YUM! Brands, Inc. (NYSE:YUM)
Q2 2015 Earnings Conference Call
July 15, 2015 09:15 a.m. ET
Greg Creed - Chief Executive Officer
Pat Grismer - Chief Financial Officer
Steve Schmitt - VP of Investor Relations, Corporate Strategy
David Tarantino - R. W. Baird
John Ivankoe - JP Morgan
John Glass - Morgan Stanley
Diane Geissler - CLSA
David Palmer - RBC Capital Markets
Joseph Buckley - Bank of America
Brian Bittner - Oppenheimer
Jason West - Credit Suisse
Karen Short - Deutsche Bank
Jeffrey Bernstein - Barclays
Sara Senatore - Bernstein
Keith Siegner - UBS
Karen Holthouse - Goldman Sachs
Andrew Charles - Cowen and Company
Jeff Farmer - Wells Fargo
R.J. Hottovy - Morningstar
Paul Westra - Stifel
Good morning. My name is Jona and I will be your conference operator today. At this time I would like to welcome everyone to the YUM! Brands Second Quarter 2015 Earnings and 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.
Steve Schmitt, you may begin your conference.
Thanks Jona. Good morning everyone and thank you for joining us. On our call today are Greg Creed, our CEO; and Pat Grismer, our CFO. Following remarks from Greg and Pat, we’ll 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 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 this recording.
Finally, we would like to make you aware of the following upcoming YUM! Investor Event. Our third quarter earnings will be released on Tuesday, October, 6.
And with that, I’d like to turn the call over to Mr. Greg Creed.
Thank you Steve and good morning everyone. As you saw in our release yesterday, EPS in the second quarter while below prior year exceeded our original expectations. I’m encouraged by the progress we’ve made and have every reason to believe we’ll deliver a strong second half and full year EPS of at least 10%.
Overall, I would summarize our second quarter performance as very similar to our first quarter results. Taco Bell is firing on all cylinders; KFC delivered another solid quarter; China continues to improve and while we are making progress, there is still much work to be done at Pizza Hut.
Let’s start today’s discussion with China. Same store sales continue to show steady but slower than expected progress. This quarter’s 10% decline marks an improvement from the 12% decline last quarter despite a more difficult overlap.
There is no doubt in my mind that we will make a full recovery over the long term and return to historic average unit volumes. We have the two strongest brands in China by a wide margin, but frankly the recovery is taking longer than we would like. We need to be more aggressive, more innovative and much more disruptive to step change the business.
I’ve challenged the China team to do all these things with a sense of urgency, because we know that when we step up our performance in China, our brands perform. So to be clear, we are 100% committed to not only recovering but growing our unit volumes in China. With overall customer metrics trending up we know we can achieve this, by sharpening our communications and bringing new excitement to our menu. We’ve learnt from experience that we must innovate our way to recovery and that’s just what we are going to do.
To this point in the second quarter we launched the first of two menu revamps at KFC. This consisted of eight new products focused on lunch and dinner. In addition to the traditional KFC offerings, this revamp included products aimed at consumers interested in healthy alternatives such as herbal tea and seafood.
We also recently launched our second menu revamp focused on breakfast. We know breakfast is an under developed day part for us in China comprising about 7% of sales. These two menu revamps provide new products throughout the day and give us a one, two punch of innovation we know our customers will love.
Additionally we continue to rollout our premium coffee. As of quarter end we offered our coffee in over 2,000 stores, providing an incremental sales lift of about a point for the stores offering coffee. The key to success in this business is grow existing or create new sales layers to build on. We’re excited that premium coffee is already driving sales and profits, while giving us another platform to grow from going forward.
We’re also making progress with digital marketing and our online delivery platform. We believe these initiatives make KFC even more contemporary maintaining a high degree of relevance to the Chinese consumer. In short, the KFC business we are building back will be based on new product innovation and balance nicely with everyday value anchors. We are continuing down the path to make KFC even more useful and contemporary. All of this is part of making China’s number one foreign brand even more relevant going forward in an increasingly competitive market.
At Pizza Hut Casual Dining in China we continue to expand units at a high pace with great returns. Same store sales declined 4% in the quarter, but this marks an improvement from our first quarter performance and the brand is positioned for a strong second half.
We continue to leverage the asset throughout the day with the rollout of breakfast and our expansion into late night. We are also excited about Pizza Hut home service offering where we have nearly 300 units in China. Anyway you look at it; Pizza Hut in China has a long runway for growth ahead.
In conclusion, we are making continued progress in China and remain bullish on our long term prospects there. With cash paybacks of about 3 years, we are confidently investing in new unit expansion. We have leading brands and an enviable competitive position in the world’s fastest growing economy. We expect to open 700 new units in China this year, and believe we can substantially expand our footprint over time.
Moving on to our KFC division, I am pleased to report the division continued to produce solid results. Same store sales grew 3% and the division opened 122 new international restaurants in 39 countries. Nearly 75% of these new restaurants were opened in emerging markets.
I’m particularly pleased with the impressive growth we continue to see out of Russia where same store sales grew 14%. I travelled to Russia in May and I have to tell you, this is one of the most impressive teams we have anywhere in the world. The combination of brand positioning, operational excellence and product innovation gives me confidence that we will continue to win in this important market.
In developed markets, the UK and Australia once again posted impressive results with excellent same store sales growth. This is evidence that our KFC brand can deliver remarkable results in both emerging, as well as developed markets. I believe we can apply the same strategy such as breakthrough product innovation, compelling value and world class operations, which are propelling these businesses to other developed markets. Just think how our results would be transformed if we could achieve Australia’s 2.3 million average unit volumes in all of our markets.
Now turning to the Pizza Hut division; same store sales were even in the quarter, but trends in the U.S. sales improved across the quarter. We complemented our innovation focus with compelling value offerings such as any medium pairs for $6.99 and the $12.99 Big Dipper Pizza, which provided momentum.
We also continue to make strides around driving more digital sales. For example, home meal replacement digital orders were 42% up 10 percentage points from the second quarter of 2014. As we discussed last quarter, we are working to attract new millennial customers with our Flavor of Now menu, while also providing our loyal mainstream customers with their favorites. I firmly believe Pizza Hut has enormous potential that recent results do not reflect.
We are intently working to become more competitive. Turning around these results will not happen overnight, but through our focus on value, our assets, digital and messaging, we are relentlessly working on realizing the full potential of our brand. We are encouraged that Pizza at international continues to develop at a high rate and we expect record international expansion this year, laying the groundwork for future growth.
Last but not least, Taco Bell. I am very pleased with the results out of the division this quarter. Same store sales grew 6%, operating profit increased 29% and we opened 58 new restaurants. Keep in mind we launched breakfast at Taco Bell in the second quarter of 2014. So this marks that first quarter we are lapping breakfast. With breakfast at 7% of mix, restaurant margin exceeding 20% and a flourishing innovation pipeline, I am confident that we’ll see continued positive momentum going forward.
Taco Bell’s goal is to be America’s favorite millennial brand and we are making substantial strides to deliver on that aspiration. For example, we just announced we are expanding our delivery testing with DoorDash in select locations. I’m delighted with the strong initial test results and this is just another example of Taco Bell proving it is on the cutting edge of QSR.
Taco Bell International continues to build awareness and improve its economic model. Same store sales grew 7% in the quarter with particularly strong performance in Latin America and Canada. We have now opened 18 new restaurants this year, including four with open kitchen formats. We are still in the first innings of international expansion for Taco Bell, but I know that this one day will become our third global brand.
So in conclusion, we have multiple opportunities for growth across each YUM! division. We are making continued progress in China. Taco Bell is going from strength to strength. KFC continues to build on its momentum and Pizza Hut is in turnaround mode.
I could not be more thrilled to lead this company into the next phase of growth. Our brand building agenda led by consumer insights is underway in driving our brand and product position. As I mentioned last call, we recently acquired the Collider Lab to help elevate this agenda. I’m especially pleased with how Kaleida has intergraded its thinking into each brand to improve our insight driven marketing.
I am also pleased that Pizza Hut team has added expertise in big data analytics. This is allowing the brand to segment customers in ways we’ve not done before that should lead to more effecting marketing going forward and in a true the YUM! fashion, we are planning to spread this knowhow throughout the organization.
Since assuming my current role I’ve been on the road visiting many of our international markets. To say I like what I’ve seen would be an understatement. I’ve walked away from each visit grateful that I’ve inherited such a strong business with great franchise partners, fantastic leaders and the potential for enormous growth. Of course everywhere I go I see opportunities to improve our company, but I’m confident that our band building focus combined with the technology innovation, marketing and operation efforts underway will help unlock this potential.
Now some of you may want to ask today about our views around corporate structuring related to our China division, including a shareholder suggestion that was well publicized this quarter. We don’t plan to discuss that and distract from our second quarter results. But we want you to know this, the YUM! Board of Directors regularly review strategic options to optimizing long term shareholder value, including those involving corporate structure. We routinely dialog with shareholders, listen to their ideas and thoroughly evaluate those, which maybe in our shareholders’ best interest.
In any event, our top priority is to get our China business back on track and we are making steady progress as evidenced by our first and second quarter results. As we’ve discussed, we expect to have a strong second half of the year based on continued progress in China and fully expect YUM! to deliver at least 10% EPS growth in 2015.
In summary, we are in a unique position at YUM! with three distinct brands that we will strengthen and grow into three iconic global brands that people trust and champion. We remain focused the three keys to driving shareholder value; same store sales growth, new unit development and generating high returns on invested capital. I believe this combination of efforts will enable us to reestablish our track record of consistently delivering double digit EPS growth in 2015 and the years ahead.
And with that, I’ll now turn things over to Pat.
Thank you Greg and good morning everyone. Today I’ll discuss our second quarter results and share perspective on our full year outlook. For the second quarter as Greg mentioned, our results were very similar to Q1. Earnings per share excluding special items decreased 5%. This was substantially better than the decline we had originally estimated.
I’m pleased with the quality of this upside as it was led by better than expected restaurant margins at KFC China and outstanding sales and margin performance at Taco Bell. With the continued progress we are expecting in China, we remain confident that we’ll have a strong second half and deliver at least 10% EPS growth this year.
Reported EPS declined 28% in the quarter. This includes a $68 million non-cash special item charge related to our decision to sell Mexico real-estate, negatively impacting reported EPS by $0.13 in the quarter. This item reduced our ex special tax rate by approximately 2 percentage points benefiting ex special EPS growth by 3 percentage points this quarter.
Now I’d like to provide some color on our second quarter results by division. In China operating profit declined 25% prior to foreign currency translation, led by a same store sales decrease of 10%, which was sequentially better than Q1’s performance despite a more challenging lap. Restaurant margins were 14.6% in a seasonally low quarter. This was 2.2 percentage points lower than last year’s Q2, yet it was a significant improvement from the 4.5 percentage point decline we saw in the first quarter demonstrating continued progress. The margin decline resulted from transaction deleverage and inflation, partially offset by pricing and labor productivity.
Our team in China continued to do an outstanding job of driving restaurant operating efficiency through our improved store level sales forecasting and better labor scheduling. Importantly they accomplished this while maintaining our high standards of customer service. This continues to bolster our belief that China division restaurant margins will return to the 20% range as sales recover and that this recovery has the potential to unlock approximately $600 million of operating profit from our existing store base alone.
In addition to the profit leverage we will realize as sales recover, we continue to open new units with confidence, which is a key driver of future growth. We opened 80 new restaurants in the second quarter bringing our first half total to 251 new units in China. We continue to shift our new unit development towards higher return investments, as we are more selective in Tier I and Tier II cities and continue to upweight development in Tier III through Tier VI cities.
Similarly we continue to shift more of our new unit development to Pizza Casual Dining, which generates our strongest returns in China. Based on the results we are seeing in these new restaurants, we are confident that these investments will yield strong returns and we remain on target to open 700 new restaurants this year.
Now moving to our KFC Global division which posted another solid quarter with growth in sales, margin and profit. System sales growth was especially strong in emerging markets, up 12% before foreign exchange led by Russia, Africa and Central and Eastern Europe. International developed markets also delivered solid system sales growth, up 5% before foreign exchange led by Australia, the UK and Western Europe. And KFC in the U.S. delivered its fourth consecutive quarter of solid same-store sales growth with comps up 3%.
Division operating margin increased 1.3 percentage points in the quarter to 21.9%, driven by same store sales growth, franchise led new unit development and stronger restaurant level margins across the board. And while increased advertising expense related to our ongoing U.S. turnaround program impacted the divisions profit by 2 percentage points in the quarter, KFC global’s operating profit still grew 10% excluding the impact of foreign exchange.
An important element of this is robust franchise led international development as KFC opened 122 new international restaurants in the quarter and is on pace to set a new record this year opening 700 new international restaurants outside of China and India, including a recent new market opening in Myanmar, demonstrating the strength and broad appeal of this iconic global brand.
Same store sales were even for our Pizza Hut Global division with growth of 2% in emerging markets and 1% in the U.S. and a decline of 2% in international developed markets. Division operating margin decreased 90 basis points to 22.6% as strategic growth investments in international G&A offset improved restaurant margins which benefited from lower cheese costs. While sales were even with last year and short of expectations, we are confident we are making the right investments to improve Pizza Hut’s overall brand position operations and digital experience globally.
New unit development continues to be a bright spot for Pizza Hut as the division opened 101 new restaurants in the second quarter, including 66 new international restaurants. Franchisees opened 92% of these new international units underscoring their confidence in the brand. We are confident we will have another year of record development with about 550 new international restaurants in 2015.
And finally, Taco Bell posted another exceptionally strong quarter with same store sales growth of 6% and restaurant margin of 23%, which is more than 5 points better than Q2 of last year. As a result, operating margin increased 4.7 percentage points to 29.5% lifting operating profit by 29% versus prior year. We could not be more pleased with the performance of our Taco Bell team and their continued focus on category leading innovation across every aspect of their business.
This obviously includes our new breakfast layer increased to a very healthy 7% sales mix. Additionally we opened 58 new restaurants in the second quarter with nearly 90% opened by franchisees and are well on our way to opening at least 150 net new restaurants this year with international development accelerating in the years to come. Anyway you look at it, Taco Bell is a powerhouse brand with outstanding momentum.
Now I’d like to shift gears and talk about our full year outlook. We fully expect to deliver EPS growth of at least 10% this year. Given our first half EPS decline of 7%, we’ll need nearly 30% EPS growth in the second half of the year to reach this target. We believe this is achievable. The key to this EPS bounce back is a sales recovery in China and we’re confident we’ll deliver solidly positive sales numbers going forward, especially as we lap the supplier incident from July 20 of last year.
I’m extremely confident that as sales return, profits will flow through nicely, given the continuous cost management initiatives we’ve seen through our first half. With first half China restaurant margin already over 16%, we now expect full year restaurant margin to be closer to 17%. As a reminder, 60% of China’s operating profit historically is earned in the second half of their fiscal year, which includes seven of 12 months.
Outside of China we expect KFC to have another solid year and Pizza Hut to fall well short of its ongoing growth target despite the improving results we expect in the balance of the year. For Taco Bell, although we expect solid performance in the balance of the year, we expect much more moderate profit growth as we overlap stronger sales and margin performance from last year.
I do want to point out foreign currency translation remains a strong headwind as we continue to expect this to impact full year EPS by about 5 percentage points. However, this impact is included in our EPS forecast of at least 10% growth. To be clear, this exposure is one of the profit translations and does not impact our ability to price our products competitively around the world.
So if you step back and think about how 2015 is developing, it’s very consistent with our expectation coming into the year, which is a negative first half followed by a very strong second half driven by China and importantly, we continue to invest behind the business, opening 2,100 new international restaurants in 2015. Outside of China approximately 90% of our new units will be opened by our franchise partners.
So let me wrap things up. We’re pleased that our second quarter results were stronger than expected due to robust performance at Taco Bell, as well as the continued recovery in China. We expect at least 10% EPS growth this year with a very strong second half.
And with that, I’ll open up the line to Q&A.
[Operator Instructions] Your first question comes from David Tarantino with R. W. Baird. Your line is open.
Hi, good morning. My question is on the China sales recovery and I guess first part is how would you frame up your current expectation for comps for the year now. I think last quarter your point was the low end of your 3% to 7% guidance. So I just wanted to understand what you’re thinking now and then specifically you mentioned that the recovery is going I guess slower than expected. So could you talk about maybe why you think that’s the case and whether you think its macro related or more specific to the brand metrics that you’re seeing?
David, this is Pat. I’ll take the first part of your question and Greg will respond to the second part. So as to our expectations for full year, same store sales growth in China, at this stage of the year it still remains difficult to call. We’ll certainly keep you updated as the year progresses, but certainly based on everything we’ve seen to date and our forecast balance of the year, full year same store sales growth in China could be in the low single digits.
We do expect both KFC and Pizza Hut same store sales growth to turn strongly positive as we lap the initial impact of the OSI publicity later this month. This will fuel a strong second half for China and enable us to deliver EPS growth of at least 10% for the year.
Now I’d also point out that from a profit perspective stronger than expected margin performance has offset the impact of the slower than expected sales recovery in China and we expect that this will continue through the balance of the year, thereby preserving our overall profit outlook.
So David, let me answer the second part of that question. I think the good news is that sales are recovering. We went from minus 12 to minus 10 despite a more difficult lap of plus 15. The good news is that the consumer metrics are improving trending in the right direction. As always, these are never linear unfortunately, but we do know that we compare this to previous recoveries. We’re going in the right direction, making progress across the board. So I feel good and we remain obviously bullish on China. We continue to invest in China and I think as you know, these customer metrics are the harbinger of future sales performance. So I think with all that said, we remain very bullish and confident and continue to invest.
Thanks David. Next question please Jona.
And your next question comes from the line of John Ivankoe with JP Morgan. Your line is open.
Thank you very much. A follow up on that and then maybe an addition as well. Could you diagnose why specifically you think China was below your own expectations in the second quarter, especially given the customer metrics which have been trending up throughout the year?
And secondly, it is clear that with it being a little bit below your expectations and perhaps a tweak down in the comps in China for 2015, it is interesting to juxtapose that with the China margin numbers going up. So just a philosophical question is, why not reinvest some of that margin to regain the traffic or in other words, how confident are you that the focus on margin is in a reason in and of itself why comps might be slightly below expectations.
Yes, I think the slower than expected recovery – remember we’ve had two safety issues, which we’ve never had before alright, so we’ve never been able to model two safety issues and there’s obviously some slowness in recovering that. But there’s been no impact on our customer metrics as we measure from an operating point of view and so I think in that sense we are going to continue to push aggressively.
We need to be more innovative and the way I look at it is, with where we are today, Pat’s giving you the right guidance, but we’ve still got six months of the year to go and right now what I’m trying to do is aggressively bring outside ideas from YUM! into China. As we said earlier, we’ve got really a number of that KFC businesses on file, whether that’s Russia, the UK, Australia or South Africa and I think there’s a number of product innovations, there’s a number of valued plays that those markets have played and I’m very confident that we can bring those to bear.
And that said, I still expect a strong second half in China. Sales will go positive, we will continue to make progress and I think we can bring the power of YUM! to bear by taking those ideas from those powerhouse countries and have China test those.
And John, this is Pat. I’ll just add a couple of other comments, which is that we feel very good about the productivity gains that the team has made in China. We believe that they are sustainable as Greg mentioned. They’ve not impacted customer service levels and frankly what they’ve effectively done is strengthen the underlying unit level economics, which not only gives us continued confidence to invest at the rate that we are behind new unit development, but also reinforces our belief that as sales recovers that we’ll see significant profit leverage in the business.
Yes, I mean if I was to make one last comment I’d say we need to balance value with innovation and there is no doubt innovating our way out of this is the best way to do and that’s what we’re going to stay focused on.
Thanks John. Jona, our next question please.
Your next question comes from John Glass from Morgan Stanley. Your line is open.
Thanks. Good morning. First on China comps, yes so the recent decline in the Chinese stock market had any impact on sales. Do you notice a correlation there at all?
We don’t. John, this is Pat. John we don’t see a correlation. We think actually a very small percentage of customers have been impacted by that as to whether or not it is impacted broader consumer confidence, we have no reason to believe it at this stage if that is the case.
Greg, if I could ask one more. Greg, you did open up and you talked about the possibility of this China spin notion. I know you don’t want it to be a distraction. Do you view that as a distraction in and of itself for the recovery of China, so that you might want to wait till China recovers before entertaining that idea?
I think as I said in my prepared remarks, we don’t want to talk about it. Obviously we review our shareholder proposals, but I can assure you the China team is focused on one thing; their number one priority and my number one priority is getting China sales back into sort of stronger growth.
Thanks John. Jona the next question please?
Your next question comes from Diane Geissler with CLSA. Your line is open.
So is it safe to assume that you've kept your guidance for the full year at at least 10% EPS growth because of the uncertainty around the China comp. Is that the biggest holdback despite the fact that the margin is so much better than you expected. And then also – I’m going to let you answer that first.
Hi Diana. This is Pat. Happy to respond to that question. I think what your implying is that maybe the full year guidance is conservative and I would say absolutely not and I do want to put it in perspective, because you have to bear in mind that we’re at that midpoint of our year. EPS is down 7% and as I said in my prepared remarks earlier, to achieve full year growth of at least 10%, EPS needs to grow nearly 30% in the second half of the year and I don’t think of that as an overly conservative number.
Obviously it's heavily dependent on the results of our China division where profits were down about 30% in the first half of the year, and in order for China to deliver on its expected share of second half EPS growth, second half profits there need to be more than double of what they were last year. But we’re confident China can deliver this result, but with 60% of their profits being generated in the second half, I don’t think it’s prudent to adopt a more aggressive stance and lean in on this.
Additionally as I mentioned, foreign exchange headwinds are much stronger than we had originally estimated, but this is factored into our overall EPS guidance. So I just want to make it very clear, we expect to have a strong second half based on continued progress in China and we fully expect to deliver at least 10% EPS growth for the year.
Okay, thank you and then I wanted to ask on the comments about the new unit mix leaning more heavily on lower tier cities and also into the Pizza Hut franchise and home delivery. Can you talk a little bit about your development expectations for this year and even into next year in terms of what we should be thinking about KFC versus Pizza Hut versus Pizza Hut Home Delivery and then higher tier cities versus lower tier cities? Just trying to kind of frame that up.
Certainly Diane. As I mentioned, our capital investment follows returns and so where we generate the higher returns is where we’re directing more of our capital spending. That has been the case for the last few years and just to put it in perspective, for the quarter 60% or 62% of KFC new unit openings were in Tier III and below cities. Back in 2012 that number was 53%. So you’ve seen a pretty significant shift there and then as it relates to Pizza Hut Casual Dining for the quarter, that business accounted for 35% of total division new unit openings. In 2012 that number was 24%. You can expect that those trends will continue, because again that’s where we see the stronger returns and our capital investment will follow the returns.
I’m not going to give preliminary guidance for 2016 as it relates to either number of units or the mix of units, but I will tell you that we’ll continue to direct more of our capital investment money towards the higher return opportunities, which at the moment are with Pizza Casual Dining and for the KFC business in the lower tier cities.
Next question please Jona.
Your next question comes from David Palmer, RBC Capital Markets. Your line is open.
Thanks. Could we talk a little bit about the marketing and menu news from China in particular and how do you think that new menu is performing at KFC China and any data points would be helpful with the impact to your marketing, even as we look into 3Q. Thanks.
Yes, I think as we said David, obviously we saw sequential improvement from minus 12 to minus 10. The new menu items are accounting for that 15% of sales, so they certainly got traction with the customers. I think that’s also another good data point and I think the consumer metrics continue to show improvement. So I think you look at our continuous improvement. You look at the percentage of mix from these new items and you look at the continued improvement in our consumer metrics and I think that all bodes well. As Pat has said that we will have a strong second half. We will go into positive same store sales growth and I remain completely confident.
Now can we take ideas from around the world between now and the end of the year and test those? Yes. Do I still have the sense of urgency? Yes. Could we do things more speedy? Yes. So as you probably expect, that’s occurring and that’s why we’re at the half year mark and there’s still plenty of time for us to still evolve and tinker with the calendar between now and the end of the year.
Is there anything specific that you learned that you think weren’t tweaking that you could call out from the first half; things that worked and didn’t work?
The other way I look at it, there’s some great products outside of China that are doing very well, whether it’s the UK, Australia, South Africa or Russia. So what I’ve done is I’ve put the China team obviously in direct contact with those businesses and I know that a number of those ideas are currently being contested in China as we speak. So it’s been more that I’ve seen some really powerful ideas outside of China that I think have relevance in China and then I’d really ask the China team to concept test those and if necessary we’ll make changes to the calendar in the back half of the year.
Thanks David. Jona, next question please?
Your next question comes from Joseph Buckley from Bank of America. Your line is open.
Thank you. A couple of questions on China as well. Do you think that the slower than expected sales trend, do you still relate it to the Shanghai Husi Incident or you think its related to broader things happening in China, whether competitively or just somewhat slower growth.
Joe, this is Pat. I think it is fair to say that what the brand or the brands are recovering from is the incident from last year, because that’s what had the dramatic impact to sales starting in the middle of last year and we are continuing to recover from that.
I think it’s also fair to say as we have said on previous calls and at our investor conference that the environment in China has changed in terms of becoming more competitive and so consumers do have more choice. That has raised the bar on us to innovate more than we have in the past, to keep pace with changing Chinese consumer and to continue to move even more aggressively on things like digital. So I think it is fait to say that the environment has changed, but that we are changing in response to that.
And just if I can build on that Joe, we have markets that are much more competitive than China that we compete in and we compete very successfully and so again we can use YUM! now to share where we’ve been very successful, in markets that have even probably two or three time the amount of competition. We can bring that knowhow to bear, to help the China team as they obviously move to more rapidly improve this out performance.
Do you have a sense of what the Chinese restaurant market as a whole is doing? Has that slowed significantly also?
I don’t. I mean that’s – no I don’t have…
No, I mean I think that generally the economy is growing at a slower pace. So it’s fair to say that and that that is putting pressure on retail generally. I think we also need to bear in mind that with GDP growing this year at around 7%, it remains the fastest growing large economy in the world.
Thanks Joe. Next question please Jona.
Your next question comes from Brian Bittner from Oppenheimer. Your line is open.
Thanks very much. My question is I think I’m just a little confused on why there is kind of a tone change in the way you’re talking about how sales are tracking versus your expectations. Just because your gains for the second quarter was for a sequential improvement, you did that. We haven’t even started lapping the July 20 fall off in the business yet. That comes in a week. Is there’s something that’s happened say in June since the quarter end that’s causing the tone change or were you expectations for the quarter just a significant sequential improvement relative to what occurred.
Brian, this is Pat. Nothing specific that has changed to drive that. Just as we step back and we look at the performance in the first half of the year, it’s fair to say that same store sales while recovering, haven’t been recovering at the pace that we had originally anticipated. Thankfully we are seeing that offset through improved productivity in the stores and those margin gains are therefore muting the profit impact of this lower than expected sales recovery.
But make no mistake, the sales recovery is happening, not only based on what we see in terms of same store sales and the fact that in the second quarter we lapped a harder comp, so we got sequential improvement on top of lapping a harder comp. But also based on what we see in our key consumer metrics, which as Greg mentioned are a leading indicator of where sales will go. But we felt that it was important to acknowledge that sales are progressing at a slower than expected pace and that is factored into our full year EPS guidance of at least 10%.
But I think I want to make sure everyone understands, we still expect a very strong second half and that we will deliver at least 10% for the full year.
And you also mentioned – am I still here with you guys?
Yes, go ahead Brian.
You also mentioned that same store sales in China could be low singles for the year, which would still imply double digit comps in the second half. Is the confidence behind that just the way the core trends accelerated from the first and second quarter, like on a two and three year basis, because that’s what ultimately gives you the most confidence in double digit one year comps in the second half.
Well, you’re right that we do expect the very strong same store sales growth in the second half, particularly as we lapped last year’s OSI incident and there are multiple indicators that substantiate this view; one year, two year, three year, four year comps for KFC. We look at absolute transaction volumes on a de-seasonalized basis, we look at key consumer metrics, which again are all moving in the right direction. So all of that together giving us confidence that we’ll get the second half bounce back necessary to achieve the profit growth objectives in China, which underpin at least 10% EPS growth for the year.
Thanks Brian. Jana, next question please.
Your next question comes from Jason West from Credit Suisse. Your line is opened.
Yes, thanks guys. I’m not sure how much you’re willing to talk about the other structural ideas, but the idea of recapitalizing the balance sheet has come up, particularly given the substantial franchise assets you guys have and I’m just wondering, if you could give your updated thoughts on that particular as you move towards sort of a 95% franchise mix outside of China. Does that start to change your thinking around the capital structure and then also looking at what’s happening across some of your franchise peers? Thanks.
Jason, this is Pat. No change to our policy, which is to optimize our capital structure based on what we believe is in the best interest of shareholders, which is to maintain that low investment grade credit rating and so our policy hasn’t changed and no specific guidance as to what that capital structure might look like when we complete the three year refranchising program we announced in December.
Okay, but even as a more franchise business you would still like to keep that in investment grade.
Well, we look at our capital structure from an enterprise perspective. We don’t segment our balance sheet according to one part of the business versus another. So we have to bear in mind that in our China business we have a substantial equity presence with all of the operating leases, which function as virtual debt if you will, which plays into how we optimize our overall capital structure for our shareholders.
Thanks Jason. Jana, next question please.
Your next question comes from Karen Short from Deutsche Bank. Your line is open.
Hi, just a couple of questions on Pizza Hut. So I guess you’ve taken some aggressive stances with your value positioning more recently, but I guess it doesn’t seem to be resonating with the customer or maybe asked another way, do you think it’s a value issue, a trial issue, a frequency issue or anything else, because obviously your peers are generally doing extremely well.
Yes, Karen, thank you for asking a non-China question. In all seriousness, if our peers actually are performing, I think there is no one silver bullet to this solution. You saw us in the quarter playing at more stronger value which actually over the quarter did show improvement across the quarter’s performance and I expect that to continue going into the second half of the year. But this is a sort of total relook, which is we have to have assets to be upgraded. We have to have the compelling value, we have to have compelling innovations, we have to deliver superior experience. We have to improve our e-commerce digital experience. So there’s a lot of work that’s got to get done.
I’m very confident in the team that’s in place to make that happen. We’ve got some new people onto the team in Pizza Hut, so we’ve invested in areas like digital, marketing, food innovation, e-commerce. As we said on the call, we’re actually getting into big data analytics and we’re really starting to see some early signs of – I think that will help us position the brand better and actually really understand where the business has gone to.
So it’s holistic, we’re on it, we’ve brought people into it. I’m very comfortable and happy with the leadership that we’ve got in place to deliver on it. We’re not happy with the progress, but we are making progress and I think you’ll see us continuing to make more progress as the year unfolds.
Thanks Karen. Next question Jana please.
Your next question comes from Jeffrey Bernstein from Barclays. Your line is open.
Great, thank you very much. Just unfortunately I wanted to get back on China for a second. Two things; one just on the comp. I’m wondering as you looked at it perhaps slightly below expectation, whether you see it, maybe this performance by market or day card or weekend, weekday, I’m just wondering as you slice that down 10%, which we can’t do, is there any particular area of concern.
Another question was just broadly on the positioning of the brand. I think most recently it kind of was focused a little bit more premium with motions and what not. I’m just wondering whether the recent challenge is digital once again, maybe broaden that out, focus a little on value to retain that lower income consumer. Thanks.
Hi Jeffery, this is Pat. I’ll respond to your first question and Greg will answer the second. First, with respect to what we’re seeing in the comps and whether when you look at various lengths of segmenting that we’re seeing material differences, the only thing I would highlight is that we are seeing stronger performance in our Tier I cities at both brands. It seems that the Tier I consumers are less phased by the supplier publicity this time around and I would say that that’s especially encouraging, because that’s where we have a higher concentration of stores and also face the strongest competition. So I think that’s further evidence of our brands ongoing recovery and resilience.
There are some regional economies that are more dependent on industrial production and they are feeling more pressure from slower economic growth and we are seeing the effects of that in weaker sales performance in those regions, particularly in some lower tier cities and in response to that KFCs recently launched regional promotions with 10 RMB Burger to help stimulate traffic. That’s the only thing that really bears mentioning in terms of any variations in comps across the entire market.
So just to talk about the positioning, I think yes, we probably have to find a better balance between innovation and value. Again, if I go back to the KFC markets that are really outperforming, whether it’s Russia, Australia, South Africa or the UK, what you will see in those markets is we have great entry price points, we have great value for money, we have really chicken focused innovation and we are really doing disruptive things in the markets place. So, I think that – and then we have, I guess it also goes without saying we have great leaders running those business as well.
So I think that we are going to have to find more balance, but I am very confident that we can find that balance and I am very confident that we have got the ideas and resources around YUM! in order to accomplish that.
Thanks Jeff. Next question please Jana.
Your next question comes from Sara Senatore from Bernstein. Your line is open.
Thank you. I have two follow-up questions. One is about Pizza Hut and one is, not to belabor the point, also about China. So on Pizza Hut, could you just talk about the developed markets outside the U.S. and in particular diagnose maybe are the issues the same out there, is it stepped up competition, digital value marketing. Just so I kind of understand, because it feels like broadly the brand sort of stepped back a little back in the last couple of quarters.
And then the follow-up on China is really one about timing. And I guess you laid out sort of $600 million in EBITDA which is a big number, but its less impressive as it takes 5 years to materialize and so do you have internally a sense of at what point you decide, okay this business may not go back to peak volumes and likewise, how long do you decide when you are looking at strategic alternatives, how long do you give yourselves to make decisions. So I’m just trying to frame timing from both fundamental and strategic standpoints.
Let me answer the first part of the question. I think with our Pizza business, strong U.S. – I’ll say strong global business, there is no doubt about that. So having said that, I think that outside the United States our assets are in much better shape than they are in the United States, but I do think in terms of things like value, e-commerce and digital we need to accelerate our progress in those areas. So I think our assets are in great shape, I think our food quality is in great shape. I think the food innovation is in great shape, but there is no doubt that I think value, as well as the whole customer experience and e-commence are areas that we need to make sure we remain competitive and as leaders in those places.
And Sara, this is Pat. I’ll respond to your second quarter as to the timing around recovering the $600 million in EBITDA. We’ve never been specific as to a timeframe for that. What I want to let you know however is that we are absolutely confident that the business will return to those 2012 peak average unit volumes and we are absolutely confident based on the progress the team has made to improve unit level economics that as the sales recover there will be significant profit flow through on the sales.
As to the timing of that, it’s tough to call and I’m not going to make a prediction based on that, nor am I going to talk about how that may play into the timing of any structural moves. Because our top priority regardless of what we do structurally is to bring that business back in terms of sales and profits and so that’s why the focus is as Greg mentioned earlier, on more disruptive innovation, continued strong value offers, all the things that we need to do to make our brand positions even stronger and in an environment that has over time become more competitive.
Thanks. Jana next question please.
The next question is Keith Siegner with UBS. Your line is open.
So Pat, I’m going to apologize, but I’m going to follow-up a little bit on that. Look, margins in China have come in much better than you expected. You reiterated 20%, with the confidence in the 20% long term. We talk about this $600 million and that’s not sure in this timing, but look when that timing would happen. But let me ask you in a different way; given the success and the productivity, initiatives and what you’ve achieved on the margins, it would seem to me that you should be able to recover the 20% long before you recovery the PKUVs. Is there any reason why that wouldn’t be the case.
No, I think that’s a fair statement, because the underlying economics have gotten stronger. So as the sales come back, the flow-through will be at a much higher rate.
That’s it from me thanks.
Thanks Keith. Next question please, Jana.
Yes, Karen Holthouse with Goldman Sachs. Your line is now open.
Hi, I’m actually going to not ask a question about a China, but instead look at the Taco Bell business in the U.S., where your tier trends continue to accelerate. Just thinking through the moving pieces of that, could you help us understand how much of that might be coming from – you still continue growth in the breakfast day part versus value versus any other specific products innovation.
I think the good news is the Taco Bell performance in the U.S. is holistic, which is it has great entry price point value. They’ve had growth in breakfast from 6% to 7% mix, which I think takes it to like $90,000 and the West Cost the mix is now over 10%.
The innovation that was run in the quarter was compelling, disruptive and the assets are in great shape, the customer experience is improving. It’s holistic, its all of the things and at the same time obviously they are starting to experiment with things like delivery and on the cutting edge of that, the mobile app. I think everywhere you turn, this brand is so relevant to its target audience and I think so clearly positioned with products that are driven out of real consumer insights. I think that’s why they’ve had a great first half and that’s why we remain confident about how they are a great second in obviously 2016 and beyond.
Great. Thank you.
Thank you, Karen.
Your next question comes from Andrew Charles with Cowen and Company. Your line is open.
Thanks. Two questions from me. First, if the key to the China term will be innovation and breakfast only represents 7% of sales, it seems to be performing well already. Why not double down efforts on lunch and dinner in the back half of the year and continue innovating on these day parts to turn China faster?
I think my answer would be having done this myself when I was running Taco Bell. You got to balance this out, which is you've got all these day parts that we are going to try and get growth from. And what we have seen in the past, even if we sort of over invest in certain areas, it’s better to have a balance spend behind breakfast, lunch and dinner and then even if you’ve got enough money, you know the day parts like late night and snaking, right. So I think that this is – we’ve got great product, we are putting the right amount of resource behind it. We got the current promotion on the wing bucket which is off to a nice start and I think this balanced investment behind all the day parts is the right way for us to invest in the business.
Andrew, this is Pat, I would just build on Greg’s comments by highlighting the important role that coffee will play in building multiple day parts. So while it’s an important part of our breakfast day part, it also contributes to afternoon tea time and it contributes to late night and we are very excited with the results we are seeing from coffee and how its lifted sales as the 2,000 units that have already gotten the coffee, the premium coffee program that we will expanding that to more units by the end of year.
Got you. So far this year there has been a seasonally high amount of KFC China store closures. Are these stores – how would you categorize them? Are they primarily located in Tier 1, Tier 2. I mean, what’s driving the decision to close these stores rather than refranchise them?
Well, this is Pat, Andrew. We make those closure decisions one unit at a time. It’s not always a function of underperformance. There may be forced closures due to – we come upon the end of a lease and were unable to renew on favorable terms. So there could be a variety of things driving that, but we don’t expect a substantial increase in KFC closures for the full year versus last year, and in fact we expect total closures to be slightly down versus last year, because last year’s number was propped by substantial consolidation of the Little Sheep estate.
Next question please Jana.
Jeff Farmer has your next question with Wells Fargo. Your line is open.
Thank you and sorry Greg to keep hitting you in on China. But the last time KFC China saw a rapid same store sales recovery. Concept has a sizable mix in menu pricing tailwind where it looks like mix alone represented more than half of that 21% same store sales growth. The concept is still in the second quarter ’14.
So with that, how should we be thinking about the role mix and menu pricing are expected to play in the China same store sales recovery in the coming quarters. And to that point, have you already begun to see the return of the higher average family visits that were a big benefit a year ago in the recovery process.
Jeff, this is Pat and I’ll respond to your question and Greg may add some things. But from the same recovery standpoint, our focus is primarily on traffic, its rebuilding traffic. From a pricing perspective our policy is unchanged, which is that we generally look to pricing to work with productivity to offset inflation. We are very conscious of the important role that value plays in building traffic over time. So we wouldn’t expect mix to be an outsized contributor to sales growth going forward. The emphasis will be more on traffic driven through a combination of value and innovation.
I would just echo that, which is this is going to be a balance of disruptive innovation and value and I think the combination of those is exactly what we need to focus on.
Just a quick follow-up, where does pricing stand right now, menu pricing, actually heading into the back half of ’15.
Jeff, this is Steve. Pricing is about 3% and that should be pretty consistent through the year and just another data point on your question. The quarter check was relatively flat. It was up about 2%, but it is primarily driven by transactions.
All right, thank you.
Thanks Jeff, Jana, next question please.
Your next question comes from R.J. Hottovy with Morningstar. Your line is open.
Thanks. I actually had a question on India. Obviously, it's a small part of the business today, but one that you've spoken about in the past having a great long-term potential. You've now had three quarters of double-digit comp declines in the region. Just curious what's driving that, and if that's changing some of your thinking about long-term unit potential in the region. Thanks.
I think we remain very bullish on India. In the long term there is no reason not to – there is massive population and urbanization of that population and there is obviously underlying economic growth.
I think that we did expect – I think with the Modi government change that there might be a sort of perceptible change in consumer perception and I guess that probably hasn’t had, we haven’t seen that. What I like is that, we have an incredibility strong team in India and I have to say they are probably the best team we have at building knowhow. The Indian team do not suffer from not invented here and they are really aggressively learning what we got and what is working as I said in countries like Australia, South Africa, the UK and Russia. And they are already concept testing and they recognize that value remains an issue; entry price point value remains an issue and obviously innovation, so the same things we keep talking about.
But what I want to give them credit for is really reaching out to the rest of YUM!, building knowhow, taking the advise back into India and with a real sense of urgency, actually putting them into the market place. So I’m long term bullish. I love the team and I think they are doing all the right things in order to accelerate the sort of improved momentum in same store sales.
Thanks Jana, I think we have one more question.
Yes, your final question is Paul Westra with Stifel. Your line is open.
Great. Thank you very much. Just for some clarity on China, maybe help here with the last question. When you say that the comp performance is a little bit below expectations, you mean below your original positive 3% to 7%, so your comments today saying comps could be in the low single digit positives. Second-half comps are still looking to be more positive than the first half that was negative. I just wanted to make sure that's clear.
That is correct.
Absolutely correct, Paul.
Great. And then when you mentioned your transaction trends on a DC line basis continue to sequentially improve, you are seeing sequential, again month-to-month traffic recovery versus…
Paul I wouldn’t say month-to-month, certainly quarter-to-quarter. We never said that the recovery was going to be linier and so there is natural choppiness from month-to-month, but as we step back and look at how traffic has rebuilt since the incident last summer, we are seeing a nice steady improvement in that curve.
Okay. I guess then my last sort of new real question, I guess go back to the color on your China average check strategy, I guess maybe before the dual crises. My understanding and I know part of the renovation program was if anything designed to enhance KFC's sort of premium brand positioning maybe moved the check up of all things being equal, move people up the menu, we certainly can understand the focus on traffic here. Is that still a sort of latent opportunity intermediate-term or how does that play in I guess the new menu here?
Paul, I think there’s a couple of things; one, the amount of remodeling going on in China is accelerating. I enjoy what’s coming and I think they are on the way for us to be much more focused on our remodeling of the assets. So the good news is we are sort of doubling the number of assets we are getting remodeled. So that is a great way of keeping our assets relative and then I think it’s just back to the point we’ve been making along, which is about balance. We actually have to balance the pay menu with what I call disruptive innovation and wow value and I think our ability to do that, as well as it will improve the assets and obviously deliver a superior customer experience. All of those combined will be what sort of makes us long term successful and as we keep saying yes, we will have a strong second half, we will go positive. We remain very confident in the long term of China.
Thanks Paul and thank you all for joining us today and this concludes our call. Thank you.
This concludes today’s conference call. You may now disconnect.
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