Yum! Brands, Inc.
Q2 2012 Earnings Call Transcript

Published: 19 Jul 2012

[Operator:]

Good morning, my name is Keisha, and I will be your conference operator today. At this time, I would like to welcome everyone to the Yum! Brands Second Quarter 2012 Earnings Conference Call. [Operator Instructions] Thank you. Mr. Tim Jerzyk, Senior Vice President of Investor Relations, you may begin your conference.

[Tim Jerzyk:]

Thanks, Keisha. Good morning, everyone, and thanks for joining us today. 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 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. We'd also like you to please be aware of a few Yum! 2012 investor events that – basically, the balance of the year. On August 22, we will host a YRI, Yum! Restaurant International Investor Conference in Plano, Texas. On September 12 and 13, we will host an investor conference in Xi'an, China. This will be followed by an event for investors in Vietnam on September 15. If you are interested at all, please get with us very soon. Seats are filling up fast. Tuesday, October 9, third quarter earnings will be released. Finally, our annual investor update meeting will take place on December 6 in New York City. As you may have seen recently, Rick Carucci, who has been our CFO for the past 7 years, has been promoted to President of the Yum! Brands. He will be [indiscernible] and will be available for questions. Pat Grismer has been promoted to CFO, replacing Rick. Pat's been with Yum! for 10 years, was previously CFO of Yum! Restaurants International and most recently Yum!'s Chief Planning and Control Officer. Pat will provide comments today, review our financial performance and David will provide comments today on the call as well. Now I'll turn the call over to David Novak, our Chairman and CEO.

[David C. Novak:]

Thank you very much, Tim, and good morning, everyone. I'm pleased to report we generated strong system sales growth at each of our divisions, China, Yum! Restaurants International, in the United States and India. In the second quarter, we did this with robust new unit development and exceptional same-store sales growth. Operating profit increased 8% while EPS growth of 1% was negatively impacted, as expected, by a higher tax rate compared to last year. Our U.S. business increased operating profit 26% in the second quarter and drove our overall operating profit growth. Based on our first half results and solid current sales trends, we reconfirm our full year guidance of at least 12% EPS growth, excluding special items. In China, our strategy is to build leading brands in every significant category. System sales increased 27%, or 23% excluding the sales associated with our acquisition of Little Sheep. This increase was driven by an 18% increase in new units and a 10% same-store sales growth. We opened 160 new restaurants in the quarter and are pleased to raise our full year projection for new restaurants in China to at least 700 from our previous guidance of at least 600. And that will be a new record. Despite this extraordinary top line growth, I'm sure you noticed operating profit was down 4% versus last year before foreign currency benefit due to a 4 percentage point decline in restaurant margin. We expect this to be short-lived as our menu initiatives, including pricing, begin to take hold and inflation moderates. As a result, we expect modest margin improvement in the second half of this year and double-digit profit growth. Pat Grismer, our CFO, will be taking you through this in more detail during his remarks. There's no question that China economy is slowing and sales for retailers, including us, will likely soften, especially as we overlap such strong performance from last year. We continue to be confident in our strategy of driving affordability to the growing consuming class and is backed by an extremely strong business model, which is driving record new unit development. Now given what we're all reading about the Chinese economy, I'm sure the question on your mind is

[Patrick Grismer:]

Thank you, David. Today, I'm going to comment on our second quarter results and our expectations for the second half of the year. Also, with the step change that we've achieved in new unit growth, I'm going to provide some perspective on how we're building momentum in retail development. Overall, second quarter financial results were marked by very strong top line performance with a worldwide system sales growth of 8% driving operating profit growth of 7%, excluding the impact of special items and foreign currency. Although EPS was up only 1% on a comparable basis, this was after an expected 10 percentage point impact of lapping last year's unusually low second quarter tax rate of 16.7%. In China, we delivered our sixth consecutive quarter of double-digit same-store sales growth, an impressive system sales growth of 23%, excluding the impact of our Little Sheep acquisition. This was offset by a 4.1 percentage point decline in restaurant margin and a significant investment in G&A to further extend our unique growth capabilities. For the second quarter and year-to-date, our margin decline in China was driven by persistent high inflation, labor investments to expand our strategic sales layers, like 24-hour operations and delivery and the incremental costs associated with the ramp-up of our restaurant development program. Our first half margin of 19.1% was about 1 percentage point lower than we had originally expected, largely due to the manner in which we implemented our pricing actions. As Rick explained on our first quarter call, we've recently adopted a more targeted and strategic approach to our pricing in China to drive everyday affordability for the growing consumer class while achieving about 20% margins over time. To that end, our plan included a phased implementation of price increases, as well as an increase in the number of pricing tiers across the country to better match our pricing to trade area-specific purchasing power and operating costs. While we're confident in this approach, it has taken more time to implement than we expected, and coupled with the restaurant labor investments necessary to enable our increased pace of development, has driven margin below our forecast. Clearly, we're not happy with a 4.1 percentage point margin decline in China even though this is short term. However, our pricing is now in place and we look at the process we've used as a responsible investment in the long-term growth of our business. This approach protects our consumer value proposition, supports an accelerated pace of new restaurant openings and helps us to achieve about 20% margins on a sustainable basis. We believe this is a winning long-term strategy. Later on, I'm going to talk about why we expect our China margin will improve modestly in the second half of the year. At Yum! Restaurants International, we delivered solid system sales growth of 7% and operating profit growth of 6%, excluding foreign currency translation. Emerging markets continue to be Yum! Restaurants International's growth engine with 9% same-store sales growth and 8% operating profit growth, excluding the impact of foreign currency. In addition to Russia, as David mentioned, we were very happy with the double-digit system sales growth in Latin America, Africa and the Middle East, further demonstrating the strength of our emerging market position. Additionally, over 60% of YRI's new units were opened in emerging markets. Despite strong sales overall, YRI's restaurant margin was down 1.1 percentage points in the quarter, driven by temporary cost pressures in Thailand and a same-store sales decline in France, partially offset by improved margin performance at Pizza Hut U.K. From a G&A perspective, YRI decided to restructure for stronger field support. We believe this will position us to grow faster in the long term, but we incurred $5 million of one-time costs in the quarter related to this decision. In the U.S., we had very strong performance from each of our brands with operating profit up 26% in the quarter. I was especially encouraged by the fact that each of our U.S. brands delivered same-store sales, margin and profit growth for the second consecutive quarter. Please note that 26% operating profit growth was after the resolution of a California employment lawsuit at Taco Bell, which resulted in a pretax charge of $17 million in the quarter. U.S. restaurant margin was a very healthy 17.5% for the quarter, including 19.4% at Taco Bell and 17.8% at Pizza Hut. Our overall increase of 5.8 percentage points over prior year largely resulted from sales leverage, as well as continued progress on supply-chain efficiency. On the latter point, Pizza Hut has led the U.S. system, a recent example being a redesigned pizza box which has not only yielded substantial cost savings, but has reduced environmental impact as well. Stepping back and looking at the first half of the year, I'm pleased with the overall quality of our growth as 8% system sales growth prior to foreign currency translation converted to 12% operating profit growth, which in turn drove an 11% increase in EPS prior to special items. Demonstrating the power of Yum!'s portfolio, the temporary margin decline in China was offset by a resurgence in our U.S. business led by outstanding performance at Taco Bell, our largest and most profitable U.S. brand. Now I'm going to talk about our expectations for the second half of the year, when we expect our China and YRI businesses will deliver a larger share of our overall earnings growth. In China, while it took longer than we anticipated, we now have our pricing in place. With the significant reduction in food inflation, we anticipate modest year-over-year margin improvement in the second half breaking the pattern of recent margin declines. This is prior to the inclusion of Little Sheep, which could adversely affect our restaurant margin percentage by about 1 percentage point in the third quarter as hot pot sales are seasonally low in the warmer summer months. This margin improvement, combined with healthy same-store sales growth and continued strength in new unit development, will deliver strong double-digit profit growth for China in the second half of the year. Looking ahead, we continue to believe our China restaurant margin will sustain around the 20% level over time. Let me take you through the 4 main reasons why we believe this. First, we have the unique ability to grow our business across the entire country with unmatched development resources and a proprietary distribution network. This enables us to increase our mix of higher-margin restaurants located in lower-tier, lower-cost cities, offsetting the lower margins of Tier 1 cities, where rent and labor costs are relatively high. Second, we're growing Pizza Hut Home Service and East Dawning, our emerging brands, which dilute restaurant margin by about 0.5 percentage point today. As we scale these businesses and improve their unit economics, overall margin should benefit. Third, we have potential upside from restaurant productivity initiatives and expect to gain more supply-chain efficiencies over time as we continue to leverage our size. And fourth, we have a strong track record. Consider this

[David C. Novak:]

Thank you very much, Pat. Appreciate it. So in summary, the Yum! business is in very good shape and we look forward to a solid second half and full year EPS growth of at least 12%. So with that, we'll open it up for any questions that you have.

[Operator:]

[Operator Instructions] Our first question comes from the line of David Palmer.

[David Palmer:]

The reason for that profit shortfall in China, it's not the usual one which we generally anticipate would be sales or maybe a food cost spike. You mentioned some reasons, the slower-than-expected pricing rollout, the accelerated unit development and why the margins were down last quarter more than expected. But obviously, The Street is hearing about these reasons more now after the quarter than we heard before. You're giving some comforting guidance and commentary about your margin opportunities in China for the second half and beyond. But the natural question comes back to Yum!'s forecasting ability for that China Division. Have you thought about that and how you can better anticipate your profit performance and communicate that to The Street going forward?

[Richard T. Carucci:]

All right. David, why don't I take that since I was the one who gave the previous forecast. China is a pretty difficult business to forecast now than compared to, let's say, 5 years ago. If you go back a long time ago, almost all of our profit growth was generated by new unit development. We could count on cost of sales being pretty stable and us getting synergies in that area, et cetera. So we pretty much were able to grow our bottom line with our top line. If you look at it, there are just more moving pieces today. There's higher labor inflation, a lot more volatility on commodities than there used to be. And probably the only thing I think we missed is we may be missed some of the inefficiencies of going from 500 new units a year to 700 new units a year. So I think we did have some teething problems around new unit development and its impact on operations, and perhaps maybe we could have anticipated better. But whenever you have a high company-owned business, China's 90% company-owned or so, you're going to have volatility when you have same-store sales and cost of sales moving. So I think that -- and then you have an uncertain economic situation to look at there. The piece that we sort of anticipated but maybe not the extent of it is we did know sort of a quarter ago that we were going to have pricing impact. And when we started executing that pricing impact, we just stretched it out a little longer than what we thought at that point last year. And that was just sort of an underground decision based on the reactions that we were getting as we were putting that in place. But as Pat said, those are done now. So from a pricing standpoint, we've pretty much done the lion's share of what's going to impact the balance of the year.

[Patrick Grismer:]

And David, the other thing I would add to what Rick has said is that we had effectively guided that margins in the quarter would be down about 3 points. And they were, in fact, down about 4 points, so we missed it by about 1 point. So yes, it was a bit off from what we had indicated. But to Rick's point, the team on the ground is in the best position to read what's happening in the retail environment and to make the right decisions as it relates to how we execute our pricing actions, and then their judgment that made sense and we support them on this to go a little bit slower.

[David C. Novak:]

And just the overall strategy, remember, is that what we want to do is to continue to drive affordable accessibility for the growing consumer class. We thought of -- and that's one of the big things that's been driving us. And what I continually tell the team is keep polishing the diamond, okay? We've got great, great brands there, keep making our brands affordable, make sure we have great operations, make sure the assets looks great and the numbers will take care of themselves. And we obviously take a great deal of pride in doing what we say, and I think we have a very good internal forecasting process. And we try to do the very best job we can guiding. And we were off 1 point in China this quarter. But I'm not going to apologize for that.

[Operator:]

Our next question comes from Michael Kelter with Goldman Sachs.

[Michael Kelter:]

Ask about the price increases that you're taking in China, given the timing. It seems like there might be a risk, at least in my mind, to traffic trends if you're taking prices when McDonald's seems to me investing in value, local competitors will have more P&L room for promotions. Given last year's food inflation, consumers are perhaps becoming a little more value-conscious over there. Can you talk about maybe some of the early experiences you've had now with the price increases in place and how you mitigate that risk?

[Patrick Grismer:]

Well, Michael, first, as to the extent of pricing that we took, as we said, the pricing was phased in over time. And that was in the low single-digit range, in the range of 3% to 4%. Moreover, the team put a great deal of thought into how and where to take that pricing based on their analysis of purchasing power and cost. And that's why we decided to take it slow. The team is very sensitive to the consumer environment currently and clearly, as David mentioned, is interested in maintaining the strong value position that we offer consumers. So in our judgment, we believe that the amount of pricing that we took was entirely appropriate based on what we've read over time. And so we do not expect that there's going to be an adverse consumer reaction to the amount of pricing that we've recently implemented.

[David C. Novak:]

Yes. The last thing the customer is going to see in China is sticker shock, okay? So I think we've done a very prudent job of managing pricing, and again, with the primary objective of being affordable. And I think that continues to be the case, and we're not really concerned about that.

[Operator:]

Our next question comes from Jason West of Deutsche Bank.

[Jason West:]

Just another question on China. You talked, David, about a sort of mid-single-digit expectation on the back half of the year. Just if you could give us any color on how things progressed through the quarter, if you're starting to see some signs of stabilization that gives you comfort with that number. Or are you still seeing consumers tighten their belts and it's unclear when things will stop deteriorating there?

[David C. Novak:]

We really don't comment on how we're proceeding during the quarter. I just think that we're very confident in our long-term business model in China. And we think we're making each of our brand stronger this year. And we'll report our numbers out like we always do and not before it.

[Patrick Grismer:]

And Jason, the other thing I would add is that I think it's important to look at our comps on a 2-year basis, right? So as David said in his speech a couple of times, as we enter the back half of the year, we are lapping an extraordinary performance, right? Over the back half of last year, same-store sales were about 20%. So with that said and given how we performed in the first half of the year, we stand by our forecast for balance of year. It's single-digits on average.

[Operator:]

Our next question comes from Jeffrey Bernstein with Barclays.

[Jeffrey Andrew Bernstein:]

Just to perhaps shift gears to the U.S. business, a two-part question. First, I was wondering whether you can assess how you view the competitive dynamic. It seems like we're seeing a little bit more aggressive value and promotional activity at a couple of your larger burger peers and others. And even in the pizza segment, we're seeing something similar. So I'm just wondering if you could talk about the landscape as we look to the back half of the year. And then perhaps as an aside, with people pushing value, I'm just wondering whether you can give us an update on the commodity inflation, perhaps for each segment of '12. I know there's obviously been a spike more recently. And I'm just wondering whether you have confidence in your second half outlook, whether there's any volatility to that or whether the risk is more to '13 from a commodity standpoint?

[Richard T. Carucci:]

I'll handle the environment before we get into commodities. I would call the U.S. as sort of in a process of a rocky recovery. So you do see from an industry standpoint, you see sort of a couple of good months and then a bad month and similar from a week-to-week basis. So things are not great and they're not terrible. They're sort of mediocre in terms of the marketplace right now. In terms of our business, I feel pretty good with -- I feel very good about the programs that we have in place. David talked about Pizza Hut, Taco Bell on the call. And if I look at the balance of year for Pizza Hut and KFC in terms of the plans we have in place, I feel good about our ability to be positive in the back part of the year.

[Patrick Grismer:]

And Jeffrey, as to your question on inflation, relative to the guidance we provided in New York on full year inflation for each one of our divisions, based on what is happening in commodity markets, what we're currently forecasting is low single-digits inflation in each one of our divisions. And as we mentioned earlier in our remarks, that's one of the reasons why we're confident that we'll see the modest improvement in margins in China in the back half of the year.

[Operator:]

Our next question comes from Joe Buckley from Bank of America.

[Joseph T. Buckley:]

Just to follow up on that. So the food cost inflation in China, you're saying the second half of the year will be up low single-digits? Or has it subsided enough as you could see that for the full year?

[Patrick Grismer:]

Yes. More on a full year basis, what we're seeing is low single-digits in China. Certainly, it would be close to flat even in the back half of the year for China, including in the fourth quarter the prospect of some deflation, given that we are lapping very high inflation last year.

[Joseph T. Buckley:]

Okay. And then just a couple of other questions on the China margin and some just to clarify what's already said. So do you think the 20% China restaurant-level margin is attainable this year? Or given the shortfall this quarter, will be below that, do you think?

[Patrick Grismer:]

It will be very difficult for us to get to 20% this year because of the decline we experienced in Q2. We see that we're going to be in the 19% to 20% range. It's tough to call at this stage, right? But long-term, no doubt about it, we see our way to 20% on a sustainable basis.

[Joseph T. Buckley:]

Okay. And then could you comment on the promotional environment there and if that had any impacts on second quarter margin? Was there more discounting or promotional activity year-over-year?

[Patrick Grismer:]

That was not a big factor in our margin performance in the second quarter.

[Joseph T. Buckley:]

Okay. And then just one more on the same topic, and then I'll let somebody else go. So is the pricing now -- you mentioned 3% to 4% pricing. Is the pricing up about 6% or so year-over-year? And when do we roll over or lap some additional pricing? I think there might have been something in September of last year, if I'm not mistaken.

[Patrick Grismer:]

That's correct. Current pricings, including our most recent actions, is on the order of 7%. There were 2 separate actions taken in the fall of last year, one in September, one in November. So those will roll off as we approach the fourth quarter.

[Joseph T. Buckley:]

Okay. How much for those? Can you share that?

[Patrick Grismer:]

2%.

[Joseph T. Buckley:]

2% each [indiscernible]?

[Patrick Grismer:]

Yes.

[Operator:]

Our next question comes from John Glass with Morgan Stanley.

[John S. Glass:]

Just first following up on that, if pricing is 7%, at least going into the third quarter, are you assuming traffic is positive in the mid-single-digit mix? Or is that not part of that assumption?

[Patrick Grismer:]

With respect to transactions, given that we are lapping extraordinary traffic growth in the back half of last year, I would say that the traffic growth will be flat to slightly positive. But that is effectively working in our guidance for now back half of year of mid-single-digits same-store sales growth.

[John S. Glass:]

Appreciate the clarification. And can you just help us decompose the labor deleverage this quarter? Because wage inflation was less than quarter, and I know you called out some specifics around both the 24-hour initiative, delivery, as well as the new stores. Is there a way to tease out how much of that is from each of those components? And how much of it is one-time and contained in this quarter? And how much is expected be an ongoing phenomena because those initiatives continue?

[Patrick Grismer:]

And John, we normally wouldn't going into that level of detail here. And clearly, it was a contributor to the margin decline in a year-over-year basis. The good news is that we're making this investment to grow these strategic sales layers. So as we roll out more 24-hour operations, as we roll out more delivery in KFC, yes, there's an upfront investment. It's slightly dilutive to our margins. But the important thing is that we're creating the platform for future growth. And also I'm sorry, John, just one last point. As you think about the impact of labor, of course the other big one, which we mentioned on the call, is what happens when you ramp up new unit development. And to the point Rick made before, when you move from a run rate of 500 to 600 new restaurants a year to something north of 700, you have to make an investment in operating capability. And that's been one of the keys to our success in China is that we don't grow ahead of capability. We build the capability first, and then we open the restaurants. And that, what that requires is an investment in restaurant labor so that we have the pipeline of RGMs fully qualified, ready to run these restaurants to our standards.

[John S. Glass:]

What is your -- just last question. What is your expectation of Little Sheep dilution to margin for the full year in China? And I presume that your guidance of 19% to 20% excludes that.

[Patrick Grismer:]

That is correct. And thank you for clarifying that. So our guidance on margin excludes the impact of Little Sheep. As we mentioned in the earnings release for the quarter, Little Sheep diluted margins by 0.3%. On a full year basis, in fact it will probably be a bit more than that. I mentioned in my remarks that the impact in Q3 alone could be up to a full percentage point. As to the impact to overall profits, at this stage, we would say that it will have a negligible impact.

[Operator:]

And our next question comes from Andy Barish with Jefferies.

[Andrew M. Barish:]

Just 2 quick updates on some bigger-picture issues. First on FX for the year, just given the dollars spent. And then secondly, with the terrific results out of Taco Bell and the margin numbers, is that -- your refranchising, I guess, is that still moving forward? Or is there some thought maybe you want to keep some more of those assets, given the improved performance?

[Patrick Grismer:]

I'll take those questions in turn. First on foreign exchange. Reflecting back on what we guided in New York, you may recall that at that time, certainly as I think everybody appreciates, given how volatile the global markets had been, it's really tough to forecast these things. I wish I had that kind of forecasting precision. But back in New York, we said that we expected for the full year China to deliver a $40 million ForEx benefit and YRI to present a $10 million ForEx exposure, so a net of $30 million. Based on what we've experienced halfway through the year and we're currently projecting based on forward rates, China, we believe, is going to deliver a benefit of $25 million, so that's down from the $40 million. And YRI, because of what you just mentioned, the situation with the dollar, YRI will present an exposure of $20 million, so a net of only plus $5 million. So we've gone from plus $30 million to plus $5 million. That is working in our current guidance of at least 12% EPS growth. And secondly, on U.S. refranchising, Rick can comment.

[Richard T. Carucci:]

Yes. No change in the plans. As sort of Pat mentioned, the goal is still to have Taco Bell go from roughly 22% to 16% ownership. And we said we'd do that over a 2- to 3-year period. We're on track towards delivering that. We feel very good, as Pat sort of mentioned, that by the end of the year we'll meet the refranchising target for KFC. So we're making good progress along that front.

[Operator:]

Our next question comes from David Tarantino with Robert W. Baird.

[David E. Tarantino:]

Just a couple of questions on China. First, I was wondering if you could maybe give us some perspective on what you're seeing in the consumer environment in general. Are you noticing any behavioral shifts or regional changes in demand? And maybe compare the slowdown that we're experiencing over there to what you've seen previously when the economy softened a bit.

[Richard T. Carucci:]

Why don't I take that just from a historical context and Pat may want to add to it. Is that we always have a hard time in that part of the world, where when China slows down, they still have pretty strong GDP growth by our standards. But to your point that the consumers do get more cautious, so we are starting to see more sales at retailers in China. We probably expect that to continue as we go over time discounting. And we expect probably that could make it necessary to continue to provide the value that David talked about in terms of our approach to China. But the thing that's so -- if you look at consumers -- we do think they're going to get a bit more cautious. The biggest trends that we continue to see, and this was probably a bit magnified in the first part of this year, is Tier 1 cities are growing at a slower rate. And as you look at Tier 1 and Tier 2 and probably coastal cities, because exports appear to be slowing, they'll probably be hit harder. So one thing we feel fortunate about is the new unit development that Pat took us through, we're doing very well -- continue to do very well in Tier 3 through 6 cities. And those are generally performing at a higher rate. And right now, it's also higher same-store sales in those areas.

[Patrick Grismer:]

David, the other thing I would add -- and I'm sure you read the same economic reports that we do. And of course, recently it was announced that GDP in China have slowed from 8.1% to 7.6%. But remarkably, consumer spending rose as a percentage of overall growth from what was 47% of GDP growth last year in the first half to 58% in the first half of this year. So broadly, the extent to which consumer spending is contributing to the growth of the economy is improving and certainly, that works in our favor.

[David E. Tarantino:]

Okay. That's helpful. And then I guess maybe one follow-up related to the step-up in unit growth. Could you maybe just talk about your confidence in ramping up the pace there? And maybe is some of the incremental openings really focused on those Tier 3 through 6 cities? Or is it more broad-based across the country?

[Patrick Grismer:]

Well, as I said in my remarks, we have an extraordinary development team in China that numbers roughly 1,000 people. And that capability is unmatched and is a competitive advantage for us and gives us the ability to drive to a new level of unit development. And as I mentioned, one of the reasons why China G&A is up, I think it's 23% on the quarter, is in part because of the investment, the significant investment we're making in this growth capability. And that gives us a lot of confidence to sustain this high rate of new unit development. As to the distribution of these new units across tiers, over the last few years, and this will continue into the future, we're seeing more of a skewing of our development toward those lower-tiered cities, where we have unique presence and capability. And that works in our advantage, as I mentioned, from a margin perspective because it is in those lower-tier cities that we have more favorable cost structures that allow us to generate higher margins and better returns.

[Operator:]

Next question is from Howard Penney with Hedgeye Management.

[Howard W. Penney:]

I was wondering if you could articulate the thought behind the acceleration and growth in China. Back at the analyst meeting in New York, you sort of articulated the thought process that you would have incremental growth coming from other regions of the world to be able to hit 10%. So is the acceleration in China allowing you to complete that 10% growth rate? Or are there other macro factors or competitive factors that are leading you to accelerate the growth rate in China?

[Richard T. Carucci:]

Well, just going back to December, I think that the biggest thing that occurred was the Chinese economic plan and the infrastructure development getting accelerated. And we talked about those cluster cities. And so a lot of new railroads, airports and then malls associated with those places have been sprouting up, and we've going in into those. And those are probably places that we didn't expect to have a couple of years ago. And then the other big part of the increase has just been, as David talked about, the great performance in Pizza Hut, and Pizza Hut also being able to be successful in the below Tier 2 cities. So those are the 2 biggest drivers that we're leveraging, and that's in -- as you know, if we went back 3 years ago, we wouldn't have anticipated that we would've hit these levels this quickly. And there was some teething pains associated with that from a profit standpoint, but we're obviously delighted that the number was able to reach what it reached so far. So we're not looking forward to accelerate beyond that.

[Patrick Grismer:]

And Howard, just as a reminder, as we mentioned, when you look at our international development outside of China, so taking YRI and India together, we're now projecting gross builds of at least 1,000, which again is a record for Yum!.

[Howard W. Penney:]

And still is the notion that there's an increased competitive presence in China not part of the process?

[Richard T. Carucci:]

Yes. Well, I think that the competitive nature in China is definitely higher in the Tier 1 cities. In the rest of China, I think as I sort of said before or we said on different occasions, I think our competitive position has actually improved because we're getting more and more units into these smaller-tier cities before anybody -- national chains, Chinese or Western, are able to get there. So it's a different dynamic by location. So definitely to your point, Howard, I think the Tier 1 cities and even the Tier 2 cities are starting to get more competitive. But we really haven't seen that in the lower-tiered places.

[Howard W. Penney:]

And will this make it harder for the competition to grow in those lower-tiered cities?

[Richard T. Carucci:]

That's our hope.

[Operator:]

And our next question comes from Bryan Elliott with Raymond James.

[Bryan C. Elliott:]

I'd like to move to the labor situation in China. Intrigued with the high rate of wage inflation, I'm wondering if that's doing anything to turnover. Are people being lured away to higher-paying jobs in other fields and turnover's rising, and so replacement and training costs are rising? Or are we able to sustain the historical turnover rates and just having to meet the market on wage increases for existing workers? And also whether it's more difficult to hire maybe potential managers in the high wage inflation environment?

[David C. Novak:]

First of all, I think that the -- our ability to hire and retain talent in China is renowned. I mean, we have outstanding operating capability there. In fact, we've recently created what we call Whampoa. It's our training academy for the entire retail industry. Basically, we're bringing in management recruits out of college, telling them that within 4 years they can become a restaurant general manager, potentially a franchisee inside of our company. And if they want to move on and move into another industry, they can be well trained and perfectly prepared to go into retail, opening up many, many different careers. So we hired thousands of management recruits this past year and we think that our goal with operations is to have KFC be the operating mecca for talent not only for ourselves, but the rest of the industry. Just like, I think historically in marketing, P&G has been the marketing training ground for lots of talent. So we have -- today when you look at our RGMs, 90% of our RGMs are at least college graduates. And we see that number actually edging up over time. The quality of our jobs, the perception of our jobs is very, very high in China. Now consider this, these people are running $1.7 million businesses. They have up to 100 employees, okay? They have huge general manager responsibilities and they're being very competitively paid. And we have a culture that is, I think, very, very highly regarded and respected in the country. One of the things that's interesting, I was in -- I gave a speech in Shanghai at Fudan University. And they had 300 seats. There were 600 people in the auditorium. They were literally packing the aisles and almost sitting on top of each other. And the dean of the business school asked, "How many of you have been to KFC or a Pizza Hut in the last week, okay?" Everybody raised their hand. And our ability to build great brands is very highly respected in China, and so we think -- the thing that I'm most pleased about is that we continue to build operating capability. It's that operating capability that's allowing us to open up all the restaurants and continue to get the great return. So I think the ability to attract and retain talent is probably -- well, we've voiced out our operations was our the biggest competitive advantage and I think it is today, that along with the local team that understands how to really build brands. But the operating capability is something we're very confident and we will never ever take our eyes off of it because we know that people capabilities is the key to getting great returns for the long term.

[Bryan C. Elliott:]

How about on the hourly side, crew side?

[David C. Novak:]

We're not seeing any real impact, one way or the other on turnover.

[Patrick Grismer:]

And just to build on that, Brian, one of the things that we -- we think our best part-time laborers in China are college students, and the percentage of college students have actually been rising over time.

[David C. Novak:]

I think over 50% now.

[Operator:]

Our next question comes from Keith Siegner with Crédit Suisse.

[Keith Siegner:]

Goes out to either Pat or Rick. Just one last thing on China margins, just to maybe ask it at a slightly different way. You answered one of the questions or saying maybe one of the things that you missed were inefficiencies of accelerating the pace of unit openings. So just at the highest level, and maybe for 2Q and the full year 2012, what is the basis point impact on China restaurant level margins from that acceleration of unit growth? Like what was the drag on 2Q? And what do you anticipate the full 2012 drag to be from that acceleration?

[Patrick Grismer:]

Yes. Keith, it was about 1 point in the quarter, and that's what we're expecting for the year.

[Keith Siegner:]

Okay. Even though fourth quarter, you'll start to lap against a really accelerated pace of unit openings last year. I would think the pressure might get a little easier as the year progresses.

[Patrick Grismer:]

I'm not calling it on the quarter in terms of our outlook. But in Q2, the impact was about 1 point. And as we look at the year, we would say it's about 1 point.

[Operator:]

Our next question comes from Mitch Speiser from Buckingham Research.

[Mitchell J. Speiser:]

On China first, regarding labor, should we just continue -- should we continue to expect double-digit wage rate growth for the foreseeable future?

[Patrick Grismer:]

Yes.

[Mitchell J. Speiser:]

Okay. And just a couple of other questions, most of my China questions have been answered. In the U.S., I think you mentioned modest third quarter profit growth. Can you discuss that? Does it have to do with any change in the top line trend? Or is it more on the cost side? If you can explain that, given a great profit growth quarter in the second quarter.

[Richard T. Carucci:]

Just let me clarify. I was answering a question, I thought, about sales growth, so what I sort of said -- they asked about the environment for sales, and we just sort of said we expect positive sales for the KFC and Pizza Hut brands combined for the balance of the year, that we didn't think the environment is going to cause anything out there. I don't think we gave a profit outlook by quarter.

[Mitchell J. Speiser:]

I thought in the prepared remarks, it was talking about modest profit growth in the U.S. in the third quarter. Did I misread that?

[Patrick Grismer:]

Yes, that is correct. But when we look at the full back half of the year, given the headwind we're facing with the lap of the 53rd week, we wouldn't say that it's modest for the back half. It's more of a third quarter phenomenon as we expect that the sales growth will temper a bit from what we've seen in the first half of the year, low single-digits.

[Mitchell J. Speiser:]

Okay. And on YRI, in the press release, it mentioned that emerging market comps were up over 9 -- about 9%, which sounds particularly strong. Can you give us a sense -- given that you have given guidance in the other regions, do you expect that emerging market comp growth to continue at a similar rate?

[Patrick Grismer:]

Generally, yes.

[Operator:]

Our next question comes from Sara Senatore with Sanford Bernstein.

[Sara H. Senatore:]

It sounds like the China topic has been exhausted, so I wanted to ask about YRI and the sort of the company margins expectation for improved performance in the back half. I know you talked about more moderate G&A growth and accelerated net unit development. And I can see why that should support faster growth. But can you just talk a little bit about what exactly went on with the restaurant margins? And is the expectation that things get better, does that embed the fact that the refranchising the U.K. business would automatically just give you back, I think, 200 basis points to margins?

[Patrick Grismer:]

Yes. Sara, first to clarify, our forecast of improved margins for YRI in the back half of the year does not assume the benefit of the Pizza Hut U.K. refranchising. When we complete that transaction, as you mentioned, we expect about a 200 basis point improvement to YRI's margins overall. As to why we believe the situation is going to improve, it's important to recognize that in the second quarter, a key contributor to the decline was that we had a spike, a temporary spike in costs in Thailand at a time we were lapping quite extraordinary margins on Thailand. Thailand margins overall are very good, but it just so happens that given the timing of certain expenses including an increase in some wage rates that we took more of a hit in the second quarter. We see the situation for YRI overall in the back half of the year moderating where there's less pressure from unusual cost increases like this. That, combined with ongoing momentum in our productivity initiatives and what we expect we will see from same-store sales leverage, leads us to have confidence that we'll see an improved margin performance from YRI in the back half of the year.

[Operator:]

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

[John W. Ivankoe:]

David, you said something interesting in an answer to your question about a manager potentially becoming a franchisee in China. I mean could you, I mean, elaborate a little bit that on what you meant? And secondly on a completely different direction, the credit markets seem to be in very, very good shape for a company like yours. And your debt to EBITDA and debt to free cash flow are at levels that probably people couldn't have imagined 10 years ago. So kind of looking at opportunities that may be presenting themselves, you have your new CFO, maybe have some different ideas in terms of what the capital structure could be, to what extent could you use the debt side of the balance sheet to enhance equity returns?

[David C. Novak:]

Let me talk about first about the China franchise -- well first of all, in China, we are and will continue be predominantly company-owned. However, we are doing franchising on a limited basis and we're doing it more on a single-store owner basis, and we've been -- one of the things that we've been experimenting with and executing to a certain extent is taking great restaurant operators in our company and giving them the opportunity to run restaurants in China. So we think that, that will continue to be the case as we get bigger and bigger and bigger, especially across the number of different concept areas that we're in. And I'll turn to my new CFO to give you some perspective on our capital structure.

[Patrick Grismer:]

And as to our capital structure, I would say that we're happy with where we're at now and how we've managed it over time because we've gotten extraordinary results. We continue to take a look at what's happening in the market and what might make sense for us and for our shareholders. And so we'll continue to do that and apply the same good discipline we have for the last several years. So no changes anticipated at this stage, but we do continue to look at it.

[John W. Ivankoe:]

And if I may ask a question, like why wouldn't there be more debt on -- I mean, just asking a little bit, being more directly, why wouldn't there be more debt on your balance sheet at this point?

[Tim Jerzyk:]

John, you've got to keep in mind, we talked about this. You've got to keep in mind everyday when we're building basically 2 new stores a day in China, most of them -- virtually all of them are leased. So we're adding leverage to our balance sheet in the minds of the rating agencies every day. So you got to keep -- they look at it from the full perspective, they capitalize the leases. So when you look at that, you've got to keep that in mind even though the balance sheet debt may look low, they definitely take that into account. And as we said previously, we had -- we were BBB- .And I think we're still BBB- with one of the agencies. We want to be BBB solid after the financial crisis. We felt like having another little bit more margin of safety was important. And that's basically where we are kind of but we're not quite yet with all 3 of them. So as much as some people would like us to add debt, we feel good about where we are, given what we've learned over the last few years, as Pat said.

[David C. Novak:]

I think the important point here that you bring up, which we take a great deal of pride in, is that we are a dramatically different company, as you point out, than we were 10 years ago and that we have the ability to invest tremendously behind the core growth of our business, which is our #1 priority. We are able to buy back stock and we're able to pay a good dividend. And our ability to do all 3 of those things has only gotten better. And I think that's what I think is exciting as we think about the tremendous growth prospects we have ahead. Okay. With that, I'd like to wrap it up, thank all of you for being on the call. As I said before, and I think it's a good summary of where we've been. The Yum! business is in very good shape, and we look forward to a solid second half and a full year EPS growth of at least 12%. So thank you very much. Appreciate it.

[Operator:]

And this does conclude today's conference call. Thanks for your participation. You may now disconnect.