YUM! Brands CEO Discusses Q1 2013 Results - Earnings Call Transcript

 |  About: Yum! Brands, Inc. (YUM)
by: SA Transcripts


At this time, I would like to welcome everyone to the Yum! Brands first quarter 2013 earnings conference call. [Operator instructions.] Mr. Steve Schmitt, Vice President of Investor Relations, you may begin the conference.

Steve Schmitt

Good morning everyone and thank you for joining us for our earnings call. This call is being recorded and will be available for playback. We are broadcasting the conference call via our website, www.yum.com. Please be advised that if you ask a question, it will be included in both our live conference and any future use of the recording.

I would also 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 statement 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. Finally, we would like you to please be aware of the following Yum! investor events occurring in the next three mos. Our April same-store sales release for our China division will be May 10, after market hours. Our Taco Bell investor analyst conference will be May 21 in Irvine, California. And our second quarter earnings release will be Wednesday, July 10.

On our call today is David Novak, Chairman and CEO; Rick Carucci, President; and Pat Grismer, our CFO. Following remarks from each, we will take your questions.

Now I’ll turn the call over to David Novak.

David Novak

Thank you Steve, and good morning everyone and thank you for joining our call. While better than expected, the first quarter was extremely difficult for Yum! Brands. As anticipated, intense media attention surrounding poultry supply in China significantly impacted KFC’s sales and profits. Earnings per share declined 8% versus prior year, as our China division operating profit fell 41%. Operating profit increased 19% at Yum! Restaurants International and 5% in our U.S. business.

While we’re certainly not happy with our overall results, as we look at how our China sales evolved through March, we were making progress and it was pretty close to where we thought we’d be. Unfortunately, our quest for a full sales recovery has been dampened by the intense publicity of avian flu in China, beginning in early April.

Now the last time we were significantly impacted by avian flu was in 2005. The sales impact was initially dramatic at KFC, but relatively short lived, lasting about three months. We anticipate this will once again be the case, but there’s no way to be certain.

Based on our results through the first three weeks of April, we expect China division same-store sales will be down about 30% for the month. You will see the actual numbers in our sales release scheduled for May 10.

Putting the avian flu situation aside, I’d like to share some of what the team in China is doing to restore consumer trust in the KFC brand and to enhance our industry leading supply chain practices. Immediately after the Chinese New Year, in late February, we launched what we’re calling Operation Thunder. To the Chinese consumer, this signifies swift, decisive action, which is exactly what we’re doing to address consumer perceptions related to the safety of our chicken in China.

As part of this initiative, we announced several enhancements we’re making to our supply chain. One specific enhancement was to work with our suppliers to eliminate over 1,000 small and less modern chicken houses, where risk could be the highest. We want our suppliers to only work with the most sophisticated chicken farms in China.

We also launched an aggressive quality assurance program including 30-second television commercials. Our strategy is to build as much awareness as possible of our industry leading quality assurance processes. Our research indicates the more people hear about what we’re doing, the more willing they are to come back into our restaurants.

Additionally, we are continuing to build the KFC brand with major news around value and innovation. Our goal is to come out of this stronger than ever on our food safety perceptions in China and get sales back on track as fast as possible.

These are certainly trying times for our KFC China business, but I want to be crystal clear that we do expect a complete sales recovery. In previous years, we have faced SARS, Sudan Red, and previous avian flu situations, and in every case, we have bounced back. And when sales do come back, we’re going to benefit from the additional 1,600 restaurants we’ll have built during 2012 and 2013.

We have a world-class team, an unmatched distribution system, and industry-leading advertising resources. KFC is a powerful and resilient brand that is loved throughout China. We expect to bounce back stronger than ever.

We think staying the course on at least 700 new units is the right number, recognizing we are still out-developing competition by a wide margin, still have first mover advantage by entering over 100 new cities, and have no urgency to expand more rapidly in the current environment. And remember, this means we will open about 1,600 new units in two years. There’s no question we are continuing to capitalize on the number one retail opportunity in the world.

As I have mentioned before, the most positive new news in recent years at Yum! is the incredible performance of Pizza Hut casual dining in China. We continue to have less than three year cash paybacks, and are successfully expanding across lower tier cities. While sales started a bit slow in the first quarter, we are pleased that March same-store sales grew 4%. We have major product news with [Stone Fan Steak] this year, and we’re beginning to expand breakfast into more cities. We’re very bullish on pizza and casual dining this year, and in the years to come.

Overall in China, we’re going to stay the course with our strategy to have leading brands in every significant category. We will continue to build our two big brands, KFC and Pizza Hut casual dining, and we will continue to invest in pizza at home service, Little Sheep, East Dawning, and we opened 226 new units in our first quarter and are well on our way to open at least 700 restaurants this year, which again, we believe is a very good number.

Outside of China, we expect solid on-target performance for Yum! Brands, and as I evaluate our strategies, I’ve concluded that just like China, we have the right strategies in place, and the best thing we can do for our shareholders is to stay the course with what we’ve been focusing on. We’re very focused to be the emerging market leader in the restaurant category, and positioned for growth in so many countries around the world.

At Yum! Restaurants International, we’re going to continue with our strategy to drive aggressive international expansion and build strong brands everywhere. Our new unit pipeline has never been stronger. We expect to open over 950 new restaurants this year, and grow operating profit consistent with our ongoing growth model of at least 10%.

And I’m very pleased that our U.S. business will be a net new unit developer for the second consecutive year. Importantly, Taco Bell, which represents about 60% of our U.S. profit, had a strong first quarter and continues to have success building on its Doritos Locos Tacos and Cantina Bell platforms. We expect our U.S. profits to grow in line with our ongoing growth model of 5%. Finally, we’re investing and developing a great business in India, which will drive substantial future growth for Yum!

So to wrap this up, 2013 is obviously going to be a difficult year for Yum! Brands due to our challenges with KFC in China. Our Yum! Restaurants International and U.S. businesses are well-positioned to deliver against our growth targets and drive future growth for years to come.

I’m confident that our China business will bounce back strongly and lead the way to restoring our track record of consistently delivering double digit EPS growth in 2014, 2015, and beyond.

Now Rick Carucci will take you through our strategies for Yum! Restaurants International and the U.S. business.

Richard Carucci

Thank you, David. Good morning everyone. At Yum! Restaurants International, our strategy remains to drive aggressive international expansion and build strong brands everywhere. What I would like to do today is review the nature of our growth.

The growth from YRI continues to be driven by our franchisees and our strength in emerging markets. In 2013, you will see that our equity presence in select emerging markets will also contribute to this growth.

One characteristic that we love about YRI is the recurring and growing nature of its franchise fees. These franchise fees will approach nearly $1 billion in 2013, which represents 10% growth versus 2012. Our franchisees are investing heavily behind our KFC and Pizza Hut brands and are aggressively building new units.

During the first quarter, we developed 147 new units, and 90% of these units were opened by franchisees. We continue our rapid pace of expansion throughout the year, and expect to set a record by building over 950 new units in 2013.

This franchise growth provides a large cash stream for Yum! It also generates significant value for our shareholders. We believe that the capital free franchise business at YRI is unique, given that it provides income and cash that is large, growing, global, and diversified.

We’re delighted to be meeting with over 500 of these franchisees, representing over 100 countries, at our upcoming biannual franchise convention in Beijing, where we will discuss our strategies and initiatives. We look forward to working together with our franchisees to develop even more profitable growth opportunities in the years ahead.

As we have said before, Yum! is the clear leader in emerging markets. 70% of the new YRI units in the first quarter were in emerging markets. The bulk of the emerging market business will continue to be led by franchisees.

However, over the last few years, we have also developed a company-owned presence in some select high-growth countries. These include Russia, South Africa, and Turkey. Three years ago, we had no company-owned restaurants in these markets. Today we now have about 230 company units.

We are bullish on all three of these markets. Over the past two years, Russia has led our entire system in same-store sales growth. This continues to be the case so far in 2013, where Russia posted system sales growth of 45% in the most recent quarter, driven by development and same-store sales growth of 25%. We have been able to step up new unit development this year and we are encouraged by the initial returns we are getting on our new company-owned stores.

In the continent of Africa, we are also expanding aggressively. We are building off an established base of about 700 stores in South Africa, where we are the clear market leader. Africa is one of the fastest-growing regions in the world, and with over 1 billion people throughout the continent, it represents a tremendous long term growth opportunity.

We completed the acquisition of our Turkey business earlier this month. Turkey is a fast-developing country of about 75 million people. With only about 60 KFC and 45 Pizza Hut restaurants, there’s no question that we have a huge potential for growth there. We’ve already ramped up development and expect to open about 25 new restaurants this year.

Our acquisitions in these three countries advance our strategy to increase ownership in high-growth, high-return businesses. I want to emphasize that we believe our company ownership is helping to accelerate growth. In 2010, we had a total of 63 new units in these three countries combined. This year, we expect to add over 170 units, and about 50 of those will be company-owned.

It is likely that the new unit builds in these countries will continue to grow. The combination of aggressive franchise growth and an equity presence in select countries should help us extend our lead in emerging markets. We are generating strong growth, and believe we can do so for a long, long time.

As a reminder, Yum! currently has around 2 restaurants per million people in the world’s 10 largest emerging markets. Assuming we maintain our current pace of development, we’d have only about 4 restaurants per million people in these markets by the year 2020. That compares to 58 restaurants per million in the U.S. today.

Overall, Yum! Restaurants International business is on track for another solid year in 2013. Clearly, we have a long runway for growth at YRI. Now on to our U.S. business.

Before I get into the U.S. business performance, it is interesting to note that the U.S. business has a royalty stream in excess of $800 million. Therefore, when you put YRI and the U.S. together, they’ll produce about $1.8 billion of franchise revenue in 2013. That’s almost double what we produced as a company 10 years ago.

While our U.S. business is beginning to development net new units, it is more reliant on growing same-store sales for its growth. In our category, you grow same-store sales by offering strong value and introducing innovative new products.

In the past year, I don’t think anyone has done a better job of innovation than Taco Bell. Taco Bell grew same-store sales by 6% in the quarter, and that’s on top of 6% growth in the first quarter last year.

We’re now in the midst of launching Cool Ranch Doritos Locos Tacos. Our new marketing campaign, Live Mas, is resonating well with consumers, and the brand is generating lots of excitement in social media. We expect to sell about 100 million Doritos Locos Tacos during the second quarter, and this continues to be one of the most successful new product launches in our history.

As we look at the balance of the year, we believe that we have strong product offerings. Because these are backed by solid operations and increased media rates, we believe that Taco Bell is well-positioned to have another successful year in 2013.

Pizza Hut and KFC sales in the U.S. during the first quarter were softer than we would have liked. In this environment, you win by providing compelling value and innovation. In hindsight, some of our competitors did a better job of this than we did. We expect to fare better for the balance of the year, and we are particularly excited about the recent launch of KFC’s original recipe boneless chicken.

We are continuing to add net new units at both Pizza Hut and Taco Bell. The Pizza Hut Delco Lite format is generating excitement among our franchisees and is allowing us to add more units in small town America.

Taco Bell is following Pizza Hut’s lead, and is also going after more rural new units. Taco Bell is again adding net units in 2013, and the combination of a new, smaller building asset design and a franchisee rural incentive should lead us to even more net unit growth and openings in 2014. When we look at the U.S. we are building the foundation for a business that we believe will provide better and more consistent performance.

To sum it up, while China is clearly experiencing a challenging year, the rest of Yum! is performing pretty well. We believe we are well-positioned for the future, and these divisions are on track to achieve our full year growth targets for 2013.

Now let me hand things over to our CFO, Patrick Grismer.

Patrick Grismer

Thank you, Rick. As you heard from David and Rick, Yum! Restaurants International and our U.S. division are delivering solid results, yet we obviously have our challenges in China. We continue to see this as a temporary setback, and remain as bullish as ever on our long term growth prospects.

As evidence of that, we are continuing to invest in the future. With these investments, and given the demonstrated growth potential of our businesses, I’m very confident that our track record of double digit EPS growth will be restored in the years to come.

I’ll now provide some additional perspective on our first quarter results and share our EPS outlook for the second quarter and full year. For the first quarter, we recorded an 8% decline in EPS before special items, which was significantly better than the 25% decline that we had previously estimated. This better than expected result was primarily driven by stronger than expected sales in China during the Chinese New Year holiday period in February.

Now I’ll share some performance highlights for each major division. In China, operating profit declined 41% in the first quarter, prior to foreign currency translation, driven by a 20% drop in same-store sales. With a sales decline of this magnitude, China restaurant margin was severely impacted, down 7 percentage points versus prior year. Bear in mind, this dynamic works in both directions, so as our China sales recover, we expect a similar rebound in restaurant margin.

On the development front, China had an exceptional quarter, opening 226 new restaurants, or nearly 4 per day. With Chinese New Year following relatively late in the quarter this year, our world-class China development team was very intentional about pulling units forward into the first quarter to benefit from peak seasonal sales.

Yum! Restaurants International reported operating profit growth of 19% in the first quarter, excluding the impact of foreign currency translation. We benefited from a major franchise ownership change this quarter, which added transfer and renewal fees, as well as from changes to an overseas pension plan.

These items added 8 percentage points of operating profit growth to YRI’s overall performance. And, as expected, refranchising the Pizza Hut U.K. dine-in business late last year benefited YRI’s operating profit growth by another 3 percentage points.

Adjusting for these items, YRI’s core business delivered about 8% operating profit growth this quarter. Importantly, YRI continued to drive impressive unit growth, opening 147 new restaurants in the quarter, including 103 new units in emerging markets. Same-store sales grew 1%, which was softer than expected, as weak results in Japan and Western Europe adversely impacted YRI’s same-store sales by about 2 percentage points.

However, we experienced strong same-store sales growth in our equity-led emerging market businesses in Russia, South Africa, and Thailand, and we’re pleased with the sustained improvement of our KFC Australia business. Restaurant margin increased 1.4 percentage points at YRI, largely due to the refranchising of or Pizza Hut U.K. dine-in business.

Moving to the U.S., first quarter operating profit grew 5% versus prior year. Excluding the impact of refranchising, operating profit grew a very respectable 7%. This performance was led by Taco Bell, which had an outstanding quarter with 6% same-store sales growth and restaurant margin improvement of 2.4 percentage points.

It’s clear that our customers love both nacho cheese and now Cool Ranch Doritos Locos Tacos. And without a doubt, Taco Bell is a leading performer in the category. In fact, this marks the fourth consecutive quarter that Taco Bell has outperformed the category, demonstrating the positive momentum we have as a powerful brand that represents about 60% of our U.S. profit. And while sales at Pizza Hut and KFC fell below our expectations in Q1, their profits were more or less on plan.

For the U.S. division overall, restaurant margin increased 2.4 percentage points in the first quarter, including 1.3 percentage points from refranchising. Importantly, this marked the fifth consecutive quarter of year over year margin gains in the U.S.

And finally, speaking of U.S. refranchising, we continue to make good progress with our program, which we expect will be substantially completed by the end of this year, bringing our franchise ownership in the U.S. to over 90%. This ownership strategy, along with our improved unit-level economics, positions the U.S. for more consistent profit growth in the years ahead.

Now I’ll turn to EPS expectations for the second quarter and full year. As you know, the most sensitive variable in this year’s profit forecast is China same-store sales, so I’ll start with that. As disclosed in our 8-K filing on April 10, March same-store sales declined 13% in our China business, with KFC same-store sales declining 16% and Pizza Hut casual dining same-store sales growing 4%.

As David mentioned, we continue to expect the sales recovery will take time. However, the recent publicity on avian flu will add even more choppiness to that recovery, weighing particularly heavily on second quarter results.

Based on our results through the first three weeks of April, we expect China division same-store sales to decline about 30% for the month, with KFC significantly negative and Pizza Hut casual dining positive. Prior instances of avian flu have been short lived at KFC, and with this as our assumption, we believe our overall recovery will be no different from our previous estimate, with China division same-store sales turning positive during the fourth quarter. We will continue to temporarily provide monthly updates on same-store sales in China, and we’ll report April sales on May 10, 2013, after market hours.

Despite the start of our recovery from the China poultry supply situations that occurred in late December, and with the unexpected impact of avian flu publicity that started in April, we are forecasting a significant double digit EPS decline for Yum! in Q2 and expect this to be the low point of our year by far.

As for the full year, our EPS expectations are essentially unchanged at this stage. We are holding our full year forecast at a mid single digit decline because of the risk of avian flu publicity added to our China sales recovery. Essentially, we are estimating that all of the EPS upside we saw in the first quarter versus our earlier estimate will be offset in the second quarter due to the impact of avian flu.

That said, I want to emphasize that it is extremely difficult to forecast sales or profits in China right now. This was already a challenging proposition, and the recent emergence of avian flu has only added to the uncertainty.

Despite our short term setback in KFC China, our long term growth model is still intact, driven by new unit development, same-store sales growth, and high returns on investment. The good thing about our business is we are a cash generating machine. Even with this year’s disappointing EPS results, we expect free cash flow well over $2 billion, which includes a franchise royalty stream of nearly $2 billion.

We also remain committed to using our operating cash flow to invest behind the growth we see in our business, with over $1 billion of capital expectations expected this year, while returning all remaining cash to shareholders through dividends and share repurchases.

Our investment in new unit development is skewed towards high growth emerging markets such as China, India, Russia, and Africa, and these development opportunities remain very robust. We continue to believe that China is the number-one retail growth opportunity in the world, and continue to forecast at least 700 new units there this year.

Given the pace of development we achieved in the first quarter, we expect our new units in China to be more heavily weighted toward the first half of the year, and we expect this intense pace to ease balance of year.

As always, we approach our China development with extreme rigor, and will continue to monitor new unit performance and adjust our expansion plans as appropriate. We also expect to open at least 150 new units in India this year, with over half of these being KFCs, thereby growing our KFC store base by over 30% versus prior year.

At YRI, we expect to build over 950 units, including 80 units in Africa, 60 units in Russia, and 50 units in Thailand. And finally, driven by the irresistible returns of our Pizza Hut Delco Lite and the improved economics of our Taco Bell units, we expect the U.S. will be net unit positive again in 2013.

In summary, 2013 is shaping up to be a very challenging year for Yum!, and while we take account of these results, we view this year as an aberration that neither erases our track record of performance nor diminishes the growth opportunity that we are uniquely well-positioned to capture. I’m confident that we will bounce back strongly and regain our status as a double digit growth company in the years ahead.

And now we’ll be happy to take your questions.

Question-and-Answer Session


[Operator instructions.] Your first question comes from the line of Sara Senatore with Sanford Bernstein

Sara Senatore - Sanford Bernstein

I just wanted to talk a little bit about your China recovery cadence. I think historically you said the avian flu has been very short in its impact. Just want to sort of get a sense of if you look back at ’05, are we talking about a month, or two months? Or kind of what the overall cadence is?

And then also, on the same, related topic, it looks like you managed margins very, very well in China, so maybe can you just talk a little bit about what kind of variable expenses are there in payroll and occupancy that allowed you to hold margins that well given the negative costs in the quarter?

Patrick Grismer

With respect to to the impact of avian flu, when we look back at how this has impacted our business in the past, what we have seen is a sharp impact initially that then diminishes over a period of about three months. So we’re expecting about the same recovery period this year. And so just to reinforce then, in terms of our overall sales recovery, what we are currently estimating is a 6-9 month recovery period, with same-store sales in China turning positive in the fourth quarter.

And then with respect to your question on margin, there were obviously a number of moving pieces here. The most significant variable in that equation is transactions. And so the transactions did hit us significantly in the first quarter, and as that reverses, it will certainly work to our advantage over the course of the rest of the year.

With respect to the composition of our restaurant costs and the variable components, there is a fair amount of variability in rent expense where many of our units have a variable rent component, as well as the fact that a portion of our labor expense is variable. And also, keep in mind that advertising, which runs about 4% of sales, is also nearly entirely variable. And so that gives us some ability to mitigate the impact of the transaction deleverage.


And your next question comes from the line of John Ivankoe with JPMorgan.

John Ivankoe – JPMorgan

Also staying on China if I may, and a few different topics. Firstly, obviously first quarter development was exceptional, especially for a two-month quarter, and I think David, for emphasis, a few times you said you expect 700 for the year. So I guess at this point, trying to get a sense whether the avian flu and the December price [unintelligible], kind of having you back off the development maybe, at least as I’m interpreting, maybe slightly, especially relative to prior years? You know, if there are other issues that we should be sensitive to?

And then the second question, if I may, is on gross margins in China, or cost of goods sold looked at inversely, that was very, very low. The COGS was very low in the quarter, and some may have interpreted that you would invest in gross margins to kind of really sell the value message to consumers, whether now or at some point in the future. So just wanted to get a sense of how you may use the COGS line or gross margins to invest to get back traffic when the time is right.

David Novak

Well, I think, first of all, on the development, we think that staying the course on the number that we provided at the analyst conference back in December was that we said we’d open at least 700 units. We still think that’s the right number.

I think the reason why we believe it’s the right number and we’re staying on it is that we’re still out developing competition by a wide margin, as I said, we still have that first mover advantage that we’re opening up in 100 new cities this year. So we don’t really see any urgency to expand more rapidly in this current environment.

I think the China team has always been given the charge that this is a business that’s a jewel. Polish that jewel, keep making it as strong as you can. And we’ve never ever forced or challenged the team to grow at a faster rate than it ought to, and I think as we look at the year, and where we’re at, we just think that we’re going to make the prudent and the right decisions as we go forward. And that number will be at least 700 restaurants, so that’s kind of how we’re looking at that.

In terms of investment in the value proposition, we have great cost structure. We’ve always done what’s right for the customer. We have a number of value initiatives planned, even with this current challenging environment.

And what I expect, given everything that’s going on, the launch of Operation Thunder, with the quality assurance campaign that we’ve launched, we’ve got some significant innovation coming, value promotions going, we expect to go into 2014 with KFC being stronger than ever. And that’s our goal.

This is obviously a challenging time, but that doesn’t mean that you just can’t keep investing and building the brand and setting yourself up for the future. And we love our positioning with KFC in China over the long term.

Patrick Grismer

And John, to build on David’s comments on the cost of sales and the implications for our margin, in the first quarter, we were fortunate enough to experience food cost deflation of 5%, and we had a 3-point benefit of pricing from actions taken last year. So a rollover pricing benefit, if you will, of 3 points.

Those two elements combined helped to blunt the impact the transaction deleverage on our overall margins, and help to keep our cost of sales percentage in a good spot, despite the fact that as you say, we were offering more value during the quarter to help support more transaction growth.


Your next question comes from the line of David Palmer with UBS.

David Palmer - UBS

I know it’s probably tough to tease this out, but has the talk about antibiotics died down? Is your team’s perception that as we get past the avian flu issue, that you’re going to be in another level with antibiotics, and maybe there’s even, crazy as it sounds, a silver lining to the avian flu issue in that it’s sort of wiped clean or perhaps permanently pushed back into the back of people’s consciousness, the whole antibiotics issue that was at the fore a few months ago?

David Novak

I think what we’re pleased with is the publicity on the poultry issue has really subsided, and we’re moving more into the process and continued process of building consumer confidence. I think basically what we need in China is just to get the time that we’ve seen historically has brought our business back. And that’s really the way we’re looking at it.

I wouldn’t even comment on your hypothesis. I’ll leave that to you. What we think we need is really the gift of time to build consumer trust back and keep building the brand forward as we move ahead.


Your next question comes from the line of Joseph Buckley with Bank of America

Joseph Buckley - Bank of America Merrill Lynch

Two questions. One back on the China margins. Can you walk through what’s happening with labor inflation? And obviously labor costs up year over year, but with a little better control than I might have guessed. And just kind of curious if the wage inflation has subsided any.

Patrick Grismer

With respect to China labor inflation in total, at the restaurant level, we experienced about 14% inflation, more or less in line with our expectations. The wage rate component of that was up 8%. So the difference reflects growth in the cost of employee benefits and growth in the cost of management labor.

Joseph Buckley - Bank of America Merrill Lynch

And then with all the poultry issues and supply chain changes, how does this affect you looking out to 2014 and beyond from a cost standpoint? And then as you continue to grow, is the poultry industry capable of growing with you?

Richard Carucci

At present, we don’t expect the increased rigor of supply chain management practices is going to have a material effect on our poultry supply costs. In fact, we have reason to believe that flock yields could improve as a result of some of these more stringent practices and that will help to diminish the cost of any new procedures that may be put in place at our suppliers to continue to drive even higher levels of quality.

And then in terms of longer term supply, we remain confident that the larger producers will continue to grow and meet our supply requirements. So we’re not concerned that we’re going to face a situation where we’re going to be supply constrained in a way that is going to put upward pressure on poultry costs.

Joseph Buckley - Bank of America Merrill Lynch

And then just going back to the China labor thing for a moment, if I look at labor costs per store, they’re very flat year over year. So is that just adjusting to the lower level of business, staffing-wise? Or is there something else that would drive that given the inflation numbers?

Richard Carucci

No. What I can tell you is that clearly in the current environment the team is very much focused on running as efficiently as possible, but because we do see this as a temporary situation, we’re not taking actions that would in any way compromise the service that we’re providing our customers.


Your next question comes from the line of John Glass with Morgan Stanley.

John Glass - Morgan Stanley

I wanted to come back to this notion of it will take time to get through this, and that’s probably true in this situation, but it won’t necessarily prevent the next episode, and it will inevitably be something else.

So there are two issues in China that seemed to be needing to be addressed longer term. One is your supply chain. And what I’m seeing is that chicken production in China is more fragmented. It’s not vertically integrated like it is in the U.S. So on that first point, is there an opportunity to help suppliers vertically integrate in China so you don’t see uncertainty. Maybe it’s using a multinational company, for example, as a key supplier. Where do you stand on that?

And secondly is response to rumors. It seems like you’ve been caught off guard a few times in terms of rumors, and social media has exacerbated this. Has there been a seismic shift, or has there been a change in the way you’re choosing to respond to rumors more quickly or more effectively?

David Novak

First of all, what I think we’ve done on the supply chain is we’ve taken swift, decisive action to work with our suppliers to get an even more enhanced supply chain system. As I talked about earlier, we’ve eliminated over a thousand chicken houses from our supply chain. To your point, we are working with our suppliers to support the integrated farming system, developing best practices, working with them very closely.

And as far as social media goes, we have beefed up our social media monitoring system dramatically. So I think our intention as a consumer company is to be best-in-class in this arena, and I think that’s happening across the board in all of our divisions. It’s the number one priority of Jonathan [Blum], our public affairs officer, and we are very, very focused on this, and I think doing an excellent job.

In fact, being world class in social media, digital, is a major strategic objective of ours, and last week we just spent, as a team, a couple of days visiting places like Twitter and Square, just to get totally on top of what’s going on in the world today. Which I think we are.

But at any rate, I think we’re taking all the actions we need to take to ensure that our industry leading supply chain is even better as we go into the future. We do everything we can to be on top of social media and use it as an advantage, and be able to counter any false claims that come about. And I think we’re on top of both of these issues.


Your next question comes from the line of Michael Kelter with Goldman Sachs.

Michael Kelter - Goldman Sachs

You guys are assuming a return to positive same-store sales before the year’s out, and it makes sense, given prior similar incidents recovered at that pace, but how do you know that this time there hasn’t been more permanent or maybe just semi-permanent damage to the KFC brand in China? Is there something you’re seeing specifically that gives you confidence? Or is it just relying on the historical analogues?

Richard Carucci

I would say the fact that we have seen sales start to come back in February and March, as David had said, about where we expected, gives us confidence that this recovery period of six to nine months is a reasonable expectation. Before the recent publicity of avian flu, we were seeing the recovery, and we continue to expect, therefore, that a full recovery will happen in that six to nine month period, particularly given the fact that we expect this dramatic impact of avian flu will persist for only about three months or so.

We’ve weathered many storms like this, so we do have a number of data points to inform our point of view at this point in time. And again, based on what we saw happen over the course of Q1, and as we reported our March sales, which as you know, for our China division, fall into Q2, we remain confident that we’re looking at a six to nine month sales recovery period.

Michael Kelter - Goldman Sachs

And then on a similar kind of a point, you guys have presented your brand tracking scores in China over the last several years. Can you tell us what you’re seeing in the latest read from the consumer in your brand tracking? What parts of your score have fallen off the most versus what’s holding up?

David Novak

I think we’d have to get back to you on those specific numbers, and maybe share them on the next call if you’d like. I think one of the things that we are tracking is as we build awareness of everything that we’re doing with Operation Thunder is just improving consumer perceptions and the answer is the more people are aware of what we’re doing, the better they feel about coming back into our business. And so I think that’s something that we’ll continue to track.

But without question, we have a beloved brand with KFC. And as you know, when you have great brands, you just have to keep doing the things that build a great brand, and you come back. Every great brand comes back, and KFC is in a powerful position. And whatever issues there are in the category, or with food safety, or whatever, we’re top of the class in terms of being a brand that people can rely on. So I think that’s what gives us so much confidence, as we go into the future. We know we’re doing the right thing.

I think the big message we have for Yum! Brands this year is staying the course. We have growth staring us in the face all around the world. Everywhere we look, we see growth opportunities. We are the leader in emerging markets, not just China. We’re continuing to build our brands the right way. And we have growth opportunity that is unparalleled. Even as we look at China. You’ve got 300 million consumers, they’re going to 600 million. And you know, we see this as the number one retail opportunity in the world.

Nothing has really changed from last year, other than the fact that we have a challenge that we have to work through, and we’ve worked through these challenges in the past, and we’re not only doing it with KFC right now, we also are building Pizza Hut. Pizza Hut, as I mentioned, is the biggest new news at Yum! Brands. We’re opening up in new cities with three-year cash on cash returns. We are definitely going to have the leading brands in every significant category.

And then, as you were listening to the call, look at what’s going on in the United States. We’ve improved our margins for five consecutive quarters. Taco Bell, which is 60% of our profits, is looking more and more like a power brand. I don’t think anybody is doing a better job of marketing or innovating than Taco Bell.

And so we really think we’re doing the things that really set this business up for the long term. Our margins improved at YRI. Why? Because we’ve restructured the business, we’ve refranchised our U.K. business.

So all of this sets us up for the future. 2013, for all of our shareholders out there, I want you to know it’s very disappointing to us. We’ve got a track record we love, but we want to get it back, and we want to come back in 2014 stronger than ever.

And every sign I see, as I talk to our people around the world, and I see what’s going on, is that we’re putting things in place to make sure that we continue to get back on that track record, and that’s the goal. Because we deliver, and we’re going to deliver consistently over the long term.


Your next question comes from the line of Brian Bittner with Oppenheimer.

Brian Bittner – Oppenheimer

I’d love to talk about something else, but I’m actually going to ask about China.

David Novak

That’s all right. It’s a big opportunity for us.

Brian Bittner - Oppenheimer

You know, this must be tough to really answer, but I’m going to ask it anyway. You know, based on the trends that you’re seeing throughout April, I think this avian flu thing really, I think the first press release or whatever came out about March 31, so it’s been about three and a half, four weeks. It’s subsided a little bit, but not a lot.

But based on the trends you’re seeing throughout the month, do you think April represents a bottom, down 30%, and you start the recovery from there? Or based on what you’ve seen historically and based on what you’re seeing in April, could it worsen in May? Or could it be as bad in May? Or do we start the recovery from this April number?

Richard Carucci

Certainly we hope this is the low point. It’s very difficult to predict the exact trajectory of a sales impact like avian flu. So it’s tough to call at this stage. But, again, based on our past experience with incidents like this, we believe that impact will go away in about three months.

David Novak

You’re right. You’re asking sort of like the mother of god question. Nobody knows the answer to this one. But no two crises are the same. We can only look back. But we’ve weathered other storms in the past.

And to put this in context, the last time the China business was significantly impacted by avian flu was 2005. Our China division operating profit was $200 million. And at that point, it declined about 6% versus the prior year. Last year we made over a billion dollars, and I think that’s a real testament to just the power and resilience of the brand.

So I don’t know what’s going to happen in the next few quarters, two months. Your guess is as good as mine. I’m not a soothsayer. I’m not a predictor on these kinds of things. So we’ll just watch the press coverage, we’ll pay attention to what’s going on, but most importantly, we’re going to continue to build the value, and build the brand, and build the innovation that we know is going to set us up for the long term.

So I can’t really call exactly what’s going to happen in the next two to three months. I don’t think anybody can. What we can tell you is that this is a dramatic impact on our business. It’s short lived, and the period, in the past, has been about three months.

Richard Carucci

And we are continuing to take actions, as we have in the past, to remind consumers that fully cooked chicken is perfectly safe to eat, and we’re reminding them, in several different ways in store and television, and so forth.

Brian Bittner - Oppenheimer

I appreciate the answer. And then another quick follow up, just on the margins. I think you said deflation of 5% in the quarter, 3% pricing. What are we thinking for kind of a full year effect as far as food cost inflation or deflation and a full year pricing impact so we can think about food margins going forward?

Patrick Grismer

At this stage, we have no reason to move off of the full year guidance we’ve provided at our December analyst conference, which for food costs is low single digits, and for labor, mid teens inflation. So we would stick to that as a full year expectation. As it relates to what our reported margin is, I’m not going to speak to what that number is going to be or what it might look like in any given quarter.

There are so many different moving pieces here, as I’m sure you can appreciate. The biggest lever for us is transactions. And so we’ve taken a big hit on transactions. We expect those transactions will come back. So the deleverage impact that we’ve experienced thus far will reverse as those sales come back, and that’s going to be the biggest driver of our margin performance balance of year.

We do have some rollover pricing benefit, which benefited us in the first quarter. That will continue to have some impact, albeit a bit less, in the second and third quarter, but at this stage, I don’t feel that it’s appropriate to provide a full year number on margin or certainly not to talk about what’s going to happen in Q2 versus Q3.

Brian Bittner - Oppenheimer

Got it. But just to be clear, what’s happened so far has not really changed the food cost inflation trajectory? You still expect back half inflation?

Patrick Grismer

That’s correct.


Your next question comes from the line of Diane Geissler with CLSA.

Diane Geissler - CLSA

I have another question on China, and this really relates to the whole issue of food safety. China has had a number of scares in a variety of industries, including dairy and hog raising, and I guess my question is really have you seen any movement on the part of the Chinese government to change regulations and/or make it easier for the big integrated processors to expand?

You’ve talked about culling from your system the small house operations, but have there been any shifts in terms of biosecurity from the government? Or helping multinationals site houses, whether that’s through better land use rights, negotiations, etc.? Just in terms of how you see that supply chain going forward over the next five, 10, 15 years?

David Novak

I think the biggest thing with the new government in China, new regime, is food safety is high on their priorities. So I expect there to be more diligence and more work with major companies like ourselves. As the leader, we see our task as setting the standard, and that we plan to work, and are working, very closely with the government to do everything we can to be the leader in food Safeway. But I think it’s really too early to talk about any seismic changes that are occurring. But I do believe that the food safety will become even better and more enhanced over the long term given everything that’s going on and the focus of the government.

Diane Geissler - CLSA

And then just on real estate, do you see any shifts in terms of development and your ability to site new stores this year and into 2014?

Richard Carucci

No material change that we see. As we’ve said before, our new unit development program is shifting increasingly to the lower tier cities where the development opportunities are more compelling, margins higher, returns higher, and we’re also shifting more from KFC to the Pizza Hut brand. And that will continue. In terms of our ability to secure the sites and the development of infrastructure to create the opportunities for us, we don’t see that changing.


Your next question comes from the line of Keith Siegner with Credit Suisse.

Keith Siegner - Credit Suisse

Just one more question on China. Thinking through the long term company restaurant margin outlook, 20% has been a number that you’ve offered for some time. 2011, 2012, and now 2013 all below this. We’ve added in the Little Sheep concept, which has slightly lower margins. Is this still the right long term target? Is that what you’re planning for? Is this something that a return to positive comps can help you achieve? Or is this now a multiyear process to get back to that target given the acute challenges of this year?

Richard Carucci

We continue to believe that 20% margins are imminently achievable with our China business, and it’s not just comps that are going to get us there. Certainly in the short term, the transaction recovery is going to be the single biggest driver of margin improvement. No doubt about it. However, there are a couple of other things to keep in mind.

The first is ongoing asset leverage as we continue to add new layers to our business, to our existing restaurants. Whether it’s 24-hour operations in our KFC business or breakfast at Pizza Hut, these new sales layers are going to better leverage the existing investment we have and provide that leverage on fixed cost.

And then the other is the impact of portfolio shift. As I mentioned, when we look at our new unit development program going forward, for the KFC brand we are continuing to shift from the tier one and tier two coastal cities to the tier two inland and tier three and below cities, where margins are significantly higher and we are continuing to shift more of our new unit program from KFC to Pizza Hut.

And I want to point out, even though this wasn’t in our release, that even in a quarter where same-store sales were down for our Pizza Hut casual dining business, margins were still well above 20%, and even close to 30% in the lower tier cities. This is going to be an increasing focus of our development program going forward, and that’s going to benefit the portfolio restaurant margin for our China business.

So I think it’s important to keep in mind those three factors. It’s transaction recovery, it’s ongoing asset leverage as we introduce new sales layers, and it’s a shift in our development program and how that’s going to benefit portfolio margins.

Keith Siegner - Credit Suisse

One very quick follow up, if I can. Thinking through Little Sheep now, which you’ve basically anniversaried since the acquisition, is this at the point now where regardless of all this other noise, can Little Sheep be a tailwind to that margin curve this year maybe, and over the next couple of years as well?

Richard Carucci

I think it’s premature to say that it’s going to be a margin tailwind this year. But our long term expectations of the growth that we will get out of that business to be high. It is a relatively small portion of our portfolio today, but we didn’t buy it, as you know, for the 400-500 units that are in the ground, but for the several hundred units that we know we will build over the next several years. And with the improvements that we are bringing to the concept and our operations knowhow, we are optimistic that the margins are going to improve significantly. And at that stage, with a larger scale business, and much better margin performance, then the Little Sheep business will be helpful to our overall margin.

David Novak

Little Sheep is very small at this stage, but we expect it to get a hell of a lot better. We’re improving the concept every which way we can, so there’s only upside. But, you know, it’s not a big tailwind for us.


Your next question comes from the line of David Tarantino with Robert W. Baird.

David Tarantino – Robert W. Baird

I just wanted to ask about your thoughts or preliminary thoughts on 2014. I know you don’t want to give any guidance at this point, or specific guidance at this point, but I was just wondering if you think 2014 could be a big rebound year in terms of the earnings growth given the expected sales recovery in China? So for example, soft year in 2013, followed by a well above average year in ’14? And by the time you get to 2015 maybe you’re back on your long run trend line? Just any thoughts on how you think it might play out would be helpful.

Richard Carucci

I think you’re thinking about it exactly the right way. Let me tell you, if 2014 is not a big bounce back year, we will all be very disappointed, because that is our expectation. We have a high degree of confidence that is going to be the case. And as I said in my remarks earlier, 2013 is an aberration.

So I wouldn’t spend too much time focusing on 2013 results. Not to suggest that we’re not focused on doing the best job possible, but as it relates to how you think about our business, and what we’re going to deliver, and how we’re set up to continue to grow, I encourage you to continue to focus on 2014. We do expect that we will begin to see a strong recovery next year.

David Novak

Our great and late chairman Andy Pearson had a great line. He said the best way to have a great year is to follow up a bad one. Well, we clearly have a bad one this year, and so we expect next year to be very, very good, and we have very high expectations for ourselves. I think the important thing for our investors to know is that we’re building the platforms that we think will establish the long term growth.

If you take Taco Bell for example, we are really leading in terms of improving our quality, innovation with what we’ve done with Frito Lay and the Doritos Locos Tacos line. We have world class operations. We’ve been focusing on that for some time, but we’re ranked in the top three across every key measure in operations that we look at. We’re building it for the long term.

At Pizza Hut, we’ve got good value proposition, good innovation. We’re working on a major platform in chicken, where we can really develop our sales as we go forward. Across the board, we’re working on the sales layers, the breakfasts and beverages and things that we think will give us the incremental sales that will be significant over the long term.

So what we’re focused on this year is staying the course and building a sustainable growth engine for the long term. And nobody expects us to grow at least 10% next year. We expect to do a lot better.

Patrick Grismer

And the other important point to reiterate, David mentioned this in his remarks earlier, is the impact of the new unit development in China. So last year we opened about 900. This year we’re saying at least 700, so that’s 1,600 between the two years combined. Collectively, that will deliver about $2 billion of system sales, which represents about a 25% increase on the base.

So think about it. As we recover from the effects of this late December incident and the more recent avian flu publicity, we have all these new assets on the ground generating sales and profits that will contribute significantly to our growth in 2014.

David Novak

But the proof’s in the pudding, you know? I mean, you can look at this and you can see all kinds of potential, but as my father used to tell me, potential means you haven’t done it yet. So we’ve got to turn around China, we’ve got to keep building these businesses, and then I think the businesses will end up being where they ought to be. And this is a growth company.


Your next question comes from the line of Andy Barish with Jefferies.

Andy Barish - Jefferies

Two quick YRI questions. On the avian flu, do you expect a little bit of impact in some of your other Asian markets? And then just a clarification on the Pizza Hut U.K. franchise renewals. The deal closed in the fourth quarter, but the renewal fees and new franchise stuff came in in the first quarter?

Patrick Grismer

I’ll respond to that piece first. The franchise ownership transfer, with the transfer fees and the renewal, wasn’t related to the Pizza Hut U.K. business. It related to a different market for us, where there was a transfer in ownership from one franchisee to another. That happened in YRI’s first quarter.

Richard Carucci

Regarding impact of avian flu, I don’t think what’s happened in China is going to impact other markets. I think what will happen is if that appears in those markets. We’re obviously going to keep a close eye on that. We’re prepared in advance to communicate what our response would be, which is what people have said here before, which is properly cooked chicken is perfectly safe to eat. So we’re ready for the possibility, but I don’t think it’s going to have an impact unless it hits other countries.


Your next question comes from the line of Mitch Speiser with Buckingham Research.

Mitch Speiser – Buckingham Research

I’ll try to avoid the China questions. It seems like we’ve gotten a lot of different angles on that. Although I’m sure there’s probably some more. But just on the balance sheet, there wasn’t a lot of share repurchase in the quarter. And you are, I think, under 1x levered. Could you maybe just discuss if there are any constraints to using the balance sheet a little more aggressively in general, and using share repurchase in particular?

Patrick Grismer

We continue to take a look at this, and we’re quite happy with where things are at right now. We’re generating enough cash to pay the meaningful dividend and return remaining cash to share repurchases at a level that will accomplish what we expect as it relates to contribution to earnings per share growth. We’re not interested in leveraging up at this stage and putting at risk our investment grade credit rating. We believe we’re in the sweet spot as it relates to how we balance these things out and the implications for our overall cost of capital. So no plans to do what you’ve suggested.

Mitch Speiser - Buckingham Research

And separately, just on the second quarter, I think you mentioned down double digit. Obviously that’s a wide range. Maybe any more particular range, obviously that could be down 10% or down 30%. Any incremental info on how to model the second quarter would be helpful.

And does the very weak second quarter results on tap, obviously it’s China driven, but does some of it relate to the very typical comparison at Taco Bell?

Patrick Grismer

No. Certainly Taco Bell was not playing into how we’ve characterized EPS results in Q2. What we’ve said is that it will be a significant double digit decline. By far our low point of the year. But because we delivered so much better results in the first quarter, that puts us in a position to cover the unexpected severe impact of avian flu on second quarter results and thus hold to our full year estimate of mid single digit down.

And just given that the wildcard here is China sales recovery, which is very difficult to call, I don’t think it makes sense to give a more precise estimate of what that second quarter will be. But we want everyone to know that it will be a significant double digit decline.

Richard Carucci

And regarding the overlap of Taco Bell from a sales perspective, it is a huge overlap, as you point out. As I said on my speech, we grew 6% in the first quarter on top of 6% last year. And the second quarter Taco Bell last year had 13% same-store sales growth, which is obviously a huge number. We look at it as anything positive being a really good result there. And what the team has put in place, in the launch of Cool Ranch Doritos Locos Tacos, I think we have a decent chance of accomplishing that.


Your next question comes from the line of Jason West of Deutsche Bank.

Jason West - Deutsche Bank

Just a bigger picture question on China. We have seen a bit of a continued deceleration in GDP growth and retail sales growth in that market. I was just wondering how that plays into your longer term thinking on unit growth. And does it really matter if GDP is up 7 or 10, or do you have just so much room in the smaller cities that it really doesn’t play into your growth algorithm at all?

David Novak

We see the biggest macro is the growing consumer class, growing from 300 million to 600 million. So let’s say it grows from 300 to 550 or 300 to 500, it’s still a lot. And we’ve got lots of upside as we go forward. So that’s the big macro that we look at, the growing consumer class and growing disposable income. We think both those things will be moving in our direction and that’s the key.


Your next question comes from the line of Jeff Omohundro with Davenport and Company.

Jeff Omohundro - Davenport and Company

Just wanted to expand a little bit on the Taco Bell momentum that you referenced. I was just wondering if you could maybe address the Cool Ranch DLT launch with regard to mix shift and just how it compared with the original DLT launch. Again, particularly since you’re overlapping such challenging prior year comparisons.

Richard Carucci

When Doritos Locos Tacos was launched in 2012, with nacho cheese, the peak mix was about 11-12%. And when it was [off air] sort of towards the end of the year, beginning of this year, it got down to about 4%. So we left it on the menu, but we weren’t promoting it for a period of time. When we relaunched Cool Ranch, we got about that same level of mix, about 11-12% of mix.

David Novak

That’s a huge number for Taco Bell. Anything over 3% is big. If you haven’t tried it yet, you ought to. If you like Doritos, you can’t eat just one. Try the boneless chicken at KFC too while you’re at it. That’s really good. Then if you need another meal, go have cheesy crust pizza.


Your next question comes from the line of Jeffrey Bernstein with Barclays.

Jeffrey Bernstein – Barclays

Two follow up questions. One on China. I know you talked about the complete confidence and the full sales recovery. Obviously some of these issues have been compounded, which makes teasing it out somewhat difficult. I think most people agree that the supplier issue and the avian flu issue will ease with time, and you have history for that.

But any thoughts on, I know we had seen a slowdown in trend in October, November, December, which was talked about at your analyst day. I know it was tough to kind of look at it. At that point in time, there was some debate whether average check had gotten too high, or whether there was too much price.

I’m just wondering how you think about what gives you the confidence in the full sales recovery, or what would you see that would make you more cautious that maybe the initial issue back in the fourth quarter of ’12 might be more severe than you might have thought. And I had a follow up.

David Novak

I think we know that we’re constantly improving our value equation, constantly building awareness of the sales layers we have, with delivery and 24-hour service, and breakfast. So we’ve got things that we’ve invested in to give us a base that we can build on. And we think it’s early days.

I mean, we’re not capacity constrained. It’s not like we can’t make more chicken, sell more products, and build our day parts. Our average unit volumes are $1.7 million to $1.8 million at KFC and Pizza Hut. The average unit volumes for McDonald’s is $2.6 million in the United States. So we think that one of the ways McDonald’s got there is they kept building those incremental day parts over time.

And that’s what we think we clearly have the opportunity, as we move ahead. And I think that’s just fundamentally, when you look at our asset base, and how we can leverage it, that gives us a lot of confidence. These are very untapped day parts that we’re just in the early days on. So I think that’s the biggest opportunity.

Patrick Grismer

The other thing that’s going to help is if you look at the quarters balance of year, the last are the less challenging, if you will, and certainly that’s going to contribute to our ability to deliver improving results balance of year on the underlying business.


Your next question comes from the line of Jeff Farmer with Wells Fargo.

Jeff Farmer - Wells Fargo

Just again staying away from the China discussion, just looking for a little additional color. I think you said 240 basis points increase in the U.S. restaurant margin. Looks like you called out Taco Bell sales leverage and some refranchising as drivers. But what was the approximate margin benefit from each of those things? And I guess more importantly, as you look out to 2013 full year U.S. margin, what type of guidance can you give us for that?

Patrick Grismer

What we saw in Q1 we expect to be about what we’ll see for the full year. The impact of refranchising was about half of the margin improvement we saw in the U.S. in the first quarter.

Jeff Farmer - Wells Fargo

And that carries through to all four quarters?

Patrick Grismer

There will be some variability from quarter to quarter, but on a full year basis we expect to see about 17% margin for the U.S.

Steve Schmitt

I think that’s our last question for the day. I wanted to thank you for joining our call. And once again, please remember to mark your calendars for our upcoming investor events. And we look forward to speaking with you soon. Thank you.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!