Yum! Brands Inc. (NYSE:YUM)
Q3 2014 Earnings Conference Call
October 8, 2014 9:15 AM ET
Steve Schmitt – VP, IR and Corporate Strategy
David Novak – Chairman and CEO
Pat Grismer – CFO
David Tarantino – Robert W. Baird
John Glass – Morgan Stanley
David Palmer – RBC Capital Markets
Jeffrey Bernstein – Barclays Capital
Keith Siegner – UBS Capital Markets
Joe Buckley – BofA Merrill Lynch
Sara Senatore – Sanford C. Bernstein
Amod Gautam – JPMorgan
R.J. Hottovy – Morningstar
Diane Geissler – CLSA Limited
Good morning. My name is Melisa and I will be your conference operator today. At this time, I would like to welcome everyone to the Yum! Brands’ Third Quarter 2014 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 of Investor Relations & Corporate Strategy; you may begin your conference.
Thanks, Melisa. Good morning everyone and thank you for joining us. On our call today are David Novak, Chairman and CEO; and Pat Grismer, our CFO. After remarks from David and Pat, we will be happy to 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 at www.yum.com 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 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.
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.