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Yum! Brands Inc.'s (YUM - Analyst Report) second-quarter 2013 adjusted earnings of 56 cents per share beat the Zacks Consensus Estimate by 1.8%, but slipped 16.4% year over year. On a reported basis, Yum! Brands’ quarterly earnings of 61 cents per share were down 13% year over year.

In the second quarter, total revenue declined 8% year over year to $2.9 billion and also fell short of the Zacks Consensus Estimate of $3.0 billion by nearly 3.3%. Yum!’s weak China division has been held responsible for such poor results during the quarter.

The outbreak of avian flu in China in early-Apr 2013 marred the division’s quarterly results. To add to the woes, an adverse publicity arising from the KFC China’s poultry supply situation in Dec 2012 continues to negatively impact on the China division’s performance. China, which used to be a major contributor to Yum!’s growth in the past few years, began to post dismal results since late 2012 due to these setbacks.

Behind the Headline Numbers

Geographically, Yum!’s business includes four reporting segments: United States, the China Division, consisting only of mainland China, Yum Restaurants International (YRI) and India.

China division’s comps have suffered a 20% decline in the second quarter as against a 10% growth in the year-ago quarter. Quarterly decline in comps was the result of a 26% fall in KFC comps owing to the negative publicity, partially offset by a 7% increase in comps at Pizza Hut Casual Dining.

Comps at the India division increased 2%. Comps also nudged up 1% in the YRI division.

The U.S. division witnessed comps growth of 1% on the back of 2% and 3% rise in comps at Taco Bell and KFC, respectively. However, comps at Pizza Hut were down 2%. Management expects Taco Bell to grow further in the U.S. with the ongoing investment in technology and equipment.

In the quarter under review, Yum! Brands witnessed a decline in its overall cost structure. Company-restaurant expenses decreased 7.5% year over year as a result of significantly lower expenses in the company’s U.S. and YRI division. Company-restaurant expenses were significantly higher in the India division.

Worldwide operating profit witnessed a fall of 20%, excluding foreign currency translation, mainly due to a 63% decrease in China division’s profit, partially offset by 12% and 4% profit growth at YRI and the U.S., respectively. While foreign currency translation helped China’s profit to grow by $1 million, the same has pulled back the YRI’s profit by $5 million. 

Restaurant margin fell 270 basis points (bps) to 12.5% as a result of a 500 bps decline in China’s restaurant margin. China division’s margin was mostly affected by the company’s lower sales in the region. However, both the YRI and the U.S. compensated the decline with a margin gain of 80 bps, driven by its refranchising initiatives.

Share Repurchase

Year to date, the company has bought back 5.7 million shares worth $390.0 million.

Outlook

The company retains its earnings outlook for 2013. Yum! expects its 2013 earnings per share to decline in mid-single digit owing to lower sales. With new sales-driven initiatives, management expects its business to pick up speed from 2014 onward.

Although the company’s China division is under pressure, it will gradually recover from the downturn and might post impressive results in late 2013 and 2014. The company plans to unveil 700 restaurants in China in 2013.

The company also remains positive on the growth prospects of its YRI and India divisions as it has a solid development pipeline in the emerging markets including India in 2013.

Our Take

Although Yum! Brands’ second-quarter 2013 earnings per share and revenues fell sharply due to the lackluster performance of the China division, management expects these hurdles to be short-term and also anticipates a strong performance in the latter half of the year. However, we believe that there is an uncertainty regarding the proper pace of recovery. 

On a brighter side, Yum!’s India  and YRI segments are expected to perform well, going ahead. The U.S. segment is also rebounding with higher profits and comps growth in Taco Bell and KFC.

Some other restaurateurs which look attractive at the current level include Krispy Kreme Doughnuts, Inc. (KKD - Snapshot Report), BJ's Restaurants, Inc. (BJRI - Analyst Report) and AFC Enterprises Inc. . While Krispy Kreme carries a Zacks Rank #1 (Strong Buy), BJ's Restaurants and AFC Enterprises both carry a Zacks Rank #2 (Buy).

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