Yum! Brands CEO Discusses Q3 2010 Results - Earnings Call Transcript

 |  About: Yum! Brands, Inc. (YUM)
by: SA Transcripts


Good morning. At this time, I would like to welcome everyone to the 2010 second quarter’s earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be question-and-answer session. [Operator instructions.]

I will now turn the call over to Mr. Tim Jerzyk, senior vice president of investor relations.

Tim Jerzyk

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 at 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 any non-GAAP financial measures that may be used on today’s call.

Finally we’d like you to please be aware of two upcoming Yum! investor events. December 8 we will host our annual investor and analyst conference in New York. Registration is required and you will be receiving more information on the conference soon. Wednesday, February 2, 2011 fourth quarter earnings will be released.

On our call today you will hear from David Novak, chairman and CEO; and Rick Carucci, our CFO. Following remarks from both, we will take your questions.

Now I’ll turn the call over to David Novak.

David Novak

Thank you very much Tim, and good morning everyone. Before I talk about our third quarter performance, I think it's interesting to note that tomorrow, October 7, is our company's Founder's Day and marks our 13th anniversary since we were spun off from PepsiCo. I especially want to thank all of our shareholders who have been with us since day one.

From the beginning, our formula for success has been people capability first. Satisfied customers and profitability follow. I'm proud of our "how we win together" ownership culture and the results that we've generated. In 13 years we've seen our stock price increase 600%, and I'm happy to say every one of our annual stock option grants are in the money for our team members.

Our people know the three keys to driving shareholder value, and believe me, we are focused on them - new unit development, same-store sales growth, and return on invested capital. We continue to believe we have the best new unit opportunity in China, India, Russia, and other emerging markets. We also have unparalleled opportunity to grow same-store sales with our 37,000 restaurants, by developing day parts and making our brands even more relevant. Meanwhile, our returns should continue to be the best in retail.

I often say the best thing about business is the unfinished business, and clearly we're in the early innings of our growth and quest to become the defining global company that feeds the world.

Now on to our results. I'm pleased to report we are raising our full-year EPS growth forecast to 14% from 12%, which will make 2010 the ninth consecutive year we meet or exceed our annual target of at least 10%. We take satisfaction that our year to date operating profit has increased 15%, excluding special items and the impact of foreign currency translation and is driving our strong EPS growth this year.

Our third quarter operating profit growth of 14%, excluding special items, was fueled by new unit development in China and Yum! Restaurants International. We are particularly pleased with our China business, which reported robust profit growth of 23%, excluding the impact of foreign currency translation.

At Yum! Restaurants International, we grew operating profit 16%, prior to foreign currency translation benefit. In the U.S. we saw modest same-store sales growth in what remains a tough environment. While our U.S. profit declined slightly for the quarter, we do expect growth for the full year.

Now let me take you through our key strategies and trends for each of our divisions. First, I'd like to thank all of you that attended our recent China conference in Shanghai and saw the leadership and tremendous operations teams we have in China. I'd like to thank Sam Su and our China team for hosting our guests at this great event.

I'm obviously very proud of our China team's continued strong performance. Units expanded 12% and same-store sales grew 6% for the quarter. Our China division's operating profit has grown 29% year to date, excluding the impact of foreign currency translation.

New unit development continues to be the major driver of our growth and we remain the largest U.S. retail developer in China. We've opened 245 new units through our first three quarters, and expect to open about 475 this year. Our China new unit returns remain a key focus for us, and continue to be the best in our business.

Now let me share with you a few highlights from each of our leading brands in China. Let's start with KFC. With over 3,000 restaurants, KFC is the largest restaurant QSR concept in mainland China. While we're certainly viewed as the chicken experts, our menu also includes beef and seafood, as well as other products with broad appeal to Chinese consumers.

We are working on three key initiatives that will grow the business, leverage our assets, and build strong unit economics well into the future. First, KFC breakfast is in virtually all of our restaurants. Our breakfast day part has seen double-digit sales growth this year, and now makes up about 10% of transactions. This sales layer is positioned well, as more Chinese consumers are eating breakfast outside their homes.

Next is delivery, which is now available in over 1400 units. The fast-growing delivery segment is primarily in higher-tier cities. Lastly, our 24-hour operations initiative is generating incremental sales and is now in about a third of our restaurants. These three big initiatives are leveraging our assets even more effectively and keeping our unit economics strong.

Pizza casual dining goes beyond pizza and continues to be the leading Western casual dining concept in China, with nearly 500 units in over 120 cities. Our new menu strategy continues to drive double-digit same-store growth. The menu is revamped twice a year and continues to offer a broad variety of entrees including beef, chicken, and rice dishes, along with appetizers, beverages, and desserts. We are having solid success building a true casual dining concept with everyday, affordable value.

We also continue to invest behind the development of our emerging brands. Pizza Hut home service in the home delivery category, now has over 100 units in 11 cities. East Dawning, our Chinese fast food brand, continues to make progress as we drive for scalable economics. Additionally, we own 27% of Little Sheep, the leading brand in the hot pot category, which is the largest casual-dining category in China.

In summary, our China business is having a fantastic year. I couldn't be happier with the progress we're making in executing our China strategy to build leading brands in every significant restaurant category.

Next, Yum! Restaurants International produced solid results in the quarter, with system sales growth of 5% and operating profit growth of 16%, prior to foreign currency translation benefits. Same-store sales increased 1% and restaurant margin improved 1.6 points. We continue to expect to have stronger sales performance in the fourth quarter.

We have opened 478 new restaurants this year, with our strong network of growth-oriented franchisees opening about 90% of these units. In fact, over 85% of the 14,000 traditional restaurants in this division are franchise units, which generate a steady, growing stream of franchise royalties. We expect to add about 900 new units for the full year, most of which are in emerging markets with growing middle class populations.

It's the new unit development in these markets that sets Yum! apart and is positioning YRI for many successful years into the future. Rick will take you through more details on our emerging markets opportunity during his remarks.

Yum! Restaurants International's new growth markets, France, India, and Russia, delivered 21% system sales growth prior to foreign currency translation this quarter. We're very excited about the opportunities in these countries and look at these businesses as a future growth engine for Yum! Restaurants International.

Taco Bell International continues to expand. Our first Taco Bell in India opened this year, and there are currently two more scheduled to open in the fourth quarter. I look forward to my trip to both India and China in the next couple of weeks.

We opened our first Taco Bell in the U.K. in June, and another is scheduled to open in November. Overall, we've opened Taco Bells in seven new countries over the past two years, and expect to enter three additional countries by the end of the year. We're in very early stages, but could not be more delighted with how consumers are responding to the taste and value of our products.

KFC, our largest concept in Yum! Restaurants International, is currently focused on value and asset utilization. Value menus are in place in all our key markets, and we'll be expanding further this year. Our Krushers line of frozen beverages continues to expand, and we remain in the early stages of testing our KFC breakfast initiative, which we call KFC a.m. Clearly, McDonald's has had great success in developing these day parts, and we intend to do the same.

Overall, Yum! Restaurants International growth and development is on track. Importantly, we have a leading position and substantial runway for growth in emerging markets. Our strategy remains to drive an aggressive expansion and build strong brands everywhere.

Next, on to our U.S. business, where our focus is to improve our brands' positions, consistency, and returns. Combined, our U.S. brands grew same-store sales 1% in the quarter. Taco Bell, our largest and most profitable brand in the U.S., grew same-store sales 3%. Taco Bell continues to leverage its position as one of the industry's value leaders in a market clearly focused on everyday value.

We also continued to make progress testing breakfast, home meal replacement options, and a new beverage platform. All these initiatives are designed to leverage our assets and build sustaining sales layers that enable accelerated growth. The Taco Bell team just had their annual franchise convention in Orlando, and our franchisees are pumped up about the future.

Pizza Hut U.S. led the way again, with 8% same-store sales growth for the quarter, driven by the huge success of our $10 any pizza promotion. We recently changed our menu pricing that reduced the price of medium and large pizzas to $8 and $10 respectively for up to three toppings. Our specialty meat pizzas like Meat Lovers or Supreme, cost $2 more. This simplified menu strategy provides consistent value to consumers and is expected to further increase our margins.

The best news for Pizza Hut is we now have everyday value and simplified pricing. We believe it is sustainable and a long-term strategy. We also continue to lead in innovation, with pizzas like the Big Italy. The combination of everyday value and new product innovation should position Pizza Hut for continued success, along with the arsenal we now have in pasta, with Tuscany Pastas, and wings, which we feature on Tuesday and Wednesday to leverage our asset.

Now, on to KFC in the U.S. As expected, same-store sales continued to be soft, and declined 8% for the quarter, driven in part by reduced media spending. As we expect media comparisons to improve in the fourth quarter, we also expect better sales.

Our focus remains on the following key areas: improved operations, value, balanced options featuring grilled products, portable product innovation, and asset upgrades. As you would expect, each of these major initiatives will take time to implement. There is no quick fix. We are absolutely committed to turning KFC around and we're seeing slow, but steady, progress. Overall, while our U.S. business profits are flat year to date, we do expect profit growth for the full year.

Let me wrap up the total Yum! story. Overall, we're having a great year and that gives us even more confidence in the power of our business model. This model relies on new unit development to drive about half of our EPS growth target of at least 10% annually. In 2011, we're well-positioned to hit our operating profit growth targets of 15% in China, 10% at YRI, and 5% from our U.S. business.

The balance of our annual EPS growth comes from our base business through same-store sales, productivity initiatives, G&A leverage, and financial strategies. We have a track record that proves how powerful this growth model is. With the expected opening of 1400 international new units this year, and our strategies in the base business, we're in a good position for next year, and expect to make 2011 our 10th consecutive year we meet or exceed our target of at least 10% EPS growth.

Now let me hand it over to Rick Carucci, our chief financial officer, and a great partner of mine.

Rick Carucci

Thank you David, and good morning everyone. In this section of our call I'm going to comment on four areas. I'll start with our third quarter results and our outlook for the balance of 2010. Given the time of year, I will also cover some early thoughts on 2011, and finally I'll provide another chapter of information related to Yum's unique growth opportunity in emerging markets.

In the third quarter, Yum's diverse global portfolio generated operating profit growth of 14% prior to foreign currency and special items. This was led by 23% growth in China and 16% growth in Yum! Restaurants International, while U.S. operating profit decreased by 2%.

As CFO, you're always happy to report double-digit operating profit growth. I'm particularly pleased that we are seeing this operating profit growth on top of 19% growth in the third quarter of last year. This is a very strong result, in what I would best characterize as a "gray hair" environment for CFOs over the past two years.

In the third quarter we grew EPS 5%, excluding special items. The strong operating profit results were partially offset by a higher tax rate in the quarter. Our tax rate prior to special items was 27.4% compared to an unusually low 19.9% rate in the third quarter last year.

There were also two newsworthy financial events for Yum! this quarter. In September, our board of directors announced a 19% increase in our quarterly dividend. Our quarterly cash payout will increase from $0.21 a share to $0.25 a share.

Since its inception in 2004, we have increased the dividend each year and Yum's dividend per share is now five times higher than the 2004 level. In addition, over the past five years, our shareholder payout of dividends plus share repurchases puts us in the top 10% of S&P 500 companies.

In the past, we've also talked about improving our balance sheet and smoothing our debt skyline. In August, we issued a ten-year, $350 million note. We plan to use those proceeds to pay down debt coming due in 2011. Our 3 7/8 coupon was the lowest rate we've ever attained. It was also the lowest ten year bond rate on record for any BBB minus rated corporate. It is great to see the recognition of our financial strength by fixed income investors.

Overall, we are quite pleased with the operational performance of our business, our financial strength, and our ability to drive shareholder value in the third quarter.

We have now delivered three strong quarters in 2010, and thanks to robust profits from China and based on the strong year-to-date performance, we raised our full-year EPS target growth to 14%, excluding special items.

Let's try to put the balance of the year in perspective by business segment. First, in China we continued to benefit from the improvement of the Chinese consumer, where consumer confidence has now been positive year-over-year in the last nine months. This has helped generate year-to-date same-store sales results of 5% and we anticipate a similar sales performance for the fourth quarter.

As we said before, we expect the cost environment to get more challenging in the fourth quarter. We expect about $15 million in labor inflation in the quarter, bringing the full-year level to $40 million.

On the commodities side, we've benefitted from year-to-date deflation of $35 million but we expect commodity inflation of about $15 million in the fourth quarter. While we don't expect pricing to have a significant impact on our 2010 results, we are confident that going forward, the strength of our brands will allow pricing to offset commodity and labor inflation.

What this all means is that our fourth-quarter margins may be about even, or go down slightly versus prior year. For the full year of 2010, we expect very strong absolute margins and an increase over the strong numbers posted last year.

We are confident in our ability to continue our rapid new unit development in China and expect to reach our 2010 target of about 475 units. At the end of the third quarter, we've opened 245 restaurants, so our development pipeline is back-end loaded. Over the last three years, we've averaged over 200 units in the fourth quarter.

When you add it up, this has been a particularly strong year for China. We expect to exceed our targets for the year, and now expect system sales growth of at least 15% and profit growth of at least 20%.

Yum! Restaurants International sales remained a bit sluggish in the third quarter, but sales comparisons continue to improve. Adjusting for the impact of the Chinese New Year, YRI same-store sales were down 1% in Q1, flat in Q2, and plus 1% in Q3. We expect same-store sales growth to continue to improve in the fourth quarter, as we overlap a 2% same-store sales decline in the fourth quarter of 2009.

Along with our franchise partners at YRI, we have developed 478 new units year to date and expect to build about 900 units for the full year. We have opened roughly 400 new units in the fourth quarter each of the last two years.

In the U.S., we see the same pattern of same-store sales. Same-store sales in the U.S. were also down 1% in Q1, flat in Q2, and plus 1% in Q3. We also expect further improvement in the U.S. in the fourth quarter, especially when you consider the 8% same-store sales decline in the fourth quarter last year.

As David mentioned, while our U.S. business profits are flat year to date, we do expect profit growth for the full year.

Now let me give you an update on our refranchising. Our refranchising in the U.S. will likely fall short of our 500 unit target for the year. Unfortunately, a potential transaction recently fell through that would have put us in position to meet this target.

Keep in mind that we just started actively marketing most KFCs in the first quarter of this year. Remember, our overriding objective is to get the stores in the hands of the best operators. We do expect to nearly complete the refranchising of the Pizza Hut units by the end of this year, and we plan to complete our total U.S. refranchising program during 2011.

On the YRI front, we expect to close a refranchising transaction of our Mexico business in the fourth quarter. In Mexico we are refranchising 224 KFCs and 123 Pizza Hut company-owned restaurants, and the buyer will also become the master franchisor of our 155-unit Mexican franchise business. The good news is that the buyer is already a Yum! franchisee in Central America and is currently one of the very best franchisees in the world.

We anticipate a pre-tax refranchising loss of approximately $50 million that will be recorded in special items in the fourth quarter of 2010.

As a reminder, we also refranchised Taiwan at the beginning of this year. Therefore, while we continue to make equity investments in growth countries like India, Russia, and France, we will also refranchise businesses that do not meet our financial and strategic ownership criteria and are better operated by franchise partners.

Overall, we are happy to raise our EPS growth forecast to 14%, excluding special items, and are very proud of the fact that 2010 will mark the ninth consecutive year we have delivered on our annual target of at least 10% growth.

Now let's look ahead to 2011. We wanted to provide you an early view of some of the key items we see in 2011. As always, we will provide a more detailed outlook at the investor update in December.

First and foremost, I have confidence in our growth model. We expect 2011 to become the 10th straight year we achieve our target of at least 10% EPS growth. Similar to 2010, we expect over 80% of our profits to come from China, YRI, and U.S. Taco Bell.

As David mentioned, we are very fortunate that a key foundation of Yum's growth is new-unit development in China and YRI. The development of about 1,400 new units outside the U.S. gives us a head start on providing profit growth in 2011. In addition, our development pipeline looks similar next year.

Now I'd like to briefly review some headwinds and tailwinds we believe we may face in 2011. First the headwinds. Based on what we are seeing today we expect some commodity inflation in 2011. In addition, with the growing number of speculators in this market, volatility is high right now.

As an example, we have seen spot corn prices in the U.S. go from $4.20 a bushel, up to $5.22 a bushel, and then down to $4.71 a bushel in just the last two months.

Our China business has had a very strong year of profits in 2010. In addition to having an exceptionally strong year in margins to overlap, the 2010 results also will include a one-time benefit of about $15 million from our participation in the World Expo in Shanghai.

Fortunately, we also expect a few tailwinds. We expect interest expense to be lower next year. That's on top of the reduction of at least $10 million in 2010. We also anticipate that we will see some benefit from currency translation in our China business. Please also note that our 2011 reporting calendar will include a 53rd week.

We will provide estimates of the magnitudes of these headwinds and tailwinds at our December meeting. We certainly expect 2011 to be another very strong year for Yum!

Now let's talk about emerging markets. As we've said on previous calls, Yum! has a unique growth opportunity and particular strength in emerging markets. We previously have outlined that we are currently the largest and fastest growing restaurant player in this arena.

We have also talked about the profit significance of this opportunity for Yum! and how we expect to generate about 60% of our profits from emerging markets in 2015. Last quarter, we provided Vietnam, Bangladesh, and Nigeria as examples of countries with high populations, where KFC has been a pioneer. Even as market leaders in those countries, we have a total of only about 100 restaurants, representing only 0.3 restaurants per million people.

Today, we'll provide a contrast by highlighting a few emerging markets where we have a longer history and are reaching significantly higher penetrations. We have been developing KFC and Pizza Hut in Indonesia, the Philippines, and Malaysia for decades. These emerging markets are growing over 7% a year.

In Indonesia there is a booming population of about 230 million people. We currently have 373 KFCs, 201 Pizza Huts, and 190 A&W restaurants. This has been a high growth business for us, as we have added 267 net units since the end of 2004.

In the Philippines, we have 200 KFCs and 150 Pizza Huts. We have added 92 net units over the past five years. With a population of over 90 million, this translates to about four restaurants to a million people.

Finally, our most substantial penetrations of these countries is in Malaysia. We have 475 KFCs and 217 Pizza Huts in Malaysia. We have achieved an estimated KFC market share of 45% of the branded fast food market and a Pizza Hut market share of 25% of the chain full-service market. With a population of almost 30 million, this represents 25 restaurants per million people, so clearly much higher penetrated. We have added 253 net units since the end of 2004.

When you look at Indonesia, the Philippines, and Malaysia, you see examples of leadership in emerging markets. We have simply excellent franchisees in all three countries. Together with our YRI Asia team, they are doing a great job of developing our brands.

These countries demonstrate the power that emerging markets can have on our growth. In the past five years, these three countries alone have added a combined 712 net units. Just by themselves, Indonesia, the Philippines, and Malaysia have added about one point per year to YRI's new-unit growth rate.

These countries also provide examples of what could be achieved in less-developed markets. Together, these three countries are home to about 350 million people and Yum! now has about five restaurants per million people. If India, for example, were to achieve this penetration rate, it would represent a 6,000-unit opportunity for Yum!

Finally, while we have achieved a lot of growth in these countries, we are just as excited about our growth prospects in the years ahead. In summary, we are very comfortable with where we stand financially. We have three quarters of significant operating profit under our belt. We are pleased that we raised our 2010 guidance to 14% EPS growth excluding special items.

At the same time, we are focused on building a foundation for future growth through development in emerging markets. Our goal is to build a business that will drive performance for our shareholders for many years to come.

Thank you, and back to you David.

David Novak

Okay, great. Let's take any questions that you guys have.

Question-and-Answer Session


[Operator instructions.] Your first question comes from the line of John Ivankoe of JP Morgan.

John Ivankoe - JP Morgan

Two, I think, somewhat related questions. First, on the major YRI refranchising of Mexico and putting also that in the context of Taiwan, does that free you up organizationally to significantly increase unit development in high-return or high-potential markets that you have elsewhere in the world from a company perspective? And then secondly, could you discuss, if any, any constraints to increasing China unit growth in the out years as well?

David Novak

Why don't I start, John? First of all, I don't think it really impacts our growth in the rest of the world. We have teams focused on growth whether they're in company restaurants or franchise businesses. So we have franchise business units that are focused on helping our franchisees develop and we had a separate team in Taiwan that was running that market. So that was more of a strategic and financial decision and we remained focus on growth everywhere.

China, as I've said before, our growth there is really tied to continued growth of the economy. We have the teams in place. We don't feel there's any limitation based on either our development team or our operations capability.

And as the country grows, we expect it to continue in the areas that have helped us in the past, which is people moving from the country into the cities; greater infrastructure, which not only helps our distribution, but also gives us new trade zones in places like railroads, airports, etc.; and continued development in the central and west part of the country.

Because we have a national presence we feel we're able to take advantage of economic growth pretty much throughout the country. So it's really just tied to continued economic growth in China.

John Ivankoe

It would seem like some signals are pointing to the fact that China could certainly bear more new units in 2011 than it could have in 2009 or even 2010. Would that be fair to say?

Rick Carucci

We at this point, we're expecting a similar number of restaurants next year than this year. We may have a bit more, because Pizza Hut casual dining is starting to spread to more cities. So that's probably our biggest opportunity if I sort of look now at '11 versus '10. But over time, as economic growth in China continues, I still think there'll be a lot more people moving from the country into the city, and my personal guess is that the absolute number will go up over time.


Your next question comes from the line of Greg Badishkanian of Citi.

Greg Badishkanian - Citi

Hey guys, you did a really nice job on the pizza brand here in the U.S. Who do you think you're taking share from and would you expect that momentum to continue into the end of the next year or even into early next year?

David Novak

We're taking share primarily from regionals and the local mom and pops. I think that we're very optimistic about Pizza Hut's future because we've made some big long term moves that we believe are sustainable - everyday value, which solved our biggest issue, which was price, especially in this tough environment, and also the expansion and marketing of both our pasta and wings business on Tuesday and Wednesday to leverage the assets. So we're optimistic about the future of Pizza Hut.


Your next question comes from the line of Andrew Barash of Jeffries.

Andrew Barash - Jeffries

Just some clarification on the $15 million of commodity and labor inflation. Was that specific just to the China business, or is that global?

Tim Jerzyk

The $15 million in commodities was specific to China for Q4. So that set of numbers was China for Q4.

Andrew Barash

Okay. Do you have a global estimate for those two categories?

Tim Jerzyk

We don't. The U.S. is going to experience very minor inflation and YRI same thing - pretty much flat.

Rick Carucci

We probably expect a little bit of inflation in the U.S. as Tim said, primarily driven by beef in the fourth quarter.


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

David Tarantino - Robert W. Baird

Just a question on the China business and your inflation outlook perhaps beyond Q4. It looks like maybe 2011 could have some inflationary pressures. Just wondering if you could talk about your philosophy related to taking pricing actions and perhaps sort of the long-term view on the margin structure there if there's opportunity to increase margins or are you satisfied where they are today?

Rick Carucci

We obviously have huge margins this year that may be a couple points higher than what you could expect on an ongoing basis. But on an ongoing basis I still expect 20+ margins in China for the foreseeable future.

Over time we've always had labor inflation and again, labor inflation now has grown to about 13% or so of our cost structure in China, so 13% of sales. If you have a healthy increase on that number, that's still - let's put it at 10% - that would require about 1.3% pricing.

So we clearly think our brands have the ability to absorb that and any other increases you could or couldn't get in commodities. I personally think commodities are likely to fluctuate year to year as opposed to inflation, where our model has built in pretty steady increases over time.

The labor thing to me is sort of a dual-edged sword. It clearly - we have to price or get cost efficiencies to cover it, but at the same time we like the fact that people have more money in their pockets and we have more consumers who could buy our products.


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

Keith Siegner – Credit Suisse

Just a question on YRI. I was a little bit surprised and very pleased, actually, with the margins, and I was wondering if you could talk about how you achieved that leverage with a 1% one-year and two-year comp. Maybe some more details around this? Was this refranchising? What else contributed to that leverage on that margin with a 1% comp?

David Novak

The two biggest leverages this quarter were first, on the margins - you hit it right, it was refranchising. So that had a significant impact on the margins this quarter. In terms of the other P&L leverage we got, we did have G&A leverage, and this quarter was a bit higher than most because we were overlapping a convention we had in the third quarter last year. But generally on an ongoing basis we usually expect to see around 6% type of system sales growth and then modest leverage in the rest of the cost structure to get to our 10% target.

Keith Siegner

And then one followup question. With this Mexico refranchising it's quite a few units. How do you anticipate this impacting, let's say, company restaurant margins for YRI going forward?

David Novak

It will improve the numbers. We'll give you more input on that at the December meeting but we think it will improve the margins and actually slightly help our profitability in 2011.


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

Joe Buckley - Bank of America

Couple questions on China as well. The labor costs were up as you mentioned. Could you talk about the wage rate inflation you experienced through your system? And then could you talk about how sales fared in markets where wage rate inflation was higher rather than lower? Did you in fact see that sales lift from wage levels going up overall throughout the country?

David Novak

I have not looked at the second part of your question, Joe. So I haven't looked at the comparison between where rates are a little higher and sales growth. Because generally speaking the percentage increases over time have been fairly similar, but it's something we'll probably take a look at.

Typically we usually see about 8% to 10% type of labor inflation. For this quarter and next quarter it was a bit higher than that. We'll probably see that again in the first half of next year. As we said it had the unusually high increase - sort of the mid-point this year.

Joe Buckley

And just one more. I think you mentioned $15 million in full-year benefits from the World Expo. So I guess there's another $5 million coming in the fourth quarter. Talk about how that comes in. Is there a revenue number associated with that $15 million of operating profits? Just to help us understand the margins a little bit better.

Tim Jerzyk

The benefit is basically just as if it's a company-owned store, and it actually is. So you see it in company sales and then company restaurant operating costs. So it's a benefit to restaurant margins, it's a benefit to profit. It's excluded from the 14 restaurants in the Expo, or were excluded from the unit count, because they're only temporary. And the same-store sales number that we gave you excludes the sales benefit.

Joe Buckley

And the operating profit margin on those 14 restaurants, would it be comparable to what you reported?

Rick Carucci

Probably higher.


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

Jeffrey Bernstein - Barclays Capital

Two questions. Just first, a follow up on China. I think you mentioned for the fourth quarter you would expect comps to kind of run similar to what you were running year to date, which I think was 5%. I know the [compares ease] a few hundred basis points. I didn't know if there were any unusuals. It seems like consumer confidence continues to improve. I would think you'd expect that comp trend to continue to improve from the 6% we saw here.

And then when you look out to 2011 is it reasonable to assume further comp recovery, or do you think the recovery stage is over and now perhaps it's more appropriate to assume more low single-digit comps as your penetration grows and you push more in the direction of maturity? And then I had a follow up question on cash.

Rick Carucci

First of all, regarding long term comps, we haven't looked into 2011 in a lot of detail yet. But typically speaking our model looks in the 3% to 5% range of same-store sales to make our model work. So that's sort of a typical type of number and obviously depending on the cost structure and the inflation environment. We've sort of covered this on some of the previous calls, looking at two-year, three-year, one-year comps, and looking at when the inflection points were with the earthquake and the softening of the economy at the end of 2009. We think the year to date number is as good a number as anything for the fourth quarter. One of the challenges on the consumer confidence side is even though it's better than a year ago it's sort of flattened out in terms of the improvement rate. So we're seeing year-over-year improvement but we're not seeing accelerated improvement in consumer confidence. So we're, with you, trying to read the tea leaves. So we just see it's a better economy, not yet booming.

Jeffrey Bernstein

Gotcha. And then just separately, Rick, on the cash usage side, I know the cash position continues to increase pretty meaningfully at more than double relative to last quarter. I know back then part of it was just due to repatriation timing. But it doesn't seem like there's a major debt due. I know there's $600 million in debt due in '11, for which you did this debt offering, but should we expect share buyback to increase meaningfully for the rest of this year and into '11? Just wondering how you determine the timing and perhaps the ultimate amount of repurchase with only it looks like $30 million in the third quarter, less than $300 million year to date. Just trying to size up the timing and how you determine the amount to repurchase. Thanks.

Rick Carucci

We expect that we'll probably have more share repurchases in the fourth quarter than in the third quarter, and then we expect more share repurchases right now in 2011 than 2010. But we don't have real specific numbers. Again, we'll try to share some of that with you in December.


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

John Glass - Morgan Stanley

Back to the China comps for a moment. Do you have any better clarity or visibility on what you think the benefits of the 24 hours and the breakfast had on comps this quarter? And what are the updated thoughts on pricing strategy? Are you going to take pricing late this year, and it's going to impact next year? Or are you going to wait until next year to talk about pricing, or do pricing in China?

Rick Carucci

We think the benefits of some of the ops initiatives that we talked about - 24 hour, delivery, etc. - probably in the 1% to 2% range. I probably expect a similar kind of number next year, a little early to tell. Regarding pricing, don't expect much impact at all. As I said in my remarks, in the fourth quarter we'll probably have some modest pricing increase either late this year or early next year. Beyond that we'll have to wait and see what our inflation expectations are.

John Glass

And then as it relates to the refranchising strategy at YRI, what is it? At this point I think this transaction is roughly 20% of your company units, which is material. Do you expect there to be other large transactions like this in the next 18 to 24 months in other more mature YRI markets? Or was this really just a one-off and we shouldn't expect to see a real change in the percentage ownership from YRI going forward?

David Novak

What happens at YRI as you know, John, we are at the same time building units in developing markets, so places like India and also for us underdeveloped markets like France are also company. So we'll be adding on that side at the same time with the selective refranchising. We'll do some more selective refranchising, probably not the size - you shouldn't expect next year to see something of the size of Mexico though.


Your next question comes from the line of Rachel Rothman of Susquehanna.

Rachel Rothman - Susquehanna

I don't know if I missed this, but can you talk about maybe traffic trends in each of your key three regions? I think someone asked about pricing power, but just backward looking, how has traffic been diverging or following along with same-store sales?

David Novak

In China most of the increase has been transactions. So almost all of it. We have had very small levels of pricing this year. So it's pretty much all transaction-driven. Generally speaking if you looked at the U.S. you'd probably get a couple of points of pricing. So if you looked at our same-store sales numbers and took off a couple of points for Taco Bell and KFC you'd probably get close. Pizza Hut is a different story because there we've actually had a net pricing decline, so our transactions are significantly above our growth rate.

Rachel Rothman

And then YRI, has it been price or traffic?

Tim Jerzyk

YRI has mostly been traffic.

Rachel Rothman

And then if I could just follow up on China, could you talk about maybe same-store sales growth trends in the newer markets versus the developed markets?

Tim Jerzyk

Actually, the same-store sales growth this year has been very balanced across all tiers and all geographies.


Your next question comes from the line of Sara Senatore of Sanford Bernstein.

Sara Senatore – Sanford Bernstein

Not surprisingly, another question on China and then a separate one actually that's a little bigger picture. On China, you said you've taken very little price, but it was noticed that the inflation data out of China are positive and have gotten a little bit more positive. So I guess I'm trying to think about let's call it cross-price elasticity. So what some of your competitors might be doing, or what food at home might be doing? And does that give you a little bit more leeway in terms of if you don't take price you gain some of the traffic? Just trying to think about how your pricing compares in China to substitutes like either away from or at home. That's the first question.

David Novak

We had some, I'd say, unusual commodities in China over the last two years. I'm not sure if we would have mirrored the at home market. Chicken obviously did go up a lot - [the 1 point late '08]. So other commodities have grown at different rates. We don't have a lot of great information, at least I haven't seen, on cross-elasticity between the take homes and take away market in China. Clearly there it is going to be more sensitive on the economy because people there generally have lower incomes so usually when something's a higher percentage of your ticket you're going to have more impact in the restaurant business when the economy is weaker than you probably would in the grocery side. That would be my guess, but I don't have data that would back that up.

Sara Senatore

Okay, thank you. And then the broader-picture question, you talked a lot about emerging markets, and how you're the fastest grower there, the biggest presence. Can you just talk broadly about why that is in so far as you're certainly bigger than a lot of restaurant companies with whom you might compete, but there are other scaled restaurant companies. So is there something about your supply chain? Do you own more of your supply chain? Is it something about how you run your business? If you could just maybe talk about some of the advantages that sustain that faster pace?

David Novak

I think, you know, KFC is our biggest brand [outside the United States]. KFC has the big advantage of being a very popular protein, where we've brought tremendous unique image to a known quantity and we've been able to grow. We were blessed to have a number of very aggressive and top flight franchisees who've invested in the markets for years before other competition every even entered, and still is yet to enter. For example, in Vietnam. McDonald's isn't even in Vietnam. So I think that it's the protein of choice with the unique brand, combined with tremendous franchisees who have invested in the supply chain.


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

Mitch Speiser – Buckingham Research

My question's on food costs and of course we all know you're very much a franchised organization, but still these store level margins do have an impact on earnings per share. Just to try to get a sense with corn up now about 40% year-over-year, and maybe just looking at the U.S. business in particular, how does that flow through to your P&L if costs are at this rate today? Does it take three or six months for that to be felt through the P&L? Just trying to get a sense of the sensitivity to that and the timing as well.

Rick Carucci

You sort of have two pieces. There's some things that you know will go up a bit, so we'll sign some contracts on certain items soon for 2011, but part of the impact this year, Mitch, is that you're probably going to be less further out in hedging given the volatility. Because it gets more expensive to hedge in that kind of a situation. Plus, with speculators - and a lot of people don't want to hedge when speculators are in because the feeling is when they go out the prices will go back down. So probably just the reality is we probably have a little bit more uncertainty than usual, and right now if you looked at the numbers we'd probably expect in an area of about a 3% increase in the U.S. But a lot could happen between now and the start of the year.


Your next question comes from the line of Howard Penney of Hedgeye Risk Management.

Howard Penney - Hedgeye Risk Management

I guess it's not unprecedented for dominant brands to lower prices to drive traffic, and I think again, you've obviously done it and different consumer categories have done it, and you've struggled with KFC for a number of years, tried a number of different new products. Is lowering prices not the right strategy? It's been successful for Pizza Hut recently. Why isn't just bringing the price points down for KFC the right strategy to get people back in the door?

David Novak

Howard, I actually think you have a pretty good comment there that I think the brand is very well aware of. Our value ratings are not as high as they should be in the category. KFC, because it's primarily a chicken on the bone dinner business, has pricing that's closer to casual dining than it does typical fast food. We have a number of things in test right now to enhance and improve our value, and the test marketing results where we've gone aggressive enough are definitely moving in the right direction. So we don't have anything to really announce on that but that's clearly an area of opportunity for us that you've identified, we've identified, the consumer's told us is an opportunity, and we're working hard on it.


There are no further questions at this time.

David Novak

Well let me just wrap things up. We had a solid quarter, and have had a great year so far. We're pleased with the performance of our business units, specifically our strong performance in China. We're confident in delivering our raised target of 14% EPS growth. We continue to execute against our global growth opportunity, especially in emerging markets. There's no doubt we are well-positioned in the fastest growing economies of the world with rapidly expanding middle class populations. We're making progress in our U.S business. We're confident in delivering 14% EPS growth, making 2010 our ninth consecutive year we meet or exceed our target of at least 10%, and we're very confident about our continuing track record for 2011. Our significant and growing exposure to the explosive growth in China, the rest of Asia, and emerging markets, gives us an unprecedented short and long term opportunity.

We look forward to sharing more on this in December, and seeing you at our annual investor conference. Thank you very much.

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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.


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