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Yum! Brands, Inc. (NYSE:YUM)

Q2 2014 Earnings Conference Call

July 17 2014 9:15 AM ET

Executives

Steve Schmitt - VP, IR and Corporate Strategy

David Novak - Chairman and CEO

Pat Grismer - CFO

Analysts

Keith Siegner - UBS Capital Markets

David Tarantino - Robert W. Baird

Jason West - Deutsche Bank

David Palmer - RBC Capital Markets

Brian Bittner - Oppenheimer & Company

Sara Senatore - Sanford Bernstein

John Ivankoe - JPMorgan

John Glass - Morgan Stanley

Joseph Buckley - BofA Merrill Lynch

Jeffrey Bernstein - Barclays Capital

Jeff Farmer - Wells Fargo Securities, LLC

R.J. Hottovy - Morningstar

Operator

Good morning. My name is Shawn and I will be your conference operator today. At this time, I would like to welcome everyone to the Yum! Brands' Second Quarter 2014 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions)

Thank you. Mr. Schmitt, VP of Investor Relations & Corporate Strategy, you may begin your conference.

Steve Schmitt

Thank you, Shawn. Good morning everyone and thank you for joining us. On our call today are David Novak, Chairman and CEO; and Pat Grismer, our CFO. Following remarks from David and Pat, we will take your questions.

Before we get started, I would like to remind you that this conference call includes forward-looking statements. Forward-looking statements are subject to future events and uncertainties that could cause our actual results to differ materially from these statements. All forward-looking statements should be considered in conjunction with the cautionary statements in our earnings release and the risk factors included in our filings with the SEC.

In addition, please refer to the Investors section of the Yum! Brands’ website at www.yum.com to find disclosures and reconciliations of non-GAAP financial measures that may be used on today's call.

We are broadcasting this conference call via our website. This call is also being recorded and will be available for playback. Please be advised that if you ask a question, it will be included in both our live conference and in any future use of the recording.

Finally, we would like to make you aware of the following upcoming Yum! Investor event. Our China Investor Analysts conference will be on September 16 and 17 in Shanghai, China. Our third quarter earnings release will be on Tuesday, October 7. And our 2014 New York Investor and Analysts conference would be on Thursday, December 11, in Midtown Manhattan.

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

David Novak

Thank you, Steve. And good morning, everyone. I am pleased to report Yum! Brands is well on its way to delivering in full-year EPS growth of at least 20% with second-quarter EPS growth of 30% excluding special items. Just as important, I'm confident we are building momentum behind major initiatives around the world that will sustain double-digit EPS growth in 2015 and beyond. Looking at the quarter, we are obviously pleased with the continued progress we are making at KFC and China as evidenced by strong sales in margin growth as well as improving new unit returns. Our KFC Division which is our second largest profit contributor behind China also continues to deliver solid sales and profit. When taken together, our China and KFC Divisions comprise nearly two third of our total operating profit. So it's great to see both performing well. Another highlight is our Taco Bell breakfast platform is off to a great start and we expect to build up this momentum going forward.

Now let me give you more color on each of our divisions. Let's begin with China. Our China Division delivered system sales growth of 21% in the quarter as we opened 104 new units and grew same store sales 15%. It's great to see such a strong top line growth. And fortunately this top line growth flowed through nicely to the bottom line as operating profit grew an impressive 188%. The China team deserves a lot of credit for doing an excellent job driving restaurant margins of almost 17% during the quarter and over 19% in the first half.

At KFC China, our goal is to improve our already strong economic model and make KFC which is the number one, most popular brand in China, even more youthful, contemporary and energetic. We've maintained our value anchors and still have 6 RMB breakfast offerings and 15 RMB lunch offerings but have shifted our focus from price value led growth to higher quality and more profitable transaction growth. Our primary focus going forward will be on more premium innovation, delivered with the superior customer experience.

We are confident we are on the right path to evolve KFC into an even better, higher quality and more profitable business model as we keep the brand contemporary. With the recent launch of the KFC menu revamp in our more than 4600 restaurants in over 950 cities across China, we introduced 15 new products at one time and leverage four popular celebrities to promote four signature product platforms. Our campaign clearly resonates with consumers as KFC delivered same store sales growth of 21% in the quarter. It's important to note that while our guest check has increased, our value scores have also improved. In addition to intensive product innovation, we are enhancing the customer experience with a launch of redesigned packaging, contemporary staff uniforms, new menu board, branded service and a new restaurant design which we will be rolling out over time. On the digital front, we began rolling out free Wi-Fi. We also have a new mobile app coming which will provide consumers the convenience of pre-ordering with electronic payment. And we have more exciting news coming balance of the year.

So let me sum things up for KFC China. We are confident we are presenting an even better KFC our customers will continue to appreciate, and a business model that is rapidly improving new unit return, setting us up for continued, aggressive development in the future.

Turning to Pizza Casual Dining which is arguably one of the greatest success stories in our industry the past few years. We are clearly the number one western Casual Dining chain in China with hardly any mid scale competition. And if you follow us, you know pizza Casual Dining goes well beyond pizza. As almost two thirds of our sales are non pizza items bringing our pizza and more positioning to life. During the quarter, we delivered system sales growth of 16% and opened 36 new units further strengthening our category leading position. Same store sales were flat in the quarter but keep in mind we are overlapping 7% positive same store sales in 2013, which was our strongest quarter last year. Looking ahead, we have exciting product news coming and the business is on track to deliver another solid year in 2014. Most importantly, the business model and new unit returns are firing on cylinders with two year cash paybacks. In fact, we are aggressively expanding into lower tier cities. We are now in 305 cities and expect to have over 1200 units by the end of the year. That's more than double our unit count only three years ago. And we are just getting started.

Now the other exciting thing about pizza is our separate and distinct Pizza Home Service business where we deliver an all meal home replacement to Chinese customers. In fact, over 40% of the menu consists of Chinese food. We have borrowed from the innovation and know how we develop with East Dawning, our Chinese fast food concept. So not only are we delivering pizza but we are delivering a full array of Chinese menu options in a small box format that will drive aggressive expansion. We believe we have innovated our way to not only offer a pizza but Chinese food in a scalable, highly profitable fast food format. We now have over 200 units in 26 cities and we are really beginning to rapidly scale this brand across the country. So with the strong foundation in place and with enormous demand for home meal replacement in China that will only grow over time, we expect our Pizza Hut Home Service business will contribute more meaningfully in the years ahead.

Last but not least, we continue to work hard to turnaround Little Sheep which is clearly been a major disappointment and continues to be so since we acquired it in 2012. We like to take a step back and look at the big picture of China. We'll always be focused on improving our unit economics by growing average unit volumes. But what excites us the most is the largest component of our ongoing growth model in China is new unit development. And we are as confident as ever we are still on the ground floor with constant, aggressive expansion ahead. That's because in China, we now generate three year cash paybacks at KFC as we've improved the business model, and two year cash paybacks of Pizza Casual Dining. New unit returns are outstanding for these two power brands and importantly our overall returns are getting stronger as we continue to shift more of our development to pizza at Casual Dining and KFC in tier 3 through 6 cities where our unit economic returns are strongest and the consuming population is getting larger and larger.

In terms of new unit potential the macro trend we remain most enthusiastic about is the large and growing consuming class which is expects to double from 300 million people in 2012 to 600 million people by 2020. And disposable incomes are growing right alongside it. In 2014, we fully expect to open at least 700 new units, and the long-term outlook is bright for KFC, Pizza Casual Dining and now Pizza at Home Service.

Moving to India. As discussed, we have made the strategic decision to invest ahead of the growth curve to develop a business that we are confident will drive substantial growth for Yum! in the years ahead. We currently have over 700 units and we are full steam ahead with this development as we expect to open another 150 new units this year. We are well on our way to a target of 2000 units by 2020. We are hopeful the new political leadership in India will create a stronger economy and more pro business environment as we invest in this country with they have well over a billion people.

Now let me shift -- now let me show you some perspective on our three brand divisions starting with KFC. Our KFC division which generates over 90% of its profit outside the United States, deliver a solid second quarter led by strong international performance. Importantly, our international new unit pipeline remained extremely robust. We expect to open at least 650 new units outside the United States this year and grow operating profit consistent with our full year guidance of more than 10%. I recently attended KFC's global marketing planning meetings in Dallas where we had nearly 30 countries represented in one room. Now during these meetings all our CMOs from around the world share their marketing calendars and plans for the coming year. There is no question we are building more know how and getting better at advertising, innovation, value and digital. Our expectation is this will result in higher same store sales growth in the years ahead. And even though we have nearly 14,000 restaurants in over 110 countries around the world with only two KFC restaurants per million people outside the United States, we still have a long runway for future growth. Our business model is powerful and our development pipeline is strong.

Now let me give you an update on pizza. We are obviously disappointed with second quarter result. In particularly with the very poor performance in U.S. business which contributes about half of pizza's divisions total profit. We now expect full year operating profit at pizza to fall well short of our initial expectations. We've had our ebbs and flows versus the competition over the years, and I can assure we will be back. In fact, we intent to launch a number of major initiatives in the United States to reignite sales beginning in the fourth quarter. Our plan is to launch a major new advertising positioning along with the innovation designed to better connect with millennials and separate us from competition. To this end, I encourage you to try our new Hershey dessert cookie. You should also know we will sharpen our focus on value and tend to leverage our more competitive offers to drive digital activations. Our goal is not only to catch the competition on the digital front but to surpass it in 2015. We know we have great brand to work with the Pizza Hut. Even with our recent challenges in the United States, pizza has the highest average unit volumes at our category in over 2800 more restaurants than our nearest U.S. competitor. Over the past two years, we've also been outgrowing the competition in terms of new unit development. In fact, we expect our fourth consecutive year of positive net new unit growth. Importantly the majority of new units will be opened by franchisee which speaks to the strength of Pizza Hut business model. All of this gives us confidences going forward and we expect to show significant progress balance of the year in 2015.

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

So to sum it up, we are bullish on our long-term growth prospects at pizza. We are confident we have the right teams in place, plans and structure. We expect much better performance going forward and to make significant progress by the yearend.

Finally, at Taco Bell, obviously the big news for the brand is that on March 27, it will be day they'll go down in history as we launch our national breakfast platform. Here the facts. Our breakfast day part mix around 7% of sales in the second quarter. We fully expect breakfast to be incremental. And anywhere from $70,000 to $120,000 per unit in annualized sales. Remember, McDonald's get about a million dollar in sales before we have even open our doors in the past. This is a huge opportunity for Taco Bell. And we are already making money in breakfast even though we've added incremental labor and food cost are slightly higher. We generated tremendous buzz around our products and marketing and we actually celebrated a record breaking sales week in the quarter. And for the long term there is now question we've enhanced our brand position as the choice of the new generation. And in fact, Taco Bell is recently recognized by MPV Crest for being one of only three restaurant brands to over index with millennials along with Starbucks and Chipotle.

So overall, we are extremely pleased with the breakfast launch and the direction we are heading for Taco Bell. Now the big question you probably asking is this given the success of the breakfast launch, why did same store sales increased only 2% in the quarter? Keep in mind that during the first two months of the quarter, our immediate emphasis was almost totally on breakfast. Once we returned to advertising our core business, it was with Cool Ranch Spicy Doritos Locos Tacos chicken. And frankly, this product underperformed versus our expectation. We believe that ended up being too much of a niche product to overlap the 15% growth we've had over the past few years with the introduction of Doritos Locos Tacos and then Cool Ranch, two of the most popular product introductions in the history of our entire category not just Taco Bell. Nevertheless, Taco Bell same store sales were positive 2% in the quarter. And we said all along the Taco Bell would be a first half second half story. In fact, trends have improved with the recent launch of Quesarito which proves that when you have great innovation, balance a day, coupled with a strong breakfast line, it is a powerful combination.

Looking ahead, we will be introducing mobile ordering and we have significant value innovation plan in our core business to drive growth balance of the year and beyond. Our franchisees are in breakfast to win and they have been also cheering us on to broaden our breakfast offerings with new products that we already in the pipeline. All-in-all, we are pleased to have lots of innovation coming across all day past to drive growth in a very challenging environment. Today's launch of our Power Cantina menu, a line of high protein products that I love is just another example. Importantly, our ongoing product innovation is backed by solid operations and attractive unit economics which allow us to open over 100 net new units this year representing a 10 year high. We are confident; we will ultimately achieve our goal of at least 8000 Taco Bell restaurants in the United States by leveraging our asset throughout the day. We have great progress now at breakfast. We have happy hour, we have the fourth meal, and we see this as a power brand that can be leveraged throughout the day.

Now taking a step back when you look at Yum! in total, we believe we are well positioned to deliver on the three things that drive shareholder value and retail. Driving new unit development, building same store sales and doing this in a way that generates high return. In terms of development, our new unit opportunity in emerging markets remains the best in retail. We have a two to one lead over our nearest competitor in emerging market and our opportunity to expand remains enormous. We have only two restaurants per million people in emerging market compared to 58 per million people in the United States today. Clearly, this is a long runway for growth and gives us tremendous confidence in our ability to continue our aggressive expansion for many years to come. Furthermore, we have over 40,000 restaurants around the world with all kinds of ideas in hopper and clearly significant capacity to grow same store sales in average unit volumes. The fact we have under leveraged asset is a great weapon as we go into the future. Meanwhile our returns on invested capital have consistently been among the highest in industry. Over 90% of our restaurants outside of China are owned and operated by franchisees. We simply love the franchise model which will generate about $2 billion of franchise fees in 2014. These franchisees provide us with a large, reliable and growing stream of cash which combined with a profit from our equity stores and enable us to invest in high return growth opportunities and return significant cash to our shareholders.

So let me wrap things up for Yum! Brands. On the whole, we are pleased with our overall second quarter and year-to-date results. We expect a strong bounce back year in China and solid full year performance in KFC. At Taco Bell, we are pleased with breakfast and confident in our balance of year plans and expect a much stronger second half. And at Pizza Hut, we expect full year operating profit to fall well below our initial expectations. We obviously have major work to do to get our pizza U.S. business on more competitive footing and we are confident that we will do so and transfer the learnings that we have around the globe. When you added all up, we expect full year EPS growth of at least 20%. Equally, important, I am confident we are building momentum behind major initiatives around the world that will sustain double digit EPS growth in 2015 and beyond.

Now let me turn it over to Pat Grismer, our Chief Financial Officer.

Pat Grismer

Thank you, David. And good morning, everyone. My remarks today, I will cover three areas. Our second quarter result, our outlook for the second half of 2014 and what we are doing to drive long-term value for our shareholders. With the second quarter, our results were similar to Q1 with the very strong bounce back in China, solid growth at our KFC Division, mixed results at Taco Bell and poor performance at our Pizza Hut Division. Overall, worldwide operating profit increased 34% in constant currency and EPS grew 30% excluding special item. We've now produced two quarters of strong EPS growth and are well on our way to delivering on a commitment of at least 20% EPS growth this year. China Division profit rebound in sharply from the second quarter of 2013 which was the low point of last year and grew 188% in the quarter. Importantly, KFC same store sales improved sequentially on one and two year basis growing 21% in the quarter on the strength of a comprehensive restage of the KFC brand. And while Pizza Hut Casual Dining same store sales were flat in Q2, we are pleased that we grew system sales 16% with continued rapid development of this highly profitable concept. We are also very pleased with our continued margin improvement in China. With first half restaurant margin above 19% and with our current outlook for the second half, we are confident that China's full year restaurant margin will be at least 18% or nearly three points above 2013 and back to where we were in 2012. I am also very happy to report that China's new unit returns have strengthened considerably. As you recall from our December Investor Conference, cash paybacks at KFC in 2013 averaged a very respectable four years despite short term sales pressures. As David mentioned, with a recovery we've seen in our business this year, cash paybacks are new KFC restaurants in China are now three years. Pizza Hut Casual Dining cash paybacks in China remained very impressive two years. This is great news for our shareholders as we expect to open at least 700 new restaurants in China this year and paves the way for high return, new unit development in 2015 and beyond. As for our other divisions, KFC produced the very solid quarter with 12% profit growth in constant currency, a significant improvement over Q1. Taco Bell also improved versus Q1 but results were mixed in a challenging U.S. environment with profits declining 2% in the quarter. Taco Bell restaurant margin decreased 2.7 percentage point as we invested in our national breakfast launch and were impacted by commodity inflation of 5%. Now David mentioned, we are pleased with a national launch of breakfast and we know the business will benefit from this additional sales layer for years to come. We continue to expect much stronger results in the second half from Taco Bell. Our Pizza Hut U.S. division on the other hand is in turnaround mode. We expect results to improve balance of year but Pizza Hut Division to fall well short of our initial expectations. As CFO I can assure that we are not holding back from making strategic investments to right the ship. We are strengthening our global digital capability and investing in field level G&A to open new Pizza Hut market and accelerate our pace of new unit development. I expect our investments in international development to begin paying dividend this year with record new unit openings and to see results from our digital investments and other brand building initiatives in 2015.

Now I would like to discuss our outlook for the second half of the year. In China, we expect to achieve at least 40% operating profit growth for the full year excluding the impact of foreign exchange driven by improvements in both sales and restaurant margins. We expect restaurant margins to remain strong as we remained diligent and making our labor model more efficient at our KFC business. Margins will also continue to benefit from our move towards higher quality, more profitable transaction as well as our development shift to lower tier cities for KFC and a higher mix of Pizza Hut restaurants. Partially offsetting this, we are expecting commodity inflation of about 3% and modestly higher labor inflation that we saw in the first half of the year. So when you added all up, we are expecting full year margins of at least 18% as I said earlier or back to where we were in 2012 even with the diluted impact of Little Sheep. Sales in China continued to be difficult to predict. Our best estimate is that with the more difficult overlapped we faced in the back half of the year, and with the current trends we are seeing in our business, full year same store sales growth will likely be towards the low end of our guidance range or in a high single digit. And as always if we can do better we will. Now David mentioned, Little Sheep results continued to be disappointing and diluted overall China restaurant margin by 0.6 percentage point in the quarter. We are continuing to focus on improving this business. However, if Little Sheep's performance does not improve, we may be required to further impair the business in the back half of the year. Outside of China, we expect KFC to continue to produce solid results. As I mentioned before, we expect Taco Bell profit performance to improve significantly in the second half as pricing should offset commodity inflation, breakfast builds momentum and higher margin products like the new Quesarito drive more dollars to the bottom line. We also expect Pizza Hut results to improve from the first half as we advanced our value proposition globally and bring more product innovation and more compelling value news and digital activation to the U.S. business.

Overall, we expect solid growth in the second half and are confident in delivering at least 20% full year EPS growth. And if we can do better, I assure you we will.

Now, I would like to share how we are driving long-term value for our shareholders. Yum! is reliable, cash generating machine. And this year we expect to generate over $3 billion in operating EBITDA, an all time high. This includes over $2 billion in franchise fees from our growing global and diversified royalty stream. We reinvest a substantial portion of our operating cash flow or about 40% to drive the growth our businesses. We also continue to optimize our equity portfolio by increasing the weight of high return businesses including emerging market overseas and Taco Bell in the U.S. where restaurants margins are in high teen. This has positioned us well for future earnings growth and importantly has set us up to achieve higher returns on invested capital which we expect will top 20% in 2014. Second, we pay a dividend which we have grown at double digit rate every year since we first paid a dividend over nine years ago making us one of only 11 companies in the S&P 500 to do so. Our dividend yield is currently just under 2% which is very competitive for a company with our growth profile. And third, after investing behind growth and paying a meaningful dividend, we return all available cash to our shareholders in the form of share repurchases. Each of these levers are large and growing franchise business combined with high equity, high return equity investment, a growing dividend and value creating share repurchase worked together to drive strong returns for our shareholders.

So let me wrap things up. We are pleased with our strong second quarter results which were led by outstanding performance in our China Division and solid growth at our KFC Division. Our strong start to the year coupled with our ongoing growth investments has clearly set us up to deliver on a strong bounce back year that we expected in 2014. I am confident in the strength of our business model and we will continue to make the investment necessary to sustain double digit EPS growth over the long term.

And with that, we will be very happy to take your questions.

Question-and-Answer Session

(Operator Instructions)

Your first question comes from the line of Keith Siegner, your line is open.

Keith Siegner - UBS Capital Markets

Thank you very much. I was wondering if you could give a little more details on the China same store sales breakdown in terms of price, mix and traffic? Assuming mix maybe was a big contributor here, where is the mix coming from? Is this the change in occasions? Is it less promotion etcetera? And then maybe how do you see those three pieces moving in the second half to jive with the guidance that you just gave for same store sales? Thanks.

Pat Grismer

Keith, very happy to do that. So we will focus on KFC where we are at 21% same store sale growth in the quarter. About half of that was driven by mix. And of that mix component the majority is attributable to the fact that we overlap a significant decline in high check family business. Now from last year, you may recall that from last year's result. Average spends however also benefited from the launch of our premium positioned menu revamp. So those two things together drove about half of that same store sales increase. Now we also had about four points to pricing which we felt good about considering that we took absolutely no pricing last year and that was more or less in line with inflation on a two year basis, and as far as we know in line with competition and then we had transaction growth that delivered another six points. I think the important thing here what I most pleased with is that despite the fact we had significant lift in average spend and we had a contribution from pricing, our value scores improved. Our value scores improved with the launch of our new menu. And they improve even with the pricing that we took. So we feel very good about the composition of our sales growth in the second quarter.

Operator

Your next question comes from the line of David Tarantino. Your line is open.

David Tarantino - Robert W. Baird

Hi, good morning. Pat, I just wanted to follow up on your outlook for the same store sales in China for the year. You mentioned that your expect comps to come in towards the lower end of your prior guidance. And I was just wondering if you could add some context to that statement. Is that because of -- simply because of a comparison that you are facing in the back half of the year or are you seeing any changes in the sequential volumes that might concern you and maybe point you more conservatively relative to your prior guidance.

Pat Grismer

Well, David, I think the first thing to point out is that we are confident that we are going to deliver at least 20% full year operating profit growth in China on the strength of our recovery and restaurant margin which I mentioned as the high end of our guidance range. Now as we said all along sales are difficult to predict with precision. And we know that China is a volatile market. But our best estimate today based on the currents that we see in our business is that sales, same store sales will likely be towards the lower end of our range. And it's with that combination of higher end margin and lower end sales if you will, so we get to that 40% operating profit growth that we need to deliver on our commitment of at least 20% EPS growth for the year. Now in terms of what driving the softer results in the back half of the year, you got to remember that we have adopted the strategy of pivoting towards higher quality, more profitable transaction and we feel very good about that because that yield a much healthier business model which bodes well for future development. The second piece is that is that the easiest overlap is behind us. Remember, in first half of last year sales were down 20%, same store sales were down 20% in China and in the back half same store sales were down only 7%. So yes we are lapping still in negative number but the overlap is harder in relative term. So it's combination of those things that we contribute to softer results in the second half versus the first half but again still ladder up to the 40% operating profit growth and the 20% EPS growth at least that we've committed to deliver.

David Novak

As I've always said in the past, we are going to always have bumps in the road with same store sales. In June, we had a Brazilian Samba themed promotion around football that frankly didn't resonate like we had hoped. We are now moving to signature value program where we borrow from the success we had at Pizza Hut where we are offering one of our revamp products per day at a half of the price, making it-- it is only product. And this has been part of our ongoing plans. So we are just beginning to launch that program. And it's early days; we will see how it does. But one thing that we know as Pat said more moving forward is that we are driving popular transaction trends and improving our business model. And importantly when we look at where we are at today, all of our major attributes for the brand are improving. We are the preferred brand, taste is better, value for the money is better and our safety score are back to where they were 2012. So the brand is certainly bouncing back and when we look at the whole China business in total, giving at least 40% profit growth this year and having at least high single digit sales growth for the full year. We feel very good about that. And it's a great base for us to move into 2015 and beyond.

Operator

Your next question comes from the line of Jason West. Your line is open.

Jason West - Deutsche Bank

Yes, thanks. I guess just going back to the comments around the China unit economics and that the store growth outlook. I mean I guess given what you guys are seeing today in the improving economics is it fair to say you're going to sustain this sort of 700 gross opening rate going forward? Or would you like to see that number go higher over time or do you feel like-- you would like to moderate that number? Just if you could talk a little bit about that will be helpful.

Pat Grismer

Well, Jason, I can assure you we wouldn't moderate that number. We expect to deliver at least 700 new units this year that lapping the 740 from last year. We remain as bullish as ever about a long-term growth prospect in China and we feel very good about how our unit level economics have strengthened. David had said before that we did some of our very best work last year in the midst of crisis to make our business even better. And new unit, I know economics are as strong as they ever been. Even last year with the pressure that we felt on sales, we had four year cash payback of KFC, this year we are back to three years, that include tier three cities and below two and half year cash payback from KFC. Pizza Casual Dining cash payback have sustained at two years. So we feel very good about the position of our brand. We feel great about the overall returns we are seeing on this investment. And we have every reason to believe that we are going to try high levels of investment going forward, maintaining the high level of discipline and rigor around our capital investment products.

David Novak

I think the other thing that we think going forward we have another weapon in our arsenal with Pizza Home Service. And this is a small pack box format where we are delivering not only pizza but also Chinese food. We think we've actually kind of back our way into Chinese fast food format with great economics coupled with the pizza that allows to get some dramatic expansions we go into future. And again this is small box so the investments costs are not that significant. The main point I would like to make on this is that we have never ever chased a number. We obviously think it will be better than 700, we want to grow that number as we go forward. We are going to stay very, very disciplined as we have in the past. What I have told Sam and the team, and this will continue to be our policy as we've got these incredible brands. They are like diamonds. We need to polish those diamonds and only grow as faster as our people capability can allow us to do it and then we can get the right location in the right places that we need to be and as we go forward. And the beautiful thing about our business in China is that the business models are great. And the business is strong. We are not any hurry. We don't have to hurry. We just need to grow this business the right way. So we will be very focused, very disciplined, look at our returns and only grow as fast as the locations are there, we have a people capability. And remember, I think this year we hired a close to 10,000 management trainees that will come into our system and three years from now will be ready to be restaurant general managers. And we are doing that in anticipation of the significant growth that we expect to have across KFC, Pizza Casual Dining and now Pizza at Home Service.

Operator

Your next question comes from the line of David Palmer. Your line is open.

David Palmer - RBC Capital Markets

Thank you. Question on Taco Bell. You mentioned Quesaritos is helping the non breakfast business. Have you been able to keep the breakfast sales stable even when you are pointing your advertising energy to non-breakfast items like Quesaritos. And in the second half we talk about specifically, should we be expecting--

David Novak

Can you speak up David, we can't hear you. David? We can't hear you.

David Palmer - RBC Capital Markets

Can you hear me okay now?

David Novak

I can hear you better now. We got the first half of the question I think but you might want to repeat it so everybody can hear it.

David Palmer - RBC Capital Markets

Let me just repeat that. We talk about; you mentioned Quesaritos is helping the non-breakfast business. Have you been able to keep breakfast sales stable even when you are pointing the advertising energy to the non-breakfast items like Quesaritos? And then in the second half just specifically with the P&L for Taco Bell, are we going to see significant digital launch cost as you roll that out for that brand? Thanks.

Pat Grismer

David, I will go and address the digital launch cost. We do expect to be launching that later in the year sometimes in the fourth quarter. The additional investment against that is working and our forecast for the full year and we continue to expect that Taco Bell division profit will be about in line with their ongoing growth target about 6%. So those costs are loaded into our G&A forecast for the year.

David Novak

And the breakfast numbers remain relatively stable. We feel very good about the base that we have with breakfast at Taco Bell. We have more news coming and we think we have the combination of the breakfast news plus the other day part news, give us the one two combination that we have to have to really go forward. I actually -- I think breakfast is just critical to us on a number of front. First of all, we got this assets with basically has been empty until 11 o'clock and so we regaining the leverage that asset, we are also leveraging on a profitable basis. Remember, I took that thing for McDonald eight years to make money in breakfast. We are already at above breakeven. So we feel good about get $70,000 to $120,000 in sales per unit on annual basis. So this is a great vehicle for us. And I think this category is very tough. You got to have constant innovation and to be able to innovate across all the important day parts to drive the same store sales versus just the traditional lunch and dinner day part. I think it gives an opportunity to even bring more consumer news, more excitement to the Taco Bell brand as we go forward. And regardless of what we market and how we market it, if you look at what we are doing it all drives the Taco Bell brand forward. The Ronald McDonald advertising took our overall brand imagery I think up to -- some of the highest levels we've ever seen. So we were building the brand in all that we do and now we can build the brand across all the day part. So I am very enthusiastic about breakfast. I just about month ago I was out in California meeting with Taco Bell franchisees. And they are into win, they are seeing now that this is really working for them. And they all understand that what this can do for their business over the long term. So when we got into this it was like how we get in with minimum investment, minimum products, and minimum complexities. Now the franchisees are saying, hey, bring us more new products. Let's really go after this. So that's a good thing. And we have obviously there is pockets of strengths where we are doing better than other places but overall we really are doing extremely well. We have a national proposition and we are going to stay after it. This is something that we are absolutely committed to make successful as we go into future. And we think we believe very much in the one-two punch. We think we got to have breakfast and we think we got to have the day part news -- product news to drive the other day part as well. So we have the Quesaritos, we have the protein group, protein line of products that we just introduced. We've got a number of values, initiatives coming forward with product innovation to go along with it. I think we had analysts meeting where many people tried lot of the products that we had up there, we had a very inventive group at Taco Bell and we think we are going to have a lot of news. So unlike some brands that are wondering what to do next, we've got day parts to leverage and we've got all kinds of product innovation that we can keep brining into hopper. So Taco Bell, we think is in very good shape and feels very good about the second half.

Operator

Your next question comes from the line of Brian Bittner. Your line is open.

Brian Bittner - Oppenheimer & Company

Thanks. Obviously the Pizza Hut business outside of China I guess continues to be drag on the profits. And obviously you are going to try to turn around that pizza business outside of China but I am just wondering if there is a scenario where as you are trying to do so maybe you look at possibly splitting that business off either through sale or spin. Or is that something that's not possible if you want to hold on to the China piece of pizza, if you could just talk about that and why you wouldn't maybe look at transaction like that?

David Novak

Well, first and foremost we believe in the power of global brands and we believe we are very good at running global brands and we are going to be able to maximize the sales and profitability of that brand over the long term. We think our structures focus so that we can get after the opportunities that we have. And we think we are going to drive significant growth for pizza in the future. We are very bullish on pizza for the long term. Lot of what we've done this year, you really -- obviously you can't see in the numbers. But we are investing heavily and doing a globally along with digital front and also in terms of driving future development. We think we have significant opportunities in the delivery carry-out business and the express business. And we've got major new initiatives that will be implemented in the United States in terms of both the advertising positioning which we think will be global and also the innovation that we think will be global. And we believe that this will travel and we think we are going to get significant growth at our Pizza Hut in next year and beyond. So we think we are structured just fine. There are all kinds of things that you can do financially to think about reengineering the business and all kinds of scenarios have been brought up over the last 15 years. We look at everything but we are absolutely committed to our current structure, believe it's right and we think our shareholders, they are going to benefit from it over the long term.

Pat Grismer

Brian, what I would add to that just to build on David's point. We look at everything through a long-term growth plan so we don't over react to short-term issues in our business. And it wasn't two years ago that pizza was on top. We have a powerful brand. We can beat the competition. Things have softened last couple of years. We've taken our learnings and we are redoubling our efforts to bring the business back next year.

Operator

Your next question comes from the line of Sara Senatore. Your line is open.

Sara Senatore - Sanford Bernstein

Just a follow-up on China, if I may. The margins keep beating to the upside I think versus the investors' or Street expectations. Can you talk a little bit about why that is? Is it your costs like commodities and labor inflation are coming in lower than expected? I recognize that you got a lot of leverage and you have more profitable transactions from the menu revamp. But if you can just talk about that in the sense of the outlook for costs. And a related question is Pizza Hut is such a good business in China, the unit economics are still very good. Is the slower comp just the difficult compare? Is there something in the environment? Could it possibly be related to the acceleration in unit growth? Thank you.

Pat Grismer

Sara, I will take the question on China margin. We are absolutely delighted with the progress that we are making -- we are continuing make with the six point improvement in margin versus prior year in the second quarter. You are right that the menu revamp helped from a mix perspective as we pivot towards those more profitable, higher quality transactions. With respect to how things are trending and what gets us to the higher end of the range. You are also right that the inflation outlook has tampered. So where as at the beginning of the year we were expecting big higher inflation on food cost or closer to around 1% for the year and labor inflation is at the lower end of our range. We had guided low double digit. So it's going to be pretty close to 10%. So those things together bolster our confidence that we are going to get to at least 80% margin for China Division for this year.

David Novak

I think regarding Pizza Hut and Casual Dining, in China obviously our same store sales were flat, is softer than what would have liked but we were overlapping 7% same store sales growth in 2013 which was the highest of that year. Our system sales growth is 16% in the second quarter. And our business model and returns are firing on cylinders. So we got two year cash paybacks on new units, we will have 20% plus margin for the full year. And remember we've grown our average unit volumes 30% in the past three years and we are doing this with basically no mid scale competition out there today or on the immediate horizon anyway. And we are expanding breakfast in more, more cities. We've now breakfast in 229 stores which is about 20% of our units. So we have a pretty amazing growth story and we are bullish as ever about the future growth prospect for Pizza Casual Dining. I think as we go forward we think we have the big story for pizza is to rapid new unit development that we have with two units -- two year returns. And with average unit volumes so they are already generating by themselves today 20% plus full year margins.

Operator

Your next question comes from line of John Ivankoe. Your line is open.

John Ivankoe - JPMorgan

Hi, great, thank you. Actually a follow-up on that question. It sounds like maybe in the second half for KFC that same store traffic might be pretty close to flat given what your menu mix is. And from what I understand, pricing that was taken in the fourth quarter and maybe some more pricing that was taken in the second quarter. So, maybe elaborate on that. And if I may, it is unusual to see a company focus on margins in a recovery - allow lower traffic growth. In other words, you're not necessarily trying to gain back the traffic that you lost in the previous year. So David you're obviously very experienced just in terms of what you've seen over your career. May be an example of previous success where you can focus on a higher margin customer and almost willingly allow some of your lower-margin or maybe more price-sensitive customers drop out of the brand as you focus on overall profitability.

David Novak

Well, John, I think first of all I don't think we are focused on margin. I think what we have been focused on is rebuilding the brand. And making the brand more contemporary for a changing China. And so I think the things that we are most excited about is that with revamp that we have, the comprehensive program we put it in terms of service, uniforms, where we headed with digital all the stuff, is where contemporary since the brand were changing in China. And the research measures basically are all moving in the right direction. So we are building the brand. We got preferred brand, taste, value for the money, safety is back where it was in 2012, all the measures that you want to see going up are going up. So I think first and foremost what Sam and team have been focused on is rebuilding the brand and rebuilding the brand the right way. We look back couple of years ago in 2012 I guess it was, at 2011 we had 20% transaction growth which kind of blew everybody away. And that came primarily from value driven transactions which are good. But they are not necessarily sustainable from a profit perspective in terms of really driving our business model for the long term. So what we've done now is we still have 6 RMB launches and breakfast in 15 RMB lunch items. But we shifted our marketing focus to more focusing on the premium one which we think is more in line with where consumers are going today. And as a result of that we are getting significant same store sales growth. Some traffic growth, but we get the much better business models as we go forward that we can build from. And we really like that as we think about where we are headed. So I don't think that we are just margin driven. I think we are very focused on building the brand and doing so in a manner that will strengthened our business model, that give us a best possible unit economics going forward, it will allow us to open up as many as restaurants as we can.

Pat Grismer

And I will just add on that to say we are not going to comment on what we expect transaction growth to be in the back half of the year but building what I have said earlier, we do expect that comps in the second half, one is strong as they were in the first half in the part because we are lagging more challenging numbers. Also there is no reason to believe and you suggested that the pricing we've taken this year is putting pressure on pricing because of the --we mentioned value scores have improved with the brand we launch and with the pricing and we feel that the pricing we've taken is entirely in line with inflation and not ahead of competitors.

David Novak

I think that's a big point. We are improving the overall brand dynamics from preferred brand to value for the money scores, both are going up. And we've been very, very mindful of the pricing. When I think about building the brand from margin perspective I -- there is a very brands that I think have been that successful okay in terms of like getting their -- by taking price and not taking price smart way and all that. So you asked me, historically, what have I learned? I mean if you price without being aware of where you stand with your brand and what your brand is capable of doing, you go down a very slippery slope. But we have priced and reorganized our menu and restructured our menu and innovated around our menu to improve the brand dynamics and that's all the feedback we are getting from the customers telling us. They think the best time to take price is before you have big news. So we did in Chinese New Year for example. We did just before Chinese New Year. And then we also did it just before we did the revamp. And so I think the big point I am making is we are not building this brand from a margin perspective. We are building this brand from a brand perspective and we are doing it in a way that happens to get us better margins.

Operator

Your next question comes from the line of John Glass. Your line is open.

John Glass - Morgan Stanley

Thanks. Pat, can you maybe just frame what your base case is for Pizza Hut this year? Your profits declined 15% to 20% in the first half. Is it very possible or likely you'll see the same kind of decline at least in the current quarter or the third quarter? And maybe help us more than - maybe just put some numbers or framework around how we should think about the full year.

Pat Grismer

John, I am not providing any more specific guidance on full year performance out of the detailed division only to indicate that the results will be below our expectations this year, well below our expectations and we had guided that the results would be below the ongoing growth model that we had established for the division and I really don't care to provide anything more specific than that at the stage.

Operator

Your next question comes from the line of Joseph Buckley. Your line is open.

Joseph Buckley - BofA Merrill Lynch

Hi, thank you. Two questions, I'll throw them both out. Again on the higher quality more profitable sales in KFC China, is there risk that you are going to confuse the consumer? In 2012, you hit value hard; so hard that on that great comp number, your margins got killed. And now in recovery mode, I'm not sure exactly how you're repositioning it higher -- if it's meal combinations or different offerings or what it is. But it sounds pretty different. And if you could elaborate on that, I'd appreciate it. And then just on Pizza Hut, the Pizza Hut international business was pretty weak also. Could you talk a little bit about that? And we're used to seeing Pizza Hut have a tough year, a good year, alternating. And this looks like two tough years in a row. And, again, if you could comment on more on the international piece, I'd appreciate it.

David Novak

First of all on KFC. I don't think we are confusing the customers whatsoever. I mean I think the brand is just being presented in a new improved way. We still have value offerings. It is not like we are advertising on television, gee; there is no value at KFC today. We still have the 6 RMB breakfast, we still have the 15 RMB lunches. We are introducing news around new products and new advertising with celebrities. And I think people -- every brand measure is moving up and there is no -- we are not getting anything from customers that says they are confused. So I would say to answer that is no problem.

Pat Grismer

And what I would say as well we all know from our experience the great brand follow the customer and give the customer what the customer wants. And consumers in China are ecstatic. Their expectations are increasing. They are becoming even more so sophisticated and this is what they want. We are giving them what they want. That's what they are telling us.

David Novak

But I think consumers want great value which we have, best in the category. And getting basis what the number-- best of we've had. They want great taste which is we know is proven -- our measures are high and we are the preferred brand. So I think KFC is absolutely fine. I think Pizza Hut globally -- the division itself is underperforming and I have already detailed all the things that we are doing to get the business turned around and we expect much stronger year next year. We have a very good brand, the best brand we think in the category. And we've underperformed versus competition. And we think we will make significant progress next year.

Pat Grismer

And it also reminds you that we expect record level development globally with pizza brand and the vast majority of that will be done by franchisees. Franchisees will not be investing behind the concept unless they believe we have a powerful economic model backed by a great brand.

Operator

Your next question comes from the line of Jeffrey Bernstein. Your line is open.

Jeffrey Bernstein - Barclays Capital

Great, thank you, good morning. Just two quick follow-ups. One, just on that topic of the value versus the premium. Just maybe you can give some color in terms of where the brand stands in terms of sales value versus premium. We often get that color in the U.S. but just - you talked about two years ago, the big value push versus today. Any kind of color in terms of how you mix value versus premium? And separately just the Taco Bell, just to clarify what you said earlier, I guess it's running still mid-single-digit breakfast. I think you had said longer-term you were pushing for high single digit. I'm just wondering how you gauge whether or not it's cannibalizing the lunch and dinner. It seems like the advertising dollars got shifted. But now as it shifts back, how do you get a good read that the consumer is now coming for breakfast and therefore not coming for lunch or dinner? Thanks.

Pat Grismer

I'll address the Taco Bell question first, Jeffrey. And we look at a several different ways. But as we read the net list that we are getting in our breakfast day part which we define as sales before at 11 AM, we compare that to what we are getting before we nationally advertised and launched breakfast, we are seeing about five point lift which relative to the mix reinforces for us -- this is a highly incremental layer for us. We also look at the performance of the stores and this is a vast majority starts which offer breakfast versus -- today a small group, but [than] less meaningful group that doesn't offer breakfast and we see a dramatic difference in same store sales growth. Those data points reinforce our belief that what we are seeing here is a highly incremental layer. And we also believe that we have a good read on what drove the relatively soft performance balance of day as we talked about before with the media shift and the underperforming promotions.

David Novak

I think in terms of the percent of the KFC menu, it’s value driven, I think it is probably 10%.

Operator

Your next question comes from the line of Jeff Farmer. Your line is open.

Jeff Farmer - Wells Fargo Securities, LLC

Good morning. Just coming back to margins a little bit but from a different tack. So with what you guys have been able to achieve with KFC China in terms of driving margin efficiencies, you've been very good at detailing this in terms of sales forecasting, labor scheduling, reduced operating hours, things like that. I'm just curious what the opportunity is for you to pull some of those same levers as you look at some of these larger developed markets in the KFC division. So I recognize that those are 90%-plus franchise markets, but it just seems to me that there's a healthy opportunity at least on the operational side, to share some of those best practices with some of your bigger franchise groups out there.

Pat Grismer

Absolutely, Jeff. We are not pleased with the overall margins we are seeing for our KFC global brand division. Bear in mind working in that number would be -- some of our businesses in more developed market which are in the low end of the spectrum as it relates to margin performance. And then we have some businesses and they are in virgin market which benefit from relatively low labor and rent costs. That's not to say that we don't have an opportunity to deliver better results for both emerging and developed markets. And we are moving aggressively to share learnings around, how we can optimize food cost, optimize labor cost as you say, capitalize on the outstanding know how we have in China given the impressive results they have delivered. And make sure that we are leveraging that to achieve similar gains in our KFC global business. We also continue to look at opportunities we have to optimize our equity portfolio, earn-the-right to own philosophy and where we have equity businesses that are underperforming then we make those adjustments in order to optimize result for our shareholders. So really through a series of tactics leveraging know how we have in our organization and the good strong discipline we have around margin management. We are keen to improve those margins because we know there is an opportunity in our KFC global business. Helpful, Jeff?

Jeff Farmer - Wells Fargo Securities, LLC

I'm sorry. Real quick, if I could add just one more quick question just on the P&L. So any type of high-level, absolute dollar interest expense number you can roughly guide us to for 2014 as we think about that relative to 2013?

Pat Grismer

I think we guide to about $10 million reduction because of refinancing we did last year, Jeff.

Operator

Last question comes from the line of R.J. Hottovy. Your line is open.

R.J. Hottovy - Morningstar

Thanks. Just a quick question about innovation on a broader level. I know you've been running a few fast-casual tests in the U.S., and just wanted to see broadly what is your plan for some of these smaller concepts? I know it's not a meaningful part of the business. But as you see longer-term -- you just testing for learning or just kind of - just probably get a sense of the fast-casual concepts start to pop up a little bit here and there, West Coast and Texas, just what the thoughts are behind those. Thanks.

David Novak

We are testing some fast casual concepts primarily innovation labs where we can really learn more about what customers think about some of these products, some of these products we expect them coming to our base business or derivatives of them. If we have some learning that suggest that we have a bigger idea I guess we might start to think about a bigger. But it is more of a real focus on learning, more about the fast casual segment and using as incubator for what can go into the base business. So, we have got a Mexican concept, it has been opened up on the West Coast. We've got chicken small box format being tested in Dallas. And so we are looking at that. And we are also looking small box derivatives are offered to our base brand to give us more opportunities as well which we think probably is the biggest idea of all.

Pat Grismer

Thanks. R. J., just a modification response in the interest expense. So that should be similar to last year. So I think David that's our last question.

David Novak

Well, thank you very much for being on the call. Let me summarize. We expect to have at least 20% EPS growth this year and will be better if we can obviously. The key points that I would like to leave you with is we are back on track with China with the better business model and better brand dynamics. We have three year payback with KFC, two year at Pizza and we are continuing to make significant progress with Pizza at Home Service. Number two, Taco Bell is successfully establishing breakfast. We believe that what we are doing at Taco Bell, how we are building the brand, the one-two combination of breakfast plus the innovation we have coming is going to continue to improve our unit economics and help us take Taco Bell from 5000 stores to 8000 stores. Our franchisees are in the breakfast program and in to it to win. Number three, KFC global is getting better and better around the world. And we expect continued success there. Pizza Hut next is major turnaround mode but we expect to go on to the 2015 very strong and benefit from the fact that we will be overlapping not so high this year and last but not least, one of our big engines at Yum! is new unit development. And we will have over 2000 new units opened in 2014. So we are very confident. We will get back to our ongoing growth model of delivering at least 10% earning per share growth on a sustainable basis. So thank you very much. Appreciate you being on the call.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Yum! Brands' (YUM) CEO David Novak on Q2 2014 Results - Earnings Call Transcript
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