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NEW YORK – Goldman Sachs, hired as a financial advisor by Yum Brands, Inc. (NYSE: YUM), released an in-depth analysis of the fast food chain’s prospects in the developed world. And it isn’t pretty. The report shows that Yum’s fast track growth in China has been to the detriment of American franchisees in its core brands of KFC, Pizza Hut and Taco Bell.
Analysts Michael Kelter and Chris Cerrone gave a sell rating on Yum’s stock and lowered the company’s estimates based on poor performance in the developed world. “We see the potential for prolonged and possibly accelerated weakness in US and Europe, which will offset some of YUM’s successes in China and other emerging markets,” they affirm in their August 1, 2011 thesis (pdf). They are lowering their 2011, 2012 and 2013 estimates to $2.80, $3.15 and $3.60 from $2.86, $3.18 and $3.65, to reflect lower American and European same store sales (SSS) projections, and they anticipate a further decline in U.S. store unit count as franchisees are increasingly likely to exit.
Andrew Selden of Briggs and Morgan, attorney for the independent Association of Kentucky Fried Chicken Franchisees, Inc. (AKFCF) said the numbers in the report speak for themselves. “Yum has not done a good job in managing their core assets in their home market and that’s what the numbers show.”
Selden said this is the first time a credible outside agency took notice of what franchisees have been saying among themselves for the past two to three years. “Yum’s CEO David Novak and his team are running the brand right into the ground just like they have in their other domestic brands.” He adds that Yum senior management tends to blame franchisees rather then acknowledge any issues with their vision or leadership.
John Gordon, principal of Pacific Management Consulting Group gave a similar view. “Michael Kelter has been the first analyst in recent memory to detail the YUM problems in our country. The U.S. story is important because it involves franchisees. YUM has spent 15 years developing their China operations. It now takes great lengths to minimize discussion about the U.S. market.”
Yum’s American operations remain crucial to total company results as Yum still has almost 20,000 units in the US, five times the total of China. The report explains, “The company still earns 20 –30% of its EBIT [earnings before interest and taxes] domestically, and profits have been declining at a double digit pace each year.” The highest potential area of future weakness is acceleration in U.S. unit closures. Because there has been an increase in store closures in 2011, they expect an increasing number of franchisees to close their door in coming years.
Why so many closures?
The analysts point out that restaurant closures are due to a lack of franchisee profitability. With 80% of Yum brands franchised in the U.S., Yum is reliant on franchise owners to operate the fast food restaurants. Same store sales in the U.S. have only grown 0.8% over the past decade, falling behind the national inflation rate of two to three percent over the same period.
The Goldman advisers believe that part of the reason the weakness in the U.S. market hasn’t attracted much attention is that margin declines have been masked by the “aesthetics of refranchising.” But their report states that refranchising is running out of steam. Since 1997, Yum has significantly reduced the number of KFC and Pizza Hut units that it operates directly. They state that the pizza chain’s refranchising has been completed and that of KFC will be limited. “As this margin tailwind dissipates, underlying margin declines will become more obvious,” their report states.
Goldman Sachs observes that Taco Bell is the cornerstone of Yum Brands. It accounts for roughly two thirds of Yum’s U.S. EBIT, or earnings before interest and taxes. The remaining third is split between Pizza Hut and KFC. Taco Bell same store sales growth has been very disappointing in 2011, having not grown in the first quarter and decreased by 5% in the second. “These results have been attributed to a highly publicized lawsuit filed in mid-first quarter that made accusations about the quality of Taco Bell’s beef,” observe the analysts on how the company dismissed its lackluster performance.
KFC has been the most challenged brand domestically in the franchising firm’s portfolio. The report states it might be nearing a critical tipping point. Goldman Sachs analyzes three causes: out-dated restaurants and perceived unhealthiness of food resulting in market share losses; cuts in advertising support; and franchisees closing restaurants.
Since 2000, KFC’s market share has eroded from 37% to 28% while Chick-fil-A and Buffalo Wild Wings doubled their respective market shares. In 2010, the combined market share of both competitors was greater than KFC, the first time that both of those chains held higher share than KFC. The report affirms that overall the chicken quick service restaurants (QSR) sector is also losing share.
Goldman research shows that KFC lacks appeal to consumers looking for a healthy dining option. KFC’s healthiness ranks at the bottom. The chicken chain’s outlets are also considered outdated, ranking near the bottom of major QSR concepts. KFC’s advertising support levels are also declining. “This is typical of the negative feedback loop that can occur in restaurants as declining sales lead to lower advertising budgets, which then lead to further sales declines,” the report states.
KFC franchisees are closing restaurants at an alarming rate. Over 20 percent of owners in 2003 have since closed their doors. “As weak results compound on weak results, the unit economics for franchisees become less attractive,” the analysts report. “Eventually, it is no longer profitable to operate restaurants and franchisees begin converting their units for other uses,” they add. Goldman Sachs said they have seen this trend occurring with KFC since 2003.
Pizza Hut has also been flat or down in 10 of the last 18 years, the report states. “. . . same store sales have averaged +1% over the period, insufficient to maintain margins in the face of labor and food inflation with CPI [consumer price index] up 2-3%/year. NPC International, the largest Pizza Hut franchisee with 1,100 units, which we view as a proxy, has seen its restaurant margins decline from 17.8% in 1999 to 12.4% in 2010,” Goldman reports. Overall, the pizza industry has been underperforming, and no pizza chain has achieved consistent results. The analysts declare,“We believe the top players are simply trading customers year to year based on promotional activity.”.
One key risk to the American market is that China plans to cut income tax rates next month. Goldman reports, “The Chinese government is initiating a tax cut effective on September 1, 2011.” The analysts are uncertain what the impact of this tax cut will be on Yum’s China same store sales. An increase in discretionary cash flow could lead to more business from higher middle class spending.
In speaking only of KFC, attorney Selden thinks that Yum’s own research for 20 years has consistently shown that customers do not want KFC to be transformed and modernized. “They want high quality group meal occasions; family meals, church picnics, and little league ball team lunches. It’s not about teenagers going through the drive-through window for a 99 cent item,” he explained.
Selden said this truism is a good example of what has happened with KFC: It’s not the customer who left the brand. It’s that the brand has left the customer. “Everything else, the litigation, who gets control of the ad fund, restaurants not updating as they should, is all a sideshow. The only thing that matters is what the customer wants. That’s what the numbers show,” Selden declared.
Although Yum Brands returned an initial phone call from Blue MauMau, they declined an interview regarding the Goldman Sachs report.
Yum Brands’ franchisee community also did not respond. Blue MauMau contacted several franchisees and associations. Lysa Little, executive director of FRANMAC, which represents Taco Bell franchise owners, would only say that it was the trade group’s policy to refer all press to Taco Bell’s corporate office.
|YUM US deep dive 8.1.11.pdf||449.62 KB|