Yum! Execs Discuss China Strategy, Franchising and the Recent Minimum Wage Uproar

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Includes: MCD, YUM
by: Ezra Marbach

From Yum! Brands' (NYSE:YUM) Q1 2007 earnings conference call last week:

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

The good news is that our high returning growth engines, China and YRI, each had blockbuster first quarter performances. The great and most differentiated news from our company lies within these two high growth, high return businesses.

I came back from China this past week and I could tell you first hand, we are confident of another outstanding year in China in 2007. Importantly, it will be driven by our rapid and continued rapid and substantial development of multiple brands in mainland China. As of the latest count, we are now in 402 cities in mainland China with KFC, and over 60 cities with Pizza Hut casual dining. No other brands have this level of penetration and we do not see this picture changing anytime soon.

Of course, it is great for us as a restaurant company that the economy continues to grow 10% per year, because obviously more consumers can buy our food.

For KFC, we expect to add 300 new restaurants in mainland China, which will continue to widen our lead over our nearest competitor. We now have 1,000 more units than McDonald’s after having only a 100-unit advantage five years ago. Our brand majors and returns remain very strong and KFC will continue to strengthen its leading position in 2007.

This year, we are celebrating our 20th anniversary in China with KFC. Our team has a great plan for the year, with exciting new products, drinks and desserts, and we are very effectively aiming for the young adult market that now has money to spend.

For our 20th anniversary, we have targeted advertising which features what we are doing to enrich the life for our Chinese customers, in addition to all the new products that we are advertising this year. The advertising includes our First Light Foundation, which provides college scholarships to kids, the KFC 3-on-3 basketball tournament, which has grown in three short years to a significant, nationally televised event with over 180,000 players. We are also advertising our educational efforts on nutrition and balanced lifestyle, where we have distributed over 600 million nutritional leaflets and tray mats, because as you’ll recall, we offer a full line of vegetables and soups at KFC as well.

We are also advertising our KFC hostess program, who have become a key part of their local communities in various outreach activities, including on average hosting two birthday parties per day in every KFC.

KFC is a power brand any way you look at it, with cash on cash returns for our new units of just 18 months.

Now let’s turn to our Pizza Hut casual dining business. We are continuing to build on our leading position. We now have over 250 restaurants and growing rapidly. We are now moving into tier three cities, which provides further growth and is a great testament to the strength and reach of the brand. We expect to open as many as 70 new restaurants in 2007, which actually would make our Pizza Hut casual dining concept in mainland China one of the fastest growing casual dining concepts in the world.

For Pizza Hut home service, we will begin expansion in more cities to build scale after the successful test in Shanghai that we conducted in 2006. We expect to add about 20 new Pizza Hut home service units in 2007.

Finally, we expect to expand our East Dawning concept in Shanghai later this year to gain scale for TV testing.

We remain very focused against our number one strategy of building dominant brands in China in every significant category. We have a huge strategic advantage with our team in place in Shanghai, our own distribution system, and our development team, which is producing results that are unmatched by anyone in mainland China and perhaps the world.

We continue to expect that our China division will be our lead growth business, with 20% growth in operating profit.

John Ivankoe - Analyst, J.P. Morgan

Thanks. Actually, all of my questions are on China. First, do you think there is an opportunity to ramp up company expansion beyond the current level in the out years?

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

I think there is obviously an opportunity to ramp it up. I mean, if you just look at what’s going on right now. We are moving in to more and more cities successfully. We have both Pizza Hut and KFC with fantastic unit economies. Pizza Hut home service is definitely looking to be very positive and we are in the expansion mode there outside of Shanghai, and we are very hopeful on East Dawning. Rick and I just recently had all the food and we are making a lot of progress. It was fantastic food. The team is very excited about it and passionate about making it happen, so we think over time that is going to happen. We think we will ramp up the expansion over time.

I had an interesting discussion. You know, a lot of this is very qualitative, but I had discussion with Mark Cho who runs our KFC business. I asked him how many restaurants he thought we could build effectively right now just with our operating capability, and he said 550 no problem.

The reason why he feels that way is you if you go -- I was on a tour in China. I was in one zone I went to a small tier three city, or four city, and you walk in there and you see a great restaurant general manager and you see three assistants that basically can run any restaurant. So we have that kind of capability.

So I think our people capability is there. The big challenge we have is to find the right sites and we are doing that, but we expect to be able to ramp up over time.

John Ivankoe - Analyst, J.P. Morgan

Okay, secondly I know that looking in that division, franchising has been relatively steady. When does that become a more important part of the China division, if ever in the near-term?

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

I think in the near-term, it is not going to be that important. Frankly, we have the philosophy of earn the right to own. Basically, the kind of operations that we have in KFC are just outstanding. We have over 20% margins. We have cash on cash return for new units that are within 18 months. Our operational measures are among the best in the world, so we are kind of taking the major big box retailer approach of a target there. We can move faster by owning ourselves.

We are franchising and bringing in new franchisees, and we see Pizza Hut home service possibly as being much more of a franchise concept versus equity.

Right now, we are moving quickly with operational excellence and we have lots of leverage by owning.

Richard T. Carucci - Chief Financial Officer

Two further points to that; one is that economically, we feel it is in our best interest to develop restaurants and then franchise because the returns are what they are. A second thing to David’s point, we are building capability in franchising. We have been franchising for a while there and we are optimistic that as the economy continues to grow there, you have more, a larger and larger franchisee pool of people who have money.

So we think over time, we will be able to build our franchise side out.

John Glass - Analyst, CIBC

Great, thanks, and then just an unrelated, or moving to China, there has been some discussion in the press about minimum wage pressure there. Could you talk to what is going on? Do workers in your restaurants there make the minimum wage, or is the market rate substantially above right now the minimum wage there?

Richard T. Carucci - Chief Financial Officer

For others, the background for that question is that there was an erroneous press report that we were not paying our students the proper minimum wage. What happens is that -- first of all, we are abiding by all the laws that occur in mainland China. Effectively, the press report got it wrong.

We do pay minimum wage to certain employees. Students are actually not included under that minimum wage. We have a separate student wage, which we had gotten approved by the government, which the press was unaware of that. The subsequent investigation by the government showed we were in full compliance.

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