At this time, I would like to welcome everyone to the Yum! Brands second quarter 2013 earnings conference call. [Operator instructions.] Thank you, Mr. Schmitt, Vice President of Investor Relations. You may begin your conference.
Thanks, operator. Good morning everyone, and thank you for joining us. On our call today are David Novak, Chairman and CEO; Rick Carucci, President; and Pat Grismer, our CFO.
Before we get started, 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 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, www.yum.com, to find disclosures and reconciliations of non-GAAP financial measures that may be used on today's call.
We are broadcasting the 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 the future use of the recording.
Finally, we would like you to be aware of the following Yum! investor events occurring in the next three months. Our Yum! Restaurants International investor and analyst conference will be on August 21, in Plano, Texas. Our Yum! China investor and analyst conference will be on September 9 and 10 in Shanghai, China. And our third quarter earnings release will be Tuesday, October 8.
I would now like to turn the call over to David Novak.
Thank you, Steve, and good morning everyone. The second quarter was extremely challenging for Yum! Brands, but sales and profits were generally in line with what we had previously communicated. Earnings per share, excluding special items, declined 16% versus prior year, as our China division operating profit fell 63% prior to foreign currency translation. Operating profit increased 12% at Yum! Restaurants International, and 4% in our U.S. business.
Now, there’s obviously been a lot going on with our KFC business in China, so let me give you an update on our progress. Beginning in April, KFC sales in China were significantly impacted by the intense media surrounding avian flu. The quarter was also impacted by the residual effect of the poultry supply incident, which occurred in late December.
Fortunately, the extensive media surrounding avian flu in China has subsided, and same-store sales at KFC are on the road to recovery. In fact, our KFC same-store sales decline in June was 13% versus the 26% decline we just reported for the second quarter. This is clearly another improvement in our trend, and further evidence the brand is continuing to recover from both avian flu and the poultry supply incident.
I was just recently with our China team and I can assure you they are weathering the adversity and executing with a great sense of urgency. So even though we believe the gift of time will be the most important contributor to our ongoing KFC sales recovery, the team remains extremely focused and are taking the necessary steps to get sales back on track as soon as possible.
For example, we launched a quality assurance advertising campaign in mid-April reminding consumers of our commitment to quality in China and that properly cooked chicken is perfectly safe to eat. Our quality assurance message speaks directly to young families, encouraging them to come back to KFC because of the care we take and the safety of our supply chain.
In addition, we recently launched a new value initiative centered on wings, a customer favorite, and we have significant news coming on the chicken front. We’re also advertising protein alternatives that are available at KFC such as our shrimp and mushroom rolls.
Looking ahead, we believe we will have solid marketing and product news coming later this year. We’re hopeful these initiatives will contribute to our overall sales recovery and help build additional momentum balance of the year. We are confident KFC remains a power brand with a great future.
Speaking of power brands in China, I couldn’t be more pleased with the very strong performance of Pizza Hut casual dining, which delivered solid same-store sales growth in the quarter, up 7% on top of 10% in the second quarter of last year.
Pizza Hut continues to lead with innovation and everyday affordable value. We just launched a major new product with Stone Pan Sizzling Steak that we know our customers will love. We’re also continuing to leverage our assets by expanding our breakfast menu into more and more cities.
Pizza Hut casual dining is unquestionably the leading Western casual dining concept in China, with over 900 units in 228 cities. Importantly, we continue to have less than three year cash paybacks on new units and the business is on track to deliver another strong year in 2013.
With the terrific performance we are seeing, we continue to broaden our new unit development at Pizza Hut and are aggressively expanding into lower-tier cities. We are very bullish on Pizza Hut casual dining. With both KFC and now Pizza Hut, we are in the early stages of our growth, with a long runway ahead.
In addition, we continue to invest behind the development of our emerging brands. Pizza Hut home service, which is in the home delivery category, now has 171 units in 21 cities. We now have strong unit economics and will ultimately scale Pizza Hut delivery service across the country, which is obviously more good news for the powerful Pizza Hut brand in China.
We’re also making slow but steady progress with East Dawning, our Chinese fast food concept, but still have much work to do to develop a scalable business model. With respect to Little Sheep, as I had mentioned on prior calls, the results have been soft due in part to the long approval process and transition of the acquisition.
We’ve been working hard to reconcept the brand to accelerate long term growth. However, we are now facing the brunt of negative publicity resulting from quality issues at other competitive hot pot concepts in China. This has resulted in a huge cloud over the hot pot category. As the category leader, Little Sheep sales have been significantly impacted, even though there never was an issue with Little Sheep quality.
We believe we will weather this issue over time. Nevertheless, our path to new unit expansion is taking longer than we envisioned. But we will continue to invest in the brand. Our goal remains to aggressively expand over the longer term.
So let me wrap up our China business. Even with our recent challenges in China, we are focused on the long term, and we’re as bullish as ever about our growth prospects. We like how we’re positioned in a country with over 1 billion people, and even though the economy is slowing, it’s still the world’s fastest growing economy, and is expected to grow about 7% this year.
The macro trend we continue to be most enthusiastic about is the growing consumer class, which is estimated to be about 300 million people today and growing to over 600 million by 2020, and disposable incomes are growing right alongside it. In 2013, our new unit development target of at least 700 new stores remains unchanged. This means we will have opened about 1,600 new units in a two-year period and the sales continue to recover at KFC. Our goal is to have substantial momentum heading into 2014.
Outside of China, we continue to expect on target performance for Yum! Brands, and we are well-positioned to deliver against our operating profit targets for the year. At Yum! Restaurants International, the business continues to have a solid year, led primarily by high-growth emerging markets such as South Africa, Russia, and Thailand.
And even though we’re being affected by a moderating global economy, new unit development remains extremely robust. In fact, we recently met with over 400 of our franchise partners representing 100 countries at our biannual franchise convention, which was held this year in Beijing.
As evidence of our franchisees’ enthusiasm for our brands, we expect to open at least 1,000 new units at YRI this year, about 900 of which will be developed by franchisees. Our franchisees’ spirits are extremely high, and it is clear they remain committed to long term growth.
In the United States, our overall same-store sales were positive, and we continue to be particularly pleased with Taco Bell. Taco Bell continues to have momentum and the franchise community is clearly excited about the future growth strategies of the brand.
I recently met with Franmac, the Taco Bell franchise leadership committee, and I don’t think I’m going too far when I say they are extremely enthusiastic about our Live Mas advertising campaign as well as our innovative new product platforms, Doritos Locos Tacos, and Cantina Bell.
They also told me they are optimistic about our national breakfast launch in 2014. It’s great to have such a progressive group of leaders at Taco Bell. They know we’re building the brand the right way for the long term, see the importance of leveraging our assets throughout the day, and are committed to operational excellence.
I’m also pleased that 2013 will mark the second consecutive year of net new unit growth in our U.S. divisions, led by new unit development at Pizza Hut, which will open about 125 net new units and Taco Bell, which will open around 80 net new units.
In India, it’s full speed ahead with new unit development as we expect to open 150 new units this year and double our restaurant count by 2015 to around 1,000 units. We have recently launched major value initiatives for each of our brands that are driving sales and further improving our business model.
So to wrap it all up, the China recovery is progressing as expected, and YRI, India, and the U.S. are basically on target with our expectations. We expect 2014 will be a strong bounce back year, so in 2013, we will continue to invest in our core business, continue to pay a meaningful dividend, and continue to repurchase shares.
Now let me hand it over to Rick Carucci who will take you through our strategies for Yum! Restaurants International and our U.S. business.
Thank you, David. Good morning. Today, in addition to talking about our results at Yum! Restaurants International in the U.S., I will also describe the diversity of our franchise business at YRI. I will then show how portfolio actions and new unit development are improving results, margins, and our growth proposition in the U.S.
At Yum! Restaurants International, our strategy is to drive aggressive international expansion and build strong brands everywhere. On our last earnings call, I mentioned that the YRI franchise revenue stream is large, growing, global, and diversified.
In the 10-year period from 2002 to 2012, our franchise units almost doubled, from 7,000 to 13,000. YRI’s franchisees have tripled over the same timeframe, from almost $300 million to about $900 million. This year, franchise fees will reach nearly $1 billion. So clearly, this revenue stream is large and growing.
Let me now spend a minute talking about how diversified this global portfolio is. Let’s first look at the regional balance. We have a large and growing presence in Asia, which accounts for 28% of our franchise fees. The Americas account for 22% of our fees. Europe also accounts for 22% of YRI fees. To round out the world, 16% of our franchise fees come from the Middle East and Africa, and 12% from Australia and New Zealand.
In addition to having strong regional balance, our franchise fees reflect our dominant presence in high-growth emerging markets. Emerging markets currently account for about 45% of our revenue stream, but make up a higher percentage of our growth. As an example, in our most recent quarter, 63% of our new units were opened in emerging markets.
We also continue to enter new emerging markets. In the past 12 months alone, KFC has entered Argentina, the Ukraine, Malawi, Angola, and just last month, we opened the first Western concept to enter Outer Mongolia. You really know you have a global concept when you can proudly open up restaurants in Outer Mongolia.
When you put it all together, YRI’s fees are generated from over 100 countries. Furthermore, no single country at YRI represents more than 10% of our franchise revenue stream. This level of diversification is second to none. We believe this large, growing, global, and diversified income stream is extremely valuable to our shareholders.
Now, at YRI we typically use the franchise model. We have also said that we will develop a company-owned presence in select high growth countries that meet our ownership criteria. These include the ability to build scale, establish a leadership position, and generate strong returns.
Last quarter I talked a bit about growth markets where we recently acquired equity: Russia, South Africa, and Turkey. Today, I’ll highlight Thailand, an emerging market where we have had company ownership for quite some time.
Excluding China and the U.S., we have more company-owned restaurants in Thailand than anywhere else in the world. We have 544 total units, 360 of which are company-owned. Thailand is clearly a strong performer and growth driver for YRI.
Since 2009, system sales have almost doubled, operating profit has tripled, and restaurant margins have increased from 14% to almost 20% today. We have clear brand leadership in Thailand. In fact, we have 473 KFCs, compared to 184 units for McDonalds. We plan on extending our lead with plans to build at least 40 additional units this year. We also have 71 Pizza Huts.
Given our powerful brand positions and attractive unit economics, we’re confident Thailand will continue to provide meaningful growth for years to come. Overall, we’re extremely excited about our YRI growth opportunities and our new unit development.
In 2012, we opened a record 949 new units, and added 513 net new units. This year we expect another new record. As David mentioned, our new unit development target for 2013 is now at least 1,000 new units, including 600 net new units. This represents an increase from the 950 new units we were expecting coming into the year.
This accelerated growth in net new unit count is significant for two reasons. First, 2013 will be the second consecutive year where we will generate 4% growth in YRI net new units. Second, this accelerating pace excludes India, which was a key growth driver for YRI before it was separated into its own division in 2012.
And while development is a key driver of our growth, our ongoing growth model also calls for 2-3% growth in same-store sales. During the quarter, YRI delivered same-store sales growth of 1%, primarily due to weakness in Japan and the U.K.
However, our emerging market business continues to see momentum, boasting 5% growth in same-store sales during the quarter. We’re especially pleased with the progress in Russia and South Africa as they continue to grow same-store sales while also developing new units.
YRI is on track to achieve its ongoing growth target of 10% profit growth as the upside in new unit development, combined with recent portfolio actions, are helping to offset the shortfall in same-store sales growth.
Now, on to our U.S. business. Our U.S. strategy should dramatically improve our brand positions, consistency, and returns. There are three factors that are helping us achieve this: Our ownership structure, the strength of the Taco Bell business, and our development program.
In terms of our franchise ownership, a decade ago 28% of our units were company-owned, while 72% were franchise. Through our franchising efforts, we are now 90% franchised. This should help deliver more consistency going forward since there is less profit volatility associated with a franchise business.
One measure where you can see how portfolio actions have changed the nature of the business is operating margin. In 2009, our full year operating margin in the U.S. was 14.5%. For 2012, operating margin was 19.9%. Year to date, in 2013, our U.S. operating margin is 24%, up 4 points over prior year, and up 9.5% since 2009.
As we have said before, our U.S. business has become more weighted towards Taco Bell performance. Taco Bell currently contributes about 50% of our U.S. operating profit, and our ownership structure reflects this. We now have 5% ownership of KFC and about 8% ownership of Pizza Hut. However, we are targeting our Taco Bell ownership at about 15%.
While we are more dependent on Taco Bell the brand is currently performing. If you look at the entire U.S. QSR landscape, I think you could make the argument that Taco Bell has done the most in the last 18 to 24 months to improve its competitive position. The team has done a great job at product innovation, and at the same time the Live Mas brand positioning has really resonated with consumers.
Taco Bell grew same-store sales by 2% in the quarter. This is on top of the 13% growth in the same quarter last year, which included the historic launch of Doritos Locos Tacos. We actually sold 100 million Doritos Locos Tacos during the second quarter of 2013, and it continues to be one of the most successful new product launches in our history. Our innovative use of social media contributed to the success of Cool Ranch Doritos Locos Tacos, and is an overall strength of our brand.
So all in all, we are quite pleased with Taco Bell. Our ongoing product innovation is backed by solid operations and increased media rates. We believe Taco Bell is well-positioned to complete a successful year in 2013.
Now let me give you a brief update on KFC and Pizza Hut. In the second quarter, KFC delivered same-store sales growth of 3%, driven by the launch of KFC’s original recipe boneless chicken. However, sales at Pizza Hut were weak. In this environment, you win by delivering a consistent and compelling value message, and our competitors have simply done a better job in this area so far this year.
We’ll have a more consistent value message going forward, and we continue to introduce new innovative products such as our flatbread pizza. We expect to deliver better sales growth at Pizza Hut during the balance of this year.
And as David said, another piece of exciting news in the U.S. is that in 2013 we’ll be at a net new unit growth position for the second year in a row. This is once again led by new unit development at both Pizza Hut and Taco Bell, as well as less contraction in KFC.
The combination of more consistent growth in new unit development in the U.S., combined with accelerating new unit development at YRI, gives us great confidence in our long term growth model for each of these divisions.
In fact, in 2009, our YRI and U.S. divisions opened over 1,100 units, including nearly 300 net new units. This year, we expect these divisions, plus India, to open about 1,500 new units, including over 800 net new units. This increase bodes well for our future.
So to sum it all up, while China is clearly experiencing a challenging year, the rest of Yum! continues to hold up pretty well. Now let me hand things over to Pat Grismer, our CFO.
Thank you, Rick. Our second quarter earnings per share were obviously very weak, due to the temporary sharp decline in our KFC business in China, but we expected these results as previously communicated.
The important thing to focus on is that our KFC China business is clearly recovering, demonstrating solid improvement in same-store sales. Additionally, our other key businesses, including Pizza Hut in China, are delivering results that are generally in line with our growth targets.
Over the next few minutes, I’ll provide some additional perspective on our second quarter results, our EPS expectations for the full year, and our preliminary thoughts on 2014. For the second quarter, we recorded a 16% decline in EPS before special items, due to the significant challenges we faced in China, partially offset by growth in our YRI and U.S. divisions and a lower tax rate.
In China, operating profit declined 63% in Q2, prior to foreign currency translation, driven by a 20% decline in same-store sales. This decline in same-store sales included a 26% decline at KFC and 7% growth at Pizza Hut casual dining.
Similar to what we experienced in the first quarter, China restaurant margins decreased significantly in the second quarter, down 5 percentage points versus prior year, driven by the operating deleverage you’d expect with a double digit decline in same-store sales.
In addition, because Q2 is a seasonally low sales period in China, the deleverage impact on division operating profit, when viewed on a percentage basis, was even more pronounced due to the relatively fixed nature of G&A expenses. Bear in mind these P&L dynamics work in both directions, so as same-store sales rebound at KFC, we expect both margin and profit to benefit significantly from operating leverage.
On the development front in China, we opened 100 new units during the quarter, which was in line with our expectations. While this was low in comparison to the first quarter, this resulted from a concerted effort by team China to pull new unit openings into Q1 to benefit from peak seasonal sales during Chinese New Year.
For the first five months of the year, which comprised China’s first and second quarters, we opened a total of 326 new units in China, which is more indicative of the run rate we expect balance of the year, and in line with our expectations of at least 700 new units in 2013. However, similar to previous years, new unit development in China will be heavily skewed to the fourth quarter.
Yum! Restaurants International reported an operating profit growth of 12%, excluding the impact of foreign currency translation. The refranchising of our Pizza Hut U.K. dine-in business late last year benefited YRI’s operating profit growth by 3% percentage points. I’m especially pleased with YRI’s rapid pace of new unit development, especially considering that of the 205 new units that YRI opened in the quarter, about 63% were in high growth, emerging markets.
Now as Rick mentioned, YRI’s same-store sales grew 1% in the quarter. This was lower than expected, because similar to other retailers, we experienced soft performance in some developed markets. However, we’re very pleased with the strong and broad-based growth we achieved in emerging markets. Restaurant margin increased 0.8 percentage points at YRI, largely due to the refranchising of our Pizza Hut U.K. dine-in business.
In the U.S., second quarter operating profit grew 4% versus prior year. This included a benefit of about 10 percentage points from the overlap of expenses incurred in Q2 of last year, related to the resolution of an employment lawsuit. Partially offsetting this, refranchising negatively impacted U.S. operating profit growth by about 3 percentage points.
Taco Bell again led the way in the U.S., delivering same-store sales growth of 2% in the quarter, successful overlapping last year’s phenomenal 13%. This was the sixth consecutive quarter of positive same-store sales growth at Taco Bell, demonstrating yet again that our combination of breakthrough innovation, compelling value, and operational excellence resonates with consumers. As Taco Bell represents about 60% of U.S. division operating profit, we’re especially pleased to see these same results.
U.S. restaurant margin increased 0.8 percentage points, driven primarily by refranchising. As expected, our refranchising strategy is leading to more consistent results and is setting us up for even better returns in the years to come.
We’re also pleased with the progress we continue to make with our U.S. development strategy, where we again expect to achieve net positive unit growth for the second consecutive year, led by our attractive investment models for Pizza Hut Delco Lite and Taco Bell.
Now I’m going to talk about EPS expectations for the full year. To be clear, we’re not changing our full year EPS estimate of a mid single digit percentage decline versus prior year. Additionally, consistent with our previous estimate, we expect that the 16% EPS decline in the second quarter will be our low point for the year.
Our full year EPS forecast is obviously heavily dependent on our sales and margin recovery in China, and we’ve estimated sales based on the actual trends we’ve observed. You’ll recall that through the end of March, we were making progress toward recovering from the poultry supply incident that occurred in late December, when in early April, we began to be impacted by publicity surrounding reported cases of avian flu.
The negative impact of this publicity peaked in mid to late April. In early May, the number of newly reported avian flu cases began to fall off, and by the end of May, every province in China had lifted their emergency alerts related to avian flu. As a result, we began to see traffic rebound at KFC as reflected by the sequential improvements we reported in monthly KFC same-store sales since April, an 11 point improvement in May compared to April and a 12 point improvement in June compared to May.
This pattern is generally consistent with what we’ve observed with past instances of avian flu in China, roughly equating to a 3-month wear off period. Based on this trend, as well as the sustained improvement in our underlying business, we continue to expect that China sales will recover throughout the year and be positive in the fourth quarter.
As we’ve said before, the shape of these recoveries is difficult to predict, as no two issues are exactly the same. As previously committed, we will continue to keep you informed of our progress by temporarily providing monthly updates on our China same-store sales. Our next update will be for the month of July, which we will report on August 12, 2013, after market hours.
Now as David mentioned, results of Little Sheep have been soft, due in part to a lower than expected approval process and ownership transition, and our new unit development progress has also been slower than we anticipated. Additionally, negative publicity resulting from quality issues with other hot pot concepts in China has further impacted sales at Little Sheep, even though there never was an issue with the quality of Little Sheep products.
If this weak performance continues, we could be required to report a noncash special charge for the impairments of trademark, goodwill, and other assets later this year. We will continue to keep you posted on this.
Moving to our other international businesses, we expect another solid year of sales growth at YRI, driven by record new unit development of at least 1,000 stores in 2013. Additionally, we continue to expect a record 150 new units in India, representing over 20% growth in total store count. And in the U.S., we’re expecting solid profit growth, driven by continued strength at Taco Bell.
So while our overall results for 2013 will be clouded by the temporary sales issues at KFC China, the balance of our portfolio is on track to deliver targeted growth. I will now share our preliminary thoughts on 2014.
Based on our assumption that China sales are positive in the fourth quarter, we expect to exit 2013 with upward momentum. In addition, as we enter 2014 we will have opened about 1,600 new units in China over a two-year period.
So with all of these units in the ground and operating, and assuming sales and margins recover as anticipated, we expect very strong growth in China operating profit in 2014. However, the magnitude of China’s rebound next year will depend heavily on the shape of China’s sales and margin recovery through the end of this year.
As I’ve mentioned several times before, the timing and trajectory of these recoveries is difficult to forecast. What we do know, however, is that China’s long term growth potential hasn’t changed, and we are uniquely well-positioned to capitalize on two powerful demographic trends that favor retail development in China: Number one, rising income levels, and number two, a rapidly growing consuming class.
We also believe that our business models for YRI in the U.S. and India have never been better, which gives us the confidence to expect these businesses will deliver profit growth in 2014, consistent with our ongoing earnings model.
Adding it all up, we are confident that Yum! is poised for a strong bounce back in EPS in 2014, and we look forward to providing a more detailed perspective on this at our December 4 meeting in New York.
So to wrap things up, I have to say that I consider it a distinct privilege to be the CFO of a company that, even with the challenges in China, and how they’ve weighed on our second quarter results, is committed to staying the course with its growth strategies. Importantly, we continue to make substantial investments behind these strategies because we believe in the durability of our growth model and the power and resilience of our brands.
And with that, we’ll be happy to take your questions.
[Operator instructions.] Your first question comes from John Ivankoe with JPMorgan.
John Ivankoe - JPMorgan
Obviously when we talk about China, we talk a lot about the Yum-specific issues that have affected the first half of ’13. But I was hoping we could maybe talk about the China macro. And to the best of your ability and your knowledge, can you separate what’s happened specifically to you guys in chicken and talk about how the China macro may have potentially affected your rate of development and the development opportunities this year, pricing, and perhaps even overall traffic to western QSR. If there’s any comments that you can make from a bigger picture perspective?
I think when we step back and we look at what’s going on in China, and as I mentioned in my remarks earlier, I think the biggest thing we see going on in China continues to go on, and that’s that the consuming class continues to grow. You know, it’s 300 million today, it’s expected to be 600 million people by 2020. And this is backed up from a number of different sources.
And as Pat just mentioned, we also see disposable income growing as well. The economy itself is growing 7%, which still makes it the fastest-growing economy in the world. So those are things that I think bode well for brands that are consumer-oriented.
When you look at just the infrastructure, what’s going on in China, it continues to expand at a rapid rate. I think China’s building over 90 airports, six of which will be at least as big as O’Hare airport. Train stations are expanding, subway lines. All these really represent fantastic opportunities for our brand.
And you know, I think what’s happening in China today is still unprecedented. It’s the largest urbanization effort in the history of the world. And I think that Yum! Brands, and our position competitively, is stronger than any restaurant company in this world.
And I think what we’re seeing, and Pizza Hut’s great evidence of this, is that if you have innovation and you have value, and an economy like China has today, you can have very strong same-store sales growth and you can open up new units very profitably and move into lower-tier cities and expand very aggressively.
And that’s what we’re seeing with Pizza Hut casual dining in spite of all the, I guess you could say, headwinds that might exist in the market. So at the end of the day, we continue to be very bullish on China. And when you look at the long term, we wouldn’t trade places with anyone.
And I think that this country is going to continue to grow very rapidly, and we’re seeing it today. There’s a bit of a slowdown, but their slowdown is, I think, a pretty rapid rate when you compare it to what’s going on everywhere else in the world.
So, again, you know, we find this to be true everywhere in the world. When you have powerful brands, you innovate, you provide everyday affordable value, you operate your business well with good service, you can win. So what we’re focused on doing in China is continuing to innovate, continuing to work on our value equation, continue to upgrade our assets, continue to open into the new trade areas, because we think it’s a winning proposition over the long term.
Your next question comes from Keith Siegner with Credit Suisse.
Keith Siegner - Credit Suisse
Just to follow up on John’s question a little bit, and maybe try to get a little bit more specific, when you think about, even if we’re decelerating to what’s still in absolute terms a great pace of growth for the economy, what could this do to that mid-teens wage inflation outlook you talked about? This quarter came in a little bit lighter. Is it still a mid-teens wage growth inflation outlook that you’re looking for? Or could we end up seeing something slightly slower?
Keith, you’re right. We did see the inflation on labor moderate a bit in the quarter. But that was more due to some productivity initiatives that helped to mitigate what would have otherwise been a rate of inflation consistent with the guidance we provided, which over the long term is driven by what the government’s policies are around driving an increase in disposable incomes, which continues to be in the mid-teens range.
Keith Siegner - Credit Suisse
So then one follow up question. As we think about pricing and how fiscal ‘12’s price increases kind of roll off mid third quarter, how do you think about your ability to raise pricing? In an environment, we just talked about that has fairly meaningful cost inflation, how do you think about - is it the macro factors that most influence this? Do you need to see traffic back to a certain level? Do you plan to take pricing? Anything around those plans for the back half and into next year would be very helpful.
At present we have no new pricing actions planned. Our number one goal is to regain the traffic that we’ve lost over the last few months, and we’re confident we can do that based on the trends we’ve seen to date. We know that it’s important to provide consumers with innovation and compelling value, and so it’s not our expectation that we would be taking more pricing later this year.
Now, obviously the situation is very different at Pizza Hut, where we remain in a position of significant strength with our brand. And we have taken some pricing this year, and consistent with our growth model for that business, we may take pricing later this year. But in the case of KFC, given where we’re at today with the brand and our goal to rebuild the brand for the long term, we’re not expecting to take additional pricing.
Your next question comes from Brian Bittner with Oppenheimer.
Brian Bittner - Oppenheimer
When I look at the store level margins for China, your labor cost deleverage was a lot less severe this quarter than Q1. So it looks like the cost control has obviously tightened. And I know you just talked about some labor productivity, but your same-store labor costs look like they were actually down over 8%.
So when we think about sales reramping, how important is it going to be for you guys to stress maybe some of the newfound cost controls you’ve found, or some of the productivity initiatives you’ve found, so that you can allow the operating leverage to really flex itself as those sales come back?
And you talked about operating leverage a little bit. Maybe other than the labor line, maybe you could point out some other sources of operating leverage as sales come back, and how we should think about the China margins.
The operating leverage actually has a greater impact on our occupancy and other costs. We have a much higher component of fixed cost. We do get the operating leverage benefit on the labor line, though, that’s true. But we do expect that the productivity initiatives that we’ve put in place will sustain and will contribute to an improving margin over time. The single biggest lever as it relates to our path back to higher margins is first regaining the transactions that we’ve lost, and beyond that to continue to build new sales layers. Because that’s ultimately what allows us to leverage the fixed costs in our business.
Brian Bittner - Oppenheimer
And just a quick follow up. If you can talk about possibly the food cost dynamics in China right now and how your food cost outlook is shaping up.
You may recall in New York what we had estimated for the China division for the full year was about 3% food cost inflation. Thankfully, due to favorable trends, primarily in chicken and cheese, we’re now expecting food inflation to be about flat on the year. What we’ve seen year to date is deflation. So we saw about 5% deflation in Q1, 3% deflation in Q2. We don’t expect that deflationary trend to continue balance of year. We expect to land on roughly flat for the full year.
Your next question comes from John Glass with JPMorgan.
John Glass - Morgan Stanley
From Morgan Stanley. Could I ask, just following up on the, I understand about the labor productivity savings. That makes sense. But occupancy only grew 5% in U.S. dollars. And unit growth was 3X that rate. So is there a substantial variable piece to occupancy, and that’s why that’s occurring? What else would cause that line to decelerate so much from a growth perspective?
Included in that line is rent and about half of our leases in China have a variable component. Also included in that line is advertising expense, which also tends to be variable.
John Glass - Morgan Stanley
And was that particularly variable this quarter? In other words, did you reduce advertising spend this quarter?
John, we did take the advertising rate up just a bit in the quarter.
John Glass - Morgan Stanley
So not down, up?
John Glass - Morgan Stanley
And then can you talk about G&A globally? There were some reductions that looked like, from a dollar perspective, some of it came from the U.S., year ago period comparison, but it feels like there was also maybe some reductions, both maybe at corporate and certainly in China. What were those? How sustainable are those? Are those just tied to compensation, or were they in other areas?
Definitely there were some overlap issues I think we called out, but in terms of anything one time, I don’t think there was really anything unusual in the quarter.
John Glass - Morgan Stanley
And how material is Little Sheep? I understand there’s maybe an impairment risk, but is there a risk that if these trends continue to be poor, that there’s going to be some risk to the China margin that’s material enough to call out, or there’s some risk to earnings in the back half because of it?
No, consistent with what we’ve disclosed in the past, the operating results of Little Sheep are not material to the China division results today.
Your next question comes from Michael Kelter with Goldman Sachs.
Michael Kelter - Goldman Sachs
On the labor line in China, expenses grew 9% in the quarter, which is less than unit growth, despite some inflation. So obviously you were able to reduce hours, which I think you guys were calling productivity initiatives. Can you maybe be more specific? Where were you able to cut back on labor at the store level in China? And then how do we think about 2014? Are these efficiencies you’ll be able to carry with you that you found in the business? Or are you going to have to flex labor hours back up when sales recover?
There were actually two things going on with China labor in the quarter. The first is that because the adverse sales impact of the avian flu, publicity was more pronounced in Shanghai than in other parts of the country. And in Shanghai, as you know, we have some of the higher labor rates. The mix of our labor across the division benefited from that, and that contributed a bit to the labor favorability we saw in the quarter.
And then the second piece is around the team’s ability to implement tighter controls around labor utilization and a more optimal mix of part time and full time employees.
Michael Kelter - Goldman Sachs
And then you guys talked about some catalysts for KFC China later this year, including new news on chicken. Can you give us just anything on what to expect there? I mean, are we talking step change type innovation? Anything you could share would be helpful.
I don’t think I’d characterize it as step change, but we think it’s very solid. That’s how we characterize it. And we really wouldn’t want to go into detail on that in the call.
Michael Kelter - Goldman Sachs
And then maybe one last clarification. June same-store sales improved to minus 10, can you tell us anything about the compares so we understand the context of that figure, meaning was June last year weak disproportionately for any reason? Or is the improvement to minus 10 in June a clean, sequential improvement and indicative of the trajectory of their recovery?
We’ve made the judgment not to break out the quarters. We reported the quarterly comps last year, and we’re going to continue to report the monthly numbers.
Your next question comes from Mitch Speiser with Buckingham Research.
Mitch Speiser - Buckingham Research
David, you mentioned the opportunity around transportation areas. I believe maybe some data was given at the analyst day in December. Could you just give us a sense of how many stores are near transportation hubs, and where you see that unit growth opportunity? It seems like that type of unit development might be a little less vulnerable to food safety related issues and perhaps macro-related shocks.
I’d have to go back and get the exact number on that, but we can get back to you on that.
Mitch Speiser - Buckingham Research
And while I’m on the line, if I could separate ask about YRI, in the emerging markets you had a very strong comps growth. Can you maybe give us a sense of where the strength was? Was it broad-based? Were there any areas of weakness? And within emerging markets, Africa has been talked about a lot, and maybe just long term, can you give us a sense of when you think Africa could start being a profit contributor?
We highlighted on the call Russia and South Africa were the big drivers. If you talk about the impact of South Africa, you have to think of it as two pieces. South Africa right now has the lion’s share of the business, so that’s what’s going to impact the current year’s results. And so South Africa has been performing very well. Over time, the cumulative impact of it, as we enter these new African countries, will come into play, but it’s probably not going to have a material impact on YRI’s results for the next two or three years.
Your next question comes from Jeff Omohundro with Davenport Securities.
Jeff Omohundro - Davenport Securities
My question is regarding Taco Bell and the DLT rollout of Cool Ranch. Just wondering about the pacing of product, compared with nacho cheese. And when looking at the Flamas that’s coming, what’s your sense about the potential of this product versus Cool Ranch? And then lastly, on this same topic, this seems to me relatively rapid pacing of new flavors in this new sales layer. Just wondering how sustainable this model might be going forward in the longer term.
Well, you know, I think consumers maybe wouldn’t call it fast-paced. As soon as we launch nacho cheese Doritos, people got the joke and they were almost asking for Cool Ranch Doritos Locos Tacos. So we actually had to wait a little longer than we would have liked to, just because the demand was so great on the nacho cheese. We couldn’t get the supply we needed to launch the Cool Ranch.
I think we think of them both as separate flavors, but also part of a portfolio. So when you saw us launch the Cool Ranch, clearly we were trying to introduce the news, and a lot of our social media was oriented towards that. So we asked consumers, in fact our fans, to come out. And they were able to try it before we even advertised the product.
But when we advertised it, we also used the slogan “Collect all two”. We wanted to reinforce we still had the nacho cheese piece. So we look at that as a portfolio and we’re looking at adding to that portfolio. We originally thought that would be early next year. We’re still evaluating the timing of that. We could right now forward possibly a little bit into this year.
So we’re excited about it, and I think that those will be the main three brands in terms of flavors. I think after that you’ll probably see some more flavors, but they may be either in and out type of ideas. We’re obviously very excited about the results we’ve got as well as the future potential to add other flavors.
I think the only thing to add on that is that no one else has this. It’s pretty nice when you have products that nobody will ever have but us. So it’s a platform that is totally unique to Taco Bell, and so every time we advertise it, whether we have product news or not, we’re advertising something that no one else has.
And, you know, as Rick said, we’ve started out with two biggies. The two biggest Doritos flavors are nacho cheese and Cool Ranch. We’ve hit on them. Flamas is obviously a much smaller segment. But it does give us an opportunity to come back and [pulse news].
I think the big thing about Doritos Locos Tacos is no one else has it.
Your next question comes from David Tarantino with Robert W. Baird.
David Tarantino - Robert W. Baird
I have a question on the longer term vision for the China margins and the type of recovery you’re expecting. I think you’ve talked about 20% margins longer term. I’m just wondering what type of average unit volume you might need to see over the next couple of years to get back to that level. Is it just a matter of recapturing the sales that you’ve lost over the last year or so? Or do you need to go beyond that to get back into the really high teens or close to 20%?
You’ll recall that prior to the onset of the poultry supplier incident in late December, we were at about 18%. So step one is to regain the traffic that we lost. And we therefore have a high degree of confidence that as that happens, we will return to that level. In terms of getting back to 20%, we still consider that an appropriate target for our business, because nothing structural has occurred to prevent that.
And so as we think about the drivers that are going to get us back to the 20% target, beyond regaining the transactions that we lost, and also benefitting from the recovery in average check, I would say there are three factors. The first is continuing to build sales layers. We’ve been very successful at this over the years, introducing new day parts and new occasions that put us in a position to leverage our fixed costs.
The second is to continue to evolve our new unit development strategy. As we’ve indicated before, we are shifting our new unit openings increasingly to lower-tier cities for KFC and more broadly to Pizza Hut casual dining, which is comfortably, today, above 20%. And so with those changes to our development program, we’ll see a benefit that will get us closer to that target of 20%.
And the final piece is given the strength of our competitive position over time to take pricing where it makes sense. You probably recall that our ongoing earnings growth model for China requires mid single digit same-store sales growth in order to offset inflation and maintain our margins.
Based on the inflation that we’ve experienced maybe over the last year and our decision not to take pricing, there will be a point in time where we may need to leverage the strength of our competitive position to take a bit more to get to the 20. I think it’s fair to say that that is an appropriate target, but it will be very challenging to get to 20% in 2014.
But you know, make no mistake, we will have a high-margin business in China. It’s difficult to say when we’re going to hit that 20%, but you have to remember that we manage our brands for the long term. We’re not chasing a 20% margin. We’re not focused on getting there next year, for example.
We love our competitive position, and even with the 18% margins we had going into the supplier issue, we had three-year cash paybacks because we have such an exceptional asset turnover ratio. It’s a powerful investment model for our shareholders, and we see extraordinary returns continuing at Pizza Hut. So we think the 20% is an appropriate target, and we have a path to get there over time.
David Tarantino - Robert W. Baird
And just one quick follow up on the step one of getting back towards that 18% figure. And given you’ve absorbed some inflation this year, and you’re likely to see some inflation next year, what type of rebound in the comps might you need to see next year to get back to that 18%? Or is that an unrealistic target for next year?
Well, given where we’re at in our recovery, and we are seeing those improving trends, it’s premature to have such a detailed conversation around 2014. We continue to believe that we will see the strong bounce back. We’ll provide a more detailed perspective, as we typically do, at our analyst conference in December. And at that time we can provide you more insight into the extent to which same-store sales and pricing and inflation will play into our margin recovery over the course of 2014.
The last thing I will say is that based on our past experience with these things, the recovery curve, or the recovery trend, is rarely linear. So, you know, it’s just important to keep that in mind. We’re giving you our best estimate. We reaffirmed that we expect the fourth quarter to be positive for China. And that will provide us the momentum that we need going into 2014 to see the strong bounce back next year.
Your next question comes from Andy Barish with Jefferies.
Andy Barish - Jefferies
Just a couple of quick ones. On the promotional side of things, was wings something that you kind of brought on? Or was it in the plan to kind of go back to value? And then just secondly, on the overall China development, can you frame it with just kind of a broader perspective on the percentage of openings in kind of tiers three through six going forward versus sort of what it has been historically, I guess?
Well, on the development front, we are continuing to shift. It’s not something that changes dramatically overnight. But I can assure you that there are two key shifts occurring in our new unit development program. For KFC, moving increasingly to tier three and below cities and increasing significantly the number of Pizza Hut casual dining openings.
And as far as wings go, wings are very popular in China. And we promote them generally in the summer period. And so I don’t think it’s extraordinary, out of the realm of what we typically do.
Your next question comes from Joe Buckley with Bank of America.
Joseph Buckley - Bank of America Merrill Lynch
Just a couple of questions focused on this year if I could. The tax rate is coming in a little lower than what you guided to. Do you think that will be the case for the full year? Or are you thinking something less than 27% for the full year now?
It’s not uncommon for us to see some unevenness or volatility, if you will, from one quarter to the next. I think it’s early at this stage to provide guidance that was different from what we provided in December, which was about 27% for the full year.
Joseph Buckley - Bank of America Merrill Lynch
And then the wage rate inflation, what did it run this quarter? And you mentioned a mid-teen rate, but hasn’t it been well below that so far this year? And would you expect it to remain below that?
So we’re talking specifically about China labor inflation. Q1 was in the mid teens range. Q2 was high single digits. In terms of where we’re going to land on a full year basis, it could be in the high single digits to low double digit range. As I said before, when we look longer term, we continue to expense something in the mid teens range.
And your final question comes from Jeffrey Bernstein with Barclays Capital.
Jeffrey Bernstein - Barclays
Just two questions. One just a follow up on the China side. It seems like the recovery is going along the expected trajectory, but I’m curious about the approach going forward. Pat, you mentioned the outlook for ’14 is somewhat heavily dependent on the sales and margin recovery in ’13. I’m just wondering if you could talk a little bit about value and the promotions you might be thinking about. Better still, if you want to talk specifically on that, is margin a focus at all? Or is it all about achieving the desired full sales recovery at all costs? And then I had a Taco Bell follow up.
Well, it is premature to talk in any detail around 2014. We wanted to give you a sense for what we expect next year, which is the strong bounce back. Certainly value is an important element of any brand strategy, along with breakthrough innovation, and our plan is to continue to offer both.
We never go after a recovery at any cost. We run a business. We’ve got a business to run, and we want to have a long term, sustainable business model and brand proposition. So we’re basically running the business the way we think it ought to be run, so that we’re relevant to customers on a continual basis. And we’re not doing anything that’s overly dramatic.
Jeffrey Bernstein - Barclays
And just a follow up on the Taco Bell. I know in your prepared remarks you mentioned the breakfast rollout. I guess it’s on track for ’14. Any color you can give in terms of the sales lift you were getting in test, or the potential impact of the comp, or any impact that might have had on the core lunch and dinner business? Any color around breakfast relative to lunch and dinner and what contribution that could make?
Not really at this stage. We may know a little bit more. We’re sort of dialing up some of our product ideas and advertising for later this year, and at that point we may have a better read for what exactly could happen.
Jeffrey Bernstein - Barclays
But in test is there any color around the sales mix or the profit contribution or anything like that?
The sales mix has been around the 4% range, but this is before we’ve now dialed it up. So like I said we have plans to dial it up in the fall, and once we dial it up, both advertising and adjusting our product line, we may have a better read.
Okay, since there aren’t any more questions, let me wrap this up by just saying that this was a slug it out quarter for Yum! Brands on our way to recovery in China. While our second quarter EPS declined 16%, it was generally in line with our expectations.
The good news is that KFC China sales are recovering as expected. At Yum! Restaurants International in our India division we expect record unit development this year, and our new unit pipeline has never been stronger. Our estimated mid single digit full year EPS decline versus prior year remains unchanged.
And importantly, we expect a strong bounce back year in 2014 as we continue to aggressively invest behind our core strategies and capitalize on the enormous growth opportunities we see around the world. We continually say we’re on the ground floor of global growth, and that continues to be the case.
Thank you very much. Appreciate it.
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