YUM Beats Expectations

The operator of Taco Bell, Pizza Hut and KFC fast food chains — Yum! Brands, Inc. (YUM) — recently reported better-than-expected third-quarter 2009 results buoyed by commodity deflation, lower costs and strong performance by its China division.

Yum!’s quarterly earnings of 70 cents a share (excluding special charges) comfortably surpasses the Zacks Consensus Estimate of 59 cents, and surged 21.0% year-on-year from 58 cents posted in the prior-year quarter.

Lower labor (down 9.0%) and food costs (down 7.0%), slide in G&A expenses (down 9.0%), and operating profit growth in both China (up 32.0%; up 31.0% excluding FX [foreign exchange] impact) and the U.S. (up 18.0%) divisions drove the earnings. These were partially offset by a 13.0% decline in Yum! Restaurants International Division’s (YRI) operating profit and a negative impact of 2 cents a share from foreign currency translation.

The strength in the China division and a lower-than-expected full year effective tax rate prompted management to raise its 2009 EPS guidance from $2.10 to $2.14 (up 12.0% year-on-year). Yum! expects EPS growth of 10.0% in 2010.

Comparable restaurant sales remained flat in mainland China and in other international markets. However, comps fell 6.0% in U.S., including a 13.0% decline in Pizza Hut. Yum!’s total revenue slipped 2.0% to $2,778 million, registering a 12.0% drop in YRI and a 13.0% fall in the U.S. divisions, offset by 22.0% growth in the China division.

Yum! seeks to expand globally, led by its highly profitable China operations. During the quarter, the company opened 88 restaurants in mainland China and 165 restaurants in the markets under YRI. Management expects to open at least 500 restaurants in China and about 900 units in international markets in 2009. The international markets comprise Asia (excluding China), Australia, Continental Europe, Latin America, France, Russia, India and the U.K.

Yum! and other fast-food chains like Burger King Holdings (BKC), McDonald’s Corporation (MCD) and Chipotle Mexican Grill (CMG) are faring better than casual and upscale dining restaurants, as budget-constrained consumers are trending towards lower-priced dining options.

Recently, Yum! raised its quarterly dividend by 11.0% to 21 cents a share, marking the fifth consecutive annual increase since the inception of its dividend program in 2004, and also increased the share buyback program by $300 million. Over a decade, the company has returned more than $6 billion to shareholders via share buybacks.

We believe that despite economic headwinds, Yum! is actively managing its capital, returning much of its free cash to shareholders. Furthermore, the stock provides relative safety and moderate growth in a turbulent environment and exposure to faster-growing international markets. As such, we retain our Outperform recommendation on the stock.

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