Yum! Brands F3Q06 (Qtr End 9/9/06) Earnings Call Transcript

| About: Yum! Brands, (YUM)

Yum! Brands (NYSE:YUM)

F3Q06 Earnings Call

October 12, 2006 2:00 pm ET


Tim Jerzyk - Vice President, Investor Relations

David C. Novak - Chairman of the Board, President, Chief Executive Officer

Richard T. Carucci - Chief Financial Officer


David Palmer - UBS

Glen Petraglia - Citigroup

John Ivankoe - JP Morgan

Jeff Omohundro - Wachovia Securities

Mark Wiltamuth - Morgan Stanley Dean Witter

Joseph Buckley - Bear, Stearns


Good afternoon. My name is Nicole and I will be your conference operator today. At this time, I would like to welcome everyone to the third quarter 2006 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session.

(Operator Instructions)

I would now like to introduce Mr. Tim Jerzyk, Vice President of Investor Relations. Sir, you may begin your conference.

Tim Jerzyk

Thank you, Nicole, and thank you for joining us on the call today. I just want to give you a reminder before we start into the normal part of our call. It is time to make plans to attend our 2006 annual conference for investors and analysts. The meeting will take place Tuesday, December 5th, from approximately 8:00 a.m. until about 2:00 p.m. Eastern time at the St. Regis hotel in New York. Online registration is required before 5:00 p.m. Eastern time Friday, December 1st. Please register at www.yum.com, click on Register Now beside this event under upcoming analysts and investor events. If you have any questions, please do call us at Yum! Brands Investor Relations, 888-298-6986.

With that, let’s get into the regular session of the call. 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 this recording. I would also like to advise that this conference call does include forward-looking statements that reflects managements’ expectations based on currently available data. However, actual results are subject to future events and uncertainties.

The information in the conference call related to projections or other forward-looking statements may be relied on subject to our Safe Harbor statement, which is included in our earnings release last night and may continue to be used while this call remains in the active portion of our company’s website, which will be until about 5:00 p.m. Eastern time, Friday, October 20, 2006.

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 will turn the call over to David Novak.

David C. Novak

Thank you, Tim, and good afternoon, everybody. As you may have seen from our third quarter release last night, we reported outstanding results for the quarter, with 11% worldwide operating profit growth and 20% EPS growth. Importantly, each of our businesses contributed to operating profit growth and margin expansion to this performance.

Our growth this quarter was led by our high return international divisions, with across-the-board strong growth in new restaurants, same-store sales, and profits. China Division profits increased by 26% and YRI by 22%. Better news yet, we expect China operating profit to be up 35% to 40% for 2006.

Based on this strong performance, I am pleased to report we have raised our forecasted EPS for 2006 by $0.06 to $2.89, or 14% growth.

We believe the growth opportunities for our portfolio of brands around the world is second to none. Consider this: China and YRI each already make more profits than companies like Wendy’s, Applebee’s, or Ruby Tuesday’s. Yum! China will generate nearly $300 million in profit and, as I said, growing by at least 35% to 40% this year. YRI will generate about $400 million in profit this year and grow by at least 10% once again.

Unlike the U.S., which is extremely penetrated, we have just begun to capture the huge new unit opportunities in our international businesses. Also unlike the U.S., we have very little competition.

This is how we very simply think about our growth opportunities outside the U.S. We have over 18,000 traditional restaurants in the United States, where there are about 300 million people. We have about 2,000 restaurants in mainland China with 1.3 billion people. YRI has about 12,000 restaurants for over 4 billion people. We think that provides us with major opportunities for expansion of our brand portfolio.

In addition to what we believe is the most powerful and proven international opportunity in our category is our tremendous cash flow generation led by our U.S. portfolio, consistently over $1 billion every year in terms of EBITDA. Additionally, our already substantial annual cash flows are enhanced by our refranchise program. This has enabled us to produce strong shareholder payouts. In fact, we expect to return over $1 billion to shareholders this year, which is a repeat of last year. Our substantial stock buy-backs will continue to be impactful, reducing our share count this year by 6% after a 2% reduction last year. Additionally, we will pay a dividend that will return another 1% to shareholders in 2006. We fully expect to return similar total amounts to shareholders for the foreseeable future.

Finally, our global portfolio enables consistency of performance. This will be our fifth straight year of at least 13% EPS growth and exceeding our annual target of at least 10% growth. In addition, the free cash flow generation from every segment of our portfolio will enable us to pay out another $1 billion plus to shareholders in 2006.

Now let’s look at each of our businesses. Let’s look at China first.

In our China division, as I said last quarter, we are back and booming once again. With KFC, we are moving at an aggressive pace in mainland China with development growth of nearly 20%. We now have nearly 1700 KFCs.

Returns remain very strong, our very best in the world and we continue to expand in more cities. We will likely be in about 400 cities by year-end, building a great base for the KFC brand everywhere in China.

The summary for KFC is we are the dominant leader and we are moving full steam ahead.

You also need to recognize that our Pizza Hut casual dining business in mainland China is now a major business as well. We have now reached major scale levels, with over 225 casual dining restaurants and development is strong with excellent returns, similar to KFC.

We are excited because Pizza Hut casual dining is growing units at a 20% rate versus last year, with solid same-store sales growth. We are in over 50 cities and clearly the undisputed leader in the casual dining category.

Now let’s talk about the third brand we have been working on developing for full scale expansion -- Pizza Hut Home Service. We have 33 units currently in five cities, and the overall economic models for this delivery business looks very promising. We are excited as we just completed a TV test in Shanghai with our first ad campaign to drive this business. The results were very good and we are ready to roll to more cities.

There is no doubt the home service market is emerging in mainland China, and we will be there to capitalize on the opportunity.

To summarize, our China business had a great third quarter with profit growth of 26%, and we are up 38% year-to-date, so clearly our two-year trends are excellent. Importantly, we are opening over 400 new restaurants and achieving record restaurant margins, even while rapidly developing and building new brands like Pizza Hut Home Service and East Dawning, our fast food Chinese restaurant concept.

We continue to believe that KFC ultimately has the potential for 14,000 locations, similar to the level of development by McDonald’s in the United States, and that we ultimately have the potential for about 2,000 Pizza Hut casual dining locations, similar to Applebee’s in the United States. That is 16,000 restaurants before you would consider the potential of Pizza Hut Home Service and East Dawning. Our belief is that ultimately, we will have at least 20,000 restaurants in China.

Now, on to our Yum! Restaurants International Division, or what we call YRI. We are very pleased to see strong performance from our YRI portfolio. For Q3, we achieved 9% growth in system sales, local currency basis, well ahead of our target of at least 5% growth. YRI opened 176 new restaurants in the third quarter, and virtually all of our 452 new restaurant openings this year, or 94% of them were by our franchise and joint venture partners.

Most significantly, franchise fees grew by 15% in the third quarter to a new record, and our overall operating margin improved versus last year to another record for the third quarter.

YRI generates solid, consistent growth that is geographically diverse with high returns. Importantly, we are not sitting on our success. We are just starting to develop in India, Continental Europe with KFC, and now Russia. We are in the early stages of developing these mega-markets, which we believe will become increasingly important to YRI.

Most importantly for YRI, our new unit pipeline looks very good and we now expect at least 770 new openings for 2006, ahead of our original plan for 750 new openings.

The fact is, YRI continues to build one heck of a track record. It will be seven straight years of opening over 700 new restaurants.

Now let’s talk about where our growth outside the United States is taking us. This year, we expect that YRI will represent nearly 30% of overall Yum! profit, and Yum! China will represent 20%. So nearly 50% of our profit today is coming from international divisions, with at least 75% of our profit growth as well from these businesses.

We think we will easily be at 60% international profits in the next five years, with Yum! China and YRI each being at about 30%.

Now, on to our U.S. businesses. Before I get into the details, let me give you our view of the U.S. business. First, for the full year, we expect our profit to be up 3% to 5%, which historically stacks up well versus our 1% long-term trend. Our blended U.S. same-store sales is expected to be flat for the year, with our third quarter results down 2%, driven by poor performance at Pizza Hut, which was down 5%.

We are working aggressively to turn around Pizza Hut. Importantly, Pizza Hut has the strongest brand equity in the pizza category, which gives us confidence.

Looking at both Taco Bell and KFC, we are confident in our market positions. When you look at the two-year growth rates for both of these brands, they are comparable to other big names in the category. For example, Taco Bell and KFC are averaging 2% to 3% growth over the past two years. McDonald’s is averaging 3% to 5%, and Wendy’s is about flat. So Taco Bell and KFC are definitely in the game.

We expect Taco Bell and KFC to be up for the full year and Pizza Hut to be down 3%.

Having said all that, rest assured that no one is satisfied and we are absolutely focused on getting back on track. In fact, I can tell you for certain we are obsessed with it and we are also very confident that we will deliver. In fact, we believe it is very realistic to target plus 2% to 3% same-store sales growth for our U.S. business again next year, based on the aggressive plans that our dedicated teams are putting in place.

Our target is also to grow our profit 5%. We realize that the proof is in the pudding, so you will have to see.

Now, let’s look in detail by brand. First, some perspective on Taco Bell, our biggest U.S. business. For Q3, Taco Bell experienced a 2% decline in same store sales, lapping a strong 8% a year ago, or two-year growth of 3%. For the remainder of the year, we do expect sales results to be in a similar pattern as we have experienced recently. We are making some adjustments to products and promotions to help regain our momentum against the difficult comparisons.

Looking ahead to 2007, we remain confident in every aspect of the Taco Bell brand. The fundamentals are solid -- brand positioning, our TV ads, our new product pipeline, and our improving operations.

We also have major new product news planned for 2007 and we have adjusted our marketing plan that reinforces Taco Bell’s compelling value in what is obviously a tougher competitive environment.

Taco Bell has been one of the leaders in growth for the past several years, with 2% same store sales growth expected for 2006, after years of plus 7%, plus 5%, plus 2%, and plus 7%. That is a track record, and we are confident we will once again be in the plus 2% to 3% range at Taco Bell in 2007.

Now, on to KFC. KFC delivered flat same-store sales growth in Q3, lapping 6% growth last year, or two-year average growth of 3%. We are up 2% year-to-date, lapping 6% growth a year ago. As with Taco Bell, we believe KFC performance also stacks up fairly well within our category in terms of two-year growth rates.

Looking at all aspects of the brand fundamentals, we are confident of the positioning and our TV ads. Operations are improving from a low base but are steadily making progress. We remain very focused on execution against building sales layers around our four new concepts -- Variety Bucket, Snacker, Flavor Station, and our Famous Bowls. You will see continued news in support of these concepts for the balance of the year, including Famous Bowls, which was a very successful new product introduction, which will be coming up in two weeks.

Additionally, for our 2007 calendar, we have pulled forward into the second-half of 2007 what we thought was our most compelling new product ideas targeted for 2008. We have an outstanding pipeline of product news at KFC.

Now on to Pizza Hut. The picture has changed somewhat, as we have begun to lap weaker performance versus a year ago. Our sales results have improved but are still not where we need to be and transactions remain down for the category overall.

I can assure you we are putting a full court press on at Pizza Hut. The good news is the team has been working through a problem detection analysis and other category and brand research to develop a roadmap to a turnaround plan. As we go forward, we will begin to implement our turnaround plan and we believe you will begin to see improved results in 2007 off of this year’s poor performance.

Our turnaround plan will be comprehensive in terms of marketing and operating plans. At this time, with a very tough category trend and two major national competitors, I cannot be more specific.

I can tell you we are all over this business and we are putting every Yum! resource to bear that will help us turn this business around. We have turned around each of our brands at one point in time, and we will do it again and we will do it with Pizza Hut. All I can say is to trust our track record -- that will happen again.

To summarize on the U.S. business, we do not see any significant change for the balance of year in terms of same-store sales growth when looking at likely results in terms of two-year growth rates. We had this factored into our forecasts. We are confident that Taco Bell and KFC each has the right plan in place for the balance of the year and 2007. At Pizza Hut, we will be lapping weak numbers next year and are in the process of making changes, as I mentioned.

Based on our Taco Bell and KFC market positions, and the progress we expect to make at Pizza Hut, we remain confident of reaching our plus 2% to 3% same-store sales target for the U.S. in 2007.

Beyond the U.S.-based business, we are excited to see that new restaurant development is beginning to ramp up at Taco Bell and with Taco Bell/KFC multi-brands, which will provide us with a new source of profit growth in the U.S. Our franchisees are excited about our new Bold Choice Taco Bell restaurant design and so are our customers. You should expect to see many more across the U.S. over the next several years. Taco Bell U.S. will expand by about 1.5% new units net of closures in 2006.

Finally, we expect to make continued progress in upgrading KFC U.S. and Pizza Hut U.S. system restaurants during 2007. For KFC, we expect 600 to 700 upgrade projects to be completed in 2007, most of these by our franchisees. At Pizza Hut, we expect 200 to 300 upgrade projects to be completed, again mostly by our franchisees. All told, there will be significant capital invested by our franchisees next year for image upgrades at KFC and Pizza Hut U.S., as well as Taco Bell for new restaurant growth.

To summarize, the power of our global portfolio and international scale and growth makes us not your ordinary restaurant company and a cash-generating machine. Importantly, we will continue to invest substantial company capital in mainland China, which provides high growth, high returns, and ultimately we believe significant scale for Yum!.

Over the long-term, we expect to continue to grow our earnings per share at least 10%, pay out substantial cash to shareholders, and build value by executing against our unique international growth opportunities, with high returns that differentiate us from other global consumer companies. Specifically, we will focus on our four key strategies -- building dominant restaurant brands in China, driving profitable international expansion, steadily improving our U.S. brands and operations, and multi-branding category leading brands.

Now I will turn it over to Rick Carucci, our CFO, who will take you through the numbers. Rick.

Richard T. Carucci

Thank you, David, and good afternoon, everyone. I am going to review five items today: first, Yum!’s third quarter results; second, Yum!’s year-to-date results; third, our full-year 2006 outlook; fourth, a brief update on our refranchising program; and fifth, an update of our full-year cash flow expectations.

Let’s now talk about our third quarter, which was another high-quality quarter. Worldwide operating profit growth was up 11%, and operating margins in all three businesses also improved nicely.

Let’s look at Q3 by business segment.

China Division restaurant margin was up over three points versus a year ago. Year-to-date margins are well over 21%, which is an all-time record. We are very encouraged by this performance. Needless to say, our China division had an even better quarter than we had expected, with 10% same-store sales growth, record margins, and 26% profit growth. Both the KFC and Pizza Hut casual dining brands had strong sales growth in quarter 3.

This quarter also demonstrated the power of development-based growth. Our two-year profit growth in the China Division was 66%. Our two-year development growth in mainland China was 55%. Because we continued to build units, when our sales did bounce back, we knew we would be in a great position regarding profit performance.

Yum! Restaurants International also had a very strong third quarter, with 22% operating profit growth. While we had expected strong growth in quarter 3, we are obviously very pleased with this result. Importantly, margin performance was strong with over 20% operating margin, an increase of nearly three points from last year.

Same-store sales in company markets increased by 4% after being flat in the first-half of the year. This resulted in an increase in restaurant margin of 0.8%.

YRI franchise fees were up 13% in local currency. This was led by a 6% increase in franchise restaurants and by 4% growth in same-store sales. The strongest performing markets were in our franchise-only areas of the world -- South Africa, Caribbean Latin America, Middle East, and Asia. These franchise results led to the strong 2.7 point increase in operating margins.

The overall U.K. business showed improved performance versus the first-half of the year. Total third quarter U.K. profits were up 4% on local currency versus prior year, driven by strong same-store sales growth for KFC.

Our Pizza Hut U.K. business struggled during Q3, as we were in the late stages of completing the acquisition of Whitbread’s 50% interest in our former joint venture. We expect stronger sales performance for this business in the balance of the year.

Turning to the U.S., we had disappointing sales in the third quarter. We did benefit from substantially lower commodity costs following two extremely tough years of commodity inflation. The commodity favorability in the third quarter was $10 million. In addition, closures and impairment expense dropped $13 million versus last year. This largely explains why profits were up slightly, about 1% versus last year, despite same-store sales being down 2%.

To summarize, the third quarter was again a high-quality quarter, driven by 11% growth in worldwide operating profit. This outstanding quarterly performance was led by strong growth from our China and YRI divisions, each with profit growth exceeding 20%.

In the financial area, we saw a slightly lower tax rate of about 26% versus last year’s rate of about 27%. The lower tax rate offset a $6 million increase in interest expense. The increase was driven primarily from higher rates on the variable rate portion of our debt, and it also reflects slightly higher debt levels this year versus last year.

Finally, we continue to make very good progress in reducing our share count, now down to 255 million shares at quarter-end, and a 7% reduction average diluted shares year over year. All of this results in an EPS growth of 20% against the third quarter last year.

That wraps up Q3. Now I want to review our year-to-date business performance as we look ahead to 2007.

Year-to-date, our worldwide operating profit increased by 14%, led by across-the-board strength in each of our businesses. China was up 38% year-to-date, well above our long-term 20% target. YRI was up 9% year-to-date, close to our long-term 10% target. The U.S. was up 8% year-to-date, above our long-term 5% target.

All in all, this represents high quality and strong performance from our global portfolio. Overall year-to-date, we are up $113 million in operating profit.

China’s year-to-date results have driven 53% of that growth and YRI 20% of that growth. That is nearly 75% of our year-to-date operating growth from our two international divisions. That has been the picture over the last eight years and we expect that storyline to continue into the foreseeable future.

Year-to-date, earnings per share was up 18%, ahead of our operating profit growth. Our significant reduction in share count more than offset a higher year-to-date tax rate and higher year-to-date interest expense.

Now let’s turn to our full-year outlook. As we look ahead to the fourth quarter, please keep in mind that our reported growth rates will be negatively impacted by the lap of the 53rd week last year. This impacts YRI, the U.S. business, and Yum! overall. Our China division will not be affected.

Let’s look first at our U.S. business. In this environment, and with the tough laps at both Taco Bell and KFC balance of year, Q4 is a little hard to read. However, we believe in the U.S., we will finish with between 3% and 5% profit growth overall for 2006, prior to lapping last year’s 53rd week. We have factored this into our overall outlook.

We are not particularly bullish on Q4 domestic sales. We do, however, expect favorable commodity costs versus last year, but with lower gains year over year than in the first three quarters. While we are working very hard to turn around our U.S. business, we feel great about Yum!’s overall business. We are confident in our brands. We know our U.S. sales will bounce back and we strongly believe our results will improve over time.

Also, we are especially confident about the outlook for China and YRI during the balance of this year. We expect China Division operating profit to be up 35% to 40% for the year, driven by another great year of new unit expansion. We will likely open more than 400 new restaurants. Same-store sales will be solid for the year, and restaurant margins will be up over 20% for the full year.

At YRI, we expect operating profit to be up at least 10% for the year, excluding last year’s 53rd week benefit. YRI will have a strong fourth quarter, with over 10% profit growth on a like-for-like basis.

For the year overall, the really good news is that we expect solid margin growth in all three businesses. Our growth model is very productive this year and looks very strong for the future.

Based on the operating profit strength we discussed, our full-year EPS guidance increases to $2.89, or 14% growth. With our global portfolio, we have a track record of consistently achieving above 10% EPS growth, despite soft results in any quarter or two from any of our businesses. Specifically for 2006, we are demonstrating that we can absorb a tough stretch of U.S. sales and yet have our global portfolio deliver solid double-digit EPS growth.

Now I would like to provide you with an update of our refranchising progress. At YRI, we are continuing to refranchise our company units in some smaller scale businesses, namely Pizza Hut businesses in Canada, France, and Australia. We continue to make progress on this front and we have refranchised 157 YRI company restaurants for the past four quarters.

With the recent acquisition of our 50% ownership of the Pizza Hut U.K. joint venture, our company ownership is now at 16% at YRI. We will be refranchising in the U.K. over the next two to three years to bring our YRI ownership down to similar levels as before the acquisition.

As a result, you should expect us to continue some refranchising at YRI over the next three years.

We continue to like our current franchise dominant business model for YRI. Where we do invest our own equity and run company restaurants, we generally look for three things: first, potential for significant scale; second, strong growth potential in the market; and third, strong returns. We will sometimes compromise on one of the first two points but not on the third, the high returns.

In the U.S., we continue to make progress against our two-year plan of refranchising at least 1,000 company-owned restaurants. We have refranchised about 200 U.S. company-owned restaurants year-to-date, with at least a similar amount for Q4.

As we previously stated, our target at the end of 2007 is to reach 20% blended company ownership in the U.S. from about 26% at the beginning of this year. We expect to reduce our U.S. company-owned restaurant count from about 4700 at the end of 2005 to less than 3700 by year-end 2007.

The good news is our two-year U.S. program is progressing well and is currently expected to be completed on time, with a large pool of capable franchise buyers. We expect to meet our financial targets of: A, a 50% basis point improvement in U.S. restaurant margin; B, no impact to operating profit dollars; and C, a 75 basis point improvement in ROIC.

We also expect to receive cash of $250 million in 2006, which is above our original $150 million estimate.

Now let’s talk about cash flow. We continue to expect to end this year with another record of about $1.3 billion in net cash provided by operating activity. We will invest about $625 million on capital spending during the year, which will result in about $700 million of traditional free cash flow. We are fortunate that even after we invest capital for growth, our China, YRI, and U.S. businesses each generate free cash flow.

We expect additional cash flow of over $250 million from refranchising proceeds, another $150 million in employee stock option proceeds, and $40 million from sales of surplus property and equipment and other items. When you add it all up, that is over $1.1 billion in available cash.

Consistent with our recent task, our stated approach is to give our share back to our shareholders in the form of share buy-backs and a dividend. We believe we received an especially great value in our stock buy-backs this year. During the third quarter alone, we bought back $337 million of stock at an average price of $47.52. Our year-to-date purchases stand at 853 million. For the full year, we expect our diluted share count to decrease by 6%.

In summary, we expect 2006 to be another successful financial year for our shareholders because we expect to deliver 2006 EPS of $2.89, or at least 14% growth versus last year, another year of strong cash flow and substantial cash payout to our shareholders, and finally, we expect to continue building long-term value in our international businesses, YRI and China -- YRI, through high return franchise expansion and development of emerging mega-markets like India, Russia, and France, and in China, with high return company restaurant expansion of multiple Yum! brands.

Yum! clearly has the opportunity and the capability for long-term growth, with annual EPS growth of at least 10% year after year.

That is it for me, David, back to you.

David C. Novak

Thank you very much, Rick. It is becoming more and more apparent we are a global growth company with tremendous upside and new unit potential. There is no doubt in my mind that we will have at least 20,000 restaurants in China someday, and we are taking the right steps to put our brands on the map in India, Russia, and continental Europe.

We obviously had an excellent third quarter and fabulous year-to-date results. Our China and YRI growth engines are firing on all cylinders. U.S. business has now softened after a string of very strong comps, but we are confident Taco Bell and KFC are in good shape, while we are focused to turn Pizza Hut in the U.S. around.

Net net, our international divisions continue to drive our growth and our U.S. business generates substantial, relatively stable cash flow, which we return to shareholders.

Before we go to Q&A, we need to make an announcement. As you may have seen, Starbucks recently announced that they are going to provide same-store sales on a quarterly basis versus by month. We have evaluated their move and believe it makes sense for us as well for the following reasons:

  1. One of our key strengths is our portfolio, and our track record has demonstrated that our portfolio has delivered each of the past five years. We have delivered consistent results and our total business is stronger than ever;
  2. We add shareholder value primarily through expansion of our brands around the world, building new restaurants in places like China with high returns. Quarterly and annual results fully explain this progress;
  3. Our focus is on the total business and longer-term quarterly results are more indicative of our performance and how we add value; and finally
  4. It sends the right message to all of our teams. We do not run this business month-to-month. It is building long-term value that counts, so we have decided that Period 10 sales will be our last period sales release.

Now, we will be happy to take your questions.

Question-and-Answer Session


(Operator Instructions)

Tim Jerzyk

Are we ready to go, Nicole?


Just one moment. Your first question comes from David Palmer with UBS.

David Palmer - UBS

Thanks. Congratulations on the quarter. I wanted to ask you about the U.S. business. It seems like September trends for the industry accelerated a bit, but maybe only as much as what the comparisons might have kind of dictated. In other words, the two-year trend did not do anything all that spectacular.

I was wondering if you are -- first, if you would comment on the industry environment. Secondly, with regard to Taco Bell and KFC, obviously you have seen an increase in everyday low pricing options out there -- McDonald’s, Wendy’s -- and you are talking about how you are pushing up some changes in the KFC product calendar for ’07. I am wondering if that is causing a bit of soul-searching on those two brands in terms of what foot forward in terms of marketing and menu innovation you put.

In other words, do you think you can just leave your menu innovation schedule intact and just go with it, or do you have to change what you are doing? Thanks.

David C. Novak

First of all, in terms of the category, we think the category is basically in the same shape it was three or four months ago. It is a tough category. I think when we look at what could be impacting our business that we did not foresee last year, I think it is the introduction of two chicken products, one of them being the $0.99 sandwich that Wendy’s introduced and the other being the $1.29 chicken wrap that McDonald’s introduced. We do believe that both of those products had impact on KFC and, to a certain extent, had impacted Taco Bell as well, because they are more in the value arena.

As we look at our Taco Bell and KFC in particular, we really feel like everything that we are doing on those brands is right in terms of the positioning of the brands, the overall advertising campaigns, and the fact that we continue to have a full-court press on developing product news.

I think the way we kind of look at it is while we had a tremendous string of continuous same-store sales growth and our two-year numbers are great, we look at it in the last three months, it has sort of been like we are down 7 to 3 at half-time, so we have kind of gone back into the locker room, we have looked at our game plan, and we really think that the playbook that we have is right, and what we want to do is just make sure that we execute it as strongly as we can.

Let’s take Taco Bell, for example. Would we change the advertising? “Think Outside the Bun” is, I think, most people would say it would be right up there with -- it is in the top tier of any advertising campaign in the industry. Then, when we look at our product pipelines at both Taco Bell and KFC, we have a lot of news coming up and so what we are doing now is just trying to decide which news is the most valuable, which news will have the most impact, and we are planning our calendar to really give the consumer as much power as we can.

I think what we have learned is that you need more news today to win. We think we are losing more out to other competitors’ product news introductions than on the value front. In other words, we think Wendy’s had more product news with their $0.99 chicken sandwich than we did when we came back and just reinforced the Snacker product that we introduced last year. We think McDonald’s had more news with their $1.29 snack wrap. We think we have been outnewsed.

Now, the good news is we have a lot of news at Taco Bell and KFC and we can get back in that game and you will see us play that game well next year.

I think the two-year trends are important because it says don’t throw the baby out with the bathwater here. The worst thing we could do is overreact to the business that we have right now, but I could tell you I think I read somewhere where somebody was wondering if we were interested in turning around the U.S. business, and that is so far from the truth it is unbelievable. We are all over this like a fly on honey and we are going to do everything we can to turn this business around.

David Palmer - UBS

Thank you.

Tim Jerzyk

Thanks, David. Next question, please, Nicole.


Your next question comes from Glen Petraglia with Citigroup.

Glen Petraglia - Citigroup

Good afternoon. Rick, just first a clarifying question. The period ending share count, if you could share that. Also, if you could maybe give a preliminary outlook for commodities in 2007.

Richard T. Carucci

The quarter end share count was 265 -- that is absolute basis shares, 265 million shares.

Glen Petraglia - Citigroup

Okay, thanks.

Richard T. Carucci

Commodity, for background for 2006 again, before we get into 2007, is that we had very favorable commodities. We were about $35 million year-to-date, $10 million in the third quarter. We expect positive commodities in the fourth quarter, probably less than the first three quarters.

We do not have a great handle yet on 2007. Right now, we are not expecting anything unusual. We will have a lot more to report at our December meeting.

Glen Petraglia - Citigroup

But it is safe to say that you would likely be flat to potentially slightly up in many cases?

Richard T. Carucci

Early indications are what I would call normal low-level inflation.

Glen Petraglia - Citigroup

Okay, thanks.

Tim Jerzyk

Thanks, Glen. Next question, please, Nicole.


Your next question comes from John Ivankoe with JP Morgan.

John Ivankoe - JP Morgan

Thanks. The question is actually on China. Obviously the returns for the overall market, and presumably new unit returns, are fairly exceptional, as driven by your sales to investment ratios and specifically the margins that we are seeing reported on your income statement.

I guess what I am looking for is, how do you feel about having a 23.7% margin? Is that the level we should be thinking about you making longer term? Is that, for whatever reason, kind of a peak-ish margin in the quarter? Will new units, do you think it would be higher or lower than that?

In kind of parenthetical view to that, does it make sense at any point to perhaps lower that margin to make your business even more attractive to more consumers as you expand throughout China?

Richard T. Carucci

Good question, John. First of all, the China margins in the third quarter are a bit normal than our full-year numbers, just because of seasonality. So seasonality did drive third quarter above normal, but our year-to-date margins are over 21%.

I personally believe that 20% margins are sustainable in China for a few reasons. First of all, as we go to these smaller cities, even though our average sales are below what we are getting in the bigger cities, our margins are actually higher, so those businesses are performing well and our returns are higher there as well. So we feel great about that development.

The second piece is our competitive position continues to improve in China. If you really look at it, we have been adding 400 restaurants for the division, but just on the KFC side, close to 300 restaurants the last couple of years, which is three-to-one our nearest competitor. So our power in the marketplace continues to improve and we have been able to leverage that on the cost side.

I feel that our margins there are sustainable and, as income grows there, we are already becoming more and more affordable to people. We are expanding our reach as much as we want to, really, because of the income level rising as opposed towards to needing to discount our products.

John Ivankoe - JP Morgan

Can I ask you a question just related to food and paper costs in China? It looks like, according to my numbers, that it has dropped about 250 basis points over the last three years. Is that something that you are able to -- is it your distribution efficiencies, is it better purchasing? Is there something going on in that market that should allow that trend to continue?

Richard T. Carucci

First of all, I think the reason we have achieved it, John, is what we were talking about earlier, that our purchasing power and the number of units we have continues to increase, so we get more efficiencies as we and our suppliers get bigger supporting us. So there has been natural ability to manage costs.

I do expect to continue to see some improvement there, probably not at the rate that we have gotten over the last several years. So we expect that rate of improvement to moderate over time, but we also believe we have the opportunity to take modest pricing over time. Because our cost structure has improved so much, we have taken very limited pricing in China. When we have taken limited pricing, the market has been able to absorb that.

David C. Novak

The other thing, John, to your point earlier about providing value to the customers. We do have over 6,000 transactions a week in KFCs, and the only way we have been able to get to that point is because we have everyday affordable value. We are going to make sure we keep that up.

Tim Jerzyk

Thanks, John. Next question, please, Nicole.


The next question comes from Jeff Omohundro from Wachovia.

Jeff Omohundro - Wachovia Securities

Thanks, just two questions. First, I was wondering if you could give us an update on your thinking on KFC U.S., the Famous Bowls, where we are on the product cycle on that with the upcoming line extension. Is the mix sustaining? Is that becoming more of a core product? What the outlook is on that.

Secondly, if you could remind us, what accounts for the differing performance between mainland China and Shanghai recently?

David C. Novak

I will speak first of all to your point about the Famous Bowls. Basically what we are coming back to with the Famous Bowl product is basically a reprise of our national introduction that we had earlier in the year, so it is the same product.

The product has been very successful. It has achieved our mix level that we are looking at and we see this as a permanent product on the menu. In fact, we have a number of line extensions in the hopper that are very unique and differentiated versus our original offering that we think will give us some product news.

Tim or Rick, do you want to --

Tim Jerzyk

Jeff, just to clarify, your question was mainland China sales performance versus division China?

Jeff Omohundro - Wachovia Securities

Yes, division China.

Tim Jerzyk


Richard T. Carucci

Again, just for background, China Division includes Taiwan and Thailand. Effectively, the bigger problem we actually had was in Taiwan, where we were lapping very strong performance last year and the market softened this year.

We also were down a little bit in Thailand, which had been strong all year, and there is a week of softer sales with the [crew] there, but those sales have pretty much bounced back.

We feel those businesses will bounce back, but just will provide a short-term -- probably for about another month or two.

Jeff Omohundro - Wachovia Securities

Great, thank you very much.

Tim Jerzyk

Thanks, Jeff. Next question, please, Nicole.


Your next question comes from Mark Wiltamuth with Morgan Stanley.

Mark Wiltamuth - Morgan Stanley Dean Witter

I was going to ask some questions here on the Pizza Hut Home Service rollout in China. If you could just give us some idea of the pacing of the rollouts you are expecting there, and maybe contrast the returns you get on that business, relative to the KFC store growth in China.

David C. Novak

First of all, we have just basically developed the Shanghai market. We are going to be going -- in November, we have our strategy plan session with the team there in China, and I think we could give you more detail on that after that meeting. We are really not at the point where we would want to talk about that yet.

Richard T. Carucci

In terms of the economic model on Pizza Hut Home Service, it is a much lower investment base, so we are spending a couple hundred thousand, $200,000, $250,000 per unit and its margins are lower than our base on KFC or Pizza Hut business, probably roughly in the 15% range. With those numbers and that investment return, it has very strong returns.

Mark Wiltamuth - Morgan Stanley Dean Witter

So higher returns than the KFCs?

Richard T. Carucci

It is similar but again, it is very early days.

Mark Wiltamuth - Morgan Stanley Dean Witter

Okay, thank you.

Tim Jerzyk

Thanks, Mark. Next question, please, Nicole.


Your next question comes from Joe Buckley with Bear, Stearns.

Joseph Buckley - Bear, Stearns

Thank you. Two questions, one on China. As you start opening more in smaller markets and the [AUBs] come down a bit, will you step up the expansion rate to keep the overall top-line growth in the low 20% area? How do you approach that from a planning perspective?

Richard T. Carucci

We try to open them as fast as we can, Joe, so we have been moving at a very high rate. I think if you look at it over time, at some point the unit growth rate will have to decline. At that point though, we still believe we will have probably more opportunity for same-store sales growth. Historically, we have really pretty much grown same-store sales with our unit development. It has been at such a high rate and we think over time, we will probably have more of a blend between unit development and same-store sales growth.

Having said that, for the next several years, we believe unit growth will still dominate what is driving the growth there.

Joseph Buckley - Bear, Stearns

China same-store sales number of 12% in the quarter -- what did that compare to a year ago?

Tim Jerzyk

We do not have it handy, Joe. I will have to give you a call back. I guess it was probably flat to up slightly, something in that range.

Richard T. Carucci

Again, third quarter last year we still had some of the effects of Sudan Red, so it was probably negative, I would guess, in the third quarter of last year.

David C. Novak

Let’s not guess. We will get back to you.

Tim Jerzyk

Yes, we will get back to you.

Joseph Buckley - Bear, Stearns

Just one on the U.S. That $250 million number that you are going to reach from refranchising this year, your original two-year number was $300 million, so I am assuming that two-year number is going a lot higher as well. Can you update us on that?

Richard T. Carucci

We will have to update you on that in December but yes, it will be higher but we will give you a more precise number.

Joseph Buckley - Bear, Stearns

Thank you.


(Operator Instructions)

There are no further questions at this time.

David C. Novak

Thank you very much for being on the call. We are off to another good year and we are going to finish another good one and we look forward to 2007, look forward to seeing you at our investor conference in December.


Thank you for participating in today’s teleconference. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!