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| YUM > SEC Filings for YUM > Form 10-Q on 22-Jul-2008 | All Recent SEC Filings |
22-Jul-2008
Quarterly Report
Introduction and Overview
The following Management's Discussion and Analysis ("MD&A") should be read in conjunction with the unaudited Condensed Consolidated Financial Statements ("Financial Statements"), the Cautionary Statements and our annual report on Form 10-K for the fiscal year ended December 29, 2007. Throughout the MD&A, YUM! Brands, Inc. ("YUM" or the "Company") makes reference to certain performance measures as described below.
· The company provides the percentage changes excluding the impact of foreign currency translation. These amounts are derived by translating current year results at prior year average exchange rates. We believe the elimination of the foreign currency translation impact provides better year-to-year comparability without the distortion of foreign currency fluctuations.
· System sales growth includes the results of all restaurants regardless of ownership, including Company-owned, franchise, unconsolidated affiliate and license restaurants. Sales of franchise, unconsolidated affiliate and license restaurants generate Franchise and license fees for the Company (typically at a rate of 4% to 6% of sales). Franchise, unconsolidated affiliate and license restaurant sales are not included in Company sales on the Condensed Consolidated Statements of Income; however, the Franchise and license fees are included in the Company's revenues. We believe system sales growth is useful to investors as a significant indicator of the overall strength of our business as it incorporates all of our revenue drivers, Company and franchise same store sales as well as net unit development.
· Same store sales is the estimated growth in sales of all restaurants that have been open one year or more. U.S. Company same store sales include only KFC, Pizza Hut and Taco Bell Company owned restaurants that have been open one year or more. U.S. same store sales for Long John Silver's and A&W restaurants are not included given the relative insignificance of the Company stores for these brands and the limited impact they currently have, and will have in the future, on our U.S. Company same store sales as well as our overall U.S. performance.
· Company restaurant margin as a percentage of sales is defined as Company sales less expenses incurred directly by our Company restaurants in generating Company sales, divided by Company sales.
· Operating margin is defined as Operating Profit divided by Total revenues.
All Note references herein refer to the accompanying Notes to the Financial Statements. Tabular amounts are displayed in millions except per share and unit count amounts, or as otherwise specifically identified.
Description of Business
YUM is the world's largest restaurant company based on number of system units, with more than 35,000 units in more than 100 countries and territories operating under the KFC, Pizza Hut, Taco Bell, Long John Silver's and A&W All-American Food Restaurants brands. Four of the Company's restaurant brands - KFC, Pizza Hut, Taco Bell and Long John Silver's - are the global leaders in the quick-service chicken, pizza, Mexican-style food and seafood categories, respectively. Of the over 35,000 restaurants, 22% are operated by the Company, 72% are operated by franchisees and unconsolidated affiliates and 6% are operated by licensees.
YUM's business consists of three reporting segments: United States, the International Division ("YRI") and the China Division. The China Division includes mainland China, Thailand and KFC Taiwan, and the International Division includes the remainder of our international operations. The China and International Divisions have been experiencing dramatic growth and now represent over half of the Company's Operating Profits. The U.S. business operates in a highly competitive marketplace resulting in slower profit growth, but continues to produce strong cash flows.
Strategies
The Company continues to focus on four key strategies:
Build Leading Brands Across China in Every Significant Category - The Company has developed the KFC and Pizza Hut brands into the leading quick service and casual dining restaurants, respectively, in mainland China. Additionally, the Company owns and operates the distribution system for its restaurants in mainland China which we believe provides a significant competitive advantage. Given this strong competitive position, a rapidly growing economy and a population of 1.3 billion in mainland China, the Company is rapidly adding KFC and Pizza Hut Casual Dining restaurants and testing the additional restaurant concepts of Pizza Hut Home Service (pizza delivery) and East Dawning (Chinese food). Our ongoing earnings growth model includes annual system-sales growth of 20% in mainland China driven by at least 425 new restaurants each year, which we expect to drive annual Operating Profit growth of 20% in the China Division.
Drive Aggressive International Expansion and Build Strong Brands Everywhere - The Company and its franchisees opened over 850 new restaurants in 2007 in the Company's International Division, representing 8 straight years of opening over 700 restaurants. The International Division generated $480 million in Operating Profit in 2007 up from $186 million in 1998. The Company expects to continue to experience strong growth by building our existing markets and growing in new markets including India, France, Russia, Vietnam and Africa. Our ongoing earnings growth model includes annual Operating Profit growth of 10% driven by 750 new restaurant openings annually for the International Division. New unit development is expected to contribute to system sales growth of at least 5% (3% to 4% unit growth and 2% to 3% same store sales growth) each year.
Dramatically Improve U.S. Brand Positions, Consistency and Returns - The Company continues to focus on improving its U.S. position through differentiated products and marketing and an improved customer experience. The Company also strives to provide industry-leading new product innovation which adds sales layers and expands day parts. We are the leader in multibranding, with over 3,900 restaurants providing customers two or more of our brands at a single location. We continue to evaluate our returns and ownership positions with an earn-the-right-to-own philosophy on Company-owned restaurants. Our ongoing earnings growth model calls for annual Operating Profit growth of 5% in the U.S. with same store sales growth of 2% to 3% and leverage of our General and Administrative ("G&A") infrastructure.
Drive Industry-Leading, Long-Term Shareholder and Franchisee Value - The Company is focused on delivering high returns and returning substantial cash flows to its shareholders via share repurchases and dividends. The Company has one of the highest returns on invested capital in the Quick Service Restaurants ("QSR") industry. Additionally, 2007 was the third consecutive year in which the Company returned over $1.1 billion to its shareholders through share repurchases and dividends. The Company is targeting an annual dividend payout ratio of 35% to 40% of Net Income.
Quarter Ended June 14, 2008 Highlights
· System sales growth from China Division of 40% and YRI of 15%
· Worldwide same store sales growth of 4%, including 14 % in mainland China, 4% in YRI and 2% in the U.S.
· Operating Profit growth of 38% for the China Division and 18% for YRI with a 12% decline in the U.S.
· Lower effective tax rate of 14.8% versus 21.5% in the prior year
· Diluted earnings per share ("EPS") of $0.45 or 15% growth
· Increased quarterly dividend by 27% with our yield now about 2%
All preceding comparisons are versus the same period a year ago.
Significant Known Events, Trends or Uncertainties Impacting or Expected to Impact Comparisons of Reported or Future Results
The following factors impacted comparability of operating performance for the quarters and/or years to date ended June 14, 2008 and June 16, 2007 and/or could impact comparability with the remainder of our results in 2008 or beyond. Certain of these factors were previously discussed in our 2007 Form 10-K.
U.S. Restaurant Profit
Our U.S. restaurant margin as a percentage of sales decreased by 2.9 percentage points and 1.9 percentage points for the quarter and year to date ended June 14, 2008, respectively. These decreases were the primary drivers in the U.S. Operating Profit decline of 12% and 9% for the quarter and year to date ended June 14, 2008, respectively.
Restaurant profit in dollar terms was negatively impacted by $30 million and $55 million of commodity inflation (primarily cheese, wheat and chicken costs) for the quarter and year to date ended June 14, 2008, respectively. Additionally, restaurant profit was negatively impacted by $18 million and $22 million, exclusive of the estimated reduction due to refranchising stores, for the quarter and year to date ended June 14, 2008, respectively, due to higher property and casualty self insurance expense as we lapped favorability recognized in 2007. The unfavorable impact of commodity inflation and lapping of property and casualty self insurance favorability for the quarter and year to date ended June 14, 2008 was partially offset by U.S. Company same store sales growth of 4% and 3%, respectively, which was driven by Taco Bell and Pizza Hut.
We anticipate that the U.S. restaurant margin in the second half of 2008 will be adversely impacted by continued higher commodity costs, with commodity inflation for the full year 2008 expected to be 8% or about $100 million. However, we expect that pricing action that we have recently taken and future pricing actions will help to mitigate this inflation on a full year basis. We now anticipate that U.S. restaurant margin as a percentage of sales for 2008 will be down approximately 1.0 percentage point from the 2007 percentage of 13.3%.
China Restaurant Profit
China Division restaurant margin as a percentage of sales declined to 17.1% and 18.9% in the quarter and year to date ended June 14, 2008, respectively from 18.2% and 20.2% in the quarter and year to date ended June 16, 2007, respectively. These declines were driven by commodity inflation, primarily chicken, of approximately $16 million and $27 million for the quarter and year to date ended June 14, 2008, respectively, and higher restaurant labor costs. In mainland China, we expect that the high commodity inflation rate (including higher chicken costs) will continue throughout 2008. On a full year basis we anticipate that China Division restaurant margin as a percentage of sales for 2008 will be down approximately 1.0 percentage point from the 2007 percentage of 20.1%.
Consolidation of a Former Unconsolidated Affiliate in China
In 2008, we began consolidating an entity in which we have a majority ownership interest and that operates the KFCs in Beijing, China. Our partners in this entity are essentially state-owned enterprises. We historically did not consolidate this entity, instead accounting for the unconsolidated affiliate using the equity method of accounting, due to the effective participation of our partners in the significant decisions of the entity that were made in the ordinary course of business as addressed in Emerging Issues Task Force ("EITF") Issue No. 96-16, "Investor's Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights". Concurrent with a decision that we made on January 1, 2008 regarding top management of the entity, we no longer believe that our partners effectively participate in the decisions that are made in the ordinary course of business. Accordingly, we began consolidating this entity.
Like our other unconsolidated affiliates, the accounting for this entity prior to 2008 resulted in royalties being reflected as Franchise and license fees and our share of the entity's net income being reflected in Other (income) expense. The impact on our Condensed Consolidated Statement of Income for the quarter and year to date ended June 14, 2008 as a result of our consolidation of this entity was as follows:
Increase (Decrease)
Quarter Year to Date
Company sales $ 68 $ 114
Company restaurant expenses 54 90
Franchise and license fees (4 ) (7 )
General and administrative expenses 2 3
Other (income) expense (7 ) (12 )
Operating Profit 1 2
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The impact on Other (income) expense includes both the current year minority interest in pre-tax earnings of the unconsolidated affiliate as well as the reduction in Other (income) expense that resulted from our share of after-tax earnings no longer being reported in Other (income) expense. The increase in Operating Profit was offset by a corresponding increase in Income tax provision such that there was no impact to Net Income.
Significant 2008 Gains and Charges
As part of our plan to transform our U.S. business we are taking several measures in 2008 that we do not believe are indicative of our ongoing operations. These measures include: expansion of our U.S. refranchising, potentially reducing our Company ownership in the U.S. to below 10% by the year end 2010; charges relating to G&A productivity initiatives and realignment of resources (primarily severance and early retirement costs); and investments in our U.S. Brands made on behalf of our franchisees such as equipment purchases. As discussed in Note 10, we are not including the impacts of these measures in our U.S. segment for performance reporting purposes.
In the quarter and year to date ended June 14, 2008, we recorded a pre-tax gain of $1 million and a pre-tax loss of $25 million, respectively, from refranchising in the U.S. In the quarter and year to date ended June 14, 2008, we recorded pre-tax losses related to U.S. severance and early retirement of $2 million and $7 million, respectively, and expenses related to investments in our U.S. brands of $2 million and $3 million, respectively. The refranchising losses recorded for the year to date ended June 14, 2008 were primarily due to our refranchising of, or our offers to refranchise, stores or groups of stores, principally at Long John Silver's, for prices less than their recorded carrying value. The refranchising losses are more fully discussed in Note 8 and the Store Portfolio Strategy of the MD&A.
These losses were more than offset in the year to date ended June 14, 2008 by a pre-tax gain of approximately $100 million related to the sale of our interest in our unconsolidated affiliate in Japan (See Note 3 for further discussion of this transaction). This gain was recorded in unallocated Other (income) expense in our Condensed Consolidated Statement of Income.
We anticipate that on a full year basis that the net impact of the U.S. business transformation measures and the gain on the sale of our interest in our unconsolidated affiliate in Japan will generate up to $50 million of Operating Profit, or approximately $0.06 of diluted EPS in 2008.
Mexico Value Added Tax ("VAT") Exemption
On October 1, 2007, Mexico enacted new legislation that eliminated a tax ruling that allowed us to claim an exemption related to VAT payments. Beginning on January 1, 2008, we were required to remit VAT on all Company restaurant sales resulting in lower Company sales and Restaurant Profit. As a result of this new legislation, our International Division's Company sales and Restaurant Profit for the quarter ended June 14, 2008 were unfavorably impacted by approximately $10 million and $9 million, respectively. Company sales and Restaurant Profit for the year to date ended June 14, 2008 were unfavorably impacted by approximately $16 million and $14 million, respectively. We estimate that the full year 2008 impact on the International Division's Company sales and Restaurant Profit will be unfavorable by approximately $38 million and $34 million, respectively. The International Division's system sales growth and restaurant margin as a percentage of sales was negatively impacted by approximately 0.4 and 1.4 percentage points, respectively, for the quarter ended June 14, 2008. Additionally, the International Division's system sales growth and restaurant margin as a percentage of sales was negatively impacted by approximately 0.3 and 1 percentage points, respectively, for the year to date ended June 14, 2008, with similar negative impacts expected for the full year.
Tax Legislation - Mainland China
On March 16, 2007, the National People's Congress in mainland China enacted new tax legislation that went into effect on January 1, 2008. Upon enactment, which occurred in the China Division's 2007 second fiscal quarter, the deferred tax balances of all Chinese entities, including our unconsolidated affiliates, were adjusted. We currently estimate that these income tax rate changes will positively impact our 2008 Net Income between $10 million and $15 million compared to what it would have otherwise been had no new tax legislation been enacted. For the year to date ended June 14, 2008, the favorable impact on our Income tax provision and Operating Profit was approximately $5 million and $2 million, respectively.
Store Portfolio Strategy
From time to time we sell Company restaurants to existing and new franchisees where geographic synergies can be obtained or where franchisees' expertise can generally be leveraged to improve our overall operating performance, while retaining Company ownership of strategic U.S. and international markets. In the U.S., we are targeting Company ownership of restaurants potentially below 10% by year end 2010, down from its current level of 21%. We recorded net refranchising losses of $25 million in the U.S. for the year to date ended June 14, 2008, primarily due to our refranchising of, or our offers to sell, certain stores or groups of stores, for a price less than their carrying values. In the U.S., we have refranchised 179 restaurants during the first two quarters of 2008 and anticipate refranchising 500 restaurants for the full year.
In the International Division, we are targeting Company ownership of Pizza Hut restaurants in the U.K. market at approximately 40% by year end 2011, down from its current level of approximately 75%.
Refranchisings reduce our reported revenues and restaurant profits and increase the importance of system sales growth as a key performance measure. Additionally, G&A expenses will decline over time as a result of these refranchising activities. The timing of G&A declines will vary and often lag the actual refranchising activities as the synergies are typically dependent upon the size and geography of the respective deals. G&A expenses included in the tables below reflect only direct G&A expenses that we are no longer incurring as a result of stores that were operated by us for all or some portion of the comparable period in 2007 and were no longer operated by us as of June 14, 2008.
The following table summarizes our refranchising activities:
Quarter Year to date
6/14/08 6/16/07 6/14/08 6/16/07
Number of units refranchised 170 74 207 191
Refranchising proceeds, pre-tax $ 47 $ 31 $ 66 $ 65
Refranchising (gain) loss, pre-tax $ (1 ) $ (4 ) $ 24 $ (5 )
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The impact on Operating Profit arising from refranchising is the net of (a) the estimated reductions in restaurant profit, which reflects the decrease in Company sales, and G&A expenses and (b) the estimated increase in franchise fees from the stores refranchised. The amounts presented below reflect the estimated historical results from stores that were operated by us for all or some portion of the comparable period in 2007 and were no longer operated by us as of June 14, 2008.
The following table summarizes the estimated historical results of refranchising:
Quarter ended 6/14/08
International China
U.S. Division Division Worldwide
Decreased Company sales $ (44 ) $ (31 ) $ (1 ) $ (76 )
Increased Franchise and license fees 2 2 - 4
Decrease in Total revenues $ (42 ) $ (29 ) $ (1 ) $ (72 )
Year to date ended 6/14/08
International China
U.S. Division Division Worldwide
Decreased Company sales $ (97 ) $ (58 ) $ (2 ) $ (157 )
Increased Franchise and license fees 5 3 - 8
Decrease in Total revenues $ (92 ) $ (55 ) $ (2 ) $ (149 )
Quarter ended 6/14/08
International China
U.S. Division Division Worldwide
Decreased Restaurant profit $ (1 ) $ (2 ) $ - $ (3 )
Increased Franchise and license fees 2 2 - 4
Decreased G&A 1 1 - 2
Increase in Operating Profit $ 2 $ 1 $ - $ 3
Year to date ended 6/14/08
International China
U.S. Division Division Worldwide
Decreased Restaurant profit $ (5 ) $ (4 ) $ - $ (9 )
Increased Franchise and license fees 5 3 - 8
Decreased G&A 2 1 - 3
Increase in Operating Profit $ 2 $ - $ - $ 2
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Results of Operations
Quarter Year to date
6/14/08 6/16/07 % B/(W) 6/14/08 6/16/07 % B/(W)
Company sales $ 2,323 $ 2,073 12 $ 4,417 $ 4,015 10
Franchise and license fees 330 294 12 644 575 12
Total revenues $ 2,653 $ 2,367 12 $ 5,061 $ 4,590 10
Company restaurant profit $ 311 $ 310 - $ 619 $ 598 3
% of Company sales 13.4% 14.9% (1.5 ) ppts. 14.0% 14.9% (0.9 ) ppts.
Operating Profit 315 310 739 626 18
Interest expense, net 52 38 (34 ) 105 74 (39 )
Income tax provision 39 58 34 156 144 (8 )
Net Income $ 224 $ 214 4 $ 478 $ 408 17
Diluted earnings per share(a) $ 0.45 $ 0.39 15 $ 0.95 $ 0.74 28
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(a) See Note 4 for the number of shares used in this calculation.
Restaurant Unit Activity
Total
Unconsolidated Excluding
Worldwide Company Affiliates Franchisees Licensees(a)
Beginning of year 7,625 1,314 24,297 33,236
New Builds 198 31 421 650
Acquisitions 12 - (12 ) -
Refranchising (207 ) (1 ) 208 -
Closures (57 ) (5 ) (338 ) (400 )
Other(b)(c) 182 (749 ) 572 5
End of quarter 7,753 590 25,148 33,491
% of Total 23% 2% 75% 100%
Total
Unconsolidated Excluding
United States Company Affiliates Franchisees Licensees(a)
Beginning of year 3,896 - 14,081 17,977
New Builds 27 - 105 132
Acquisitions 1 - (1 ) -
Refranchising (179 ) - 179 -
Closures (35 ) - (213 ) (248 )
Other - - 4 4
End of quarter 3,710 - 14,155 17,865
% of Total 21% - 79% 100%
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Total
Unconsolidated Excluding
International Division Company Affiliates Franchisees Licensees(a)
Beginning of year 1,642 568 9,963 12,173
New Builds 12 - 306 318
Acquisitions 4 - (4 ) -
Refranchising (26 ) (1 ) 27 -
Closures (7 ) - (117 ) (124 )
Other(b) - (567 ) 568 1
End of quarter 1,625 - 10,743 12,368
% of Total 13% - 87% 100%
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