YUM! Brands’ Earnings Hurt by Refranchising, Separation Costs

Completed the separation of its China business on October 31st, 2016

Fast food giant YUM! Brands Inc. (NYSE: YUM) announced its Q4 FY16 and full-year FY16 financial results on February 09th, 2017.

The Louisville, Kentucky-based Company, through its subsidiaries, operates quick service restaurants. It operates in four segments: YUM China, the KFC Division, the Pizza Hut Division, and the Taco Bell Division. The Company operates, franchises, and licenses a system of restaurants, which prepare, package, and sell various food items.

As of April 21st, 2016, it operated approximately 43,000 restaurants in 130 countries, primarily under the KFC, Pizza Hut, and Taco Bell brands, which specialize in chicken, pizza, and Mexican-style food categories. Worldwide, the Yum! Brands opens an average of over six new restaurants per day. Read more about YUM! Brands’ financial results below.

Q4 FY16 financial highlights

YUM! Brands’ Q4 FY16 overall net sales grew 2% to $2.02 billion versus the year-ago same period, of which the Company’s sales accounted for $1.32 billion and franchise and license fees accounted for $700 million. Worldwide system sales grew 8%, while same store sales grew 1% during the quarter versus the prior year’s comparable period. For YUM!, the third straight quarter of sluggish sales reflects a broader industry slowdown, intense price competition from other burger companies, menu stagnation, and the continued popularity of McDonald’s Corp.’s (NYSE: MCD) all-day breakfast menu.

Of the total revenues during the quarter, KFC brought in $1.04 billion, Pizza Hut accounted for $327 million, while Taco Bell brought in $655 million. During the reporting quarter, the Company’s restaurant expenses grew 1% to $1.09 billion, while total costs and expenses grew 1% to $1.53 billion. Despite higher costs, operating profit grew 14% to $489 million, while net income fell 3% to $267 million during the reporting quarter. Foreign currency translation negatively impacted operating profit by $11 million during the reporting quarter. Q4 FY16 GAAP EPS from continuing operations was $0.76, a rise of 15%, while EPS from continuing operations excluding special items was $0.79, a growth of 19%.

During the reporting quarter, the Company completed the separation of Yum China Holdings Inc. on October 31st, 2016. YUM! refranchised 232 restaurants, including 120 KFC, 83 Pizza Hut and 29 Taco Bell units, for proceeds of $200 million. The company recorded refranchising gains of $64 million and as of December 31st, 2016, its franchise ownership mix was 93%. Total restaurant openings were at 1,188 during the reporting quarter.

During Q4 FY16, the Company incurred $39 million in special items related to the strategic transformation of YUM! Brands, the biggest component of which was severance costs. In addition, the Company recorded a non-cash charge of $30 million related to share-based compensation award modifications related to the separation of Yum China, and a charge of $24 million related to settlement charges associated with payouts from a deferred vested pension payout program.

FY16 financial highlights

YUM! Brands’ FY16 overall revenues fell 1% to $6.36 billion from $6.44 billion in the prior year. Worldwide system sales grew by 5%, excluding foreign currency translation. Total restaurant openings were at 2,316, with net-unit growth of 3%. Foreign currency translation negatively impacted operating profit by $55 million during the year.

Total costs and expenses grew 6% to $4.74 billion during the year. Despite higher costs, operating profit grew 16% to $1.62 billion from $1.40 billion in the prior year, while net income jumped 25% to $1.61 billion from $1.29 billion. Full-year GAAP EPS from continuing operations was $2.48, an increase of 18%. Full-year EPS from continuing operations excluding special items was $2.45, an increase of 5%.

Segmental highlights

KFC Division: This segment’s system sales increased 8% for Q4 FY16 and 7% for FY16, excluding foreign currency translation. The KFC Division opened 593 new international restaurants during Q4 FY16. For FY16, KFC Division opened 1,086 new international restaurants in 81 countries, including 885 units in emerging markets. Restaurant count grew 3% to 20,604 in Q4 FY16 versus 19,952 in the year ago corresponding period.

Operating margin increased 1.9% for Q4 FY16 and 1.4% for FY16 driven by franchise net-unit development and same-store sales growth. The 53rd week provided a benefit of 2% to system sales growth and 4% to core operating profit growth for Q4 FY16. For FY16, the 53rd week provided a benefit of 1% to both system sales growth and core operating profit growth. Foreign currency translation negatively impacted operating profit by $8 million for Q4 FY16 and $48 million for the full year FY16.

Pizza Hut Division: This segment’s system sales increased 3% for Q4 FY16 and 2% for FY16, excluding foreign currency translation. The Pizza Hut Division opened 379 new international restaurants during Q4 FY16. For FY16, Pizza Hut Division opened 745 new international restaurants in 74 countries, including 551 units in emerging markets. Restaurant count grew 2% to 16,409 in Q4 FY16 from 16,063 in the year-ago same period.

Operating margin increased 9.0% for Q4 FY16 and 4.8% for FY16 driven by decreased G&A as a result of lower litigation costs and refranchising. The 53rd week provided a benefit of 3% to system sales growth and 5% to core operating profit growth for Q4 FY16. For FY16, the 53rd week provided a benefit of 1% to system sales growth and 2% to core operating profit growth. Foreign currency translation negatively impacted operating profit by $2 million for Q4 FY16 and $7 million for the full year FY16.

Taco Bell Division: This segment’s system sales increased 12% for Q4 FY16 and 6% for FY16, excluding foreign currency translation. Taco Bell Division opened 134 new restaurants in Q4 FY16. For FY16, Taco Bell Division opened 294 new restaurants. Restaurant count grew 3% to 6,604 in Q4 FY16 from 6,407 in Q4 FY15.

Operating margin increased 4.5% for Q4 FY16 and 2.4% for FY16 driven by same-store sales growth, decreased G&A and franchise net-unit development. The 53rd week provided a benefit of 6% to system sales growth and 8 percentage points to core operating profit growth for Q4 FY16. For FY16, the 53rd week provided a benefit of 2 percentage points to both system sales growth and core operating profit growth.

Other highlights

Restaurant count: During Q4 FY16, YUM! opened a total of 1,188 restaurants. For the full-year FY16, total restaurant openings were at 2,316.

Share repurchase: As of December 31st, 2016, there was $1.9 billion remaining in the Company’s share repurchase authorization through year end 2017. During FY16, the Company returned over $6 billion in capital through quarterly dividends and through repurchasing approximately 68 million shares.

Dividends: On December 21st, 2016, the Board of Directors declared the Company’s first dividend since separation of its China business of $0.30 per share of common stock. The quarterly dividend will be distributed February 03rd, 2017 to shareholders of record at the close of business on January 13th, 2017. Over the long-term, Yum! targets a payout ratio of 45%-50% of annual net income, before special items.

Refranchising: By the end of 2018, Yum! Brands aims to have at least 98% of its restaurants owned by franchisees, which would lower costs and increase its dependence on more stable franchise and license fees. As of December 31st, 2016, its franchise ownership mix was 93%. According to CEO Greg Creed, the Company plans to have at least 95% of its restaurants worldwide owned and operated by franchisees by the end of 2017.

Yum! Brands plans to reduce annual capital expenditures to about $100 million in 2019 from about $500 million in 2015. The Company is also aiming to cut general and administrative expenses by a cumulative $300 million by 2019, half of which would come from shifting restaurant expenses to new franchisees, while the remainder would come from job eliminations and tighter expense controls.

Separation of China unit: YUM! completed the separation of its China business on October 31st, 2016, thereby creating two independent, focused growth companies. In October 2015, YUM! had agreed to hive off its China business from its US operations to better focus on the Asian markets. The China unit, which includes 7,200 stores, is valued between $8 billion-$11 billion. The divestment is part of the Company’s plan of gradually reducing exposure in a business with shrinking market share and move from owning restaurants towards pure franchising. According to CEO Greg Creed, the Company plans to have at least 95% of its restaurants worldwide owned and operated by franchisees by the end of 2017.

Yum!’s China business assumed the name Yum China Holdings Inc., and began trading on November 01st, 2016, on the New York Stock Exchange with the ticker symbol “YUMC”. The new company will become a licensee of Yum Brands in Mainland China and will have exclusive rights to the KFC, Pizza Hut, and Taco Bell brand names. China’s contribution to Yum! Brands earnings, which now stand at 45%, are expected to fall to 14% after the spinoff, when it will begin paying Yum! Brands a license fee of 3% of restaurant system sales.

Yum China to triple restaurant count: Yum China plans to triple the number of restaurants and have 12 KFC restaurants per million people in China. Yum now has more than 7,300 KFC and Pizza Hut outlets. Yum China is targeting a 15% earnings expansion, and open restaurants in mega cities, major transportation hubs, and new shopping malls. Currently, China has about 4 KFC stores per million people versus 13 stores per million people in the US.

Stock Performance

YUM! Brands’ stock stood at $67.67, slipping 1.07%, at the close on Tuesday, February 21st, 2017, having vacillated between an intraday high of $68.58 and a low of $67.49 during the session. The stock’s trading volume was at 3,592,360 for the day. The Company’s market cap was at $24.85 billion as of Tuesday’s close.

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