Weak China Sales Trends Bite Into Yum's Forecast

In advance of its annual investor meeting on Dec. 6,  Yum Brands (YUM) updated its fourth-quarter expectations, introduced 2013 forecast (including 10% earnings per share growth excluding one-time items, implying EPS of at least $3.56), and reaffirmed several components of its "ongoing" growth assumptions (including long-term operating profit growth of 15%, 10%, and 5% in the China, YRI, and U.S. segments, respectively). Weak sales trends in China--where same-store sales are now expected to decline 4% during the fourth quarter, a considerable change from management's most recent guidance calling for flat to low-single-digit growth--are rightfully garnering much of the attention from management's updated outlook. 

However, we largely view these trends as cyclical in nature and consider the long-term segment goal of same-store sales growth in the mid-single-digit range as achievable over a longer horizon as a result of increased discretionary spending among lower- to middle-class Chinese consumers as well as the continued maturation of units in lower-tier cities. We believe the China results (where the company will generate 45% of its operating profit this year) may take the market's focus off the considerable margin expansion potential in Yum's other segments, and we believe today's sell-off may offer an opportunistic entry point for longer-term investors. We plan to adjust our model based on the updated fourth-quarter outlook and preliminary 2013 guidance, but still firmly believe management's long-term revenue and margin goals support our $70 fair value estimate, which is unchanged.

With the updated same-store sales outlook and a moderate deceleration in planned unit openings in China for 2013 (700 versus 800 in fiscal 2012), management will undoubtedly focus much of the analyst day on its growth trajectory in China. Management noted that the fourth-quarter comp declines come against a 21% gain in the year-ago period, though two-year stacked comps of 17% still represent an 800-basis-point decrease compared to the third quarter. Based on commentary from other quick-service restaurant operators with China exposure, we consider the softness to be tied to largely to macroeconomic factors and not necessarily a sign of increased competitive activity. 

Although it now appears as if China same-store sales trends will probably fall short of management's long-term mid-single-digit goal in 2013--even with a 4% pricing increase in the system heading into the year--we still think this goal is achievable over a longer horizon. While we don't consider the updated unit growth plans for China to be a red flag and believe some unit openings may have been pulled into 2012, we're curious about management's explanation and believe that guidance for 700 units could ultimately prove conservative (recall that management called for 600 unit openings in China heading into 2012, but ended up with 800). During the analyst day presentations, we expect management to provide an update on the unit economics in Tier 3 cities and below in China (where average unit volume has been between $1.3 million and $1.4 million and cash-on-cash returns between 24% and 27%). 

Despite heightened macroeconomic pressures in certain regions, we believe lower-tier average unit volumes remain relatively strong, which supports our long-term outlook of 25,000 traditional-format locations (15,000 KFC, 5,000-plus Pizza Hut casual dining, and several thousand units from East Dawning and Little Sheep). Management's objective of 15% operating income growth in China--based on double-digit unit growth, midteens system sales growth, and moderate general and administrative expense leverage--also remains consistent with our estimates over the next five years, though some volatility from year to year is likely.

We also expect management to elaborate on its game plan for driving unit-level productivity and building scale in other key YRI growth markets (including India, where Yum plans to open about 100 units next year), where we forecast 19,000 units by the end of 2020. At last year's event, management emphasized plans to better leverage its existing restaurant assets across the globe through daypart expansion (primarily breakfast), delivery options, and new product platforms (including beverages and value menus). While we don't necessarily expect the company to replicate its successful China segment productivity initiatives (where average unit volume for all tiers is running around $1.6 million compared with approximately $1.2 million five years ago) in every market, we believe Yum has a meaningful opportunity to expand unit-level productivity across the globe in the years ahead. 

We forecast average unit volume for Yum's consolidated restaurant base will grow to at least $1.4 million-$1.5 million by the end of the decade (compared with $1.1 million today), suggesting $66 billion in systemwide sales by 2020. We recognize some investments must be made to overcome infrastructure hurdles in some emerging markets, but believe this rate of productivity improvement (coupled with the impact of refranchising transactions) will push returns on invested capital near 25% over that period, reinforcing our narrow economic moat rating. Our model forecasts more than 10% average annual operating income growth from the YRI segment over the next few years--consistent with management's outlook--but fading to the high-single-digit range over our explicit 10-year forecast period.

During the analyst day presentation, we also expect additional color on new product innovations in the United States, where the launch of the Doritos Locos Taco has helped to elevate brand awareness among consumers and the success of the Cantina Bell menu (an upscale menu inspired by celebrity chef Lorena Garcia) has demonstrated that the chain can attract a wider target audience while maintaining higher price points. We expect management to touch on new flavor varieties (possibly a Cool Ranch Doritos Locos Taco) and product extensions for both platforms in 2013, which should keep Taco Bell same-store sales squarely in the low- to mid-single-digit range over the medium term. 

We continue to believe that many components of Taco Bell's 2012 recovery plan and Pizza Hut's recent improvements can be used as a blueprint to drive sustained improvement at KFC in the U.S. Assuming the U.S. segment can maintain its current pace of low- to mid-single-digit same-store sales growth (management's long-term guidance calls for "at least 2% growth"), food input costs remain on their downward trajectory, and refranchising transactions continue to have a positive impact on the occupancy expense line, we forecast restaurant-level margins can remain in the mid- to high teens range over a longer horizon. While our model assumes moderately more conservative operating income growth assumptions than management (which is calling for 5% growth over a longer horizon), we believe that these new product innovations could lead to upside in our base-case assumptions.

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