Yum! Brands, Inc.
Q3 2006 Earnings Call Transcript

Published: 12 Oct 2006

[Operator:]

Good afternoon. My name is Nicole and I will be your conference operator today. At this time, I would like to welcome everyone to the third quarter 2006 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. (Operator Instructions) I would now like to introduce Mr. Tim Jerzyk, Vice President of Investor Relations. Sir, you may begin your conference.

[Tim Jerzyk:]

Thank you, Nicole, and thank you for joining us on the call today. I just want to give you a reminder before we start into the normal part of our call. It is time to make plans to attend our 2006 annual conference for investors and analysts. The meeting will take place Tuesday, December 5th, from approximately 8

[David C. Novak:]

Thank you, Tim, and good afternoon, everybody. As you may have seen from our third quarter release last night, we reported outstanding results for the quarter, with 11% worldwide operating profit growth and 20% EPS growth. Importantly, each of our businesses contributed to operating profit growth and margin expansion to this performance. Our growth this quarter was led by our high return international divisions, with across-the-board strong growth in new restaurants, same-store sales, and profits. China Division profits increased by 26% and YRI by 22%. Better news yet, we expect China operating profit to be up 35% to 40% for 2006. Based on this strong performance, I am pleased to report we have raised our forecasted EPS for 2006 by $0.06 to $2.89, or 14% growth. We believe the growth opportunities for our portfolio of brands around the world is second to none. Consider this

[Richard T. Carucci:]

Thank you, David, and good afternoon, everyone. I am going to review five items today

[David C. Novak:]

Thank you very much, Rick. It is becoming more and more apparent we are a global growth company with tremendous upside and new unit potential. There is no doubt in my mind that we will have at least 20,000 restaurants in China someday, and we are taking the right steps to put our brands on the map in India, Russia, and continental Europe. We obviously had an excellent third quarter and fabulous year-to-date results. Our China and YRI growth engines are firing on all cylinders. U.S. business has now softened after a string of very strong comps, but we are confident Taco Bell and KFC are in good shape, while we are focused to turn Pizza Hut in the U.S. around. Net net, our international divisions continue to drive our growth and our U.S. business generates substantial, relatively stable cash flow, which we return to shareholders. Before we go to Q&A, we need to make an announcement. As you may have seen, Starbucks recently announced that they are going to provide same-store sales on a quarterly basis versus by month. We have evaluated their move and believe it makes sense for us as well for the following reasons

[Operator:]

(Operator Instructions)

[Tim Jerzyk:]

Are we ready to go, Nicole?

[Operator:]

Just one moment. Your first question comes from David Palmer with UBS.

[David Palmer:]

Thanks. Congratulations on the quarter. I wanted to ask you about the U.S. business. It seems like September trends for the industry accelerated a bit, but maybe only as much as what the comparisons might have kind of dictated. In other words, the two-year trend did not do anything all that spectacular. I was wondering if you are -- first, if you would comment on the industry environment. Secondly, with regard to Taco Bell and KFC, obviously you have seen an increase in everyday low pricing options out there -- McDonald’s, Wendy’s -- and you are talking about how you are pushing up some changes in the KFC product calendar for ’07. I am wondering if that is causing a bit of soul-searching on those two brands in terms of what foot forward in terms of marketing and menu innovation you put. In other words, do you think you can just leave your menu innovation schedule intact and just go with it, or do you have to change what you are doing? Thanks.

[David C. Novak:]

First of all, in terms of the category, we think the category is basically in the same shape it was three or four months ago. It is a tough category. I think when we look at what could be impacting our business that we did not foresee last year, I think it is the introduction of two chicken products, one of them being the $0.99 sandwich that Wendy’s introduced and the other being the $1.29 chicken wrap that McDonald’s introduced. We do believe that both of those products had impact on KFC and, to a certain extent, had impacted Taco Bell as well, because they are more in the value arena. As we look at our Taco Bell and KFC in particular, we really feel like everything that we are doing on those brands is right in terms of the positioning of the brands, the overall advertising campaigns, and the fact that we continue to have a full-court press on developing product news. I think the way we kind of look at it is while we had a tremendous string of continuous same-store sales growth and our two-year numbers are great, we look at it in the last three months, it has sort of been like we are down 7 to 3 at half-time, so we have kind of gone back into the locker room, we have looked at our game plan, and we really think that the playbook that we have is right, and what we want to do is just make sure that we execute it as strongly as we can. Let’s take Taco Bell, for example. Would we change the advertising? “Think Outside the Bun” is, I think, most people would say it would be right up there with -- it is in the top tier of any advertising campaign in the industry. Then, when we look at our product pipelines at both Taco Bell and KFC, we have a lot of news coming up and so what we are doing now is just trying to decide which news is the most valuable, which news will have the most impact, and we are planning our calendar to really give the consumer as much power as we can. I think what we have learned is that you need more news today to win. We think we are losing more out to other competitors’ product news introductions than on the value front. In other words, we think Wendy’s had more product news with their $0.99 chicken sandwich than we did when we came back and just reinforced the Snacker product that we introduced last year. We think McDonald’s had more news with their $1.29 snack wrap. We think we have been outnewsed. Now, the good news is we have a lot of news at Taco Bell and KFC and we can get back in that game and you will see us play that game well next year. I think the two-year trends are important because it says don’t throw the baby out with the bathwater here. The worst thing we could do is overreact to the business that we have right now, but I could tell you I think I read somewhere where somebody was wondering if we were interested in turning around the U.S. business, and that is so far from the truth it is unbelievable. We are all over this like a fly on honey and we are going to do everything we can to turn this business around.

[David Palmer:]

Thank you.

[Tim Jerzyk:]

Thanks, David. Next question, please, Nicole.

[Operator:]

Your next question comes from Glen Petraglia with Citigroup.

[Glen Petraglia:]

Good afternoon. Rick, just first a clarifying question. The period ending share count, if you could share that. Also, if you could maybe give a preliminary outlook for commodities in 2007.

[Richard T. Carucci:]

The quarter end share count was 265 -- that is absolute basis shares, 265 million shares.

[Glen Petraglia:]

Okay, thanks.

[Richard T. Carucci:]

Commodity, for background for 2006 again, before we get into 2007, is that we had very favorable commodities. We were about $35 million year-to-date, $10 million in the third quarter. We expect positive commodities in the fourth quarter, probably less than the first three quarters. We do not have a great handle yet on 2007. Right now, we are not expecting anything unusual. We will have a lot more to report at our December meeting.

[Glen Petraglia:]

But it is safe to say that you would likely be flat to potentially slightly up in many cases?

[Richard T. Carucci:]

Early indications are what I would call normal low-level inflation.

[Glen Petraglia:]

Okay, thanks.

[Tim Jerzyk:]

Thanks, Glen. Next question, please, Nicole.

[Operator:]

Your next question comes from John Ivankoe with JP Morgan.

[John Ivankoe:]

Thanks. The question is actually on China. Obviously the returns for the overall market, and presumably new unit returns, are fairly exceptional, as driven by your sales to investment ratios and specifically the margins that we are seeing reported on your income statement. I guess what I am looking for is, how do you feel about having a 23.7% margin? Is that the level we should be thinking about you making longer term? Is that, for whatever reason, kind of a peak-ish margin in the quarter? Will new units, do you think it would be higher or lower than that? In kind of parenthetical view to that, does it make sense at any point to perhaps lower that margin to make your business even more attractive to more consumers as you expand throughout China?

[Richard T. Carucci:]

Good question, John. First of all, the China margins in the third quarter are a bit normal than our full-year numbers, just because of seasonality. So seasonality did drive third quarter above normal, but our year-to-date margins are over 21%. I personally believe that 20% margins are sustainable in China for a few reasons. First of all, as we go to these smaller cities, even though our average sales are below what we are getting in the bigger cities, our margins are actually higher, so those businesses are performing well and our returns are higher there as well. So we feel great about that development. The second piece is our competitive position continues to improve in China. If you really look at it, we have been adding 400 restaurants for the division, but just on the KFC side, close to 300 restaurants the last couple of years, which is three-to-one our nearest competitor. So our power in the marketplace continues to improve and we have been able to leverage that on the cost side. I feel that our margins there are sustainable and, as income grows there, we are already becoming more and more affordable to people. We are expanding our reach as much as we want to, really, because of the income level rising as opposed towards to needing to discount our products.

[John Ivankoe:]

Can I ask you a question just related to food and paper costs in China? It looks like, according to my numbers, that it has dropped about 250 basis points over the last three years. Is that something that you are able to -- is it your distribution efficiencies, is it better purchasing? Is there something going on in that market that should allow that trend to continue?

[Richard T. Carucci:]

First of all, I think the reason we have achieved it, John, is what we were talking about earlier, that our purchasing power and the number of units we have continues to increase, so we get more efficiencies as we and our suppliers get bigger supporting us. So there has been natural ability to manage costs. I do expect to continue to see some improvement there, probably not at the rate that we have gotten over the last several years. So we expect that rate of improvement to moderate over time, but we also believe we have the opportunity to take modest pricing over time. Because our cost structure has improved so much, we have taken very limited pricing in China. When we have taken limited pricing, the market has been able to absorb that.

[David C. Novak:]

The other thing, John, to your point earlier about providing value to the customers. We do have over 6,000 transactions a week in KFCs, and the only way we have been able to get to that point is because we have everyday affordable value. We are going to make sure we keep that up.

[Tim Jerzyk:]

Thanks, John. Next question, please, Nicole.

[Operator:]

The next question comes from Jeff Omohundro from Wachovia.

[Jeff Omohundro:]

Thanks, just two questions. First, I was wondering if you could give us an update on your thinking on KFC U.S., the Famous Bowls, where we are on the product cycle on that with the upcoming line extension. Is the mix sustaining? Is that becoming more of a core product? What the outlook is on that. Secondly, if you could remind us, what accounts for the differing performance between mainland China and Shanghai recently?

[David C. Novak:]

I will speak first of all to your point about the Famous Bowls. Basically what we are coming back to with the Famous Bowl product is basically a reprise of our national introduction that we had earlier in the year, so it is the same product. The product has been very successful. It has achieved our mix level that we are looking at and we see this as a permanent product on the menu. In fact, we have a number of line extensions in the hopper that are very unique and differentiated versus our original offering that we think will give us some product news. Tim or Rick, do you want to --

[Tim Jerzyk:]

Jeff, just to clarify, your question was mainland China sales performance versus division China?

[Jeff Omohundro:]

Yes, division China.

[Tim Jerzyk:]

Okay.

[Richard T. Carucci:]

Again, just for background, China Division includes Taiwan and Thailand. Effectively, the bigger problem we actually had was in Taiwan, where we were lapping very strong performance last year and the market softened this year. We also were down a little bit in Thailand, which had been strong all year, and there is a week of softer sales with the [crew] there, but those sales have pretty much bounced back. We feel those businesses will bounce back, but just will provide a short-term -- probably for about another month or two.

[Jeff Omohundro:]

Great, thank you very much.

[Tim Jerzyk:]

Thanks, Jeff. Next question, please, Nicole.

[Operator:]

Your next question comes from Mark Wiltamuth with Morgan Stanley.

[Mark Wiltamuth:]

I was going to ask some questions here on the Pizza Hut Home Service rollout in China. If you could just give us some idea of the pacing of the rollouts you are expecting there, and maybe contrast the returns you get on that business, relative to the KFC store growth in China.

[David C. Novak:]

First of all, we have just basically developed the Shanghai market. We are going to be going -- in November, we have our strategy plan session with the team there in China, and I think we could give you more detail on that after that meeting. We are really not at the point where we would want to talk about that yet.

[Richard T. Carucci:]

In terms of the economic model on Pizza Hut Home Service, it is a much lower investment base, so we are spending a couple hundred thousand, $200,000, $250,000 per unit and its margins are lower than our base on KFC or Pizza Hut business, probably roughly in the 15% range. With those numbers and that investment return, it has very strong returns.

[Mark Wiltamuth:]

So higher returns than the KFCs?

[Richard T. Carucci:]

It is similar but again, it is very early days.

[Mark Wiltamuth:]

Okay, thank you.

[Tim Jerzyk:]

Thanks, Mark. Next question, please, Nicole.

[Operator:]

Your next question comes from Joe Buckley with Bear, Stearns.

[Joseph Buckley:]

Thank you. Two questions, one on China. As you start opening more in smaller markets and the [AUBs] come down a bit, will you step up the expansion rate to keep the overall top-line growth in the low 20% area? How do you approach that from a planning perspective?

[Richard T. Carucci:]

We try to open them as fast as we can, Joe, so we have been moving at a very high rate. I think if you look at it over time, at some point the unit growth rate will have to decline. At that point though, we still believe we will have probably more opportunity for same-store sales growth. Historically, we have really pretty much grown same-store sales with our unit development. It has been at such a high rate and we think over time, we will probably have more of a blend between unit development and same-store sales growth. Having said that, for the next several years, we believe unit growth will still dominate what is driving the growth there.

[Joseph Buckley:]

China same-store sales number of 12% in the quarter -- what did that compare to a year ago?

[Tim Jerzyk:]

We do not have it handy, Joe. I will have to give you a call back. I guess it was probably flat to up slightly, something in that range.

[Richard T. Carucci:]

Again, third quarter last year we still had some of the effects of Sudan Red, so it was probably negative, I would guess, in the third quarter of last year.

[David C. Novak:]

Let’s not guess. We will get back to you.

[Tim Jerzyk:]

Yes, we will get back to you.

[Joseph Buckley:]

Just one on the U.S. That $250 million number that you are going to reach from refranchising this year, your original two-year number was $300 million, so I am assuming that two-year number is going a lot higher as well. Can you update us on that?

[Richard T. Carucci:]

We will have to update you on that in December but yes, it will be higher but we will give you a more precise number.

[Joseph Buckley:]

Thank you.

[Operator:]

(Operator Instructions) There are no further questions at this time.

[David C. Novak:]

Thank you very much for being on the call. We are off to another good year and we are going to finish another good one and we look forward to 2007, look forward to seeing you at our investor conference in December.

[Operator:]

Thank you for participating in today’s teleconference. You may now disconnect.