Yum! Brands' (NYSE:YUM) "China problem" is proving more difficult to solve than expected. The restaurant operator's second-quarter earnings report showed a 10% decline in same-store sales in China.
While that's better than the 12% drop recorded last quarter (though much worse than the 15% gain notched a year ago), it marks the fourth straight quarter of falling comp sales in China since the company became embroiled in yet another food quality scandal. It was also much worse than the 8.5% drop analysts had expected.
Because China still accounts for half of Yum! Brands' total year-to-date revenue and 38% of its operating profit, the continuing impact of the food scandal is taking a toll on overall performance.
Tentative steps toward improvement
Revenue was down 3% in the second quarter to $3.11 billion, missing Wall Street's expectations of $3.19 billion. Last year, Yum generated $3.20 billion in Q2 revenue.
Yum! Brands said net income fell 30% year over year to $235 million, or $0.53 per share, which, after one-time adjustments, actually beat forecasts. The restaurant operator posted adjusted per-share profit of $0.69, much better than the $0.62 analysts anticipated, though still below last year's $0.73 per share effort.
Fortunately, Yum! Brands continues to get strong results from its Taco Bell chain to help make up the shortfall. Same-store sales grew 6% at the Mexican fast-food restaurant, compared to a 3% increase witnessed at KFC and the flat comp sales recorded at Pizza Hut, which still struggles to gain traction.
Yum! Brands has benefited from new product introductions like the breakfast menu at Taco Bell and the chicken and rice bowls at KFC. Additionally, It has enjoyed pricing tailwinds for commodities such as cheese and chicken. It's also trying to tap into the new trend among food manufacturers to eliminate artificial ingredients. Earlier this year, Yum! Brands said it would remove artificial colors and flavors from food items at both Taco Bell and Pizza Hut.
Still a jewel in its crown
While that may incrementally benefit the restaurant operator, the outsized importance of the China division means the country's recovery is really the key to future gains.
Back in May, hedge funds Corvex Management and Third Point Capital each took substantial positions in Yum! Brands with the idea of pushing for a spinoff of the China business. By doing so, Yum! Brands would reduce its risk. The food scandal at its supplier was actually the second such crisis to hit the restaurant in as many years. Yum! Brands' sales were hit sharply by a similar problem in 2013, and it had only just emerged from regaining Chinese consumer trust when the current scandal struck.
That could also explain why the company is taking longer to bounce back this time. Although comparable sales didn't crater quite as badly as they did the first time around (when KFC in China was also hit by an outbreak of the avian flu virus), the continued comp sales declines indicate that consumers remain wary.
Yet despite the many hurdles that Yum! Brands still needs to overcome, it remains on track to open more than 700 restaurants in China this year.
Challenge of changing tastes
Here at home, however, the shift in consumer preferences for fresher, more wholesome ingredients presents its own headaches. Like much of the rest of the fast-food industry, the rise of fast-casual chains that have made healthy food the centerpiece of their marketing has resulted in the perpetual skimming off of customers to the competition. Hence Yum! Brands' commitment to better sourcing.
Although Yum! Brands stock gave up 3% following the earnings release, the restaurant operator remains on course to build out its global brand further, even with the myriad problems in China. But because the situation is moving in the right direction, albeit at a slower than expected pace, the slight setback represented by this quarter shouldn't deter investors, though waiting for a better price might be warranted.
Yum! Brands trades at 41 times earnings, 22 times next year's estimates, and over three times sales. Its enterprise value goes for more than 40 times its free cash flow. All of this suggests its stock is still richly valued, and investors may want to take the slow boat before putting their money to work here.