Yum! Brands Inc. ( YUM - Analyst Report ) reported second quarter 2012 adjusted earnings of 67 cents per share, missing the Zacks Consensus Estimate of 70 cents. Earnings per share nudged up just 1% year over year. A hike in tax-rate, inflated cost structure, especially in China and settlement of a California employment lawsuit at Taco Bell were responsible for the underperformance of earnings per share.

On a reported basis, Yum! Brands’ quarterly earnings were 69 cents per share, up 6% year over year.

The company reported a 12% year-over-year increase in total revenue to $3,168.0 million. System Sales growth in China, Yum! Restaurants International (YRI) and the U.S. division was 27%, 7% and 1%, respectively, excluding foreign currency translation. In YRI, India witnessed a considerable growth of 32% in system sales.

Behind the Headline Numbers

Comparable-restaurant sales (comps) improved 10% in mainland China, 4% in YRI and 7% in the U.S. division. There were comps increases of 13% at Taco Bell, 4% at Pizza Hut and1% at KFC. Comps increased 7% in Yum! Restaurants India.

In the quarter under review, Yum! Brands saw a spike in its overall cost structure. Company-restaurant costs and general and administrative (G&A) expenses increased 14% and 12%, respectively. China and the YRI division were unable to reduce their cost structures. However, their increases were partially made up by a 16% cut in company-restaurant costs at the U.S. division.

Consolidated operating profit grew 8% year over year, considering foreign-currency translation. Three major geographic segments, China (flat year over year; and down 4% excluding foreign currency translation), YRI (up 3%; and up 6% excluding foreign currency translation) and the U.S. (up 26%) contributed to the growth.

While foreign currency translation helped China’s operating profit by $6 million, it bore an adverse impact of $5 million at YRI. Operating profit at the U.S. division was affected by 1 percentage point due to the divestiture of Long John Silver's and A&W brands.

As expected, restaurant margin slid 4.1 percentage points to 15.6% in China due to wage and commodity inflation as well as increased pre-opening costs associated with geared up development. Restaurant margin fell 1.1 percentage points to 11.8% in the YRI division, hurt by comps decrease in KFC France, as well as increased costs incurred due to last year’s Thailand floods. However, the margin saw an improving trend, increasing 5.8 percentage points to 17.5% at the U.S. segment, backed by solid sales leverage.

Unit Growth

Strong performance in the China division during the quarter was primarily driven by 160 new openings. Further, Yum! Brands solidified its footprint internationally by opening 172 new units in the quarter under review, 81% of which are located in potentially strong emerging markets.

Management has plans of opening 1700 new restaurants worldwide this year, out of which 700 locations will be in China. Among 1000 international units, management plans to place 65% of outlets in emerging markets with enticing growth prospects.

Financials

At quarter end, Yum! Brands had cash and cash equivalents of $984.0 million with long-term debt of $2,995 million, and shareholder equity of $2,227.0 million.

Outlook

The company reiterated its full-year 2012 earnings per share growth expectation of at least 12.0%.

Our Take

Although we still see China as a crucial player in Yum! Brands’ growth story, heightened inflation and slowdown in economic growth concern us. China, which accounts for a major portion of consolidated operating profit, was a dampener in the quarter.

However, these hurdles are deemed short-term by management, which anticipates a double-digit profit growth in the latter half of the year. Stiff competition from other quick-service restaurant operators also remains an overhang.

However, the U.S. segment is also rebounding slowly but steadily mainly owing to the strong comps recorded by Taco Bell. This success can be attributed to management’s efforts to reignite the brand through innovative initiatives.

Yum! Brands, which competes with McDonald’s Corp. ( MCD - Analyst Report ) , currently retains a Zacks #3 Rank (short-term Hold recommendation). We reiterate our long-term Neutral rating.