International restaurant chain Yum! Brands (click ticker for report: YUM) reported satisfactory second quarter results Thursday. Earnings per share only increased a penny compared to the second quarter of 2011 to $0.67 per share, $0.03 short of consensus expectations. Revenues grew 12.5% year-over-year to $3.2 billion, roughly in-line with what the Street expected. Though results did not disappoint, we think shares are trading near the high-end of our fair value estimate range.
We, and the rest of the investing community, were focused on results in China, which were strong, in our view. System-wide sales in China grew 27%, driven by same-store sales growth of 10%. On an individual restaurant basis, same-store sales at KFC grew 9%, and Pizza Hut same-store sales grew 10% year-over-year. This slight divergence between the two restaurants isn’t out of the ordinary since KFC is a far more saturated brand in China than Pizza Hut. Yum opened 160 restaurants in China in the second quarter and remains on pace to open at least 700 stores for the year. We were slightly disappointed that restaurant operating margins fell 410 basis points year-over-year due to commodity price and wage inflation. As a result of these headwinds, operating profit was flat year-over-year. We think lower operating margins could be a permanent fixture since wages likely won’t go anywhere but up. Still, there may be room for increasing operational efficiencies in the country.
Results in the US were also strong, though the segment is now not as meaningful as China. Same-store sales grew 7% system-wide thanks to 13% growth at Taco Bell and 4% growth at Pizza Hut. Taco Bell has succeeded with new product offerings, including the Doritos Tacos Locos. KFC continues to struggle, with same-store sales growing only 1% year-over-year. Unlike McDonald’s (click ticker for report: MCD) and Burger King (BKW), which have cleaned up not only food offerings but also restaurants, KFC struggles from low capital investment, few healthy menu options and weak marketing support. Though the firm supports unique marketing and menu initiatives at Taco Bell, management doesn’t seem excited to help KFC in the US. Fortunately for Yum!, competition in the fried chicken space isn’t as intense as it is in burgers, though we think it’s clear McDonald’s rollout of Spicy McBites and McBites is a clear indication the Big Mac maker sees an opportunity to steal share from KFC.
Same-store sales in the Yum Restaurant International segment came in at 4%, driven by weak growth in Europe. Operating margins decreased 40 basis points as increased franchise fees failed to offset generally lower restaurant margins (down 110 basis points). We suspect restaurant margins will return to higher levels once input prices moderate. Sales in India grew 32% (excluding currency) driven by 29% unit growth and 7% same-store sales growth. We’re interested to see if India can become the newest cash cow for Yum brands. Though Indians haven’t quite urbanized to the same extent as the Chinese, it appears they may share the same appetite for chicken and the KFC brand.
Even though we think Yum has fantastic potential in emerging markets, we think shares are fairly valued at current levels. Yum reiterated its full-year earnings guidance of at least $3.22 per share, which gives the company a forward earnings multiple of about 21, suggesting shares are more expensive than McDonald’s on a relative basis. Yum’s annual dividend yield is only 1.7% at current levels, less than McDonald’s 3% dividend (search our dividend reports here). We also think McDonald’s could have a longer runway in China, though we aren’t crazy about either firm at current levels.