Yum! Beats By Moving With Times

Yum! Brands Inc. (YUM) is on track to meet or exceed its earnings growth guidance of 10% in 2009.

After the market closed yesterday, the operator of the Taco Bell, Pizza Hut and KFC fast food chains reported that 1Q09 EPS excluding special charges grew 14% to $0.48 for 1Q09, surpassing our estimate of $0.42 and the consensus of $0.40.

Stringent cost controls, moderating commodity prices, unit expansion, share repurchases and modest same-store sales growth more than offset the negative effect ($0.02) of currency translation.

Cost containment was particularly impressive in an environment of moderating same-store sales. As a percentage of company-owned unit sales, labor contracted 170 basis points, occupancy declined 80 basis points, and G&A expenses fell 270 basis points.

Global same-store sales inched up 1% from the prior-year quarter: +2% in China, +6% in YRI, and -2% in the U.S.

China - which generates 27% of Yum!’s revenue and most of its earnings growth - generated 21% operating profit gains (27% was reported and included FX translation). Unit growth continues to drive China’s earnings, with the base expanding by 18%. The division’s modest 2% same-store sales increase missed guidance of 3% but looks more impressive when considering it lapped a 12% surge in 1Q08.

Margins expanded 170 basis points, driven by menu price increases and moderating commodity inflation - a trend we expect to continue until the economy recovers.

YRI, which produces 27% of the company’s revenue and includes restaurants outside of the U.S. and China, grew same-store sales by 6% and expanded the predominately-franchised unit base by 5%. YRI operating margins, excluding FX translation, declined less than 1%.

The U.S. dollar’s recent surge remains the major headwind facing YRI. Currency translation whacked reported operating profit, which declined 11% from the prior-year, but gained 4% excluding translation.

Cost cuts saved the quarter for the U.S. division, which remains Yum!’s trouble spot. Results from both Pizza Hut and KFC remain weak. We expect KFC’s ongoing launch of grilled chicken offerings to bolster sales over time. The company more than offset the damage from declining same-store sales (-2%) through cost cuts and moderating commodity prices, expanding margins by 270 basis points and growing operating profit by 7%.

We are maintaining our Buy rating on shares of Yum! Brands. Investors should focus on Yum!’s huge lead over McDonald’s (MCD) — its nearest competitor — in market share and brand awareness with 3,000 units in China, its strong international operations outside of China, and its huge strides in cutting overhead costs. It also has a viable plan to improve KFC’s U.S. business through a launch of grilled chicken wraps that will cater to healthier eating trends.

Though the current P/E multiple of 15x appears pricey relative to Yum!’s depressed 2009 earnings growth target of 10%, it is reasonable given the company’s ability to consistently generate ROICs near 30% and its potential to exceed 2009 guidance and elevate earnings growth to 13% in 2010 and beyond.

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