Yum! Brands, Inc. — Q2 2012 Form 10-Q
Business context and period. The filing covers the 12-week quarter and 24 weeks year to date ended June 16, 2012; comparatives ended June 11, 2011. Yum operates KFC, Pizza Hut and Taco Bell through China, International (YRI), U.S. and India segments. It reported nearly 38,000 system units across more than 120 countries and territories. Results are unaudited interim financial information.
Financial performance and position
| Metric | Quarter | Year to date |
|---|---|---|
| Total revenue | $3.168 billion, up 12% | $5.911 billion, up 13% |
| Operating profit | $473 million, up 13% | $1.118 billion, up 36% |
| Net income attributable to Yum | $331 million, up 5% | $789 million, up 36% |
| Diluted EPS | $0.69, up 6% | $1.65, up 38% |
| Company restaurant margin | 15.3%, down 0.6 percentage points | 16.9%, up 0.2 percentage points |
| Operating cash flow | Not separately presented | $924 million, versus $923 million |
Quarterly company sales were $2.762 billion and franchise and license fees and income were $406 million. Q2 reported operating margin was approximately 14.9% (operating profit divided by revenue). Segment operating profit was $182 million in China (flat reported), $150 million at YRI (up 3%), $166 million in the U.S. (up 26%) and a $2 million loss in India. China profit declined 4% excluding favorable currency translation; YRI profit grew 6% excluding unfavorable currency translation.
Quarterly system sales grew 8% excluding foreign currency translation; same-store sales grew 10% in China, 4% at YRI and 7% in the U.S. Worldwide restaurant margin excluding special items declined 0.6 percentage points to 15.2%, with pressure in China and YRI; U.S. restaurant margin increased 5.8 percentage points.
At June 16, cash and cash equivalents were $984 million, down from $1.198 billion at year-end. Short-term borrowings were $316 million and long-term debt was $2.995 billion. Current assets were $2.231 billion versus current liabilities of $2.313 billion. The company had $1.2 billion of unused capacity on its $1.3 billion revolving credit facility, with no facility borrowings outstanding, and reported covenant compliance with considerable cushion.
Year-to-date investing cash outflow was $596 million, including $406 million of capital spending and $542 million of acquisition payments, partly offset by $132 million of refranchising proceeds and a $300 million release of restricted cash. Financing cash outflow was $539 million, including $289 million of share repurchases and $262 million of dividends. The company repaid $263 million of senior notes in July 2012, after quarter-end.
Material changes and unusual items
- On February 1, 2012, Yum acquired an additional 66% of Little Sheep for $540 million net of acquired cash, raising ownership to 93% and adding 475 units. Remeasurement of its prior 27% stake produced a $74 million non-cash gain, with no related tax expense. Little Sheep increased China revenue by 4% for the quarter and 2% year to date versus prior periods; management said its effect on operating profit and Yum-attributable net income was not significant.
- Reported year-to-date results include $115 million of net special-item income before tax, mainly the Little Sheep gain and U.S. refranchising gains, partly offset by a $20 million Pizza Hut UK impairment. Special items contributed $0.22 to year-to-date diluted EPS; EPS before special items was $1.43 versus $1.29 a year earlier. Q2 EPS before special items was $0.67 versus $0.66.
- The Q2 effective tax rate was 23.7% versus 16.4%; year-to-date it was 23.9% versus 20.7%. Management attributed the increase principally to lapping prior-year favorable foreign audit-reserve changes and, year to date, the prior-year tax benefit from the LJS and A&W impairment. The higher Q2 tax rate reduced EPS growth by 10 percentage points, according to management.
- A $17 million pre-tax charge was recorded in the U.S. for the quarter related to settlement of a California Taco Bell employment lawsuit. The company refranchised 200 restaurants year to date and received $132 million in proceeds.
Outlook, risks and contingencies
- Management’s longer-term earnings growth models call for average annual operating profit growth of 15% in China, 10% at YRI and 5% in the U.S., supported by unit development, same-store sales, and operating leverage. These are multi-year expectations, not a specific full-year 2012 earnings forecast. Management expected Little Sheep to increase China revenue by about 4% in 2012, with no significant remaining-year operating-profit impact versus the prior equity-method treatment.
- Management cited inflation in China (year-to-date wage inflation of 15% and commodity inflation of 7%) and higher costs in YRI as margin pressures. The filing also notes that a new China VAT rule’s applicability to some food sales was unclear; the potential impact could not yet be quantified.
- The IRS has proposed adjustments concerning transferred foreign intangible rights that could result in approximately $700 million of additional tax plus $200 million of net interest for 2004–2006, and an estimated further $350 million of tax plus $25 million of interest through 2011 if similar claims apply. Yum disputes the proposal and is defending its position; resolution is not expected within 12 months. The company warns payments could exceed its reserve and materially affect financial position or results.
- Yum continued marketing its Pizza Hut UK dine-in restaurants for refranchising; the assets did not qualify as held for sale at quarter-end. Further charges, including from buyer incentives, were possible.
- Potential undiscounted lease-guarantee payments were approximately $650 million (present value $575 million), though the recorded probable-exposure liability was not material. The company also disclosed employment, accessibility and other litigation; some outcomes and potential losses could not be reasonably estimated. Self-insured property and casualty liabilities were $143 million, and management noted actuarial estimates could change materially.
- Yum identified additional risks related to Little Sheep, including limited experience with hot-pot cooking, seasoning manufacture and the business’s minority interest in a meat-processing facility.
Important facts for investors to verify
- Separate recurring operating performance from the $74 million Little Sheep remeasurement gain and other special items; compare reported and adjusted EPS and segment results.
- Track China restaurant margins and cost inflation, alongside the contribution of Little Sheep and new-unit growth.
- Monitor the IRS tax dispute, reserve adequacy and potential financial exposure.
- Assess liquidity and capital allocation after acquisition spending, share repurchases, dividends and the post-quarter-end $263 million debt repayment.
- Follow Pizza Hut UK refranchising progress, potential additional impairment or incentive costs, and the status of material litigation.