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Investors Are Focusing on the Wrong Numbers at KFC

By Rich Duprey - Oct 10, 2014 at 9:20AM

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The market seemed to find the chicken joint's quarterly numbers tasty yesterday, but they might still end up with indigestion

The China supplier problem was not part of the Colonel's secret recipe. Photo: Flickr user Marufish.

Yum! Brands (YUM 2.82%) stock jumped 3% higher at one point Wednesday October 8, 2014 following its latest quarterly results, despite the continued fallout from the China tainted food scandal on its KFC and Pizza Hut businesses and the restaurant operator slashing its earnings outlook for the year.

While the shares eventually settled about 1.5% higher at the market's close, probably because the rest of its business didn't seem to be similarly falling apart -- Taco Bell looked to be doing OK -- investors seemed to adopted a Zen-like philosophy of "and this too shall pass."

I'm not so sure they're right, and I think Yum! has more problems facing it than investors are willing to acknowledge.

The Orient Express to nowhere
Look at what's going on in China. Because this division is the biggest moneymaker for Yum!, anything that impacts its profitability there is going to take on out-sized importance.

It could be KFC's name that's also tainted by the latest scandal. Photo: Flickr user Michael Robinson.

Management properly points out the tainted food scandal barely touched it and it had only two food items affected, and breakfast items at that, it's confident it will bounce back quickly, though its six to nine month time frame makes it a relative equation.

McDonald's (MCD 2.46%), after all, was much more reliant upon that supplier, and its outlets in Japan couldn't even get some product for awhile.

The burger shop will be reporting its earnings later this month, and it's already warned that it's not going to be a pretty sight.

Yet Yum!'s outlook ignores what could be the lasting damage done to its brand. Amounting to what was essentially the third crisis involving tainted food at KFC, consumers may not be so willing to return.

It took a full year for it to finally turn the corner from the complete breakdown in sales resulting from a supplier using unapproved levels of antibiotics in its birds along with a drug used to treat Parkinson's disease that's banned for use in food. And occurring just before the complete breakdown, it was revealed that ice cubes it served at some stores were allegedly dirtier than toilet water. It became a PR disaster for the chicken joint.

Yum! derives more than half its revenue and 35% of its operating profits from China. Same store sales in its just completed third quarter plunged 14% at KFC and 11% at Pizza Hut causing a near-5% drop in restaurant margins.

An incomplete picture
But it's even worse than those numbers look.

First, the scandal hit in late July. Yum!'s quarter for the Chinese division runs from June through August. Aside from missing nearly a week's worth of sales (or lack thereof) that the rest of the company gains -- the quarter officially ended Sept. 6 -- those comps numbers include all of June and the first three weeks of July, presumably a time when the restaurateur was on the comeback trail.

That means there are about five weeks of bad news going up against about seven or eight weeks of good news, and same restaurant sales still fell off the table.

But worse is the fact that it was going up against comparatively weak results from the year ago period. Comps are supposed to show sales in relation to their position in the prior period. In 2013, Yum's comparables were down 13%, 16%, and 12%, respectively, in June, July, and August.

KFC's goose was cooked last year as it death with another tainted chicken scandal. 

Going on the theory that sales this year in June and most of July were positive, that means they just completely vanished in August to get it to a point where comps were down 14% this quarter. In fact, that number is just as bad as the quarterly decline it recorded at KFC last year.

Let's call it Taco Smell
And it doesn't really get much better when you look at the rest of its operations either, and that's not good since that's what investors were seemingly hanging their hat on Wednesday.

The breakfast burrito has been well received by consumers. Photo: Flickr user Mike Mozart.

Taco Bell, for instance, saw same store sales rise 3% in the quarter despite all the hoopla surrounding the launch of its new breakfast menu in March, which actually accounted for 6% of the mix along with a few points thrown in for pricing. What that means is whatever Yum! gained from the new breakfast daypart, it lost much more in lunch and dinner, significantly so.

And Pizza Hut also saw comps fall 1% in the third quarter, continuing to struggle as rivals clamor for a piece of the, um, pie.

A long road downhill?
Which leaves us with India, it's big long-term market that it's investing heavily in. While this may truly be a growth story in the future, right now it provides some serious drag on performance.

System sales rose 14% for the new division because new stores increased by 26%. Comps at stores open for a year fell 4% in the quarter leading to an operating loss of $3 million, which is a complete reversal (and then some) from the $1 million gain it recorded last year.

You have to expect there will be some rough patches as it rolls out the business, particularly since that market is one-third vegetarian. Yum! may be working on a vegetarian menu that will resonate with customers, but for a business heavily vested in chicken and beef, this won't be a fast-growth story.

The markets are taking a more sober look at Yum!'s results. For example, on Thursday October 10, 2014  its stock was down almost 1% in midday trading, which is a more appropriate response to its earnings news the other day. Despite the spin that's been placed on it, ought to be ruffling a lot more feathers than it has. Unfortunately for Yum! Brands shareholders I suspect those chickens will come home to roost before long.


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