Yum! Brands, Inc.
Q3 2011 Earnings Call Transcript

Published: 5 Oct 2011

[Operator:]

Good morning. My name is David, and I will be your conference operator today. At this time, I would like to welcome everyone to the Yum! Brands Third Quarter 2011 Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to your host, Tim Jerzyk, Senior Vice President of Investor Relations. Sir, you may begin.

[Tim Jerzyk:]

Thanks, David. Good morning, everyone, and thanks for joining us. This call is being recorded and will be available for playback. We are broadcasting the conference call via our website, www.yum.com. Please be advised that if you ask a question, it will be included in both our live conference and in any future use of the recording. I would also like to remind you that this conference call includes forward-looking statements. Forward-looking statements are subject to future events and uncertainties that could cause our actual results to differ materially from these statements. All forward-looking statements should be considered in conjunction with the cautionary statements in our earnings release released last night and the risk factors included in our filings with the SEC. In addition, please refer to the Investors section of the Yum! Brands website to find disclosures and reconciliations of non-GAAP financial measures that may be used on today's call. Finally, we would like you to be aware of a few upcoming Yum! investor events. Our Annual Investor and Analyst Conference in New York City will be Wednesday, December 7. Please register for that as soon as possible. Monday, February 6, 2012, fourth quarter earnings will be released. This was previously scheduled for February 1, so please adjust your calendars. On our call today, you will hear from David Novak, Chairman and CEO; and Rick Carucci, our CFO. Following remarks from both, we will take your questions. Now I'll turn the call over to David Novak.

[David C. Novak:]

Okay. Thank you, Tim, and good morning, everyone. Before I talk about our third quarter performance, I think it's interesting to note that this Friday, October 7, is our Founders' Day and marks the 14th anniversary of our company. From the very beginning, our formula for success has been people capability first, satisfy customers and profitability follow. I'm proud of how we win together, ownership culture we have developed and pleased with the strong returns we have generated for our shareholders, with our share price up well over 500% since our spinoff from PepsiCo. I'm even more pleased we continue to have tremendous optimism about the future growth of our company. Our people know the 3 keys to driving shareholder value, and believe me, we are focused on them now more than ever

[Richard T. Carucci:]

Thank you, David, and good morning, everyone. Today, I'm going to provide some commentary on our third quarter results and our outlook for the balance of 2011. I will then review changes we are making to our business portfolio and provide some of our initial expectations for 2012. During the first 2 earnings calls this year, I categorized our 2011 results as a tale of 2 cities. Strong international growth, especially in China, has been a contrast to poor U.S. performance. This quarter is essentially more of the same. China produced another impressive quarter. Revenue increased an amazing 35% as we benefited from new unit growth, same-store transaction growth of 27% and favorable foreign exchange. On the other hand, profit growth and margins were less than what we would expect with this type of sales increase. Operating profit grew 7% in the quarter, excluding foreign exchange, or 11% adjusting for the 2010 impact of the Shanghai World Expo. Margin declined 3.9 percentage points to a little over 21%. Let me walk you through the details on margins. With commodity inflation of 8% and labor inflation of about 20% in the quarter, we had some significant headwinds. Margins in the quarter were also affected by the new business tax this year and the overlap of the Expo. Taken together, commodity inflation, labor inflation, the business tax and the Expo overlap caused about 7 points of margin pressure. The pricing we took in the first quarter helped to offset about 3 of the 7 points. There were some other moving pieces, but the gap between the inflation and pricing is by far the biggest contributor of the 3.9-point margin decline versus last year. So let's briefly discuss some of the other moving pieces. First, our new unit development pace picked up significantly this year. The additional labor and preopening expenses offset some of the margin benefit of our transaction growth. Additionally, some of our same-store sales growth was driven by targeted daypart value initiatives that David walked you through. Due to the higher costs of these initiatives, the profit flow-through through this transaction growth was less than what you would normally expect. Going forward, we realize we have some work to do to close the gap between pricing and inflation. We're taking actions to do this. Our first step was a 2% price increase implemented the last week of September. Going forward, we expect even higher inflation in the fourth quarter. We now expect mid-teens food inflation and labor inflation of about 20% in the quarter. To help offset this, we expect to tweak our value offerings later this year. Despite these initiatives, this level of pricing still lags the impact of a high inflation rates. We therefore expect a decline in fourth quarter year-over-year margins. We continue to expect restaurant margins of about 20% for the full year. Going forward, we see no reason why we cannot continue to deliver at least 20% margins in China. We believe that we will perform well financially because we have all the necessary leverage, including a strong competitive position, purchasing scale, a seasoned management team, a nationwide presence and expanding dayparts. In addition, the combination of our cell phone distribution system and large development team allows for profitable unit expansion in lower tier cities. We really like our position in China. We have excellent sales momentum and expect solid double-digit same-store sales again in quarter 4. Our development continues to be robust. 600 new units is clearly an impressive number, and we continue to generate cash paybacks of less than 3 years. This is a portfolio that delivers high returns and high growth. Let's move to Yum! Restaurants International. Our YRI business had another solid quarter, with same-store sales growth of 3%. Operating profit growth of 3% prior to ForEx included the impact of some onetime items. Excluding a $6 million impairment expense for the Pizza Hut U.K. business, operating profit growth was 8% for the third quarter. Additionally, YRI experienced a $4 million expense for the biannual franchise convention. On the positive side, we received $5 million generated from the change in ownership of one of our large KFC franchisees in Australia. Restaurant margin declined 0.2 points to 12.3%. This decline was driven by soft sales and inflation in Australia and weak margins in the Pizza Hut U.K. business. Although margins continued to improve in Thailand and France, the year-over-year impact was less than in previous quarters. We still expect margins to improve significantly for the full year. As we continue to update our ownership portfolio and increase our scale in key markets, our margin should continue to improve. Overall, we believe that Yum! Restaurants International business is gaining strength. We are particularly pleased with our new unit development and exceptionally strong performance in emerging and underpenetrated markets. We believe that these factors provide a solid base for sales and profit growth in 2012 and beyond. Our U.S. business had a disappointing quarter. Sales improved versus the second quarter, but inflation hurt margins. Looking to the fourth quarter, we expect that sales will remain a challenge. We will likely see another same-store sales decrease. Fortunately, we expect to benefit from the overlap of high G&A costs from last year, as well as the 53rd week this year. This should help improve U.S. operating profits in the fourth quarter considerably. As we finish looking at 2011, let me provide some more expectations about the impact of the 53rd week this year. The 53rd week provides a $25 million operating profit benefit. This represents a $0.04 EPS benefit in the fourth quarter. This benefit is split between the YRI and U.S. businesses, and for the full year, we committed about $20 million in higher-than-normal spending. This spending includes development and operational initiatives for our Pizza Hut U.S. business and the higher impairment expenses at Pizza Hut U.K. The bulk of this spending is already reflected in our year-to-date financial results, while about $3 million of the $20 million is spending that is anticipated in the fourth quarter. When you put all of this together, we are still quite confident that Yum! will deliver EPS growth of at least 12% in 2011. Before we look ahead into 2012, let's first reflect on some key decisions we made this year to realign the Yum! portfolio. Our philosophy is simple. We reduced company ownership in highly penetrated or underperforming markets. We increased exposure in emerging and underpenetrated markets. We have continued to be disciplined and proactive in managing this aspect of the business. In 2011, we made several decisions that will serve to reduce our financial footprint in highly penetrated markets. First of all, we continued our U.S. refranchising program. This year's focus is on refranchising KFC restaurants. For the full year, we expect to refranchise about 400 restaurants, and the majority of these are KFC units. We expect to end the year with about 500 KFC company-owned restaurants. The game plan is to retain 5% ownership or less than 250 units. This quarter, we also announced an agreement to sell Long John Silver's and A&W All American Restaurants. I know it's tough to run a business during a selling process, and I would like to thank the LJS and A&W teams for all of their hard work this year. The deal is expected to close in the fourth quarter, and we wish our franchise partners and the teams every success going forward. In our release, we also announced a decision to refranchise our Pizza Hut U.K. business. We believe this will improve Yum! Restaurants International's profits and margins. Every year, we increase our exposure in high-growth emerging markets through our new unit growth. This year, there are also 2 potential transactions that could increase our ownership in underpenetrated markets. We made a bid to acquire Little Sheep in China, and we plan to acquire a KFC South African franchisee. We are still awaiting China government approval and have nothing new to report on Little Sheep, so let me talk about Africa. We expect to close on the South African deal later this month. We already have a great franchise business in South Africa with over 600 restaurants. We believe that the 70 units we're acquiring provide another growth vehicle in that country. These restaurants will also provide a base for us to train our franchisees in the balance of Africa. We remain hopeful that in the long term, Africa can become a large franchised business and a meaningful source of growth. In the past year, we opened KFCs in 4 new countries in Africa, and our goal is to spread aggressively across the continent. As we head into 2012, we believe that our portfolio has never been stronger, and that we're building upon our advantage in emerging markets. We are still in the process of developing detailed plans for our businesses in 2012. Therefore, I will not talk about sales and profit plans today. As usual, we will share information on these subjects at our December meeting. However, I do want to share some initial thoughts for 2012 and some items that will influence our performance. We are fortunate that our new unit development usually provides us with a head start on building a profit plan. This year is no exception. The development of 1,500 new units outside the U.S. in 2011 will provide us with a head start for 2012. Overall, we expect new unit development to contribute about half of our 2012 growth. We expect to see benefits in 2012 from share repurchases. In our release, we have pointed to year-to-date 2011 share repurchases of $545 million. We expect about $800 million in repurchases for the full year and a similar amount in 2012. The impact of these share repurchases should provide 2 points of 2012 EPS growth. While it's uncertain how the dollar will perform against most other currencies next year, it's probably a good bet that we get RMB translation benefits again in 2012. Now don't get me wrong. We expect 2012 to be another challenging year. The economic climate is very uncertain. Inflation could also rear its head, especially in the first half of the year. We know that we need to turn around our U.S. business. But Taco Bell is a resilient brand, and we will have easy overlaps next year. As David mentioned, in addition to our innovation pipeline, we will be taking a hard look at managing costs within our U.S. business. I do have a lot of confidence in our business model. I have faith in our team's ability to grow the business and manage costs tightly. Our global portfolio has led with 13% annual EPS growth over the past decade. This decade has included quite a few individual challenging years. I also just told you that our portfolio has never been stronger. Therefore, I believe 2012 will be another year where Yum! will deliver strong results for our shareholders. Back to you, David.

[David C. Novak:]

Okay, Rick. Thank you very much, and let's open it up for questions.

[Operator:]

[Operator Instructions] Your first question comes from the line of David Palmer with UBS.

[David Palmer:]

I'm sure you're going to get a lot of questions about the China margins this quarter, and there are many reasons for that. You stated some of them. But just taking a step back, I'm curious about the strategy for China in 2011. Are you getting from this business what you thought you would get at the beginning of the year? And I guess, I'm drilling into the fact that you had accelerating inflation, and you knew that. You were also pursuing 2 major value-menu launches, one at breakfast earlier in the year, one at the beginning of the third quarter with the lunch stuff. And you -- and all this time, you've waited on pricing. Since late January, you have not raised price, and even in the -- back in January, it wasn't a hell of a lot of price. And then on top of that, you're embracing a rather expensive ramp-up in unit development here in the third quarter, putting further pressure on margins. And so I'm wondering, and I guess a lot of folks are wondering, why have you been so stingy on the price? And are you getting some sort of reactions on all this stuff that you weren't expecting? Any help on this will be great.

[Richard T. Carucci:]

David will talk about the consumer side, and then I'll have the financial aspect of it, David.

[David C. Novak:]

Okay. Well, first of all, David, our strategy is a brand-building strategy and an asset leverage-building strategy, and what we're trying to do is make our brand as compelling and as relevant and as ubiquitous as it can possibly be in China. And if you look at the real success factors in this category, you have a broad menu, you leverage your asset throughout the day and you make your products affordable on an everyday basis. And in China, we're doing this, and we're doing it with great margins this year. And I think what I feel terrific about is that we're getting everything that we want to get out of China. We're continuing to grow this business, and we have a great team of people there that are focused on building this brand and building dayparts and leveraging that asset throughout the day. But they are, first and foremost, brand builders, and I think that's what we're doing. We have tremendous operational excellence. We're maintaining fantastic operations as we're dramatically improving our transactions. Our average unit volumes now are $1.7 million. So we're getting -- our new unit cash flows and margins are as good as they've ever been, and so we're having another excellent year in China on top of a great year last year. So strategically, the only thing I think we've done is further solidified our strength with the customer. We will have -- this year, we're going to set a record for new units. We're going to have 600 new units. So just think of the transaction growth we're achieving, sales growth we're achieving, the margins that we have, and we're still adding a record number of 600 units. So to me, looking back and stepping back and looking at China, it would be hard for me to say, if I could -- if someone said, "Can we write this story? Last year, at the beginning of January, could we have this kind of performance?" I'd say, "Give it to me. Give it to me this year. Give it to me next year. Keep it going." And the best thing about our business is that we've got KFC moving in all cylinders in China. And also, as I mentioned in my earlier remarks, we've got Pizza Hut now, which has been dramatically transformed. We're going into 100 -- we're going to open up 100 stores of Pizza Hut this year. We're going into Tier 3, 4 and 5 cities. In Pizza Hut, we only have 500 units. So we are constantly just trying to build these brands the right way. I've always said that we've got these tremendous diamonds. We just got to keep polishing them and growing them the right way. And our people capabilities have never been better, the brand's never been stronger, and Yum! in total is going to have another excellent year.

[Richard T. Carucci:]

Just on the financial side, David, and by the way, I'm in the same place that David is, is I think China is having a spectacular year overall. We are still new at the game of value in China, some of the value initiatives. So the first ones we did were earlier this year in breakfast, and then around April time, at lunch and snacking. So we're still on version 1.0 of doing value initiatives, and all along, we recognize we're going to read the consumer and see what it did. I think we're very happy with the transaction gains that we had. We have quite a bit of growth in breakfast, which is fantastic. We probably had a little bit higher mix to some of those value initiatives that we would have guessed at lunchtime. But we always knew going into this that we could adjust. Now the only thing that makes the adjustment tricky is in the fourth quarter, inflation -- towards the end of the third quarter it was a little higher than what we were anticipating. To your point, we were anticipating high inflation, but the labor inflation, starting the year, we thought would be in mid-teens. And in the quarter, it was 20%, and we think it's probably going to be about 20% in the fourth quarter as well. And then commodity inflation, we thought, would not get up or not get higher in the fourth quarter. So that -- the biggest issue that we probably have is the adjustments towards the value. It will take us a little bit of time, but again, I couldn't be happier with the overall results. The profit results we have year-to-date, excluding ForEx, are 15%, and that's on top of 26% last year. So we feel -- I'll take it as David says. Regarding the unit development, I mean, to me, that's a no-brainer if you could get more units in China. The team is extremely disciplined on development, and one of the good things that came out of the last 5-year plan is that the government is sort of starting to build city clusters around some of the major -- about 20 or 25 major cities. We think that gives us new unit opportunities once some new trade zones will be developed as they're going to build housing in those areas. But they're also building trains and buses and stations and all of that, which those type of infrastructure things help us. So it's really been a combination of that investment and the trade zones, if that opens up for KFC, as well as David in his speech talked about how Pizza Hut is now able to get into Tier 3 and Tier 4 cities much more profitably than before. So that's allowed us to increase our Pizza Hut development significantly. So if I could -- if we could build 600 units a year going forward, and if that causes us a quarter issue with labor, that's like a no-brainer. We still get less than 3-year paybacks on those investments. So we feel great about where we stand in China.

[David C. Novak:]

So in summary, both KFC and Pizza Hut brands have never been stronger. Both brands are more ubiquitous than ever before. We're leveraging our assets throughout the day. We're opening up new units with returns that are at least, if not better, than any that we've ever had, and we're more optimistic than ever about the breadth and future of these 2 brands. And with the China consuming class going from 300 million to 600 million over the next -- in the coming years, we couldn't be in a better place. So very pleased with this year in China.

[Operator:]

Your next question comes from the line of David Tarantino with Robert W. Baird.

[David E. Tarantino:]

Just a quick follow-up on some of the discussion related to China margins. Rick, I was wondering if you could maybe comment on how the team there is planning to manage the long-term structure of the China margins. I know you've given up a little bit of ground this year, but the economic model still remains quite healthy. So should we think about China as maybe a 20%-type restaurant margin over the next several years, and the plan is not to necessarily recover some of the margins that you've lost this year? Maybe just explain how you're thinking about that business.

[Richard T. Carucci:]

Yes, I think to your point, David, clearly, the inflation this year is higher than normal. So it's hard to chase the inflation when it's that high. Our hope is that inflation, especially commodity inflation, will abate by midyear next year. Labor inflation, we think, will remain high but not as high as it was in the back part of this year. So in terms of how to deal with inflation though, I do want to emphasize that we're in a better position to do it than, we think, everybody else. We have a different levers that I talked about in my speech in terms of different dayparts, strong distribution system, and so we could take pricing in different areas, in different parts of the country, et cetera. And with our capability, we think we're better equipped than pretty much anyone else there to deal with inflation. Part of the game plan is that we will gradually take pricing and catch up to inflation. And then when inflation abates, we'll be back -- to your point, I think we expect, I'd call it at least 20% margins. But, again, we knew that we were off of very high margins a year ago. So we never thought -- going into this year, we didn't anticipate that we would keep that level of margin. So I think somewhere between a little over 20% is probably where the margins will shake out over the next couple of years.

[Operator:]

Your next question comes from the line of Greg Badishkanian with Citigroup.

[Unknown Analyst -:]

It's Jack Holland [ph] actually on behalf of Greg. Yes, it looks like you guys had a nice improvement at Taco Bell this quarter, and maybe even a little bit sooner than you had initially anticipated. I think you called out 4Q for that improvement back in the 2Q. So what do you think are the factors behind that improvement? Has the lawsuit concern sort of abated? And has that momentum continued into 4Q as well?

[David C. Novak:]

Well, I think that Taco Bell is making steady improvement, but a slow improvement, and we're obviously not pleased with our same-store sales. Any time your same-store sales are down, you can't be at all pleased about it. But to your point, we have improved. We went from down 5% in the second quarter to down 2%, and our 2-year numbers are plus one, if you look at a 2-year basis. But I think it's been just more of the same without any real significant breakthroughs. And what we've really been working on this year is, first of all, just across the board and around the world at Yum! Brands, we've been focused on operational excellence and making sure that we deliver a great experience to our customers. We've been focused on maintaining our #1 value initiative. But what we really think is going to really get Taco Bell moving and back on the growth track is more category innovation. And so what I'm really pleased about is this year, we have proven and test marketed that we do have exactly that coming forward, which will be launched at the end of first quarter. Taco Bell, in conjunction with our 50th anniversary, will be reinventing the taco. We've got some major news coming. So I think you're going to see some pretty much blocking and tackling, more of the same until we get to the end of the first quarter, and then we think we'll have a significant uplift in our business.

[Richard T. Carucci:]

And just to add to David's comments about what we see through the balance of the year and into the early part of next year, just as a reminder, the laps for Taco Bell do get a little bit more challenging in Q4. So that, combined with the fact that, as David said, the real look forward is the new innovation coming at the end of Q1 next year.

[Operator:]

Your next question comes from the line of John Glass with Morgan Stanley.

[John S. Glass:]

I have 2 questions. The first one is, is it worth or is it even possible in China to get better visibility on pricing for -- on food for the security purposes? In other words, McDonald's is experiencing what they claim is low single-digit inflation right now. And I know you can't speak to that specifically, but it does underscore that it is possible to get lower volatility in food. It would seem that since you've got the ownership and the distribution, you would have a natural advantage there and see lower volatility, and yet you're seeing higher volatility. So can you explain why that is the case? And is there a movement, not a change, of how you purchase food to avoid these situations in the future?

[Richard T. Carucci:]

I really, John, can't talk to McDonald's, but I will talk to what we have. I mean, if you look at -- to your point, if you look at what our food inflation has been, if you go out and go to the last 5 or 6 years, it's been way below what the inflation rate has been for food. And we were getting purchasing efficiencies and all of those benefits as well. So we have a world-class supply chain group in China. We have very strong distribution. So our costs are very, I think, very well-managed there. The challenge that we've had really has been on the proteins the last several years. So when you've seen this spike, it's been really related to -- we think it's been going with the market on both pork and chicken. So pork has had a lot of several price spikes the last few years. That has impact on [indiscernible] because those are the 2 leading proteins in China. So that's really what's been driving the volatility, we think, on the chicken has really been what's happened on the pork side in China. We're hoping that, that will abate early next year on the pork side, and it will start seeing better chicken cost, I'd say starting in around the second quarter next year, but that's a guess at this point. We'll give you better data if we have it in December.

[John S. Glass:]

Okay. And then can you just decompose that 700 basis points pressure you talked about, Rick, on the labor side between wage rate inflation, what the openings put on that? And then on the food side, what's just the inflation versus what's the impact of these promotions?

[Richard T. Carucci:]

Yes, if you just want to think about it simplistically on a year-over-year basis, there's obviously a lot of moving parts. If you take 8% food inflation on our base of about 34% or so, you get a little under 3 points of inflation on the food side. If you take 20% inflation on labor, which was about 14% last year of our base cost, that gets you to, again, a little under 3%. So food inflation and labor inflation in Q3 is equal to about 6% impact on margins.

[John S. Glass:]

I'm sorry, and then the remaining 100 basis points has to do with the value promotions?

[Richard T. Carucci:]

Well, yes, and then there's a lot of other moving part points. In my speech, I talked about the business tax, the Expo lap. In Q3, that was about 1 point, but then you obviously have benefits from transaction gains, et cetera. But from an inflation standpoint, it was about 6 points of the issue. Unfortunately, in Q4, that goes up to about 8 points because we said we expect mid-teen in inflation on the food side and still about 20% on the labor side. And so the September price increase will basically offset that increase. And then I mentioned before, we're going to tweak our value initiatives, which will be another step in that direction. But yes, that's what we didn't expect. We didn't expect the fourth quarter to be 2 points higher than the third quarter, so that piece we were taken by surprise on.

[Operator:]

Your next question comes from the line of Michael Kelter with Goldman Sachs.

[Michael Kelter:]

I was curious to follow up on your comments about rightsizing the cost structure in the U.S. Now with operating profits down as much as they are, are we talking about just sharpening the pencil or further on the spectrum, a formal restructuring or somewhere in the middle? What kind of things are you looking to do?

[Richard T. Carucci:]

Well, we've always looked aggressively at our cost structure. We've also -- over time, we mentioned where we continue to refranchise our business in KFC, and therefore, as we do that, that will have a modest impact on our cost structure. We will continue to look at this, and we're still developing plans as we go forward. We'll probably have more to say on it in the fourth quarter, Mike.

[Michael Kelter:]

All right. And then on an unrelated kind of housekeeping note, from a financial perspective, what should we expect the impact of the Long John, A&W and Pizza Hut U.K. refranchising on the P&L? Are those actions accretive, dilutive or roughly break-even? What do you think?

[Richard T. Carucci:]

About break-even. The LJS will be very slightly negative impact, about flat. And then the Pizza Hut U.K., depending on when it occurs, will be slightly positive.

[Operator:]

Your next question comes from the line of Joe Buckley with Bank of America Merrill Lynch.

[Joseph T. Buckley:]

Rick, first, a simple one. If you said this, excuse me, but what are you thinking on the full-year tax rate? Are you still thinking around 26%?

[Richard T. Carucci:]

No change there. Again, as we said before, it's the hardest one to predict. Just so -- it moves around based on onetime events. That's just how the accounting works.

[Joseph T. Buckley:]

Okay. And then another question on the China margins. The strength in breakfast and the development of the delivery and even the 24-hour business, are all of those dilutive to margins? And can you quantify the impact of developing those additional sales layers, the impact on margins?

[Richard T. Carucci:]

In breakfast -- what we're selling now at breakfast is probably about 8 points higher of food cost as a percentage of sales basis than the rest of the menu. Delivery, I really can't speak to.

[Operator:]

Your next question comes from the line of Larry Miller with RBC.

[Larry Miller:]

Yes, 2 quick questions as well. So you mentioned tweaking the value menu in China. Can you give us a sense of what you're doing and how you might stack up competitively? It looks like a lot of other folks are doing value as well. And then secondly, just on the negative mix in China, you said half of it was related to your value initiatives. What would you describe the other half to?

[Richard T. Carucci:]

Sorry, could you repeat the second part of the question again?

[Larry Miller:]

So you had a negative mix in China. I think it was close to 8 or 9 points of negative mix. You said half of that was related to the value initiatives at breakfast. What's the other half on the negative? Is it consumer pushback on pricing? Is it some other initiatives that you have? Or is it competitive pressure? What might be the other half?

[Tim Jerzyk:]

Yes, Larry, I think -- we're assuming you're talking about check average. We said breakfast was about half of that. If we're wrong on your -- the assumption list, no, but the rest of it would be the value initiatives at lunch and afternoon snack.

[Richard T. Carucci:]

And we're not going to tell you, obviously for competitive reasons, exactly what we're going to do on the value side, but we're looking at those bundles. So, for example, we have a 6-RMB offering at breakfast and a 15-RMB offering at lunch, and we're looking at what the composition of those bundles are.

[Operator:]

Your next question comes from the line of Jason West with Deutsche Bank.

[Jason West:]

Just 2 questions. First, on the outlook for 2012, I know you don't want to get too specific. But big picture, should we assume another sort of above-average type of year on China comps, given the amount of pricing you're probably going to have in the menu for next year? Or how should we think about the mix versus traffic? You're lapping some big traffic numbers but also some big negative mix numbers. Just trying to think about the components of comps in China next year.

[Richard T. Carucci:]

Yes, it's a hard one to call. To your point, we are going to get the benefits of pricing. On the other hand -- we expect that to continue into next year. On the other hand, we're lapping some extraordinary large increases in transactions. So we just don't know where it will shake out, to be honest with you. But again, I do want to remind you, our model doesn't require the type of sales growth that we had this year. Our model requires I think about a 5% or 6% same-store sales growth. So we may have more visibility as we get deeper into this year, but obviously, we expect the fourth quarter to still be strong. We have a lot of momentum right now.

[David C. Novak:]

I think the other thing too is that as we look at the sales, remember, we're very early days in all of the daypart initiatives that we're driving up against. So breakfast, for example, is only 7% of our total sales mix. We've only got delivery in 1,500 units. So we're in 24-hour services. All this is early days on the asset leverage. And we of course will have lots of product news, like we have in our China business, above brand. So I think there's tremendous upside as we go forward.

[Jason West:]

Okay. And just a quick one on the unit growth. Is the 600 number for China kind of the number going forward that we're using for 2012 as well, I'm assuming?

[Richard T. Carucci:]

I think it's as good a number as any right now.

[Operator:]

Your next question comes from the line of John Ivankoe with JPMorgan.

[Unknown Analyst -:]

It's Ahmoud Ganomon [ph] for John. Just in terms of the U.S., it sounds like you've committed yourself to a pretty major reinvestment in terms of Taco Bell beginning early next year, and I know that the brand probably does have the highest probability of your 3 brands. But it does seem like the return on investment would be higher if you directed it towards maybe an acceleration of growth in one of the international businesses. So could you just talk a little bit about your thoughts based on the "you earn the right to own" premise about refranchising that brand, potentially even down to 5% like KFC and Pizza Hut?

[David C. Novak:]

Well, first of all, we have the "earn the right to own" mentality around the world. So we're looking at Taco Bell just like we've looked at Pizza Hut and KFC, and we do think that there's some opportunity there. I think in terms of next year, I don't think we look at it as a year of reinvestment. We just think we look at it, a year a lot of the investments that we've made paying off, because we've made investments in the pipeline. We have some proven products that we feel good about, and we expect that we'll be able to drive the top line. The biggest thing that's impacting our business at Taco Bell this year is the sale de-leverage, and we think we ought to be able to get same-store sales growth as we go forward. We're also going to be expanding breakfast next year in the Western part of the United States, and we think that will begin at March, towards the long-term rollout of breakfast on a national basis.

[Richard T. Carucci:]

And, John, just to build on David's point, the margins and the profit history of Taco Bell over the last decade has been quite different than KFC and Pizza Hut, and that will be reflected in our plans.

[Operator:]

Your next question comes from the line of Jeffrey Bernstein with Barclays Capital.

[Jeffrey Andrew Bernstein:]

A couple of questions, just first looking to -- on the China front, I think you mentioned a couple of times that momentum thus far in the fourth quarter has sustained itself. Obviously, we've heard a lot of cautionary comments on China and the slowing in trends. So just wanted to confirm that over the past months, since these results are reflecting that you're not seeing any deceleration or any shift in kind of the consumer spending habits on the China comp. And then just kind of looking at China with the high teens comp you're doing right now, once you lap the value side of things, like where do you think is the underlying run rate x the value that we should be assuming? Like how much of that comp lift that you're getting is value-offer driven, so we can kind of assess the underlying run rate? And then I have a follow-up.

[Richard T. Carucci:]

We don't discuss trends within a quarter, but we do discuss that there's a major change from the last quarter. So we have nothing to tell you, which I guess tells you something. Regarding what the underlying rate -- it's really hard to call. There's just too many moving parts

[Jeffrey Andrew Bernstein:]

Okay. And then just to follow up, you mentioned Taco Bell, specifically next year, obviously benefits from having easy compares as you mentioned. And then it seems like the back half of the first quarter, you're pretty excited about the product innovation. I'm just wondering whether the breakfast reference was something totally additive to those other things. Any color you can give. I know breakfast has been a focus for a long time now, and it's been in test for a long period of time. I'm just wondering if you can give any color in terms of what you're seeing in the test markets to give confidence to roll it out in '12, at least to the Western part of U.S.

[David C. Novak:]

Well, we've had test markets in the Western part of the U.S. which says basically we'll be able to expand breakfast there and do it well. And we're continuing to develop the breakfast daypart and our product innovations around that and how we approach value for the rest of the country. So we're beginning the rollout in the area where we think that we have the greatest opportunity for success.

[Richard T. Carucci:]

Yes, I think it will only have a modest impact next year. I think the bigger thing that we're trying to do at breakfast is -- we mentioned a while back, we're doing, I call it, gradual breakfast, where we're opening earlier and serving breakfast items and then continuing those breakfast items for a good part of the day. So we think that given that trend, that we could get a fair number of franchisees to pick up breakfast over time. So the first tranche of that is really in the West next year. So I look at that as a key. If that's successful, then the other parts of the country should be able to go along, because it's not nearly as big an investment than when you're opening up very early for breakfast and have the labor challenge that we've had before. So I think what you'll probably see happening is a gradual roll and a gradual impact on sales.

[Operator:]

Your next question comes from the line of Farah Fenatore (sic) [Sara Senatore] with Sanford Bernstein.

[Sara H. Senatore:]

It's Sara Senatore at Bernstein. So actually, I just wanted to follow up a couple of things that have been touched on already. One was the unit growth outlook in China. Actually, I had sort of been hearing -- I think for a while, we've been hearing this idea that unit growth would -- like the number of units would step up, but the pace of unit growth would slow. But it actually feels like the pace of growth is kind of holding steady, so I wanted to see if anything had changed there. And then the second question was more about back to the inflation issue, which is only that historically most of your inflation, I think, and certainly most the volatility has come from food. So we could be fairly comfortable that your comps would kind of move with that food inflation directionally, generally speaking. Now a lot of it's coming from wages. So is there any concern that it won't be -- the matching won't be quite as good between what you are able to do on the top line and what kind of margin pressure you're seeing on that line item?

[Richard T. Carucci:]

Let me do the second question first. I think the inflation piece, the volatility just makes it hard to get the timing exactly right. So I think that to your point, the commodity inflation will probably dictate what happens to quarterly margins. So the labor side of it, to your point, is a structural component. But as you also pointed out -- so we expect that to continue. So we expect high labor inflation to continue, not at the pace we had in the third quarter, but it's going to be at least double-digit. It could even approach the mid-teens, would be our guess over the next couple of years. So we think that's structural, but to your point, we sort of know that's coming, so we could plan our margins and our pricing accordingly for that. It is a commodity thing. It's a harder one to call, and therefore, that's the one that we may get ahead of or behind on over time. In terms of the development part of your question, if you really look at it, it's really hard to predict when do we get the spike in development. But it hasn't been a continual climb. So if you look at what's happened historically, we were about 250 units, and we were at that for a few years. Then we went up to the 350 to 400, and then we quickly went to 500. And then we've been at 500 for a few years now. And so we couldn't call when we would get to the other jump. So what we used to say to your point -- or what I personally used to say is we expect the absolute numbers to go up, but the percentage to go down just because our pace -- our base keeps getting bigger. I think, over time, that's probably still a good generalization, but we have a hard time predicting when the spikes will come. We didn't know that they would do these city clusters. We weren't sure when Pizza Hut dine-in would get more profitable in Tier 3 and Tier 4 cities. So that's just hard to call. So right now, I feel very pleased we're at a 600 base, and we'll just have to play it by ear from there.

[Operator:]

Your next question comes from the line of Mitch Speiser with Buckingham Research.

[Mitchell J. Speiser:]

In emerging markets, in general, the comps seem to be very strong, obviously driven by your brand and compelling value. But if we were to drill down to perhaps the relationship between wage rate growth and comps growth, do you find a clear correlation between the 2? And if so, does that maybe make the year-ago comparisons less important when you're thinking about setting your comps targets?

[Richard T. Carucci:]

It's a good question. We don't -- I don't know if we have enough data, because you had the spike-up occurred just this year. So we think it's generally unbalanced. It's probably a good thing. In the short term, it's harder because we have to deal with it from a pricing and managing-the-inflation side of it, but it is bringing more people in terms of affordability into our restaurants. And we just don't have the visibility to give you sort of more math around that. So that's just sort of what it looks like at a broad basis.

[Mitchell J. Speiser:]

Okay. And just a quick follow-up. With traffic up so tremendously, are there any capacity issues? It sounds like most of the traffic was probably at breakfast or the increase, which is probably low capacity. But when we think about KFC in particular in China, can you just talk about any capacity constraints whatsoever?

[Richard T. Carucci:]

Well, we had a lot of units. I mean, that's one of the reasons we had units is to make sure we could still provide a great experience to our customers. Breakfast, we were -- we knew we had capacity at breakfast. So we weren't really capacity-constrained there at all. That was a daypart that was light. So we had to bring some more labor in over time. We actually started breakfast a long time ago. So we have still a lot of capacity at breakfast. Our hardest time is still weekends. So our biggest capacity situation are weekends. So, for example, when we did the daypart initiative in China that was a weekday-only lunch initiative, as an example. So that's probably where our biggest bottleneck is. And the way we relieved that bottleneck has been through adding units, and as David's mentioned in the past, we should have really good operations there as well. So we think we're still providing good experience to our customers, and when the lines sort of get too big, we sort of build more units.

[Operator:]

Your next question comes from the line of Keith Siegner with Crédit Suisse.

[Keith Siegner:]

Just a question on YRI. At the company store base, the AUVs were up 35%. I'm just having a little bit of a hard time understanding that against the system comp of, let's say, 3%. So I know that FX and both the Mexico refranchising helped, but they can't account for the whole difference. If you could just help me get a little bit of an understanding of, say, where that AUV growth is coming from. Is it different comps at company stores versus franchise? Is it because most of the new company openings are in France where AUVs are high? And then one quick follow-up to that. Well, I'll come back to the follow-up. Let's start with that.

[Tim Jerzyk:]

Keith, it certainly is the portfolio mix issues that we talked on several occasions in the past. France is definitely entering into the mix with the highest average unit volumes. And then also, same-store sales have been stronger this year in company stores.

[Keith Siegner:]

Okay. And then the follow-up is, as you refranchise Pizza Hut U.K., whenever this happens, it's roughly 470 units. It's 1/3 of the YRI company store base. As that happens, like, what does this do to company AUVs and margins? Just a general direction or more detail. Whatever you'd be willing to offer would be helpful.

[Richard T. Carucci:]

The AUV is probably not as big an impact. Margins will be very favorable, probably about 1.5 points or so. We'll have to give you the math as we get closer to it.

[Operator:]

There are no further questions, sir. Do you have any closing remarks?

[David C. Novak:]

First of all, I'd like to thank everybody for being on the call. Yum! Brands is going to have another very strong year, achieve at least 12% earnings per share growth. I'd also like to -- today, since this is our founders' week, I'd like to thank all of our shareholders who have been so supportive over the year. We have a number of shareholders who've been with us from the very beginning. So I'd like to thank you for that support. We've done well at Yum! Brands in the past. What has us most excited is about what we can get done in the future. We believe in our business model, we believe in our brands, and our people capability has never been better. So I am very confident that we will be able to continue to deliver. So thank you very much.

[Operator:]

This concludes today's conference call. You may now disconnect.