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Yum! Brands Inc.'s (YUM - Analyst Report) first-quarter 2013 adjusted earnings of 70 cents per share were ahead of the Zacks Consensus Estimate by 12.9% but slipped 8% year over year. On a reported basis, Yum! Brands’ quarterly earnings of 72 cents per share were down 24% year over year.

In the first quarter, total revenue slid 8% year over year to $2.54 billion and fell shy of the Zacks Consensus Estimate of $2.65 billion. The year-over-year decline in revenues and earnings was due to the poor performance by the China division. The negative publicity arising out of the allegation regarding the quality of chicken supplied to Yum!’s KFC in China in late Dec 2012 marred the company’s quarterly results.

It seems the Chinese division of  Yum!, which is also the largest contributor to its revenue stream, is going through a bad phase. Yum!’s KFC in China has suffered a couple of setbacks of late due to adverse publicity and the recent outbreak of H7N9 Avian flu.

Behind the Headline Numbers

Comparable-restaurant sales (comps) plunged 20% in China with a 24% decline in KFC owing to the negative publicity and a 2% decline at Pizza Hut Casual Dining. Comps at India division also declined 3%. Comps nudged up 1% in the YRI (Yum! Restaurant International) division. The U.S. division witnessed comps growth of 2% on the back of 6% growth in Taco Bell, partially offset by 1% decline at both Pizza Hut and KFC.

In the quarter under review, Yum! Brands witnessed an increase in its overall cost structure. Company-restaurant expenses rose 7%. Although, these expenses in China were slightly down, it was significantly up in the US and YRI division.

Worldwide operating profit declined 14%, excluding foreign currency translation, mainly due to a 41% decline in China, partially offset by 19% and 5% profit growth at YRI and the U.S. respectively. While foreign currency translation helped China’s operating profit by $2 million, it had a negligible impact on YRI.

Restaurant margin fell 270 basis points (bps) to 15.9% as China witnessed a decline of 700 bps in restaurant margin. However, YRI and the US compensated the decline with a respective gain of 140 bps and 240 bps.

Share Repurchase

During the quarter, the company repurchased 1.7 million shares worth $112.0 million at an average price of $65.0.

Outlook

YUM remains optimistic about further improvements in the U.S. and YRI businesses. The company’s KFC brand will remain under pressure in China due to the lingering effect of the adverse media attention and the recent Avian Flu scare. Based on the results through the first three weeks of April, Yum! foresees its China Division comps to decline about 30% for the month.

Yum! expects its 2013 earnings per share to decline in mid-single digit owing to low sales. Management expects sales to pick up speed from 2014 onward.

Our Take

China plays a crucial role in Yum! Brands’ growth story. Hence, the current turmoil in KFC China may be detrimental to the company’s overall business in the near term. Although the company is trying to overcome this adversity through an aggressive quality assurance marketing campaign and various promotional offers, it will take time to recover fully. Further, all these initiatives will likely incur incremental expenses and weigh on the bottom line.

However, on a positive note, all the threats faced by the company are mostly external. This Zacks Rank #3 (Hold) company has a proven business model and has survived similar threats in the past quite well in some other brands and geographies. Further, Yum! remains relatively well positioned in the US and YRI.

Another industry behemoth McDonald’s Corp. (MCD - Analyst Report), which reported last week, missed the Zacks Consensus Estimates on both lines. Two other restaurateurs, Red Robin Gourmet Burgers Inc. (BKW - Analyst Report) and The Wendy's Co. (WEN - Analyst Report) will report next month.

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