YUM! Brands, Inc. — Q1 2012 Form 10-Q
Reporting period: Twelve weeks ended March 24, 2012; comparison is the twelve weeks ended March 19, 2011. Unless noted otherwise, amounts are in millions of dollars. The interim financial statements are unaudited and were reviewed by KPMG, not audited.
Business context and reporting period
YUM operates KFC, Pizza Hut and Taco Bell through company-owned, franchised, affiliated and licensed restaurants. It reported four segments: China, YRI, U.S. and India; India became a separate reporting segment in 2012, with prior-period segment data restated. On February 1, YUM acquired an additional 66% of Little Sheep, raising ownership to 93% and bringing the business under consolidation.
Financial performance
| Metric | Q1 2012 | Q1 2011 | Change / context |
|---|---|---|---|
| Total revenue | $2,743 | $2,425 | Up 13% |
| Company restaurant sales | $2,344 | $2,051 | Up 14% |
| Franchise and license revenue | $399 | $374 | Up 7% |
| Company restaurant profit margin | 18.8% | 17.6% | Up 1.2 percentage points |
| Operating profit, reported | $645 | $401 | Up 61%; includes material special items |
| Operating profit, before special items | $544 | $466 | Up 17% |
| Net income attributable to YUM | $458 | $264 | Up 73% |
| Diluted EPS, reported | $0.96 | $0.54 | Up 76%; special items contributed $0.20 and $(0.09), respectively |
| Diluted EPS, before special items | $0.76 | $0.63 | Up 21% |
| Net interest expense | $37 | $43 | Down $6 |
| Effective tax rate | 24.1% | 25.2% | Lower partly due to the untaxed Little Sheep remeasurement gain |
Worldwide system sales grew 7% excluding foreign currency effects. Same-store sales increased 14% in China, 5% at YRI, 5% in the U.S. and 8% in India. Operating profit before foreign currency translation increased 14% in China, 9% at YRI and 27% in the U.S.
Reported operating profit included $74 of non-cash gain from remeasuring YUM’s previously held Little Sheep interest, $45 of U.S. refranchising gains, and a $20 non-cash impairment charge related to the planned refranchising of Pizza Hut UK dine-in restaurants. These and other items produced $101 of net pretax special-item income, or $94 after tax. The prior-year quarter included $68 of pretax costs related primarily to the LJS and A&W divestitures.
Cash flow, balance sheet and liquidity
- Operating cash flow was $484, versus $508 a year earlier; management cited payment timing, partly offset by higher operating profit before special items.
- Investing cash outflow was $402, including $540 for the Little Sheep acquisition, partly offset by $102 in refranchising proceeds and release of $300 in restricted cash.
- Financing cash outflow was $188, including $131 of dividends and $78 of share repurchases. Cash and cash equivalents ended the quarter at $1,099, down $99 from year-end.
- At March 24, total debt comprised $319 of short-term borrowings and $3,006 of long-term debt. The company also reported $1.2 billion of unused capacity on its new $1.3 billion revolving credit facility; there were no borrowings under that facility.
- Total assets were $9,343 and total liabilities were $7,064. Current assets were $2,425 against current liabilities of $2,391.
- YUM signed a five-year revolving credit facility on March 22, replacing facilities due to expire in November 2012. It reported compliance with debt covenants with considerable cushion. $263 of senior notes were due in July 2012.
Material changes and management outlook
China led reported revenue growth, with segment revenue of $1,218 versus $906 a year earlier; reported China operating profit was $256 versus $215. YRI operating profit was $168 versus $158, and U.S. operating profit was $158 versus $123. The quarter included 297 international new restaurant openings, including 168 in China. YUM refranchised 139 restaurants, including 126 in the U.S.; refranchising can reduce reported revenue while shifting earnings toward franchise fees.
Management’s longer-term earnings growth model calls for average annual operating profit growth of 15% in China, 10% at YRI and 5% in the U.S. China’s model includes system sales growth of at least 13% and same-store sales growth of at least 5%; YRI’s includes system sales growth of 6% and same-store sales growth of at least 2%–3%. These are ongoing-model expectations, not a specific quarterly forecast. Management said Little Sheep was expected to contribute about 5% to China revenue in 2012, with only a modest operating profit benefit, if any, for the remainder of the year; Little Sheep’s operating results were to be included from February through April in Q2 reporting.
Management expects operating cash flow to remain substantial, while noting that a business downturn could reduce it. It may adjust discretionary capital spending, acquisitions, repurchases and dividends in response. YUM targets an annual dividend payout ratio of 35%–40% of net income. A $0.285-per-share dividend was declared for payment in May 2012.
Risks, contingencies and unusual items
- IRS tax dispute: The IRS proposed about $700 of additional tax plus approximately $175 of interest for 2004–2006, and YUM estimated potential additional tax of about $350 plus $25 of interest for later years through 2011 if the IRS prevails. YUM disputes the proposed adjustment; resolution is uncertain and not expected within twelve months. The company warned that amounts beyond recorded reserves could materially affect financial position or results.
- Legal matters: Disclosed cases include California wage-and-hour claims and a Taco Bell accessibility class action. Outcomes and potential losses in several cases could not be reasonably estimated; YUM states it intends to defend the claims.
- Lease guarantees: Potential undiscounted payments were approximately $650, with a present value of approximately $575; the recorded probable exposure was not material. Franchisees are primary lessees for most of these obligations.
- China VAT: The applicability of a new value-added tax rule to certain food sales was unclear; YUM could not quantify any potential impact.
- Little Sheep integration and valuation: Purchase accounting was preliminary, including approximately $300 of goodwill and $500 of other intangible assets. YUM disclosed limited experience with aspects of the business, including hot-pot cooking, soup-base manufacturing and Little Sheep’s minority interest in a meat-processing facility.
- Other exposures: Self-insured property and casualty liabilities were $143. Management noted actuarial estimates can be volatile. Debt covenant cross-default provisions and investment-grade credit ratings also bear monitoring.
Key facts for investors to verify
- Separate recurring performance from the $101 pretax net special-item contribution; reported EPS growth substantially exceeded growth before special items.
- Track China same-store sales, restaurant-level cost inflation and operating margin; China operating margin was 21.0%, down 2.7 percentage points year over year, despite higher operating profit.
- Monitor Little Sheep’s contribution after consolidation, purchase-price allocation updates and the risks YUM identified in its new business.
- Assess cash generation against acquisition spending, dividends, repurchases and upcoming debt maturities, including the $263 due in July 2012.
- Follow developments in the IRS dispute, China VAT applicability and significant litigation, including any change in reserves or estimated exposure.