By Sarfaraz A. Khan and Gohar Yousuf
Yum! Brands (NYSE:YUM), the owner of the world’s largest chain of restaurants which includes KFC, Taco Bell and Pizza Hut, is still unable to recover from the controversy that started last year following the safety violations by the company’s chicken supplier in China. Moreover, the avian flu has made things more difficult for KFC in China. Once again, the company has reported disappointing quarterly results for its Chinese operations.
In its quarterly results announced earlier this month, Yum reported net income of $152 million or $0.33 per share, which is down by 68% from $471 million or $1 per share from the same period last year. Its revenues also dropped by 3% to $3.47 billion from $3.57 billion a year ago. The significant drop in earnings is mainly due to the adverse market conditions China and higher than expected tax rates. Its earnings were also dragged by the non-cash charges of $0.55 per share related to the write down of Little Sheep’s intangible assets (discussed later in the article). However, Little Sheep is still the biggest brand in China’s casual-dining market and has the potential to make significant contributions to Yum’s earnings in the long run.
Chinese Woes Continue
Yum Brands is one of the few American companies that generated most of its income from China. In its previous quarter, Yum got 66% of its revenues and 96% of its operating profit from its China division. Naturally, the company’s success critically depends on the Chinese market sales. In this region, Yum’s quarterly operating profit fell by 11% year over year to $335 million while its revenues rose 2% to $2 billion. The operating margin of Yum’s China division also dropped to 16.5% from 18.8%.
Yum’s KFC is its primary source of revenues from China. It has a total of 6,035 restaurants in China; which includes Pizza Hut, East Dawning and Little Sheep units, and of this, 74%, or 4,463 units, are KFC. Since Yum’s overall performance depends heavily on its Chinese operations, therefore it’s no surprise that the health scandals and avian flu in China are having an adverse impact on Yum’s revenues in general and Chinese sales in particular. The company has consistently reported a double-digit drop in China’s same store sales (for restaurants open more than a year) due to the drop in KFC’s sales. Although Pizza Hut has been reporting mid-single-digit percentage growth but since it’s a small part of its overall Chinese operations; therefore, it could not offset the massive double-digit decline in same store sales reported by KFC. The company’s monthly and full quarter’s sales numbers are shown in the table below.
|Year-Over-Year % Change in Same Store Sales for China Division|
Yum acquired China’s local hot pot chain Little Sheep last year. As mentioned earlier, although its long-term future prospects look bright, but so far, the chain’s performance has not been impressive. This unit has received a lot of negative publicity in the past so I believe it will take some time before Little Sheep starts reporting better results. The recent write down includes a reduction in goodwill, from $384 million to $162 million, and trademark, from $415 million to $345 million.
Bad News: Tough Outlook
The bad news for investors is that Yum has revised its full-year outlook as the company is expecting negative numbers from China in the fourth quarter. Due to the drop in sales in China and higher annual tax rate, the company has changed its earnings estimate to “a high-single to low-double-digit full-year EPS [year-over-year] decline.” According to data provided by Thomson Reuters, the markets are expecting annual earnings of $2.91 per share, which will be an approximately 14% decline from 2012.
Good News: But Yum Remains Undeterred
However, the good news is that Yum’s management is undeterred by the tough market conditions. The current problems appear to be of a short-term nature and the company will continue to invest in its long-term future in China. In the third quarter, the business opened 132 new units in the country taking its total year-to-date count to 458 new units. This year, Yum will open at least 700 new restaurants in the country which will then translate into 1,600 new units over a period of two years.
These new restaurants will provide a solid foundation for Yum to grow as the market conditions in China improve. The company itself is expecting 2014 as its “bounce-back” year. The management is targeting EPS growth of 20% in 2014 as it aims to bring back the golden days of double-digit earnings growth in the coming years.
Meanwhile, Burger King (BKW) has been planning to ramp up competition in China. A few months ago, Burger King announced the formation of a joint venture with Kurdoglu family in China. The company is now planning to open 1,000 new restaurants in the region within next five to seven years. On other hand, Yum’s biggest competitor, McDonald’s Corp (NYSE:MCD), whose same store sales have also suffered in China due to the avian flu and difficult macro-economic conditions, has delayed the opening of new restaurants in the emerging markets, including China. Notes:
Yum Brands Q3-2013 Results (Pdf File)
Disclosure: This article was written by Sarfaraz A. Khan, with valuable contribution from Gohar Yousuf, research assistant at Half Bridge Business Review. Neither Sarfaraz A. Khan, nor Gohar Yousuf have any positions in the stock(s) mentioned in this article.