China Notes from the Yum! Brands Earnings Call
By Global Macro Monitor
Today’s Yum! Brands’ earnings conference call was dominated by China. Management talked a lot about commodity inflation running around 8 percent and 20% labor inflation, which they do not yet see abating. This doesn’t square with the August official inflation rate of 6.2 percent. A China hard landing scenario is now on traders’ radar and needs to be closely monitored. The stock closed down 2.7 percent.
- Operating profit grew 7% in China and 3% at Yum! Restaurants International (“YRI”), prior to foreign currency translation. Operating profit declined 16% in the U.S.
- Foreign currency translation positively impacted operating profit by $32 million.
- Worldwide system sales grew 6%, prior to foreign currency translation, including 29% in China and 8% at YRI. System sales in the U.S. declined 3%.
- Strong international development continued with 331 new restaurants opened, including 138 new units in China. We are now expecting to open a record 600 new units in China this year. Additionally, we expect to open 900 new units in YRI.
- Same-store sales grew 19% in China and 3% at YRI, and declined 3% in the U.S.
- Worldwide restaurant margin declined 1.9 percentage points to 17.2%.
- During the quarter, the Company announced a 14% increase in its quarterly dividend.
Money Quotes from Conference Call (Direct Quotes from Management)
Our strong performance in China and other emerging markets continues to be the catalyst of our growth. We now expect to open about 1,500 new international units this year, which not only adds to earnings for 2011, but sets us up for an incremental growth in 2012.
We are particularly pleased with our China business, which reported record transaction growth and record expected new unit growth. There’s no question China has powerful brand equity of both KFC and Pizza Hut with outstanding new unit returns. At Yum! Restaurants International, system sales grew 8%, including 13% system sales growth in emerging markets, both prior to foreign currency translation. In the U.S., we saw another quarter of poor results in what remains a tough environment.
…I’m obviously very proud of our China team’s continued strong performance. For the third quarter, units expanded 14%, and same-store sales grew 19%, driven by same-store transaction growth of 27%. Our China division’s operating profit has grown 15% year-to-date, excluding the impact of foreign currency translation. Operating profit grew 7% this quarter, excluding foreign currency translation. Keep in mind that we are overlapping our participation in the World Expo in Shanghai, which added about $10 million of profit to last year’s number. Excluding this overlap, our China team delivered another double-digit earnings growth quarter. New unit development continues to be the major driver of our growth, and we remain the largest U.S. retail developer in China. We’ve opened 329 new units through our first 3 quarters and expect to open a record 600 this year, which will be record development year for us in China. Our China new unit returns remain a key focus for us and continue to be the best in our business.
Any way you look at it, the KFC brand in China is having an incredible year. All our research tells us we’re building our leadership position and making our brand even more relevant. The tremendous increases in new units and traffic puts us in a nice position to continue our strong growth in 2012…
Now we also have achieved tremendous growth and vibrancy at Pizza Hut in China. Pizza Hut Casual Dining goes beyond pizza and continues to unquestionably be the leading western casual dining concept in China with over 560 units in over 120 cities. This quarter marks the seventh consecutive double-digit same-store sales growth quarter for Pizza Hut Casual Dining. The menu has revamped twice a year and continues to offer a broad variety of entrées, including beef, chicken and rice dishes, along with appetizers, beverages and desserts. We are having tremendous success building a true casual dining concept with everyday affordable value. In fact, our new unit returns are now comparable to KFC, and we expect to open about 100 Pizza Hut Casual Dining restaurants this year. We’re especially pleased to be opening Pizza Huts not only in the largest cities but in Tier 3, 4 and 5 cities as well…
In summary, our China business is having a fantastic year. The progress we’re making in executing our China strategy to build leading brands in every significant restaurant category is exceptional.
China produced another impressive quarter. Revenue increased an amazing 35% as we benefited from new unit growth, same-store transaction growth of 27% and favorable foreign exchange. On the other hand, profit growth and margins were less than what we would expect with this type of sales increase. Operating profit grew 7% in the quarter excluding foreign exchange or 11% adjusting for the 2010 impact of the Shanghai World Expo. Margin declined 3.9 percentage points to a little over 21%.
Let me walk you through the details on margins. With commodity inflation of 8% and labor inflation of about 20% in the quarter, we had some significant headwinds. Margins in the quarter were also affected by the new business tax this year and the overlap of the Expo. Taken together, commodity inflation, labor inflation, the business tax and the Expo overlap caused about 7 points of margin pressure. The pricing we took in the first quarter helped to offset about 3 of the 7 points. There were some other moving pieces, but the gap between the inflation and pricing is by far the biggest contributor of the 3.9-point margin decline versus last year.
Going forward, we expect even higher inflation in the fourth quarter. We now expect mid-teens food inflation and labor inflation of about 20% in the quarter. To help offset this, we expect to tweak our value offerings later this year. Despite these initiatives, this level of pricing still lags the impact of a high inflation rate. We therefore expect a decline in fourth quarter year-over-year margins.
We really like our position in China. We have excellent sales momentum and expects solid double-digit same-store sales again in the quarter 4. Our development continues to be robust. 600 new units is clearly an impressive number, and we continue to generate cash paybacks of less than 3 years. This is a portfolio that delivers high returns and high growth…
And the best thing about our business is that we’ve got KFC moving in all cylinders in China. And also, as I mentioned in my earlier remarks, we’ve got Pizza Hut now, which has been dramatically transformed. We’re going into 100 — we’re going to open up 100 stores of Pizza Hut this year. We’re going into Tier 3, 4 and 5 cities. In Pizza Hut, we only have 500 units. So we are constantly just trying to build these brands the right way. I’ve always said that we’ve got these tremendous diamonds. We just got to keep polishing and growing them the right way. And our people capabilities have never been better, the brand has never been stronger. And Yum! in total is going to have another excellent year.
…But we always knew going into this that we could adjust, and the only thing that makes the adjustment tricky is in the fourth quarter inflation. And for the end of the third quarter is a little higher than what we were anticipating. To your point, we’re anticipating high inflation, but the labor inflation, starting the year, we thought would be in mid-teens. And in the quarter, it was 20%, and we think it’s probably going to be at 20% in the fourth quarter as well…. And then commodity inflation, as we thought, would not get up or not get higher in the fourth quarter. So that — the biggest issue that we probably have is the adjustment towards the value…
Regarding the unit development, I mean, to me, that’s a no-brainer if you could get more units in China. The team is extremely disciplined on development, and one of the good things that came out of the last 5-year plan is that the government is sort of starting to build city clusters around some of the major — about 20 or 25 major cities. We think that gives us new unit opportunities once some new trade zones will be developed as they’re going to build housing in those areas. But they’re also building trains and buses and stations and all of that, which those type of infrastructure can help us. So it’s really been a combination of that investment and the trade zones if that opens up for KFC, as well as David in his speech talked about how Pizza Hut is now able to get into Tier 3 and Tier 4 cities much more profitably than before. So that’s allowed us to increase our Pizza Hut development significantly. So if I could — if we could build 600 units a year going forward, and if that causes us a quarter issue with the labor, that’s like a no-brainer. We still get less than 3-year paybacks on those investments. So we feel great about where we stand in China.
… with the China consuming class going from 300 million to 600 million over the next — in the coming years, we couldn’t be in a better place. So very pleased with this year in China.
… Labor inflation we think will remain high but not as high as it was in the back part of this year. So in terms of how to deal with inflation, I do want to emphasize that we’re in a better position to deal with it than we think everybody else. We have a different leverage that I talked about in my speech in terms of different dayparts, strong distribution system, and so we could take pricing in different areas, in different parts of the country, et cetera.
… we have a world-class supply chain group in China. We have very strong distribution. So our costs are, I think, very well-managed there. The challenge that we’ve had really has been on the protein the last several years. Sowhen you’ve seen the spike, it’s been really related to — we think it’s been going with the market on both pork and chicken. So pork has had a lot of several price spikes the last few years. That has impact on [indiscernible] in proteins in China. So that’s really what’s been driving the volatility. We think the chicken has really been what’s happened on the pork side in China. We’re hoping that, that will abate early next year. On the pork side, and it will start seeing better chicken cost, I’d say starting in around the second quarter next year, but that’s a guess at this point. We’ll give you a better data if we have it in December.
… If you’d take 8% food inflation on our base of about 34% or so, you get a little under 3 points of inflation on the food side. If you take 20% inflation on labor, which is about 14% last year of our base cost, that gets you to, again, a little under 3%. So food inflation, labor inflation in Q3 is equal to about 6% impact on margins.
Analyst Question: Obviously, you’ve heard a lot of cautionary comments on China and the slowing in trends. So just wanted to confirm that over the best months, since these results are reflecting, that you’re not seeing any deceleration or any shift in kind of the consumer spending habits on the China comp.
Answer: We don’t discuss trends within a quarter, but we do discuss that there’s a major change from the last quarter. So we have nothing to tell you, which I guess tells you something. Regarding what the underlying rate, it’s really hard to call. There’s just too many moving parts with different inflation rates, different labor rates, et cetera. What I would say though is that I’ve seen a lot of reports on China, and people are trying to estimate what’s going to happen in their economy. And I’m not sure if they’re going to be any better than people trying to estimate what happens in the U.S. economy. I think from our business, what we keep our eye on is the point that David made earlier about what’s happening in the middle class. And everything that we see is that the increases in the labor rates, the people moving from the countryside to the city, the establishment of these city clusters, et cetera, I sort of like those type of macro trends, and to me, I haven’t seen any deterioration of those. If anything, I think the 5-year plan may have helped us a little bit because labor is going to grow a little bit — labor rates are growing a little bit faster, and we’re going to get that infrastructure in those city clusters. So I feel pretty good still about the, I call it, the broad macros. In terms of month-to-month, quarter-to-quarter economic trends, I don’t know if we’re any better than anybody else who’s out there. But as I sort of said before, I feel we could deal with the environmental shifts, wherever they are, pretty well given the quality of our team, our national presence and the different day parts that we have.