of economics at Taco Bell, we are seeing an acceleration of development with over 100 net new units this year which represents a 10 year high. And we have even better development pipeline headed into 2015. We are confident we will ultimately achieve our goal of at least 8,000 Taco Bell restaurants in the United States.

Finally, we are investing for the long-term and develop the great brands in India which will drive substantial future growth for Yum! KFC will be bigger in units than McDonald by the end of the year, Pizza Hut sales of deliver unit economies are getting stronger and more competitive with Dominos. And at Taco Bell, early results are encouraging with plans for accelerating the pace of development.

Now to sum things up, in spite of our short-term issue in China, the fundamentals of Yum!’s growth model remains extremely compelling. As you know, there are three keys to driving shareholder value in retail. New unit development, same store sales growth and generating high returns. In terms of development, our new unit opportunity in emerging markets including China remains the best in retail and our opportunity to expand is huge. We have three iconic brands and while we have about 60 restaurants per million people in the United States today, we only have two restaurants per million people in the Top 10 emerging markets including China and India. This is a long runway for international growth and gives us tremendous confidence in our ability to continue our aggressive expansion for many years to come. We also see significant opportunity to grow units at Taco Bell in the United States and make it a truly global brand.

Furthermore, we have over 40,000 restaurants around the world that have significant capacity to grow. And as I said, we are building momentum behind major initiatives around the world that would drive same- store sales growth in 2015 and beyond. Remember, in China, average unit volumes are well below where they were two years ago, and we expect to get back to these levels in more over time. We are making KFC even more contemporary, have huge upside at breakfast delivery and late night and are building off of our best operations in the world.

At Pizza Casual Dining in China, we will continue to grow the core with constant innovation while we grow the breakfast and late night day part. At our KFC Division, we are sharing know how and getting better at advertising, innovation, value day part expansion mention and digital, which we expect will result in higher sales growth in the years ahead. We are particularly pleased with our progress in breakfast in Asia. The initial results of expanding our happy afternoon hour, through our learnings from Taco Bell, and the beginning of the US turnaround at KFC.

At Taco Bell, our breakfast day part is now established and already profitable. What’s more, our dollar cravings menu is resonating, product and digital pipeline is full and ready for 2015.

And finally at Pizza Hut, we are making significant progress on the digital front and have a comprehensive turnaround plan now in place at our US business that we will expand globally. Additionally, we will be overlapping 2014 results which will give us the short-term boost in 2015. Meanwhile, our returns on invested capital are consistently been among the best in the retail industry. Over 90% of our restaurant outside of China are owned and operated by franchisees. We love the franchise model which will generate about $2 billion in franchisees in 2014. These franchisees provide us with a large, reliable and growing stream of cash, which combined with the profit from equity stores, enables us to invest in high return growth opportunities and return significant cash to our shareholders.

So let me wrap things up for Yum! brands. At our three global divisions, KFC continues to be delivering solid results, we are making solid progress at Pizza Hut and we are pleased Taco Bell is delivering on our expectations for a much stronger second half. We had an unexpected issue in China, but we fully expect to be on the path to a full sales recovery and continued aggressive growth in the years ahead.

Now let me hand it over to Pat Grismer, our CFO.

Pat Grismer

Thank you, David. And good morning, everyone. In my remarks today, I will cover three areas. Our third quarter result; our revised outlook for the full year and our capital allocation philosophy. For the third quarter, I’ll highlight some key aspects of financial performance to add further dimension to our reported results.

Starting with China. David outlined why our same -store sales declined 14% in the quarter. So I’ll explain how this impacted our restaurant margin which came in at 14.9% or 4.6 percentage point below prior year. First, same-stores transaction declined 17% which not only significantly de-leveraged our fixed cost but also made it difficult for our teams to manage restaurant level expenses, leading to inefficiencies in food and labor. Combined these issues to over negative margin impact of about six percentage point. Rollover pricing actions provided approximately four points of margin benefit but half of this offset by 10% labor inflation. Restaurant margins were also negatively affected by inventory write- off related to the disposable of OSI products. Collectively, these items account for the roughly five point margin decline for the quarter.

Clearly, had it not been for the de-leverage and inefficiencies triggered by the OSI incident, we would have reported restaurant margins of over 20% for the quarter. We are confident that as we rebuild sales in China, margins will rebound as well. One of the thing I would like to point out about China’s third quarter results, we continue to shift our new unit development program to a higher return investments. For example, year-to-date to Q3, 67% of KFC China development was in Tier 3 through six cities compared to 53% in 2012. Similarly, 36% of total China development with Pizza Hut Casual Dining compared to 23% in 2012. Over time this evolution of our development program will enhance portfolio margins and returns.

Now moving to our Global KFC Division which posted its best quarter of the year with solid improvements in sales, margins and profit. System sales throughout was especially strong in emerging market, up 12% led by Russia, Thailand and Africa. International developed market also delivered solid system sales growth, up 6% led by the UK, Continental Europe and Australia. Profits grew an impressive 14% before the impact of foreign exchange, excluding a two point benefit from the overlap of franchise convention expenses. This compares to 8% profit growth in the first half of the year and demonstrates the strong momentum that we see in this business across both emerging and developed markets including our KFC US business which delivered 2% same-store sales growth in the quarter.

Our Global Pizza Hut Division also posted its best quarter of the year, although still well below our ongoing expectations. While total same-store sales declined 1%, our US business which represents more than half the division’s profit, actually turned same-store sales positive in the second half of the quarter. Despite this improving trend, operating profits declined 6% excluding a four point benefit from the overlap of franchise convention expenses. We are obviously not happy with these results. However, comparing this to the 17% profit decline we recorded for the first half of the year, it’s clear that many of the turnaround efforts launched earlier this year including the digital initiatives which David mentioned, are beginning to have impact and are providing upward momentum in advance of a new brand advertising campaign in the US.

And finally for Taco Bell. Again, their best quarter of the year. We’ve long said that Taco Bell in 2014 would be a first half, second half story from a profit, growth perspective. And the division’s third quarter result certainly bares this out. Profits grew 14% compared to a 9% decline in the first half of the year. Importantly, restaurant margins swung from a 2.6 percentage point decline in the first of the year to 1.8 percentage point gain in the third quarter as targeted pricing actions and restaurants cost savings more than offset food inflation, which is unexpectedly escalated significantly over the past several months.

Additionally, we are on pace to open nearly 200 new stores this year. Our strongest rate of development in more than a decade. Over 80% of these new restaurants will be franchised demonstrating the brand’s attractive unit economics.

The last financial highlight, I would like to draw your attention too is tax. Since the second quarter of 2010, we’ve disclosed in our SEC filings a dispute with the IRS regarding the valuation of intangible assets. I am pleased to report that we’ve resolved this matter in the third quarter. In conjunction with this, we made an initial cash payment to the IRS of $120 million, which was effectively fully reserved. Remaining cash payments due under the terms of our agreement are also fully reserved. In the aggregate, these additional payments are expected to be less than the amount we paid in Q3. Including adjustments related to this settlement, our third quarter effective tax rate was nearly 11 point lower than prior year as we lapped an incremental tax reserves that we recorded in 2013. We are pleased to put this matter behind us.

I would now like to shift gears and talk about our full year outlook. In China, sales remained difficult to call, however, based on current trends and expected recovery period of six to nine months, and the knowledge that this recoveries are rarely linear, we expect same-store sales to be negative for the fourth quarter. This is obviously disappointing, but I can assure that the team is working very hard to restore consumer trust, accelerate the sales recovery and rebuild margins responsibly. Importantly, we are continuing to build new restaurants and expect to open 700 new stores this year. Although, the current sales declines have dampened our new unit returns, these returns on average still exceed our internal hurdle rates. And because we expect sales will full recover, we are confident that our restaurant expansion program is not only extending our competitive lead, but is also creating shareholder value over the long term.

Keep in mind; KFC and Pizza Hut are the leading brands in China with enviable competitive advantages. No other retailer has the scale, the development expertise, the advertising clout, the supply chain infrastructure or the people capability that we do in China. We believe that with the benefit of long-term macro tailwinds, the restaurant category in China will grow significantly over the long run and we are better positioned than anyone else to capitalize on this opportunity.

Outside of China, third quarter results at KFC, Pizza Hut and Taco Bell are indicative of the momentum that we expect will deliver on our promise of second half results that are substantially better than what we delivered in the first half of the year. Trends are clearly moving in the right direction.

Now when you added all up and include our updated 2014 tax rate of approximately 25% to 26%, we estimate full year EPS growth to be between 6% and 10% versus prior year excluding special items. As you would expect, the single greatest variable in this equation in China sale, which I said earlier, remain very difficult to predict. This recovery, combined with the fact that the OSI incident occurred in the middle of our peak summer seasons, figures very heavily in our full year results. We will provide an update on our 2014 outlook as well as 2015 at our Annual Investor meeting in December.

Now, I would like to discuss our capital allocation philosophy. Our business continues to generate a significant amount of cash. Year-to-date, we’ve generated EBITDA of over $2 billion versus $1.9 billion in the same period last year. And importantly, we remained disciplined in how we use this cash. We concentrate our investments in high growth, high return businesses. And we re-franchise when we believe the franchise model creates more shareholder value. We have a good track record of doing this and this will continue. In fact, we’ve begun to re-franchise a portion of our equity position in Western Europe, where margins and returns have lagged our expectations. Additionally, as KFC restaurants in higher tier cities in China trend toward lower margin, we expect the franchise mix of these restaurants to increase gradually over time. We also have a good track record of returning all available cash to our shareholders in the form of dividends and share buybacks. For example, over the last five years, we’ve repurchased 57 million shares representing 12% reduction in outstanding shares. And I am sure you read our recent announcement of 11% dividend increase. This marks the 10th consecutive year we increased our dividend at a double digit rate, one of only 12 companies in the S&P 500 to do so. With this latest increase, we also raised our dividend payout target to 40% to 45% of annual net income before special items. Our resulting dividend yield of about 2% compares very favorably to other companies with the similar growth profile.

So when you consider the growth opportunity we have with our brand and the cash we return to our investors, we believe our company is set up to provide a compelling total shareholder return over the long run.

So let me wrap things up. We are urgently working to overcome the temporary, negative impact that the China supplier publicity has had on our business. We are confident that we will bounce back in China and regain the momentum we saw in the first half of 2014. This combined with the momentum we are building outside of China, positioned us for an impressive 2015. Most importantly, we believe our double digit growth model will endure for many years to come.

And with that I’ll hand things back over to David.

David Novak

Okay. Thanks, Pat. We are reading to take questions but before I do, I want to point out that this will be my last earnings call as CEO, and the Greg Creed will be the CEO beginning January 1, which time I will assume my new role as Yum!’s Executive Chairman of the Board. We’ve been working on seamless transition together and I couldn’t be more pleased to have a leader of great stature taking the helm. I have worked with Greg for over 17 years, he lives and drives our culture, he knows all aspects of the business call, he has worked on every brand, and he has been Yum!’s chief operating officer in the past, he has a great brand builder and what he has done at Taco Bell, I think has been absolutely sensational. The Board and I are absolutely convinced that he is just the guy to take the company to the next level. Greg will join me and take a lead at our December Investor Conference in New York. And with that, we are happy to take any questions that you may have.

Question-and-Answer Session

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