百勝餐飲集團 (YUM) 2014 Q3 法說會逐字稿

Good morning. My name is Melissa and I will be our conference operator today. At this time I would like to welcome everyone to the Yum! Brands third-quarter 2014 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

I would now like to turn the call over to Mr. Steve Schmitt of Investor Relations and Corporate Strategy. You may begin your conference.

Thanks, Melissa. Good morning everyone and thank you for joining us. On our call today are David Novak, Chairman and CEO, and Pat Grismer, our CFO. After remarks from David and Pat we will be happy to take your questions.

Before we get started, I would 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 investor section of the Yum! Brands website at yum.com to find disclosures and reconciliations of non-GAAP financial measures that may be used on today's call.

We are broadcasting this conference call via our website. This call is also being recorded and will be unavailable for playback. 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.

Finally, we would like to make you aware of the following upcoming Yum! investor events. Our 2014 New York Investor and Analyst Conference will be on Thursday, December 11, in Midtown Manhattan, and our fourth-quarter earnings release will be on Wednesday, February 4.

With this I would like now to turn the call over to Mr. David Novak.

Okay, thanks, Steve, and good morning everyone. Despite the recent supplier incident in China which has impacted China sales and reduced our full-year EPS outlook, I am absolutely confident in Yum! Brands ability to deliver strong sustainable growth in the years ahead.

Here is why. We fully expect China to fully recover, KFC Global is having a strong year and building momentum, Taco Bell has successfully and profitably introduced breakfast and is now expanding in the United States with new unit growth, and Pizza Hut Global should have a strong 2015 led by an expected US turnaround which is in its early stages.

For the third quarter, earnings per share increased 3% excluding special items. We clearly had unexpected negative sales in China and continued soft performance at our Pizza Hut division. On the positive side, we delivered solid results at our KFC and Taco Bell divisions and had the benefit of overlapping a higher tax rate in the prior year. Importantly our China sales are on the path to recovery and we expect a strong bounce back in 2015.

Now while it is clearly yesterday's newspaper, let me remind everyone that through the first half of the year we are well on our way to delivering on our objective of at least 20% full-year EPS growth excluding special items. First half EPS growth of 27% was driven by particularly strong results in China where system sales grew 19% and we delivered restaurant margins of nearly 20%. However, our strong first-half results have been offset by an unexpected and highly publicized food supplier incident in China which significantly impacted sales at both KFC and Pizza Hut. As a result, we are now estimating full-year EPS growth of 6% to 10% prior to special items.

Now I am sure you have a lot of questions about China so let me get right to it. First, here is what happened. On July 20, an undercover investigation was televised in China depicting alleged illegal actions by employees of Chinese food service supplier, Shanghai Husi, a division of OSI, which is a large and global food service supplier to many in the restaurant industry. To be clear, OSI was not a major supplier to Yum! and represented only a small percentage of our sales at KFC and Pizza Hut in China. However, given our size and category-leading positions in China, our sales were disproportionately impacted because we were mentioned with the same media weight as our major competitor who was a large customer of OSI in China.

Also, the fact that this followed the December 2012 poultry incident at KFC clearly didn't help.

Upon learning of the televised report we terminated our relationship with OSI not only in China but globally. We also began taking unprecedented measures to further strengthen our supply chain practices in China to prevent and identify fraudulent and deceptive behavior by suppliers going forward. For example, we are now requiring standards for suppliers in China to install closed-circuit televisions and implementation is underway.

We are also establishing a whistleblower system to encourage suppliers and employees to report any potential food safety violations.

Unfortunately, no matter how many controls we have in place it is extremely difficult to prevent a company from deceiving us if they resort to illegal activities. Nevertheless, we will learn from this incident and are committed to developing even better quality assurance processes as we move ahead.

Let me be clear, we expect all of our suppliers to follow the law and we are absolutely appalled with the alleged outrageous behavior of OSI. In fact, their actions are under investigation by the Chinese government, six employees have been arrested and OSI has publicly admitted to wrongdoing. We are awaiting the final outcome of this government investigation and I assure you we will pursue every legal recourse available to recover damages from this incident.

While we are doing everything we can to turn the situation around, what we need most right now is the gift of time. As we have said before, experience tells us it takes six to nine months to fully recover from these type of events and this will most likely be the case with this situation as well. But make no mistake, KFC and Pizza Hut are beloved brands in China and around the globe and have proven to be absolutely resilient. We have complete confidence in a full sales recovery and expect our bounce back to be strong.

Now this is the quarter when we typically share some perspective on the upcoming year so as we look towards 2015, China is obviously the key variable. I am sure you can imagine it is difficult to predict the exact shape of our bounce back in sales at this stage of the recovery process. However, sales are on the path to recovery and we expect a strong bounce back in 2015.

Equally important, we firmly believe we are building momentum behind major initiatives around the world that will drive strong sustainable growth in 2015 and beyond.

Let me give you a little color on each of our divisions starting with China. As I said, we have a short-term issue and we are weathering the storm. While primarily staying the course with our marketing plans, we supplemented this with a short quality assurance advertisement in August and communicated our action plan via social network. Our consumer trust scores clearly dropped but our research indicates that we are on our way to rebuilding trust.

At KFC China, we have over 4600 restaurants and nearly 1000 cities across the country which is more than twice our nearest competitor. Going forward, we are continuing to roll out our new restaurant design and introducing new digital technologies to contemporize the customer experience. Additionally, we expect to build off the most successful learnings of our KFC menu revamp and will launch a new group of products in the first half of 2015. Our goal is to present an even better KFC our customers will appreciate and restore the stronger business model we had in the first half of the year.

Even with our short-term sales issue, we still have the underlying economics that give us confidence to keep investing in aggressive new unit expansion.

Turning to Pizza Hut Casual Dining, which is by far and away the number one Western casual dining chain in China and it has no major competitor. Pizza Hut continues to lead with menu innovation and everyday affordable value. In fact, 20% of Pizza Hut's menu is revamped twice a year with the most recent update occurring on September 29.

We are also continuing to leverage our assets by expanding our breakfast offering into more and more cities. With this new sales layer, our long-term goal is to create and own the midscale casual dining breakfast occasion in China on a scale that matches what exists in the United States today. This is a huge opportunity and we are well positioned to capture it.

Today we have nearly 1200 restaurants in over 300 cities in China for Pizza Hut. We have a powerful economic model that generates fantastic new unit returns. So with strong underlying economics even in a temporary downturn, we continue to accelerate our new unit development of Pizza Hut Casual Dining and plan to open over 250 units this year further strengthening our category-leading position. In fact, no other major casual dining chain in the world that we are aware of is growing units at such a rapid pace. Pizza Hut Casual Dining is clearly a power brand with a great future.

Taking a step back, let me put KFC and Pizza Hut brands in China into perspective. Basically today at KFC we have restaurant margins of about 15% on depressed average unit volumes of $1.4 million. While these unit economics are strong, this compares to restaurant margins of 20% and average unit volumes of $1.7 million in 2011. There is no question in our minds KFC will eventually get back to these sales and margin levels. Remember, McDonald's has average unit volumes of $2.5 million in the United States. We firmly believe we are still early on in our journey to leverage our asset base in KFC in China.

Looking at Pizza Hut Casual Dining, our average unit volumes have dipped slightly below $1.6 million and we have restaurant margins of about 19%. This compares to average unit volumes of over $1.6 million and restaurant margins in excess of 20% just last year. Again with breakfast, late night, continued innovation, a strong economic model and accelerated new unit development, we fully expect to get back to previous sales levels and more in the years ahead.

In addition to our opportunity to grow same-store sales and margin, the biggest opportunity we have in China is to penetrate the country with new stores. Yum! currently has five restaurants per million people in China where the consuming class is expected to grow from 300 million people in 2012 to over 600 million people by 2020. This compares to our about 60 restaurants per million people in the United States where the consuming class is about 300 million people today. We continue to believe we will ultimately have well over 20,000 restaurants across all of our concepts in China.

So in 2014 our new unit development target of at least 700 new unit stores remains unchanged. This means we will open over 1400 new units in a two-year period and we expect another strong year of development in 2015, all of which will provide substantial momentum for our China Division as sales continue to recover.

Now let me share some perspective on our three global brands -- divisions starting with KFC. Our KFC division which is our second largest profit contributor behind China, continues to deliver solid sales and profit growth led by strong international performance. Importantly our international new unit pipeline remains extremely robust. We expect to open at least 650 new KFC units outside the United States this year and grow operating profit in this division consistent with our full-year guidance of more than 10%.

As you may know, we have nearly 14,000 restaurants in over 110 countries around the world, 91% of which are franchised. We are especially pleased with our continued strength in emerging markets led by high-growth countries such as South Africa and Russia.

Looking ahead, our new unit opportunities in emerging markets are arguably the best in retail. With about two KFC restaurants per million people in emerging markets, we know we have a long runway for growth.

Moving to our more developed KFC markets, we have very solid businesses in Australia and the UK and we are also pleased with the progress we are making in the United States. KFC is in strong shape and well positioned for 2015.

At Pizza Hut, while we are disappointed with the full-year operating profit and it will fall well short of our initial expectations, we are pleased with the progress we are making and expect this to continue into next year. We have sharpened our focus on value in the United States and have leveraged more competitive offers to drive digital activations and consumers are responding. In fact sales turned positive during the last two months of the quarter and our digital mix is now over 40% on our delivery and carryout business which represents a more than 5 percentage point increase over second quarter.

Our system is now fully aligned around competing more effectively and winning in the digital and social world. You will see more evidence of this going forward.

Looking ahead we expect to build out this momentum with the launch of further initiatives to drive same-store sales growth beginning in the fourth quarter. Our plan is to launch a new advertising position designed to better connect with millennials. We recently had good success with our Hershey's dessert cookie and our bacon and cheese stuffed crust pizza. We plan to reinforce Pizza Hut's leadership, quality, innovation and superior value as we continue to implement a comprehensive turnaround plan.

Globally we are sharing best practices to drive sales growth and we are making focused investments to accelerate our pace of new unit development especially across the delivery and express channels. We expect to open a record 450 new international units this year for Pizza Hut and are counting on this number to grow significantly in the years ahead.

Turning to Taco Bell, we are definitely well-positioned to deliver on expectations for a strong second half. During the quarter, we delivered same-store sales growth of 3%, clearly outpacing the QSR category. Importantly breakfast sales are sustaining with a 6% daypart mix without the benefit of high launch level media waves. I would go so far as to say we are one of the very few companies in the history of the QSR industry to launch breakfast successfully and profitably in year one. Not only are breakfast sales largely incremental but we are making money and sustaining it with margins of nearly 21% in the quarter.

Without question, we now have a great platform to grow from. Remember, McDonald's breakfast daypart is 25% so this gives us an opportunity to grow in that daypart for many years ahead.

Going forward, we will introduce mobile ordering and payments in the fourth quarter and we have significant innovation planned in our core business to drive growth balance of the year and beyond.

With strong unit level economics at Taco Bell, we are seeing an acceleration of development with over 100 net new units this year which represents a 10-year high and we have an even better development pipeline headed into 2015. We are confident we will ultimately achieve our goal of at least 8000 Taco Bell restaurants in the United States.

Finally, we are investing for the long term and developing great brands in India which will drive substantial future growth for Yum!. KFC will be bigger in units than McDonald's by the end of the year; Pizza Hut sales and delivery unit economics are getting stronger and more competitive with Domino's; and at Taco Bell, early results are encouraging with plans for accelerating the pace of development.

Now to sum things up, in spite of our short-term issue in China, the fundamentals of Yum!'s growth model remains extremely compelling. As you know there are three keys to driving shareholder value and retail, new unit development, same-store sales growth and generating high returns.

In terms of development, our new unit opportunity in emerging markets including China remains the best in retail and our opportunity to expand is huge. We have three iconic brands and while we have about 60 restaurants per million people in the United States today, we only have two restaurants per million people in the top 10 emerging markets including China and India. This is a long runway for international growth and gives us tremendous confidence in our ability to continue our aggressive expansion for many years to come.

We also see significant opportunity to grow units at Taco Bell in the United States and make it a truly global brand.

Furthermore, we have over 40,000 restaurants around the world that have significant capacity to grow. As I said, we are building momentum behind major initiatives around the world that will drive same-store sales growth in 2015 and beyond. Remember in China average unit volumes are well below where they were two years ago and we expect to get back to these levels and more over time. We are making KFC even more contemporary, have huge upside at breakfast, delivery and late night and are building off of our best operations in the world.

At Pizza Hut Casual Dining in China, we will continue to grow the core with constant innovation while we grow the breakfast and late night dayparts.

At our KFC division, we are sharing know-how and getting better at advertising, innovation, value daypart expansion and digital which we expect will result in higher sales growth in the years ahead. We are particularly pleased with our progress in breakfast in Asia, the initial results of expanding our happy afternoon hour through our learnings from Taco Bell and the beginning of a US turnaround at KFC.

At Taco Bell, our breakfast daypart is now established and already profitable. What is more our dollar cravings menu is resonating and our product and digital pipeline is full and ready for 2015.

Finally at Pizza Hut, we are making significant progress on the digital front and have a comprehensive turnaround plan now in place in our US business that we will expand globally. Additionally, we will be overlapping 2014 results which will give us the short-term boost in 2015.

Meanwhile our returns on invested capital have consistently been among the best in the retail industry. Over 90% of our restaurants outside of China are owned and operated by franchisees. We love the franchise model which will generate about $2 billion in franchise fees in 2014. These franchise fees provide us with a large, reliable and growing stream of cash which combined with the profit from our equity stores enables us to invest in high return growth opportunities and return significant cash to our shareholders.

So let me wrap things up for Yum! Brands. At our three global divisions, KFC continues to be delivering solid results, we are making solid progress at Pizza Hut and we are pleased Taco Bell is delivering on our expectations for a much stronger second half. We had an unexpected issue in China but we fully expect we are on the path to a full sales recovery and continued aggressive growth in the years ahead.

Now let me hand it over to Pat Grismer, our CFO.

Thank you, David, and good morning everyone. In my remarks today I will cover three areas, our third-quarter results, our revised outlook for the full year, and our capital allocation philosophy.

For the third quarter, I will highlight some key aspects of financial performance to add further dimension to our reported results starting with China. David outlined why our same-store sales declined 14% in the quarter so I will explain how this impacted our restaurant margin which came in at 14.9% or 4.6 percentage points below prior year.

First, same-store transactions declined 17% which not only significantly deleveraged our fixed costs but also made it difficult for our teams to manage restaurant level expenses leading to inefficiencies in food and labor. Combined, these issues drove a negative margin impact of about 6 percentage points. Rollover pricing actions provided approximately 4 points of margin benefit but half of this was offset by 10% labor inflation.

Restaurant margin was also negatively affected by inventory write-offs related to the disposal of OSI products. Collectively these items account for the roughly 5 point margin decline for the quarter. Clearly had it not been for the deleverage and inefficiencies triggered by the OSI incident, we would have reported restaurant margin of over 20% for the quarter. We are confident that as we rebuild sales in China margins will rebound as well.

One other thing I would like to point out about China's third-quarter results, we continue to shift our new unit development program toward higher return investments. For example, year to date through Q3, 67% of KFC China development was in Tier 3 through 6 cities compared to 53% in 2012. Similarly, 36% of total China development with Pizza Hut Casual Dining compared to 23% in 2012. Over time this evolution of our development program will enhance portfolio margins and returns.

Now moving to our global KFC division which posted its best quarter of the year with solid improvements in sales, margins and profits. System sales growth was especially strong in emerging markets up 12% led by Russia, Thailand and Africa. International developed markets also delivered solid system sales growth up 6% led by the UK, Continental Europe and Australia. Profits grew an impressive 14% before the impact of foreign exchange excluding a 2 point benefit from the overlap of franchise convention expenses. This compares to 8% profit growth in the first half of the year and demonstrates the strong momentum that we see in this business across both emerging and developed markets including our KFC US business which delivered 2% same-store sales growth in the quarter.

Our global Pizza Hut division also posted its best quarter of the year although still well below our ongoing expectations. While total same-store sales declined 1%, our US business which represents more than half the division's profits actually turned same-store sales positive in the second half of the quarter. Despite this improving trend, operating profits decline 6% excluding a 4 point benefit from the overlap of franchise convention expenses.

We are obviously not happy with these results. However, comparing this to the 17% profit decline we recorded for the first half of the year, it is clear that many of the turnaround efforts launched earlier this year including the digital initiatives which David mentioned, are beginning to have impact and are providing upward momentum in advance of a new brand advertising campaign in the US.

Finally for Taco Bell, again their best quarter of the year. We have long said that Taco Bell in 2014 would be a first-half second-half story from a profit growth perspective and the division's third-quarter results certainly bear this out. Profits grew 14% compared to a 9% decline in the first half of the year. Importantly, restaurant margins swung from a 2.6 percentage point decline in the first half of the year to a 1.8 percentage point gain in the third quarter as targeted pricing actions and restaurant cost savings more than offset food inflation which had unexpectedly escalated significantly over the past several months.

Additionally, we are on pace to open nearly 200 new stores this year, our strongest rate of development in more than a decade. Over 80% of these new restaurants will be franchised demonstrating the brand's attractive unit economics.

The last financial highlight I would like to draw your attention to is tax. Since the second quarter of 2010, we have disclosed in our SEC filings a dispute with the IRS regarding the valuation of intangible assets. I'm pleased to report that we resolved this matter in the third quarter. In conjunction with this, we made an initial cash payment to the IRS of $120 million which was effectively fully reserved. Remaining cash payments due under the terms of our agreement are also fully reserved. In the aggregate, these additional payments are expected to be less than the amount we paid in Q3.

Including adjustments related to this settlement, our third-quarter effective tax rate was nearly 11 points lower than prior year as we lapped an incremental tax reserve that we recorded in 2013. We are pleased to put this matter behind us.

I would now like to shift gears and talk about our full-year outlook. In China, sales remain difficult to call. However based on current trends and a expected recovery period of six to nine months and the knowledge that these recoveries are rarely linear, we expect same-store sales to be negative for the fourth quarter. This is obviously disappointing but I can assure you that the team is working very hard to restore consumer trust, accelerate the sales recovery and rebuild margins responsibly. Importantly, we are continuing to build new restaurants and expect to open 700 new stores this year.

Although the current sales decline has dampened our new unit returns, these returns on average still exceed our internal hurdle rates and because we expect sales will fully recover, we are confident that our restaurant expansion program is not only extending our competitive lead but is also creating shareholder value over the long term.

Keep in mind KFC and Pizza Hut are the leading brands in China with enviable competitive advantages. No other retailer has the scale, the development expertise, the advertising clout, the supply chain infrastructure or the people capability that we do in China. We believe that with the benefit of long-term macro tailwinds the restaurant category in China will grow significantly over the long run and we are better positioned than anyone else to capitalize on this opportunity.

Outside of China, third-quarter results at KFC, Pizza Hut and Taco Bell are indicative of the momentum that we expect we will deliver on our promise of second half results that are substantially better than what we delivered in the first half of the year. Trends are clearly moving in the right direction.

Now when you add it all up and include our updated 2014 tax rate of approximately 25% to 26%, we estimate full-year EPS growth to be between 6% and 10% versus prior-year excluding special items. As you would expect, the single greatest variable in this equation is China sales which as I said earlier remain very difficult to predict. This recovery combined with the fact that the OSI incident occurred in the middle of our peak summer season figures very heavily in our full-year results.

We will provide an update on our 2014 outlook as well as 2015 at our annual investor meeting in December.

Now I would like to discuss our capital allocation philosophy. Our business continues to generate a significant amount of cash. Year to date we have generated EBITDA of over $2 billion versus $1.9 billion in the same period last year and importantly, we have remained disciplined in how we have use this cash. We concentrate our investments in high growth, high return businesses and we refranchise when we believe the franchise model creates more shareholder value. We have a good track record of doing this and this will continue.

In fact, we have begun to refranchise a portion of our equity position in Western Europe where margins and returns have lagged our expectations. Additionally as KFC restaurants in higher tier cities in China trend toward lower margins, we expect the franchise mix of these restaurants to increase gradually over time.

We also have a good track record of returning all available cash to our shareholders in the form of dividends and share buybacks. For example, over the last five years, we repurchased 57 million shares representing a 12% reduction in outstanding shares and I am sure you read our recent announcement of an 11% dividend increase. This marks the 10th consecutive year we have increased our dividend at a double-digit rate, one of only 12 companies in the S&P 500 to do so.

With this latest increase, we also raised our dividend payout target to 40% to 45% of annual net income before special items. Our resulting dividend yield of about 2% compares very favorably to other companies with a similar growth profile. So when you consider the growth opportunity we have with our brands and the cash we return to our investors, we believe our Company is set up to provide a compelling total shareholder return over the long run.

So let me wrap things up. We are urgently working to overcome the temporary negative impact that the China supplier publicity has had on our business. We are confident that we will bounce back in China and regain the momentum we saw in the first half of 2014. This combined with the momentum we are building outside of China positions us for an impressive 2015. Most importantly, we believe our double-digit growth model will endure for many years to come.

And with that, I will hand things back over to David.

Thanks, Pat. We are ready to take questions but before I do, I want to point out that this will be my last earnings call as CEO and that Greg Creed will be the CEO beginning January 1 at which time I will assume my new role as Yum!'s Executive Chairman of the Board.

We have been working on a seamless transition together and I couldn't be more pleased to have a leader of Greg's stature taking the helm. I have worked with Greg for over 17 years. He lives and drives our culture, he knows all aspects of the business cold. He has worked on every brand, he has been Yum!'s Chief Operating Officer in the past, he is a great brand builder and what he has done at Taco Bell I think has been absolutely sensational. The Board and I are absolutely convinced that he is just the guy to take the Company to the next level.

Greg will join me and take a lead at our December investor conference in New York and with that, we are happy to take any questions that you may have.

(Operator Instructions). David Tarantino, Robert W. Baird.

Good morning. First, David, congratulations on your great run as CEO of Yum! and good luck with your transition upcoming.

My first question is really related to the China trends and I know you mentioned the trends are starting to stabilize or improve there. I am just wondering if you could give a little bit more context on how deep some of the same-store sales declines were initially and perhaps what you are seeing more recently? And then related to that, what level of decline are you embedding in your fourth-quarter outlook?

David, I am certainly not going to provide specific numbers around what happened in any given month but happy to speak to overall trends.

First let me remind you we had a very strong first half of the year with same-store sales up 12% demonstrating the strength and resilience of our brands. So even as we have been impacted here in the last quarter, we expect our brands to bounce back strongly. We remain very confident that we will see a recovery in what we estimate is a six- to nine-month period because we saw in the month of September that sales were substantially better than they were in the month of August which was the month immediately following the publicity incident. So we are clearly recovering.

We are also seeing consumer scores improving and that further reinforces our belief in this recovery. But remember, we are in the very early stages of this recovery cycle so it is appropriate to a bit more cautious at this stage when we are guiding sales. And we also know from our past experience that these recoveries are rarely linear.

The other thing I would point out is that China's hardest same-store sales overlap this year is in the fourth quarter so when you add all of those things together, our best estimate today again based on current trends we see in the business is that same-store sales will be negative for the fourth quarter which as a reminder, spans the months of September through December.

But make no mistake, we expect sales to continue to improve across the quarter and again history tells us that our brands are resilient and we will be prepared to provide more color in context on this at our investor conference in December.

Great, thank you. And then maybe second and relatedly, is there any more color that you could share on what actions you are taking to restore trust with consumers? I know you mentioned a quality assurance campaign that you ran but is there anything that you can share about what you are doing currently or planning to do for the rest of the quarter to restore the trends there?

I think, David, we basically have announced all of our action plans that continue to make our supply chain even stronger, unprecedented things that we are doing to work with our suppliers. That has all been publicized. We had a quality assurance advertising campaign that was very brief just to let people know that we were clearly addressing the issue and that our food is safe to eat which it absolutely is and has been and always has been.

So that is what we have done. Right now we are in the midst of just running our basic marketing programs that we have had. We are currently doing promotions around our rice-based products, rice and chicken-based products and we are basically waiting for the business to come back.

Like I said, the biggest thing that we need is to get to time and that is exactly what we are doing is we are aggressively marketing the brand and hoping that time takes its course which we are very confident the business will come back.

Thank you.

John Glass, Morgan Stanley.

Thanks and I will add my congratulations, David. I think by my calculations you have probably suffered our questions for 70 conference calls now. So I will lob in one more.

Can you compare the rate of improvement in China sales this incident versus the prior? I think last time you lost some family business over concerns. So are consumers responding differently? Is there different product mix? And also can you just map out the rate of improvement versus the prior incident in December of 2012?

John, as you know, no two crises are ever the same. However, as we step back and look at how sales and consumer scores have trended in the two months or so since the incident, I would say that the trend is broadly in line with what we saw the last time. But again, we are relatively early in the stage of this recovery and we continue to believe that we will see a full recovery in a six- to nine-month timeframe.

And Pat, you had indicated sort of the breakdown of margins which was helpful. What in your mind was truly one time and maybe didn't do the math quick enough. You talked about some inventory or food waste. Can you just talk about what you thought was really discrete to the third quarter and what was just sales delevering?

In the past you have been very good about moderating labor. Have you been even better and faster this incidence? Are you able to correct going forward at a more rapid clip correct labor scheduling to benefit margins going forward?

John, I would clearly characterize the extreme sales deleverage as a one-time event. This is not something that we would expect would happen regularly and the impact to our business was quite severe just given how sharp and sudden the transaction decline was and our teams did the best they could to respond to that situation. You never want to pull out labor too quickly because you don't know how consumer traffic is going to trend and we want to make sure that the consumers who are coming to our brands are having a very good experience.

Yes, as I mentioned in my prepared remarks, there were some inventory write-offs that were quite substantial that translated into over 0.5 point of a drag on our margins for the period. This related to a product from OSI. So again, I think that it was a transaction deleverage that clearly was the biggest driver and I would characterize that as a one-time event.

Again, had it not been for all the effects we saw of the OSI incident to our margins we would have posted a margin in the quarter of over 20%. And I think that is a better indication of how we are thinking about our business on the longer-term and what we are striving to get back to as quickly as possible.

David Palmer, RBC Capital.

Good morning and congrats, David. Two real general investor concerns that we hear about and it might be too broad to comment today maybe we will have to save it for the December Analyst Day. But the first is that KFC and Pizza Hut brands in China are somehow impaired due to the result of multiple incidents happening. Are you seeing lower lows on some of these scores in a way that implies to you that these brands are getting hit harder and deeper with each of these incidents?

Second, there is a concern that there is some thread that connects these incidents even though they don't seemed linked, maybe it is the fact that the press is more active or there is an underlying distress to the food supply chain broadly in China, but this implies that Yum! China has a higher risk of sale shocks going forward as well. Could you comment on those two concerns?

I think first of all, the research trends that we see are basically similar so we haven't seen anything move one way or the other regarding that.

In terms of the impact in the future, I can only tell you that we monitor and respond to social media 24/7 and we actually responded quicker this last time around and the sentiment turned positive a lot faster this time around.

We really can't predict the future. I would never be one to say that we could never have an incident like this again but I can tell you we get stronger from everything that we have that ever happens like this, we get a lot stronger at and stronger from. We improve our processes that are already strong, we do everything we can to learn from it and get better.

We are really confident that China is going to be a continued growth vehicle for us. We have got 300 million people today going to 600 million people by 2020. This consuming class is going to grow. Our brands are clearly the leading brands in China. Even as we take short-term sales losses, our margins are still very good, we have very good business models as we go forward.

I think what we have proven over time is that we are resilient enough and strong enough to weather storms like this. Now hopefully we won't have another incident like this for a long time to come. Believe me, we are doing everything we can to make sure that we don't.

Jeffrey Bernstein, Barclays.

Great, thank you very much. David, congratulations.

Thank you. Should have these more often, this is the nicest you guys have ever been to me. I know the high hard ones are coming so let's do it.

I've got two for you. One, just specific to the China unit growth, you talk about this year being another year of that 700 plus. Just wondering whether anything that has happened over the past few months or perhaps the past couple of years leads you to change that view and we should think something materially different as we look to 2015 whether it is by brand or by tier or whether we are full speed ahead in terms of 700 plus for the next few years?

The other question is just in your prepared remarks you talked about China and being obviously a very high growth company operated business model. The rest of the world needless to say is more franchise and slower growth. Is there any updated thoughts on whether you would ever consider separating the China business? It just seems like you are running two different tracks and they might be greater appreciation for people who would like to invest in one or the other but rather not both. Thanks.

We believe in our business model, it has served us well in the past. We think it is going to serve us well in the future. We think what we have right now is not a structural issue. We think we have a short-term brand issue that we have to deal with. Our challenge in China is basically to recover and grow. That is 100% of our focus. And I guess I ought to rephrase that, I guess that is 1000% of the focus that we have. The single biggest thing we can do for our shareholders right now is to put every inch of muscle, fiber, whatever you want to call it into turning this business around and get it back where we really know it is capable of. That is our focus.

The one thing I would tell every shareholder is that we have always had a right to own philosophy. You have to earn the right to own. 90% of our business outside of China is franchised which I think you point out very well. China is primarily our equity business, it is where we put our capital in and that is because we have great returns on invested capital and we have had cash on cash returns in three to five years. We expect that to be the same as we go forward and we think that will serve our shareholders very well. We have that earn the right to own mentality and that is going to guide our thinking on structure as we go ahead.

And Jeffrey, to respond to your first question around the pace of development, we have no reason at this stage to back off our commitment to continued aggressive development. We will however continue to evolve our development program to pivot toward the higher-margin, higher-return opportunities as we have done for the last couple of years increasing the weight of KFC new units in lower tier cities and increasing the weight of Pizza Hut Casual Dining restaurants which again offers superior economics. But we remain bullish on the long-term growth opportunity in China and we believe that we have the very solid business model that is currently under short-term pressure but is going to bounce back and bounce balance back strongly and provide the returns necessary to sustain the high rate of development.

Greg and I are heading towards China in a couple of weeks. We are going to have the annual operating plan, we're going to hear what the team has to say. We have a very focused new unit tracking system where we look at the returns and monitor returns on a quarterly basis and see how they are doing versus our internal rates of returns, our CapEx requirements. And we will sit down, we will have very, very focused discussion on that with the shareholder in mind. But we have nothing to believe other than the fact that we will continue our strong rate of development based on what we know today and I don't anticipate any new revelations.

Keith Siegner, UBS.

Thanks and in addition to you David, please pass the congratulations on to Greg and look forward to giving him some hard questions going forward.

He will be capable of handling them.

I can't imagine how frustrating this has been especially post restaging the KFC brand earlier this year. But you talked about staying the course, hunkering down, sticking to the basic motions. Just wondering, can you talk a little bit about that decision weighing that approach versus say going and buying back some traffic, getting people back in, reminding them how good the experience is. How do you think about those two approaches? If you could give us some color there that would be great. Thanks.

First of all, we are working on marketing right now that really gets to exactly what you are talking about, reminding people of the role that KFC plays in their life, the good times that you've had in the past, the good times you can have today and that we are contemporary and we are on the money in terms of what you are looking for in China as China ever changes.

So the marketing direction that we are taking I think is very similar to what you are suggesting that we do. When you look at value, value is a very important component of the basic quick service restaurant industry. We've got very good entry pricing today. We will have promotions as we go forward that will entice trial back into the business. We will be looking for massive retrial of the brands over time. And right now for example, we are offering free drinks at KFC.

So whether that is put into the right context now to get everybody in the country to come back tomorrow I'm not going to say that but we are offering free drinks with a soup or rice purchase at this stage.

I think we are pretty aligned with the fact that retrial and getting lapsed users back in is clearly the goal and that is what we will be talking about with the KFC team.

Pat, can I sneak in one real quickly? Just in terms of the margins to follow-up a little bit, are you seeing any major changes, like where is COGS inflation, how do we think about that? Also it is rare to see occupancy dollars down in that China business year-over-year. Was there anything one time that hit that line item as well?

Nothing one-time on the occupancy line. What falls into that category however would be rent and a large portion, the vast majority of our leases have a variable component so as sales come down then so do rents and so that would account for a decline in the absolute level of rent expense which falls to the occupancy and other line.

With respect to cost of sales, that is an area that is going to put a bit of pressure on margins in the fourth quarter because we have had three straight quarters now of flat commodities cost in China and we are expecting the fourth quarter to show 3% food cost inflation.

Keith, just one more point to that, keep in mind that our advertising is also a flat percentage of sales so as sales come down, that line will also be reduced.

Joe Buckley, Bank of America Merrill Lynch.

Thank you. Hey, David, I am not going to be nice to you now. I mean why start now is kind of what I am thinking.

That is what I expect from you, Joe. Fire away. I kept saying, when is Joe going to be on?

I wish you the best. A question on the China sales cadence again. I realize you expect improvement sequentially but because this incident was a second half incident I'm imagining the first half, second half performance in China was like dramatically different. So maybe to put it in some perspective, do you think the fourth quarter will be down less than the 14% full quarter decline in the third quarter?

Again, Joe, given where we are at in the recovery process we are not going to be any more precise in how we guide same-store sales. We do expect an improving trend consistent with our past experience and we anticipate full recovery within a six- to nine- month period. It just isn't appropriate I think at this stage to be any more specific or precise than that.

We will know more, Joe, in December. We don't know what we don't know and we will know more in December and we will update you in December with all the color that we ought to provide you on that.

Can I switch gears for a moment and ask one on Taco Bell. The 3% comp I think you mentioned a couple of points of price and a 6% breakfast mix. So doesn't that add up to the lunch dinner business being down pretty significantly at Taco Bell?

There is no doubt that other dayparts are under pressure consistent with what we are observing across the entire QSR category in the US. We feel very good about how the breakfast layer has added incremental sales to our business and has helped us to deliver same-store sales growth in a tough environment.

I think the big thing is our margins were 21% and we've launched breakfasts. To me we are indifferent where the sales come. The great thing for us next year if we are up 5%, I don't care if it comes from breakfast, late night, lunch, dinner, whatever. I don't care where they come from. We just need them. And what we have now is we have a lot more muscle in the Taco Bell box to go out and get those sales.

I love the fact that we've got 6% mix at breakfast and our margins are 21% and we know that McDonald's has 25% of their business from breakfast. And it has killed me four years driving by all those McDonald's that are full and before we even open up our doors. So I think this is like taking our awareness and taking our usage of breakfast up over time, it is like the biggest new product we could have ever introduced to grow the base business.

The trade-off, the margin trade-off between lunch and dinner aren't that significant for us. So we are able to leverage the box and that is the name of the game. Now when we talk to our franchisees, one of the reasons why we really believe so much in breakfast was we thought this was essential for us so that we would have more growth options as we go forward in the future.

So I think just early days. If you look at breakfast, everybody thinks Taco Bell has a great late-night business, fourth meal. Our Sunday, Monday, Tuesday breakfast is higher than our late-night business. So we are building a pretty damn good business that is only going to get better as we go forward and I am glad, Joe, that we have it in our arsenal.

Now we also launched the $1 craver menu which is being very well received. We launched that recently which really upholds our value story. The thing about this is that these $1 craver products are actually products that people crave and they are really good value for $1 and so we think that is going to be a good winner.

The other thing that we feel good about with Taco Bell we are breaking new ground with mobile and digital and our social work is I think a best practice not only in our industry but for any consumer goods as we go forward. So there is lots of good news. I think the best barometer about breakfast is our franchisees are saying stay on it.

Sara Senatore, Sanford Bernstein.

Thank you. So I actually wanted to ask about the China growth story as well which is opening 700 new units but actually the net growth looks a lot lower than that. So I guess the two questions are one is, ultimately I think that is what we care about when we are trying to figure out revenue growth is kind of net unit growth. And then also, is there any kind of mix shift going on there and is that what might have shown up in your occupancy cost, more closures in Tier 1 and 2 higher costs markets? And then I will have a follow-up. Thanks.

Okay. Thank you, Sara. First on the net units, yes, we are concerned about net units so it is not just a matter of growth but also looking at the closures. In fact in the closures, there was a bigger story which was that a disproportionate share of those closures were Little Sheep units so not a reflection of the overall strength of our business model and the development opportunity with KFC and Pizza Hut.

Okay, great. And then the follow-up was you said that you responded more quickly as time -- sentiment turned around more quickly on the China scandal and yet still expecting kind of the same six- to nine-month recovery. So could you just talk a little bit about that? I know in the past, David, has said accurately that really time is your best friend but just this idea that you learned a lot from last time, you handled it potentially better this time and yet the cadence of the recovery is pretty much the same.

I think what we have learned is that no matter how much love our brands and we do. We love our brands beyond belief in our Company. We have learned that consumers have lots of options. They do not have to use us every single day and they can figure out when they want to come back. What we have learned over time it really doesn't matter even almost how big the issue is, if there is a highly publicized event, it takes you six to nine months to recover just because consumers are cautious when it comes to food intake.

And I want to point out nobody was ill because of this, there was no real tangible personal issue that took place because of this other than the fact that we were tainted by this and it was highly publicized. And this one was really tough to take because this was illegal and deceptive behavior that there is no process in the world I think that could overcome. And the fact of the matter is when I watched that CCTV event and I saw the coverage, you had McDonald's, Pizza Hut and KFC mentioned in absolute equal amounts. And I would say it would be hard to argue that we probably had more mention and it was like when I saw that I said uh oh, here comes six to nine months of problems. I was not at all surprised by this.

So I think that is just what we have learned. We have always said that with our business, we have great business model, we have great brands, we have -- the single biggest risk we have in our business is when we have any publicity around food safety issues and now that is exacerbated with social media. We are getting better at responding to social media but it is still out there. So it is one of those issues that we are just going to have to deal with and hopefully we won't have future events.

(Operator Instructions). John Ivankoe, JPMorgan.

Hi, thanks, it's Amod Gautam filling in and on behalf of John as well, congrats, David.

The question was on productivity, could you remind us of when the productivity initiatives were put into place at KFC in China? And then secondly, where does that fall in terms of the priorities of the China team, where do they tell you they are in terms of margin initiatives whether food, waste or labor scheduling? Is there still an opportunity there?

You may recall last year we started to see significant productivity gains in the third quarter. So in the third quarter of this year, we lapped those productivity gains and actually we added to them a bit so the team remains very focused on sustaining those initiatives to drive higher levels of labor productivity. It remains a priority for them to continue to drive margins back to a level that they were a couple of years ago. So even as we look to recover from sales pressure, the team is not taking their eye off of the continued opportunity to drive high rates of labor efficiency.

I suspect going forward as we introduce newer technologies back of house that will probably provide the next leg of opportunity on labor productivity.

And if I could just add, how soon might that happen, the back of house technologies?

Probably in the next couple of years.

R.J. Hottovy, Morningstar.

Thanks. I had a question about the reach of the food supplier issue and the publicity in China. More specifically, were there any noticeable differences in the same-store sales results in the higher tier cities versus the lower tier cities and does the shift you have gone to over the last couple of quarters more toward the lower tier cities help in the overall recovery and what it might mean over the next couple of quarters?

We didn't see any meaningful differences in same-store sales performance or the impact of the publicity across city tiers for either brand.

Thanks.

Diane Geissler, CLSA.

Good morning. I wanted to ask about your point, David, about the competitor set. So obviously you were mentioned, Pizza Hut, KFC, McDonald's, local brands were sort of swept up into this OSI issue as well.

Can you just talk about your dialogue with the consumer, what you are seeing maybe in terms of your market share? Did they trade out into local brands, did they trade away from fast food in general? Just any color around your brand versus the competitive set would be very helpful. Thank you.

We have not been able to do a source of business study where we can really track where people are going. So maybe the China team will have more color on that when we meet with them in the next couple of weeks. Be happy to share that with you then if we have it.

Okay, great. Thank you.

Okay. I want to thank everyone for being on the call. There is absolutely no question that we have taken a tough blow but we performed well in adverse situations in the past and I'm absolutely confident we will fully recover in China and we will deliver strong, sustainable growth in the years ahead. As I hope we have conveyed on the call, we are very confident about the future and Yum! is definitely well-positioned to deliver on the three things we know drives shareholder value, the new unit growth, the same-store sales growth, and the high returns which we are ever mindful of all three of these key dimensions of our business.

I want to thank all of you for the nice congratulations. It has been a great joy and a great honor to be the CEO of this Company and I am really excited for our Company to have Greg take the helm in January and I look forward to working with him to help us continue to build what we hopefully believe is one of the best global companies in the world. Thank you very much.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.