Weakness in China currently overshadows many of Yum! Brands' strengths, Photo credit: The Motley Fool.
Normally when a company misses earnings expectations and lowers guidance, shares plunge. But that's certainly not the case with Yum! Brands (YUM 0.81%) stock today.
Yum! Brands shares rose about 1.4% this morning after the fast-food company announced that third-quarter revenue came in at $3.35 billion, which translated to adjusted earnings of $0.87 per share. Both numbers fell short of analysts' consensus estimate, which called for revenue of $3.48 billion to produce earnings of $0.89 per share. What's more, thanks primarily to recent bad publicity surrounding a Chinese supplier, Yum! revised its estimates for 2014 earning-per-share growth of between 6% and 10% over 2013. Previously, Yum! told investors to expect EPS growth of at least 20%.
However, as fellow Fool Rick Munarriz pointed out, investors seem pleased that both Yum!'s core Taco Bell and KFC divisions saw comps climb 3%, which helped them to 14% and 16% growth, respectively, in operating income. It also helps that Yum! shares have fallen roughly 13% since the supplier issue first came to light in mid-July.
Shortly after the report was released, I had the opportunity to chat over the phone with Jonathan Blum, Yum! Brands' senior vice president, chief of public affairs, and global nutrition officer. Blum offered some compelling insight into not only Yum!'s recent struggles, but also its longer-term plans for global domin ... I mean, growth.
"Two breakfast items, that's it."
When I asked for additional perspective on Yum!'s struggles in China, Blum first rightly noted that sales there were "going very strong" through the second quarter. Then, sales plunged in light of reports of meat handling issues with one of Yum!'s Chinese suppliers, OSI. And though sales in China are already showing signs of improvement, Blum said, they are still expected to take between six and nine months to fully recover. Blum elaborated on the incident:
Here's the interesting thing: The supplier was a very minor supplier to KFC. Two breakfast items, that's it. But because we're a category leader there and twice the size of our nearest competitor, the publicity disproportionately focused on KFC. Consumer trust declined, sales declined, and profitability declined. The Shanghai FDA did a thorough investigation. Six people have been arrested, [supplier] OSI admitted wrongdoing, and we immediately terminated their supply agreement not only in China but around the globe.
Blum also noted that Yum! is now requiring suppliers to install video cameras, and is even implementing a whistleblowing program to provide incentives for workers to report such transgressions. Even so, he said, "No matter what we put in place, if a supplier is going to resort to an illegal activity as this one did, there's nothing you can do to prevent that except send a signal that you won't tolerate it."
On Pizza Hut's turnaround
But what about Pizza Hut, which suffered a 1% same-store sales decline outside of China last quarter? Yum's press release noted that the company has "major actions in place to drive same-store sales growth" going forward, so I asked for more details.
Blum first responded, "Pizza Hut global should have a strong 2015, led by an expected U.S. turnaround that's in its early stages." That seems fair enough, especially considering Pizza Hut's most recent results are a notable improvement over the preceding quarter's 3% same-store sales decline.
Blum also said the company would be "aggressively marketing product innovation and value all around the globe." In the U.S, he said, that will involve more advertising and positioning, including a focus on improving Pizza Hut's digital presence. He also pointed out that Yum! "opened a record 450 international Pizza Hut units [over the past year], and this number will grow over the years."
Accelerating development abroad
Speaking of which, Yum! opened 400 new restaurants internationally during the quarter (compared to 298 in the previous quarter), 77% of which were in emerging markets. Blum said that is Yum!'s methodical approach given the staggering growth potential these markets hold. To illustrate his point, he noted that the company has only two restaurants per million people in emerging markets. In China, it's five restaurants per million people. In the U.S., it's closer to 60.
What's more, he said, though China's population sits north of 1.3 billion, the size of the nation's consuming class at the end of 2012 was estimated to be "only" 300 million -- roughly the same size as the United States' entire population. By 2020, that number is expected to double to 600 million.
As a result, Blum said he could see Yum! ultimately growing its unit count in China to 20,000 restaurants -- albeit over the very long term -- more than triple its current China total of roughly 6,400 units. Over the near(er) term, Yum! remains focused on reaching its previously stated goal of hitting at least 14,000 units in China, which would give it roughly the same footprint as McDonald's (MCD 2.37%) in the U.S.
Where does India stand?
Then there's India, where system sales increased 14% over the same period in 2013 before foreign currency translation. But those results were hindered by a 4% same-store sales decline, driven entirely by 26% unit growth now comprised of 345 KFCs, 286 Pizza Huts, and just five Taco Bell units. When I asked about that decline, Blum said development there is still in its early stages, and that Yum! is "investing in India for the long term."
More specifically, Yum! Brands teams are working hard to provide a compelling vegetarian menu in India, to appeal to the demographic that represents roughly a third of the market there. Pizza Hut, in particular, is seeing stronger and more competitive sales and delivery unit economics. And though it's still early with Taco Bell, he said "the early results are encouraging." As it stands, Blum insisted, "We believe we're building the brand the right way in India and putting the building blocks in place for a solid foundation."
Final thoughts
All things considered, it's no surprise Yum! Brands raised its quarterly dividend by 11% to $0.41 per share last month -- its tenth-consecutive year, by the way, of double-digit percentage increases.
In the end, I find myself more impressed than ever by Yum! Brands' immense long-term potential. With shares trading 16% below their 52-week-high and roughly 18 times next year's estimated earnings -- and even if those estimates come down as analysts have time to fully digest today's news -- I'm convinced Yum! Brands remains a solid buy for patient, long-term investors.
