Yum! Brands: Cheap Eats Curb the Blues

As consumers scale back, the outlook is more appetizing for the operator of KFC, Taco Bell, and Pizza Hut. Growth in China is helping, too

Soaring commodity prices and economic gloom have taken a bite out of some restaurants' profits this year, as consumers opt to cook at home or order less expensive takeout. That bodes well for Yum! Brands (YUM), the fast-food operator with the largest number of restaurants in the world.

The owner of 35,000 restaurants under the KFC, Taco Bell, and Pizza Hut brands is poised to report solid second-quarter results on July 16, according to industry analysts. Wall Street consensus estimates predict earnings per share to come in at 42¢, nearly 8% growth over the same quarter a year ago, at the start of an earnings season that's already seen many publicly traded restaurant companies' stock prices plunge. On July 15, shares of higher-end restaurant chains including Ruth's Hospitality (RUTH), Benihana (BNHN), and Denny's (DENN) all hit yearly lows under $10. And the Dow Jones U.S. Restaurant and Bar Index is down more than 9% since the beginning of 2008.

While its stock has been flat over the last year, Yum Brands may be dodging some of the gloom because its stores emphasize affordability. In May, Taco Bell launched its "Why Pay More," menu, an assortment of foods including tacos and burritos priced between 79¢ and 99¢. The result so far has been positive, and same-store sales for Taco Bell should increase by about 9%, according to UBS (UBS) restaurant analyst David Palmer. "Some of the value on that menu is pretty eye-opening to the consumer," says Palmer.

Global Growth

International growth, especially in China, is the main earnings driver for Yum, analysts say. Last year the company's China division—with more than 2,200 KFC stores—contributed 24% of Yum's operating income and is targeted to rise 20% this year, says Banc of America Securities (BAC) analyst Joseph Buckley in a note. Long term, Yum expects to open 20,000 stores there. Investing in the company "is a way to invest in China," says Buckley. "Yum has a more developed China business presence than most consumer companies."

Yum hasn't been immune to the food industry's doldrums, though. Consumers who got a financial boost from the U.S. government's economic stimulus checks in April through June are still cautious about spending. Consumer confidence in the economic climate six months from now dropped to its lowest level since 1980, according to July figures from the University of Michigan and Reuters. That has hurt some of Yum's efforts to refranchise its company-owned stores and buy back shares with the proceeds. According to Palmer at UBS, the company has lowered its initial refranchising goals for 2008 by about 300 stores since there is less demand for franchises in a tight economy.

Also, the first restaurant meal that customers tend to shun in a slowdown is dinner, he says, which comprises about 50% of Yum's business with Pizza Hut and KFC.

Double Squeeze

The other problem for restaurants such as Yum is rampant commodity inflation (BusinessWeek.com, 4/8/08). The twin bears of wholesale food inflation and slowing consumer spending are cutting what were already thin margins for eateries, says David Tarantino, senior research analyst for Robert W. Baird. If commodity prices continue to rise, many restaurants will have to eat the loss instead of raising menu prices for price-sensitive consumers. Through May, menu prices have increased only about 4% this year, while wholesale food prices are up 7.9%, says Hudson Riehle, senior vice-president of research at the National Restaurant Assn.

Low-priced fast-food outfits such as Yum's KFC risk losing cost-conscious customers if they raise prices. The more upscale eatery Chipotle Mexican Grill (CMG) recently raised prices on its menu. Says Tarantino: "It's not always the lowest price that wins."

The restaurant industry, which the National Restaurant Assn. estimates will book $558 billion in sales this year, up 4.4% from 2007, is hoping an eventual economic turnaround will entice customers back to family dinners and business luncheons. Says Riehle: "The industry overall is recession-resistant, not recession-proof."

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