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Yum! Brands, Inc. (NYSE:YUM)

Q2 2007 Earnings Call

July 12, 2007 9:15 am ET

Executives

Tim Jerzyk - IR, Treasurer

David Novak - Chairman, CEO

Rick Carucci - CFO

Analysts

John Glass - CIBC

Glen Petraglia - Citigroup

Larry Miller - RBC Capital Markets

Victoria Hart - Merrill Lynch

Steven Kron - Goldman Sachs

Joseph Buckley - Bear Stearns

Ashley Woodruff - FBR

Jeffrey Bernstein - Lehman Brothers

Tom O'Neill - Barclays Capital

David Palmer - UBS

Mark Wiltamuth - Morgan Stanley

Jeff Omohundro - Wachovia Securities

Jason West - Deutsche Bank

Presentation

Operator

At this time I would like to welcome everyone to the Yum! Brands second quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. Tim Jerzyk, Senior Vice President of Investor Relations and Treasurer. Sir, you may begin.

Tim Jerzyk

Thank you, Tanya and good morning, everyone. Thanks for joining us today. Before we start I would like to go through some calendar events that we have coming up this year for Yum! investors. First of all, September 6th and 7th the Yum! team will host a third China investor conference in Beijing, China. Investors and analysts are invited to attend this two-day meeting with the Yum! China management team. Just as a reminder this event is only eight weeks from now, so please, we need to hear from you right away if you plan to attend. Please contact Yum! Investor Relations as soon as possible.

Also, we will be in Hong Kong and Shanghai the following week, September 10th through the 14th. October 23rd we will be in Tokyo. The 24th of October we'll be in Shanghai meeting with investors. October 30th we have a Taco Bell Investor Day. December 12th we'll have our annual investor meeting in New York at the New York Stock Exchange. Please call us for more details.

This call is being recorded and will be available for playback. We are broadcasting the conference call via our website, www.yum.com. Please be advised that if you ask a question, it will be included in both our live conference and in any future use of the recording.

I would also like to advise you that this conference call includes forward-looking statements that reflect management's expectations based on currently available data. Our actual results are subject to future events and uncertainties.

Information in this conference call related to projections or other forward-looking statements may be relied on subject to our Safe Harbor statement which was included in the earnings release last night, and may continue to be used while this call remains in the active portion of the company's website, which will be until midnight Eastern Time, Friday July 20th, 2007.

On our call today you will hear from David Novak, Chairman and CEO and Rick Carucci, our CFO. Following remarks from both we'll take your questions. Now I would like to turn the call over to David Novak.

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David Novak

Thank you, Tim and good morning, everybody. I am pleased to report that we had a strong quarter with growth of 15% and that we are increasing our full year EPS outlook to 12% growth from 11%. As you know, we are targeted to achieve at least 10% growth every single year, therefore we are particularly proud that we expect this to be the sixth straight year that we will beat that target.

Once again, our Mainland China and YRI businesses led the way in the Yum! portfolio. In Mainland China, we grew same-store sales by 7% and are on our way to another year of opening 375 new restaurants, further strengthening our competitive position.

At YRI, we grew same-store sales 5% and had one of our best-ever quarterly system sales performances as we head towards another year of new unit development that leads the industry. In fact, we expect 2007 to be the eighth straight year that the YRI division has added 700-plus new units.

When you look at this quarter's numbers, you will also see that we got a very nice boost from our tax rate which helped us offset challenging commodity inflation, higher prior-year refranchising gains, and weak but improving results in the United States. The quarterly tax rate will be volatile and it is important to note that the year-to-date is in line with our full year expectations.

Now let's review what with we see in each of our businesses and talk about their plans and trends.

In the China division, specifically Mainland China, our brands consumer dynamics are very strong and our brand regard is higher than ever as witnessed by the exceptional top line growth. KFC is celebrating the 20th anniversary of being in Mainland China, and we are very proud of the fact that we were the first U.S. brand there back in 1997 with our first KFC. We fully expect KFC will end the year with over 2,100 KFC restaurants and be in more than 400 cities.

There is no doubt that we are entrenched as a powerful brand that is part of the Chinese culture. Just to give you two factoids to support that fact. First, we do an average of two birthday parties every day in all our restaurants and we sponsor a very popular nationwide three-on-three basketball tournament with over 16,000 teams with the finals being broadcast on national television.

We are positioning KFC as your local community center as we build around the theme of Life is Tastier with KFC. We just reviewed the calendar with Sam Su and the team yesterday and we're confident about the programs that we have in place.

In addition, we also now have 289 Pizza Hut casual dining restaurants, the undisputed leader in the category, and we grew units by 31% versus last year during the second quarter. We are now in 60 cities and opening restaurants in less-developed cities, which a few years ago we didn't think could sustain a high-end restaurant; proving once again the strength and reach of our brands. We continue to expect to add 70 new Pizza Hut restaurants this year.

About three years ago we made a deliberate effort to separate the delivery business away from our Pizza Hut casual dining business, and we now have 41 Pizza Hut home service restaurants. In fact, we just added our second call center to handle the expected expansion of this business, and that call center is located in Beijing. We are doing everything we can to capitalize on the convenience of the delivery occasion, which will become more and more important as the economy continues to grow.

Finally, we continue to expand our East dining concept in the Shanghai market. Remember, this is a fast food Chinese concept. In fact, we now have eight restaurants which moves us closer to being able to conduct a television advertising test.

Now onto our Yum! restaurants international division, or YRI. I want to publicly congratulate Graham Allan and the YRI team on the exceptional quarter. We are in 113 countries and our overall business continues to be very strong around the world. For example, our Middle East franchise business unit drove a phenomenal second quarter systems sales growth of 32%; South Africa plus 28%; Caribbean plus 13%; and Asia up 12%.

In addition, we are seeing great initial results from our KFC advertising test in India and strong sales growth from our Rostik KFC co-branded units as well in Russia.

I just returned from a trip to Europe where we don't have much of a presence today. While McDonald's generates about $1 billion in profit from this region of the world, let me say that we have made great progress there the past few years. We already have a franchiseable proposition in Holland and France. In fact, we are seeing record average unit volumes with our KFC restaurants in France -- and when I say record average units, I am not talking about France, I am talking about the entire world where we have the highest sales on a per-unit basis now in France.

We're even making progress in Germany where we had early challenges. We believe our investments and patience are start to go pay off in continental Europe, and there is no doubt that we will eventually build a great business there.

Furthermore, we are tapping into new opportunities and countries like Vietnam which has more than 85 million people with a very young population. We are really starting to take off there. We now have 32 KFCs and two Pizza Hut restaurants with excellent opportunity and lots of growth. I look forward to going to that market next year. Frankly, I haven't even been to Vietnam yet, but to give you a sense of how quickly we have grown in that market, we only had 15 units at the end of 2005. We are in the early innings in lots of key developing countries like these, and we expect to see continued momentum across the world.

YRI's biggest challenge is Pizza Hut UK where we are making progress but still have too many ups and downs sales periods. However, given the process and discipline that the new team is implementing, we're confident that we're moving towards making more consistent performance with Pizza Hut UK.

Now, onto the United States businesses. Our U.S. businesses are recovering and we expect better results in the second half of 2007. Pizza Hut is making significant progress improving its value proposition with the successful re-launch of Pizzone and a number of test initiatives. We also now have system-wide Internet ordering capability and are seeing a steady rise in Internet ordering.

Our America's Favorite advertising is clearly resonating with the pizza category type consumers and our key brand measures are improving at a significant rate. KFC is also seeing its brand regard increase with the launch of zero trans fats. We just had our quarterly review at KFC and we are very confident with the approach the team is taking.

Taco Bell is our biggest challenge with same-store sales down 7% in company stores. While that represents improvement from the first quarter, we clearly have work to do. We are currently launching Chicken Taquitos and plan to launch another new product in the second half. Fortunately, we expect a benefit as well from an easier overlap.

All in all, we expect full year U.S. operating profit growth to be slightly positive but clearly below our 5% growth target. The U.S. continues to be a stable profit and cash flow contributor, but we know that we can and should be performing better.

Here are some of the long-term themes that we are focusing on:

Adding more balanced meals and choices for our customers;

Expanding in multiple day parts;

Broadening our protein offerings;

Creating destination desserts and beverages and ensuring that we have a solid positioning in everyday value; and,

Finally, developing system-wide contemporary assets including multi-branding on a focused basis.

Finally, in addition to driving more consistent results and leveraging our existing assets, we are also focused on ensuring that our company restaurants are earning their right to own, reducing our U.S. company ownership down from 26% in 2006 to 17% by the end of 2008, which will improve our returns from this business.

To summarize, the power of our global portfolio of leading restaurant brands continues to generate consistent EPS growth and significant free cash. This year we will generate a record $1.4 billion in cash from operating activities, while investing $650 million in growing and maintaining our brands around the world.

With such a significant cash generating capability, we expect to return $1 billion plus for the third consecutive year to our shareholders. In fact, we expect to buy back over $1 billion of our stock, reducing our share count by at least 3% and pay our shareholders a meaningful dividend with an approximate 2% yield. We are returning 5% cash to our shareholders through our share buyback and dividend. We expect to do at least similar levels in the next three years.

Over the long term, we expect to continue to grow our earnings per share at least 10% and build value by executing against our unique growth strategies with high returns that differentiate us from other global consumer companies.

Specifically, we will focus on our four key strategies:

(1) Building dominant restaurant brands in China;

(2) Driving profitable international expansion;

(3) Improving the United States' brands positionings and returns; and,

(4) Driving high ROIC and strong shareholder payout.

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

Rick Carucci

Thank you, David and good morning, everyone. I am going to review three areas today:

First, our second quarter results;

Second, the 2007 full year outlook and key trends across our businesses; and,

Third, a brief update of our refranchising program and our full year cash flow expectations.

Looking at the second quarter, we were certainly pleased to report EPS growth of 15% despite some challenges. As you look at the numbers this quarter, overall Yum! results were clearly driven by strong operating performances from China and YRI, as well as the financial benefit of a lower tax rate and a 3% reduction in our share count. These factors more than offset a down quarter for our U.S. business, lower refranchise gains in last year, and higher commodity inflation in both the U.S. and China. Now let's look at the second quarter by our three business segments.

First, let's cover our China division. In quarter 2, China division profits were up 14% on a reported basis and plus 9% in constant currency. China division results were negatively impacted by the smaller business portions of the division, Thailand and KFC Taiwan. In the written disclosures of the earning release you can specifically see our Mainland China performance for some key measures.

Operating profit growth in Mainland China for quarter 2 was 20% on a reported basis. Our Mainland China business continues to be a key growth driver for Yum!'s overall results. In Mainland China, same-store sales and unit growth remain very strong. Mainland China business is driven by a rapidly growing economy and exceedingly strong competitive positions for both KFC and Pizza Hut.

One issue that began to impact our business in the second quarter was increased commodity inflation. There have been issues in Mainland China related to pork with both tight supply and increased prices. This contributed to greater demand for chicken. In addition, domestic chicken supply in China was further impacted by lower than expected output as well as increased exports to other markets. This led to a significant spike in chicken prices. We believe this impact is short-term in nature but will affect third quarter restaurant margins in terms of higher food costs.

In quarter 3 we expect to see double-digit commodity inflation as most of our needs are already contracted at higher prices. It is difficult to accurately predict our quarter 4 situation although we expect pricing in quarter 3 to help offset this impact.

To summarize, in Mainland China we have a stronger top line performance as well as some higher costs in the near term. Additionally, we are benefiting from a strong Chinese currency. Overall, our unit economics remain very strong, and we are continuing to rapidly expand both KFC and Pizza Hut, as well as develop new brands.

For Yum! Restaurants International, or YRI, the second quarter was a very strong quarter with operating profit growth of 15% or up 11% in local currency. Our top line performance at YRI is very strong with systems sales growth of plus 11% in local currency terms, lapping a plus 8% last year which was not an easy comparison.

Importantly, our sales growth strength is broad based with very few markets underperforming. Overall, our franchise market business grew second quarter profits by more than 20%. This was led by double-digit profit growth across the board including Asia, the Middle East, Europe, South Africa and Caribbean Latin America. Our company markets in total grew profit by 5%.

Strong performance in Mexico and KFC UK businesses were offset somewhat by our Pizza Hut UK business performance. Company restaurant margins declined slightly due to the inclusion of our wholly-owned Pizza Hut UK business versus last year when it was a 50/50 joint venture. Excluding this impact, our margin rose by 0.9 percentage points.

Finally, our second quarter was achieved despite higher G&A costs related to the UK acquisition, the costs of our biannual franchise convention and investment spending in Russia, India and Taco Bell. These are businesses which will potentially be large sources of future growth. Hopefully, you can see that we believe this business is doing well and is extremely valuable to Yum!.

Now onto our U.S. businesses. Overall, it was a disappointing performance with systemwide same-store sales flat versus last year and operating profit down 2%. Generally, the results were in line with what we laid out for our full year U.S. expectations last quarter.

Certainly you know from previous comments on these calls that we're not happy with this performance. Each brand team is working hard to improve performance both for the short term and long term, as David mentioned earlier.

Same-store sales performance for the second quarter improved across the board versus what we saw in the first quarter. We continue to believe the second half results will improve with stronger second half marketing programs and taxable changes to our balance of year programs.

In terms of our cost structure, we did experience the expected commodity inflation in quarter 2 -- about $10 million -- primarily in cheese, beef and wheat. Additionally, our restaurant margin was adversely impacted by state minimum wage laws enacted over the last 12 months and, of course, operating deleverage from the 3% decline in company same-store sales.

We continue to experience favorability in our insurance costs which helped to mitigate the unfavorable impacts I just mentioned. In addition, some productivity initiatives that have been put in place in the last year-and-a-half provide a profit upsides that helped offset inflation.

Overall for Yum!, in Q2 we benefited from share repurchases and a lower tax rate. Due to our substantial share buybacks, we saw another 3% reduction in our diluted share count year over year. Our tax rate was considerably lower than last year's rate and had a very significant impact to our quarter 2 EPS growth rate. Please note that our year-to-date tax rate is right in line with our full year guidance.

As we said on a number of occasions, the quarterly tax rate will be volatile. This volatility is caused by accounting rules that require booking certain tax events in the current quarter versus smoothing changes over the balance of the year.

Now let's review our 2007 outlook. First let me briefly reiterate our Yum! long-term growth model which includes 20% operating growth from our China division, 10% operating growth from YRI, and 5% operating growth from our U.S. business. This adds up to 9% to 10% growth in annual operating profit.

At this point, we expect China will meet its full-year target, YRI will meet or exceed its full-year target, and U.S. profit growth will be slightly positive.

For the full year, we increased our full year guidance to plus 12% or $1.63 per share. Our previous guidance was 11% growth. Our confidence is based on the strength of our global portfolio and a combination of the strong first half China and YRI results, a rebound in the U.S. in the second half of the year and continued substantial share buybacks.

In terms of our key trends in our business, I would cite these four:

(1) U.S. inflation is above historical rates in commodities and labor.

(2) As global economic growth has picked up pace, so has commodity inflation outside the U.S.

(3)A continued strong global economy and our strong competitive position globally will lead to continued growth in China and YRI.

(4) Our emerging markets for YRI continue to look better and better.

In terms of dealing with inflation both here in the U.S. and globally, we'll need to continue to deliver productivity initiatives and be disciplined and thoughtful in our menu mix and pricing action. We believe we are taking appropriate steps in both of these areas. For example, Pizza Hut has made progress in reducing discounting in the way that we believe has not had a negative impact on transactions.

At KFC, we have implemented a shift accountability program to improve restaurant level cash control and are beginning to see significant benefits from this initiative.

In terms of our global competitive position, we showed at our investor conference last December that over the last five years we really strengthened our competitive position as the leader of international development in our industry. We are pleased to report that for 2007 we expect to further improve this position.

Our new unit pipelines look strong for both Mainland China and for YRI. We now expect to open about 1,200 new units this year in China and YRI.

Finally, we are very pleased with the progress we're making in our YRI emerging markets. We see continued improvement quarter to quarter in our sales trends and markets like Russia, India, and KFC France. While still a small segment of YRI's business, system sales for the emerging markets grew at a 47% rate in the second quarter. When you look at these trends in total, we remain extremely confident that we will grow our EPS at least 10% in 2007, at least 10% in 2008, and for many years to come.

Now let's talk about what everyone appreciates about our business, and that is our cash flow. Before we get to the cash flow details, let me provide a brief summary of our refranchising plan. We are still on track to reach our U.S. target of about 83% franchise ownership and 17% company ownership by year end 2008. Therefore, through year end 2008 we should expect to see continued cash proceeds from U.S. refranchising, increases in U.S. franchise fees, positive impact to U.S. restaurant margin and operating margin, positive impact to Yum! ROIC, and less demand on capital expenditures from the U.S. business. You can continue to expect us to take a hard look at our global company ownership each year using our Earn the Right to Own principles as a guiding force.

For 2007, you should expect another year of substantial levels of free cash available for payout to our shareholders. We expect to return $1.3 billion in cash in 2007, which is even more cash than the $1.1 billion returned in 2006. For the full year 2007 we continue to expect at least 3% to 4% reduction in our share count to be share buybacks, and our dividend yield is now nearly 2%.

To wrap up, we expect another successful operating year performance from our global portfolio generating consistent financial performance, impressive global growth, and strong global cash flow.

Back to you, David.

David Novak

Okay, let's take some questions.

Question-and-Answer Session

Operator

Your first question comes from John Glass - CIBC.

John Glass - CIBC World Markets

Good morning. A couple of questions on China. First, what is the pricing opportunity there, maybe what you need in the near term to offset the commodity inflation? Also, how do consumers respond to price increases there? Is it the same or maybe different than in your domestic markets?

David Novak

Well historically we have not taken a lot of pricing in China until the last couple of years. That was just because our buying power improved so much as we grew the number of units that we had and continued to improve our competitive position. So far we've taken modest price increases in China they've been absorbed quite easily into the marketplace. We still have very low relative pricing in China compared to other places in the world.

Regarding what's going to happen going forward, we're actually looking very hard at what our pricing should be in the third quarter, but we're not going to comment on the exact details.

John Glass - CIBC World Markets

In China is there the same opportunity to hedge or to contract commodities as there is here? Can you go out as far, and has that changed recently?

David Novak

Not yet. Really in China we're generally shorter than we are in other markets. The reason is the commodity market there is a bit more volatile, and suppliers don't want to commit to longer durations. We especially face that this time around when the export market opened up for the China poultry producers.

John Glass - CIBC World Markets

Last question on China. Can you remind us what the Thailand and Taiwan issues are that hurt the second quarter profit growth? How are they factored in the second half projections or that 20% profit growth?

David Novak

Well, in general, first of all from a profit basis, Taiwan and Thailand collectively are less than 10% of the profitability of the division.

Regarding what happened in the second quarter, two things. First of all, Thailand has had a lot of political issues that have translated into economic issues and has hurt our growth rate there. Taiwan is just a more competitive market for us. We generally have a fair amount of volatility in our growth rate although it is a good growing market over time.

So if you look at it over time, usually Thailand and Taiwan are a slight drag on the profitability just because it is only 10% of the business and it has a lower growth rate. At this time it just hit us particularly hard because we were down in those businesses versus prior year.

Operator

Your next question comes from Glen Petraglia - Citigroup.

Glen Petraglia - Citigroup

In terms of Taco Bell, in terms of why are the company restaurants in the U.S. so much under-performing the franchise restaurants, what's going in the company-owned markets?

David Novak

I think basically in the company markets and the franchise markets the marketing program is pretty much the same. We have very little local marketing. Everybody is dealing with the same national marketing plan. I think we're just seeing a slightly stronger performance by our franchisees than in the company markets.

Rick Carucci

Just to add to that, the franchise performance overall in the U.S. across our brands has been higher than our company, and that led to the difference; system sales growth was actually flat for the quarter versus companies were down a bit.

We think it is driven by two main factors. One is the franchise restaurants tend to be more concentrated in rural markets which are performing better. Secondly, tend to have on average lower average volumes, so they tend not to get maxed out at peak periods.

Glen Petraglia - Citigroup

In terms of UK if you could share with us the status of refranchising some of the Pizza Hut restaurants and if you could just refresh us on what perhaps the issues are that are preventing a more rapid turnaround there?

Rick Carucci

Plans are going about as we expected in the UK. The plan was to buy back that business. We started the marketing campaign, but we said all along that most of the actual transactions aren't really going to start until the back end of the year, just getting time for people to send out the books, people to look at the business and start doing transactions. We're on pace.

David Novak

Actually from an overall brand-building perspective, we put a new team in place. They're taking all the right actions, putting the right processes and discipline in place. We've actually had some very encouraging sales recently.

The problem that we have is that we'll have one big up period and the next period will be down, so we're just trying to work on getting more consistency. I think the team is really on track, and you'll see continued progress on the consistency front.

Rick Carucci

Our goal on the refranchising is just to get down to what our effective ownership was before the acquisition which is 40% company ownership, and there is huge demand for the Pizza Hut brand in the UK so the real charge that we have given the team is to move towards our goal but to do it the right way and get the very best partners and that is really the objective.

Glen Petraglia - Citigroup

Rick, how long do you think it will take it get back down to roughly 40% company-owned from where you are today?

Rick Carucci

We thought about three years.

Glen Petraglia - Citigroup

Just quickly on the outlook for cheese costs, I know it is notoriously hard to predict, but any sense we might be seeing a peak in some of the dairy?

Rick Carucci

Glen, if you can forecast cheese prices, I think you definitely have another future ahead of you. I think if you look historically it is hard to say if this year is going to follow the historical seasonality, but typically cheese prices tend to peak going into the September timeframe and begin to drop off after that.

I think the good thing is our team did a very good job. We laid out for you I believe 2.5% to 3% commodity inflation for the U.S. back in December which had some pretty solid expectations for cheese prices. We're only a little bit above that right now based on what we see in the cheese market. We have hedged some positions as we always have said in the past, so that's definitely helping us. But we have assumed some normal historical trends, seasonality that cheese prices, some improvement in the back half of the year, and we're expecting a little bit more than 3% and a fraction of total U.S. commodity inflation for the year with the cheese prices that we have.

Operator

Your next question comes from Larry Miller - RBC.

Larry Miller - RBC Capital Markets

Thanks very much. My question was on the U.S. franchising initiative. You mentioned there was good demand for the Pizza Huts there. You said you're going to do about 1,400 stores over the next two years. Can you talk about the appetite by the U.S. franchise system? Would it be correct to assume that these are less profitable KFCs and Pizza Huts because you probably sold off some of the better ones? Is that correct?

Rick Carucci

Let me answer the first part. Regarding where we are in the three-year process, we started with 1,500. We have about 1,000 to go. We still feel good about the process which is both targeting existing franchisees as well as looking at new franchisees to enter our system.

Versus historical, we always are selling on average lower-performing restaurants, but again remember we started with a fair amount of refranchising when we first found it, so when we got the ownership mix down to the 20% range, most of these are decent restaurants that we're refranchising, but still lower performers. The way that that works out is we're usually trading margin that's slightly above what we would get on a royalty rate basis, but then you get offsets in G&A to make us about neutral on an operating profit basis.

Larry Miller - RBC Capital Markets

Can I ask one question about the emerging markets? You said they were growing at a good clip, 47% I think you said. Are we starting to see some of the losses in those markets narrow or still at a investment phase at this point?

David Novak

It varies from market by market where it is in the investment cycle, so in total it is getting a bit better, but what you're going to see is certain markets where we've invested for awhile you will have actually rapid improvement in sales and profits, and then others we still need to put more money in. So, for example, it will be awhile before we get positive profit growth out of Russia while India and France we've been at it longer and we do expect to see some profit growth in those markets over the next few years.

Larry Miller - RBC Capital Markets

Just on Taco Bell relative to your internal plan for rate of recovery, how did that shape up? Where are you?

David Novak

Well, I think the second quarter was less than what we had hoped because we had the setback from the publicity standpoint that we really weren't anticipating. We're inching forward at Taco Bell. We're working on our marketing plans and we expect to do significantly better, particularly in the fourth quarter because of the overlap. So steady as she goes.

As I mentioned in the last call, it takes you anywhere from six to nine months any time you have any kind of food safety issues that you have to overcome. I think we look at our brand measures, they're strong. The brand is in good shape. We just have to weather this period and get our marketing plans in line and make them stronger and we think we'll come back. We anticipate a very good year in 2008.

Operator

Your next question is from Victoria Hart - Merrill Lynch.

Victoria Hart - Merrill Lynch

On the last call you had alluded to the fact that you would be interested in increasing the leverage. Can you comment on your capital structure and what you think you would be doing?

Rick Carucci

Well, I will reiterate pretty much what we said last time. We're still studying that. We expect to have an answer by the end of the year. We do certainly have debt capability on our balance sheet. Depending on what we decide to do in terms of our ratings, if we stay within the investment grade category, we certainly have -- I think everyone has done calculations and said that we've got about $2 billion potential capability. We can see that obviously.

We're taking a look at everything to see what makes sense. We know we've got more of a franchise mix than we had several years ago, so our business, we believe, is definitely stronger in terms of returns, and steady and dependable cash flow. But again, we'll have an answer by the end of the year.

Victoria Hart - Merrill Lynch

Do you want to keep within the same rating?

Rick Carucci

Same thing. We'll have a full answer on that by the end of the year.

Victoria Hart - Merrill Lynch

Alright. Can you speak to us a little bit more about the remodel at KFC? What the progress has been and how the franchisees have been coming along?

David Novak

Just as a reminder for others, KFC has to upgrade its system by the middle of 2008. That's pretty much on schedule. We've got about 70% of the system completed at this time, and we're going to keep moving forward. We expect modest closures to occur during that period of time, hard to estimate exactly, but we think in the 200 range. We're also starting to see some franchise consolidations, some franchisees are buying out some others who may not be willing to upgrade their assets.

Victoria Hart - Merrill Lynch

So when you say 200-range in terms of closures, is that with the current unit count on the franchisee level at KFC? Can you give us a sense for how many closures have been done to date?

David Novak

None of that 200 is in the numbers yet so far, so it would be an additional 200 of our total unit count of 5,000 roughly for KFC.

Rick Carucci

You should expect to see that later this year and in the first half of next year.

Victoria Hart - Merrill Lynch

I apologize, I am not sure if you spoke to this earlier, but the dairy outlook for the Pizza Hut U.S.?

Rick Carucci

We didn't specifically speak to dairy, but our expectation is for inflation to be a little bit above 3% for the full year which is just above what we expected coming into the year.

Victoria Hart - Merrill Lynch

And chicken, is that fully contracted?

Rick Carucci

Chicken we're pretty much locked through the balance of the year. But really the only category we're not is beef where we're subject to market conditions.

Operator

Your next question comes from Steven Kron - Goldman Sachs.

Steven Kron - Goldman Sachs

First in the U.S. as I listen to your prepared remarks and you go brand by brand, it seems as though you guys are looking at this as very much company-specific things you can improve upon to improve the sales trajectory there. I guess if we take a step back and comment a bit on the environment and maybe whether it is economic or otherwise and how competition might be influencing some of the results? What are you guys seeing?

David Novak

Yes, I think that there is no doubt in the United States you got a very competitive market, and I think the consumer retail is being pressed on a number of fronts. Having said that, we still find that the market responds to good initiatives. I mentioned in my prepared remarks that we had a successful relaunch of the Pizzone and we feel we're making solid progress at KFC and Pizza Hut. We're recovering more slowly at Taco Bell than we would like although we are recovering, and that is the big challenge that we have in the U.S. right now.

Obviously value is very important to every brand at this point in time, so your value impression is key. The good news for Taco Bell is that we are top tier, number 1 in value, and that will bode well as we go into the future.

Basically what I am saying is we have got Pizza Hut and KFC making some pretty good progress, and the big challenge we have is Taco Bell, and we're confident we're going to right the ship and we're anticipating a stronger 2008.

Our profit goal in the U.S. is to grow at least 5%. This year we're going to be slightly positive, and that's not where we want it to be, but that's where we expect to be for the year, and we're focused on building new sales layers at each one of our businesses, and we think that 2008 will get back on track.

Steven Kron - Goldman Sachs

Are the challenges that you're seeing at Taco Bell influencing the timing or the results from any breakfast testing you might be doing?

David Novak

We're testing our breakfast products right now. We're very confident that we're going to be able to make breakfast a national idea for Taco Bell. We went into a number of markets and got some great operating experience. The consumer response to the products is excellent. We've done a lot of research now. We're backing up and taking a look at the learning, and then we're going to go and do some concentrated, more focused test marketing as we go forward.

But the products that we have are just absolutely terrific, and we're confident that over time we can make breakfast work. As I said before, this is definitely the toughest day part to move into because you're dealing with such entrenched behavior and so we've got our work cut out, but we really believe that we can make this work. Greg and the team are very focused on making that happen, but it is not something we expect to roll out in 2008.

Steven Kron - Goldman Sachs

I know you're not in the habit of giving quarterly comps for Pizza Hut and KFC any more, but can you give some sense of comfort that for both those brands year-to-date that comps are positive?

Tim Jerzyk

We disclosed everything we're going to do in terms of anything for the quarter and year-to-date.

Operator

Your next question is from Joseph Buckley - Bear Stearns.

Joseph Buckley - Bear Stearns

A question again on China on the commodity cost pressures. How significant are the pork issues? What does your team say there in terms of how quickly that can correct and what the implications might be for chicken costs?

David Novak

I am not really a pork expert, but the hardest piece of the pork, the issue really started about a year-and-a-half ago. They had some disease issues that affected their supply. That market hadn't been that profitable for awhile, so you also had some of the farmers struggling financially.

My understanding is that it is getting a bit better, but they did see about a 25% increase in pricing in pork during that period of time. So we think it is recovering, Joe, but I don't have a sense for when there will be a full recovery.

Joseph Buckley - Bear Stearns

The China G&A numbers looked a little high in the quarter. Anything unusual going on there? I realize you're growing the business and it is going to be up, but it was up a little bit higher than I thought it might be.

David Novak

Yes, it was a bit high. What we've seen in China is we have what we call surges and plateaus in G&A. Part of the reason you get some surges there is we are investing for growth and new concepts. Right now, for example, we're investing G&A ahead of businesses like the Pizza Hut delivery business and East Dining, and then it usually moderates. For example, we expect lower growth in the back end of this year regarding China G&A.

Joseph Buckley - Bear Stearns

On your forecast update, it looked like your refranchising proceeds you expect to be maybe $50 million to $100 million less. Is that U.S. driven? You mentioned Pizza Hut UK is on track for the second half launch of that effort. Could you talk about that and talk about if the total proceeds from refranchising over a couple-year period is impacted or is that just a timing shift to '08?

Rick Carucci

Joe, the full program is absolutely in good shape. It is totally just timing and trying to identify some of the bigger transactions. We believe some of that may actually fall into '08, but the full program is absolutely right on track.

Operator

Your next question comes from Ashley Woodruff - FBR.

Ashley Woodruff - FBR

Just a couple more questions on China and pricing in particular. When you did take that price increase last year, is that something your customers even really noticed? Was it even too minor for them to notice and did you see any shift in the mix of items ordered?

Rick Carucci

We saw very little impact to the business and obviously China has been a great growth business for us, and you didn't really see a bending of the trend.

Ashley Woodruff - FBR

Very recently with the increase in food cost inflation, what have the competitors been doing? The other big chain there, but even just on a very local basis? Have they been raising prices?

Rick Carucci

Definitely there has been price increases, for example, at the supermarket level on poultry and pork and the consumers have definitely felt that. That's why my sense is they almost seem to be expecting a price increase because they've seen it on the supermarket side. In terms of competitors we're probably the big dog and they may be watching us.

Ashley Woodruff - FBR

Lastly on China, what is the government doing with high inflation? We've seen a couple of press reports on the government trying to put in price controls. Has that had an impact, and do you expect them to be able to keep the prices from increasing further?

David Novak

We haven't seen anything to that anticipates any price controls or anything in that nature in China, so we don't see the government making any big moves.

Operator

Your next question comes from Jeffrey Bernstein - Lehman Brothers.

Jeffrey Bernstein - Lehman Brothers

Thank you very much. First just a question on the U.S. operating profit and your guidance. Just looking at back half of the year, obviously you have some comfort in improving trends. You mentioned some productivity initiatives that you have in place.

I am just wondering, other than productivity improvements it seems like you're anticipating second half performance. Just wondering if you have seen that in recent months, some support from trends moving in the right direction? Thanks.

Rick Carucci

David commented that we are seeing progress on the KFC and Pizza Hut side. As you look at the balance of the year we're looking at two things and David commented on this a little bit. One is improving sales trends. We think we like our marketing programs. The second piece is we're overlapping both weak sales and weak profits, particularly in the fourth quarter last year. You should factor that in when you look at our balance of the year.

Jeffrey Bernstein - Lehman Brothers

Also it seems like you have a $10 million reduction in the closure and impairment expense this year versus last, which definitely helped the operating profit. I am just wondering how you look at that for the back half of the year and do you see further significant reductions?

Rick Carucci

That's a full year reduction, and it is hard to predict that, Jeff, in terms of when those will happen. The best thing to do is just really take a look at the prior year quarterly spend and use that as your guide.

Jeffrey Bernstein - Lehman Brothers

A last thing on YRI. A couple of moving parts there but food costs seems to be down huge for three straight quarters while it seems like payroll costs are up significantly the past two quarters.

Rick Carucci

Yes, that's the impact of the Pizza Hut UK business now being included in the P&L. That's primarily the impact there.

Jeffrey Bernstein - Lehman Brothers

It is shifting from one to the other? I would be surprised you would see it move from one to the other.

Rick Carucci

It is just a different business. You're adding a pretty significant Pizza Hut business.

David Novak

When it was a joint venture, it was not in the margin numbers. Now it is in the margin numbers and it is a significant part of the mix.

Jeffrey Bernstein - Lehman Brothers

You would expect over the next few quarters that would normalize?

Rick Carucci

We acquired it last October, so the benefit will start to go away basically in the fourth quarter, and then by first quarter next year it will have normalized.

Jeffrey Bernstein - Lehman Brothers

Lastly you mentioned multi-branding very briefly in your commentary and I know that used to be category-leading brands, multi-brand focus, just wondering your outlook and what we should think about in term of the impact that has on results going forward, if it has much at all? Thanks.

David Novak

Where we see multi-branding playing a primary role will be in the development of new units in the U.S., primarily with KFC and Taco Bell combinations leading that effort. Our goal is to get to net new unit development in the U.S. with Taco Bell and Taco Bell KFC combinations really leading the way.

Rick Carucci

That's the case on the quick service side. On the Pizza Hut side we also expect to see more and more penetration of Wing Street with Pizza Hut as a multi-brand partner.

David Novak

We're having outstanding success with the Pizza Hut Wing Street restaurant conversions. So the franchisees are getting more and more excited about that. Our goal is to try to scale that idea on as much of a national basis as we can. The two big combinations in summary are Pizza Hut Wing Street and also KFC/Taco Bell.

Operator

Your next question comes from Tom O’Neill – Barclay’s Capital.

Tom O’Neill - Barclay’s Capital

Based on your answers to the capital structure question it seems that you left the window open for your rating to either be investment grade or non-investment grade. There is no question as I watched your progress over the years with your strong free cash flow, you really created a much more stable cash flow generating organization.

In terms of the capital structure review though, we've had a lot of names go private in both the retail and restaurant space. You're talking about fine tuning the balance sheet or could this possibly end up in a situation where you're no longer a publicly traded entity?

David Novak

I would say, why would we mess with happiness? We have a great business. We like being a public company. We like our opportunities over the long term, and there is nothing that's keeping us from continuing to be a great value for our shareholders.

Rick Carucci

As Tim said, we're going to study the capital structure. We are leaning towards staying investment grade.

Tom O’Neill - Barclay’s Capital

Thanks for that clarification.

Operator

Your next question comes from David Palmer - UBS.

David Palmer - UBS

Is there any update that you can give us on your confidence level on Pizza Hut? You were just noting that your biggest challenge is Taco Bell, and I am wondering if that might say anything positive about how Pizza Hut may be evolving in your mind? In particular, can you comment about how you feel about the pipeline in marketing as well as innovation pipeline versus where it might have been six months or a year ago? And if you feel more confident, why you might feel more confident about Pizza Hut?

David Novak

I think the team is really working on the right things at Pizza Hut. We've got basically three areas that we're attacking with I think pretty good success from everything that I can see. One is just the whole value proposition. We just launched Pizzones and you saw the abundant value propositions we had for that business or for that brand, and we think we have Pizzone and nobody else has Pizzone, which is another nice thing about that.

We have other initiatives and tests on the value front. As I mentioned before, that's where the real battleground is in the categories. You've got a win on that front and then also come in with innovation. We've been lacking on really true value initiatives, and we now believe that we are getting closer at having more in our arsenal as we go forward.

The second thing that we're very excited about is that we did reposition the brand around America's Favorite, getting more. All the consumer data we're seeing tells us we're on the right track there. Nobody else can say they're America's Favorite pizza, and in a category that if you let it go commodity or can get more commoditized, have you to differentiate yourself, and I think the team is very committed and coming up with more and more ways to demonstrate we're America's favorite because we always give you more. I think you will see more and more news on that front.

The third thing we're excited about is we really do think we have an asset transformational idea with Wing Street. It is working in our delivery, in carryout units, and also working now in the restaurant units. So we see that becoming a bigger and bigger player in our franchise system down the road.

The pizza category, as I said in the past, is always competitive. It is the toughest one we're in with two very strong national competitors. I think it is always going to be a dog fight. We're not predicting robust growth at Pizza Hut, but we think we can get on that 2% to 3% same-store sales growth track with some consistency as we go forward. Obviously we'll try to do better than that, but clearly we've been trying get ourselves in the positive territory, and we want to get there and stay there, and keep building on that.

Frankly, I feel a lot better about Pizza Hut than I have felt in a long time in terms of just the direction that they're taking, but the proof is in the pudding for the long term.

David Palmer - UBS

Rick, a quick question on food costs. You guys have done a great job, your team and your supply guys have done a great job on the U.S. food cost side for '07. I am wondering, given all that we're seeing out there, does that mean '08 might be some tough laps on the good hedging and contracts you set for '07? Is the bias definitely to the upside on the 3% to 3.5% you got going this year?

Rick Carucci

Yes. It is really hard to predict what's going to happen on the commodity side. Again, it will depend as we get into the balance of the year when we decide what contract to sign and for how long to sign it. We have to wait and see. We do have, as you mentioned, we would like to thank you for complimenting our team. We do have a good team that works on it, and they work on it for both us and our franchisees.

What we try to do as well is to make sure we have productivity initiatives that continue to work on two fronts. One is within the supply chain itself, to make sure we try to do things, for example, at KFC, utilize dark meat and bigger birds and then also productivity outside the food chain to combat inflation. We're working hard on all of those fronts.

Operator

Your next question comes from Mark Wiltamuth - Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

A question for Tim or Rick. As you're looking at your capital structure, I am sure you have seen a lot of the restaurants do these securitization of franchise fees at 5.3% to 5.5%. We really haven't seen a lot of this in the international market. Is there a barrier to that and can do you this for the YRI business?

Tim Jerzyk

We really are not going to go that route, probably either in the U.S. or the international market.

Operator

Your next question is from Jeff Omohundro - Wachovia.

Jeff Omohundro - Wachovia Securities

My first one relates to the evolution of the Red Roofs and Wing Street's role in that over the next few years. Assuming that's the direction you go, is there a way you can work with the franchisees, incentivize them? Is that necessary? How do you see that evolution occurring?

David Novak

The best way to incentivized the franchisees is to give them unit economics to get them excited about the propositions, and that's why we believe we have a national proposition now with Pizza Hut Wing Street. We've been doing a lot of testing ourselves. Now the franchisees are opening up units. We have one franchisee in Texas who really led the way on this. He has given his presentations to the franchise community, and that's going to be the biggest driving force.

We're going to do everything we can to work with the franchisees to try to scale the ideas as fast as we can. Obviously the more we can scale it, the more we'll be able to advertise it and the more we can make it a more powerful idea and differentiated idea in a category that's obviously very competitive.

Jeff Omohundro - Wachovia Securities

One other question on Taco Bell. When you look at the opportunity to recapture lapsed users in the Northeast, is it the kind of thing where you would consider stepping up your efforts there promotionally as we move into the second half? Or is it just a natural recovery against the easier comparisons?

David Novak

I think we've looked at these things in the past and for someone who is not very patient -- and I am not very patient, as most people would attest to -- you have to tell yourself to give it time. I think that's our biggest ally in this whole thing is to let time takes its course. There is some local promotions that's going to be done, and we're looking at other ways that we can accelerate the timing of the time, okay, but it is going to take us six to nine months, and the good news is we've got six months out of the way.

Operator

Your next question comes from Jason West - Deutsche Bank.

Jason West - Deutsche Bank

Can you give us the profit growth in the Mainland China business ex currency? I think you said it was 20% on a reported basis.

Tim Jerzyk

You can call us back after the call and we will get that for you. The difference is probably pretty close to the total division number. Most of the currency change is in the Chinese currency.

Jason West - Deutsche Bank

Can you update us on where you stand on extended hours at KFC and if you expect that to have any kind of lift in the back half and what that might be?

David Novak

We're in the midst now on a geographical basis, citywide basis expanding late night in a number of our company markets, so we expect that to have some positive impact in the second half of the year.

Jason West - Deutsche Bank

But it is just in company markets right now?

David Novak

We're doing it with the franchisees in those markets. We try to go DMA by DMA basis, but it is being company led.

Operator

Your final question comes from Glen Petraglia - Citigroup.

Glen Petraglia - Citigroup

It is just a quick follow-up. In the release you mentioned labor inflation in China. Now I believe every year there is some sort of mandated labor wage increase in China. Can you maybe comment on, are you seeing inflation above that rate, and what's causing it?

Tim Jerzyk

No, the inflation rate we're seeing in terms of labor is pretty much consistent with what we've seen over the last several years. There has really not been much change there. The only other thing going on within that division P&L, keep in mind as Rick mentioned earlier, you got the other two small parts of that division; Taiwan and Thailand are not doing so well, and that's impacting that.

Glen Petraglia - Citigroup

Thank you.

David Novak

Let me wrap this up. I appreciate everybody on the call. We're on track for another year of strong EPS growth with the current forecast of 12% growth up from our previous guidance of 11%. I think it is demonstrating once again the reliability of our global portfolio to deliver consistent EPS performance.

The overall consumer dynamics outside the United States have never been stronger, as shown by the strong top line sales from our Mainland China business and exceptional system sales results from our YRI division. We are making steady improvement towards full recovery in the U.S. businesses and look forward to a much better year in 2008 from a profit and sales standpoint.

I want you to rest assured that we are putting plans in place to get better performance in the U.S. going forward and doing everything we can to make sure that all of our brands have growth performance for 2008.

Thank you very much for being on the call. Appreciate it.

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