Yum! Brands Q2 Earnings Call Transcript

123jump.com Staff
06 Aug, 2010
New York City

The restaurant chains operator second quarter revenue rose 4% to $2.57 billion. Net quarterly income fell 6% to $286 million helped by strong growth in China and Yum! Restaurants International. Earnings per share declined to 59 cents a share from 63 cents a share a year-ago quarter.

Yum! Brands, Inc. ((YUM))
Q2 2010 Earnings Call Transcript
July 14, 2010 9:15 a.m. ET

Executives

Tim Jerzyk – SVP, IR
David Novak – Chairman, CEO & President
Richard Carucci – CFO

Analysts

Jeff Omohundro
David Palmer – UBS
John Glass
Joe Buckley
Jake Bartlett
Jeffrey Bernstein
Jonathan Komp [ph]
Larry Miller
John Ivankoe
Tom Forte – Telsey Advisory Group
Keith Siegner – Credit Suisse
Linda Farquhar – Friess
Sara Senatore – Sanford Bernstein
Mitchell Speiser – Buckingham Research

Presentation

Operator

Good morning. My name is Jasper and I will be your conference operator today. At this time, I would like to welcome everyone to the 2010 second quarter’s earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be question-and-answer session. If you would like to ask a question during this time, simply press star then the number one on your telephone keypad. If you would like to withdraw your question press the pound key. Thank you.

I would now like to turn the call over to Mr. Tim Jerzyk. You may begin sir.

Tim Jerzyk

Thanks, Jasper. Good morning, everyone and thanks for joining us today on our call. The call is being recorded and will be available for playback. We are broadcasting the conference call via our website at www.yum.com. Please be advised that if you ask a question, it will be included in both our live conference and in any future use of the recording.

I would also like to remind you that this conference call includes forward-looking statements. Forward-looking statements are subject to future events and uncertainties that could cause our actual results to differ materially from these statements. All forward-looking statements should be considered in conjunction with the cautionary statements in our earnings release and the risk factors included in our filings with the SEC.

In addition, please refer to the investors section of the Yum! Brands’ website to find disclosures and reconciliations of any non-GAAP financial measures that may be used on today’s call.

Finally we would like you to be please be aware of an upcoming Yum! Investor Event, where you will have a great opportunity to meet leadership team from one of our businesses. September 21, we will host our Yum! China Investor Conference in Shanghai. Space is limited, so please notify us if you are interested in attending as soon as possible. Also on Tuesday, October 5, our third quarter earnings will be released and a conference call will be held the following morning of October 6.

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

David Novak

Thank you Tim and good morning everyone. I am pleased to report we are raising our full-year 2010 EPS growth forecast to 12% based on our strong second quarter and first half performance. Our second quarter EPS growth of 17% before special items was fueled by profit growth in each of our three divisions.

We were particularly pleased with our business in China which reported robust profit growth of 33% driven by same-store sales growth, margin improvement and continued unit development. In the U.S., we were also pleased to see significant improvement in operating profit despite flat same-store sales.

Our primary focus is to drive same-store sales growth balance of the year given the challenging consumer environment. At Yum! Restaurants International, we increased system sales 4% prior to foreign currency translation benefit. We expect stronger sales and profit growth for the balance of the year at YRI.

Now let me take you through our key strategies and trends for each of our divisions. First, I am obviously very proud of our China team’s performance. Same-store sales grew by 4% and units expanded 12%. Our China division generated operating profit growth of 33%. Through the first half of this year our China division’s profit growth has been 35%.

New unit development continues to be the major driver of our growth and we remain the largest U.S. retail developer in China. We have opened 155 new units in our first two quarters and expect to open about 475 this year. Our China new unit returns continue to be the best in our business.

Now let me share with you a few highlights from each of our leading brands in China. Let us start with KFC. We just opened our 3,000th KFC in June and as you know we are in over 600 cities with average unit volumes of $1.4 million. KFC continues to be the largest western QSR concept in mainland China.

We have three key initiatives to grow our business and leverage our assets. First, KFC breakfast is in virtually all of our restaurants. We are opening at 6 A.M. and breakfast now makes up 10% of transactions.

Next is delivery, which is now available in 126 cities and nearly 1300 units. Last, our 24-hour operations initiative is generating incremental sales and is in now about 1000 restaurants.

Pizza Hut Casual Dining continues to be the leading western casual dining concept in China with 469 units in 122 cities. We expect to open 63 Pizza Hut Casual Dining restaurants this year, which is up from 55 last year. You may recall that beginning last year we slowed the growth of this concept substantially while we repositioned our menu. With the success we had we have begun to increase development in Tier 1 to 3 cities.

Our new menu strategy continues to drive double digit same-store sales growth. We offer a broad variety of entrees including beef, chicken and rice dishes along with appetizers, beverages and deserts. We are having solid success building a true casual dining concept with everyday affordable value.

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

In summary, we are very pleased with the progress we are making, executing our China strategy to build leading brands in every significant restaurant category.

Next, Yum! Restaurants International, where our strategy is to drive aggressive expansion and build strong brands everywhere, similar to our China business, new unit development is a key driver for growth.

Our Yum! Restaurants International growth strategy differs from China and that nearly 90% of our 284 new units so far this year that we have developed, have been developed by our strong network of franchises. In fact over 85% of the nearly 14,000 traditional restaurants in this division are franchise units, which generate a steady growing stream of franchise royalties. We expect to add about 900 new units for the full year.

Our second quarter system sales grew 4% excluding foreign currency translation, while same store sales were up 1%. Overall, we drove 7% operating profit growth excluding foreign currency translation for the quarter.

Based on the success we have had in China, we are aggressively going after sales layers at YRI. In particular, KFC our largest concept in Yum! Restaurants International is making major progress on driving value. Value menus are in place in all our key markets and we will be expanding further this year.

Our Krushers line of frozen beverages continues to expand and is now available in over 2,100 stores and over 35 countries. Our KFC breakfast initiative, which we call KFC A.M., also continues to grow.

Pizza Hut continues to make progress elevating its brand offering and strengthening its position as the leading western casual dining concept with everyday affordable prices. While we have weaker transaction trends due to Pizza Hut’s higher average guest check, we are encouraged by the progress we are making with our expanded menu, including a wider variety of appetizers, beverages, entrees and desserts.

Yum! Restaurants International’s new growth markets, France, India and Russia, delivered 13% system sales growth prior to foreign currency translation this quarter. For the first time, our KFC France business used national television in May and as you would expect saw strong upward shift in sales. Scale then enables television advertising is the result of us now having 100 restaurants in France.

On July 1, the Company also completed the exercise of our option with our Russian partner and we now have full management control of the KFC-Rostik’s brand in Russia and the Commonwealth of Independent States. This market includes more than 150 co-branded KFC-Rostik’s across Russia and the CIS of which we now own approximately 50 with the remainder owned by our franchises. We are excited about this market due to its large population and its appetite for chicken. Our business in India continues to perform well with solid same-store sales growth and new unit expansion. We now have over 70 KFCs and 160 Pizza Huts in India. Taco Bell International also continues to expand.

We opened our first Taco Bell in the United Kingdom on June 28 and our first in Korea just last week. In fact, we have opened Taco Bells in seven new countries over the past two years. Early results are promising and we are working very hard to make Taco Bell a global brand.

Overall, Yum! Restaurants International growth and development is on track. Importantly, we have a leading position and substantial runway for growth in emerging markets. I would like to take a moment to thank our growth-oriented franchise partners for the investment that they continue to make and for partnering with us to build a global business we can all be proud of.

Next, onto our U.S. business where our focus is to improve our brand positions, consistency and returns. Our U.S. business achieved solid operating profit growth of 10% with substantial improvement in restaurant margin while posting flat same-store sales.
We are happy with the improvement in the business and are pleased with the strategies we are executing across each brand. We look for sales growth to improve modestly at Taco Bell in the second half and stay strong at Pizza Hut. At KFC, we remain confident in our long-term strategy, but expect sales to be soft for the balance of the year.

Taco Bell, our largest and most profitable brand in the U.S. and in fact the second most profitable brand in our category in the U.S., continued its trend of growing transactions and grew same-store sales 1% for the quarter. Taco Bell’s pipeline of products is strong for the balance of the year focusing on value to the consumer in a market clearly focused everyday value. We also continue to make progress testing breakfast, home meal replacement options and a new beverage platform. Taco Bell is performing well in this challenging market and we have never been more confident than we are today about our future prospects for this great brand.

Pizza Hut led the way with 8% same-store sales growth for the quarter and our “$10 Any Pizza” promotion continues to be a huge consumer hit. We continue to leverage this promotion as well as discount a day of the week special such as Tuscani Tuesdays for our Pasta line and Wing Wednesdays. People ask us about the sustainability of our “$10 Any” promotion and one thing I certainly know is what is not sustainable and that has maintaining the high menu prices we had in our restaurants previously. Pizza Hut is very focused on working with our franchisees to maintain everyday value.

We are also very focused on leveraging our asset like we are doing with the Tuscani Tuesdays where we introduced pasta. Now we are marketing on Tuesdays and we are doing the same thing with the Wings on Wednesdays. So, we have talked about leveraging our assets in the past. That strategy is definitely being executed and being done very well by the Pizza Hut team. Pizza Hut’s performance is strong and I want to assure you that we are working very hard to sustain it.

Now let me put KFC into perspective. As I said earlier, we expect sales to be soft for the balance of the year. Our focus remains on the following key areas, improving operations, value, balanced options, featuring our grilled products, portable product innovation like the Double Down and asset upgrades. As you would expect each of these major initiatives will take time to implement. There is no quick fix. We are however, making progress.

Recently KFC had the single largest year-over-year improvement of any major QSR brand in the American Customer Satisfaction Index. We take this as a positive sign that our efforts to launch Kentucky Grilled Chicken to complement our world-class, our world famous fried chicken and simultaneously improve our operations are beginning to pay off. In spite of this progress, sales have been underperforming and we expect continued weak sales in the third quarter, however.

That said, we are in the midst of a transformation to truly make KFC a more relevant and better operated brand and make no mistake, we have a great team that is providing the customer-focused leadership required to do just that.

However, from a pure financials perspective given our tremendous global growth and the success that we have had with Taco Bell in the United States, KFC represents less than 10% of the U.S. division’s profits and less than 3% of the Company’s overall profits.

We expect 2010 profit at KFC to be higher than last year and the execution of our re-franchising strategy sets the brand up to make more money going forward with less capital investment. Overall, our U.S. performance has improved, particularly with operating profit growth in the second quarter. We are encouraged that same-store sales are now positive at Taco Bell, pleased with the continued success of Pizza Hut and confident in the long term strategy at KFC.

So let me wrap this up. Quite simply, we have had a great first half of the year with strong operating profit growth. We are pleased with the profit growth in each of our business units, specifically our strong performance in China. We are confident in delivering our raised target of 12% EPS growth.

Now let me hand it over to our Chief Financial Officer, Rick Carucci.

Richard Carucci

Thank you, David and good morning, everyone. In this section of our call, I am going to comment on three areas. Our second quarter results, our outlook for the second half of 2010 and Yum!’s unique position in emerging markets. As we outlined on the last call, our second quarter results were similar to the first quarter. Worldwide system sales grew by 4% and operating profit increased 21% prior to foreign currency translation benefits and special items. EPS before special items grew by 17%. We have now produced two solid quarters, thanks to impressive performance from our China business and the benefit of $37 million of global commodity deflation. Based on this first half performance, we raised our full-year EPS growth target and are well on our way to delivering 12% growth.

Yum! had solid profit balance in the quarter. Despite having only 1% same-store sales growth at YRI and flat same-store sales in the U.S., we were able to generate profit growth in these segments. When you add it all up, China grew operating profits by 33%, YRI by 7% before forex and the U.S. by 10%. U.S. margins benefited from improved margin performance at KFC, re-franchising other cost favorability and modest commodity deflation.

Overall, we continue to employ tight cost management. For the second quarter, our G&A declined by $2 million in the U.S. and by $6 million at Yum! corporate. On the flipside, our EPS was negatively impacted by overlapping last year’s very low tax rate in the quarter. Our reported EPS declined by 6% due to the lap of the significant one-time gain in the second quarter of 2009.

We noted in our release last night that we had a $60 million non-cash gain in 2009 related to increasing our ownership in the KFC Shanghai joint venture. Overall, with the strength of our global portfolio, we achieved really solid operating performance in a fairly tough climate. As we look ahead to the balance of 2010, we believe we will need to rely more and more on improving sales to drive profit growth.

Let us try to put the balance of the year in perspective by business segment. First in China, during the first half of the year, we benefited from an improvement in the Chinese consumer where consumer confidence has now been positive year-over-year in the last six months. At the same time, we saw a substantial benefit of about $30 million from commodity deflation in the first half of the year.

We do not expect this highly favorable cost environment to continue. We now expect very high labor inflation in the second half of the year. In addition, instead of the benefits of deflation, we expect significant commodity inflation in the fourth quarter. Therefore, we continue to expect restaurant margins to increase only modestly for the full year. That means while we expect very strong first full year margins, we will give back some of the first half gains during the balance of the year.

We also now expect that there will be some favorability from currency in the balance of 2010 as a result of the Chinese government’s decision to loosen the peg of the Yuan to the U.S. dollar. This year our development is back end loaded, but we feel good about delivering on our 2010 development goal of about 475 units. We expect China to continue to be a high growth and high return market. We continue to like our position in this highly important market of the 21st century.

While our first half operating profit at YRI was 4% excluding foreign currency translation, we are excited about the opportunities in the second half of the year. Markets around the world continue to launch street-wise our KFC branded value menu which we expect will benefit transactions in the balance of the year. We also have plans to continue to launch of our Krushers beverage line. We will continue to test and build others sales layers as David mentioned.

Please remember that our same-store sales comparisons will get easier as the third and fourth quarter of last year’s were flat and down 2% respectively. On a reported basis, we expect the benefits of foreign currency to reverse as we anticipate headwinds from currency translations in the fourth quarter.

In U.S. we are still facing sustained unemployment and a concerned U.S. consumer. Again, the good news is we are lapping minus 6% same-stores sales in the third quarter and even weaker minus 8% in the fourth quarter. We believe that our focus on value across all brands will drive modest same-store sales growth in the second half of the year.

As I mentioned earlier, our margins benefited from commodity deflation and other costs variabilities in the first half, while we do not expect some of this upside to continue, we will remain focused on cost management and help deliver profit growth in the second half.

Our U.S. re-franchising initiative remains on track. We have made significant progress against re-franchising in the past couple of years. Importantly, we have marketed substantially all remaining stores to be re-franchised at KFC and Pizza Hut and we are actively pursuing this pipeline. We are not in a hurry, but we do remained focus on getting these stores in the hands of the best operators. While it is difficult to forecast the timing of re-franchising with precision, we still expect to complete re-franchising during 2011. Overall, we are very confident that Yum! is well positioned to achieve our revised target of 12% earnings per share growth.

On our last call, I shared with you our unique strength in emerging markets. We outlined that we are currently the largest and fastest growing restaurant player in this arena. Today, I would like to give you more insight into the profit significance of this opportunity for Yum!. I will also briefly highlight a few emerging markets.

To use a common reference point, we are following the World Bank’s guidelines in defining emerging markets, which generally includes countries whose gross national income per capita is less than $12,000. This group includes countries like China, Indonesia, Malaysia, India, Russia, Vietnam and Brazil. Our growing presence in emerging markets is adding to our bottom line. Back in 2006, about 30% of our overall operating profit came from emerging markets, but in three short years, it had grown to about 45% of our profit mix. By 2015, we expect about 60% of Yum!’s operating profits to be generated by emerging markets. This equates to 15% compounded annual growth for these markets.

People often ask me, what is our next China? I don’t know if we have another China out there, but in partnership with our franchisees, we are investing in a host of emerging markets that we expect to drive growth for many years to come.

The two leaders in emerging markets are Yum! and McDonald’s. Yum! is in about 70 emerging market countries, while McDonald’s is in about 60. Obviously, we love to invest in countries that have large populations and strong GDP growth.

Dave is going to highlight a few of these markets, Vietnam, Bangladesh and Nigeria. Interestingly, these are three countries where even McDonald’s doesn’t have a presence today.

Vietnam is the second fastest growing Asian economy behind only China. The country’s 86 million people are young with 60% of the population under the age of 27. We opened our first KFC at the end of 1997 and we are now the most trusted QSR brand in the country with almost 80 KFCs. Pizza Hut has about 10 stores. We expect this country to have about 150 stores by 2015.

Bangladesh is another country with a young population that we have recently begun to develop. About 60% of the almost 160 million people are under the age of 25. Right now, we have 11 restaurants with no other western restaurant brands in site. We would have 50 restaurants by 2015 in this country.

In Nigeria, the largest country in Africa with over 150 million people, our franchisee just opened the first two KFCs this year. We are excited about Nigeria and really the rest of the African continent is home to over one billion people.

These three franchised markets are examples of the huge opportunity ahead of Yum!. Together, Vietnam, Bangladesh and Nigeria, are the home of almost 400 million people. We are the market leaders and we have only 100 restaurants. This represents less than 0.3 restaurants per million people compared to the international average of three or the U.S. level of 60 restaurants per million people. So clearly, we have a huge runway for growth.

In the coming calls, investor meetings, we plan to provide more and more information around our position in emerging markets and the tremendous growth opportunity that these markets represent.

So in summary, we are very comfortable with where we stand financially. We have two quarters under our belt and very significant operating profit growth. We are confident that we will again deliver our target of at least 10% EPS growth and we are pleased that we raised our 2010 guidance to 12% growth.

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

David Novak

All right, Rick, thank you very much and we look forward to taking your questions.

Tim Jerzyk

Hey, we are ready to take questions, Jasper.

Question-and-Answer Session

Operator

At this time if you would like to ask a question, please press star then the number one on your telephone keypad. And your first question comes from the line of Jeff Omohundro.

Jeff Omohundro

Thanks. Just two. First on the 12% revised growth target. What sort of FX outlook is embedded in that overall broken down by China in YRI? And then my second question is on Pizza Hut and the positioning regarding value, how do you see transitioning from the $10-a-pizza promo or do you think more of a longer-term repositioning towards greater deliver value to consumers, thanks?

Rick Carucci

Thanks for the questions, Jeff. I will go first, this is Rick on the forex question. In our balance of year forecast, we are assuming some upside in China from forex in about the $10 million range. We expect about $5 million negative in YRI for the balance of the year. So when you add that up, we figure about $5 million positive in the balance of the year. I will let David handle the pizza value question.

David Novak

Well, Jeff, as you know, we have had a dramatic turnaround in transactions and same-store sales growth since we launched the $10 anyway you want it, large pizzas. Same-store sales growths were up 8% in the second quarter. So, it has been a great success for us because what we have basically done by doing this is we addressed the single biggest problem that we have had and frankly in our history we have always been perceived to be the most expensive pizza.

So now we have made our products, our pizzas very affordable and the consumer response has been overwhelmingly positive as you would expect. The good news for us is our comparable margins have held steady as we had the sales lift and we have had good strong flow through to offset this kind of discounting, and our brand metrics are obviously improving, certainly on the value side.

So as we go forward, we think when we look at the overall category, we think everyday value is a fact of life and that we are going to have to work very hard to make sure that we make everyday value a staple of Pizza Hut, and we will have some premium priced pizzas, primarily, those pizzas that we provide category breakthrough innovation around, but we are really working hard at attacking our cost structure and working with our franchisees to make sure that we continue a very strong everyday value proposition as we go forward.

So I think you will continue to see great value coming from Pizza Hut, which is a terrific opportunity for us. One thing we have learned is being premium priced in this kind of environment that we are in right now is certainly not the strategy anyone can pursue and we think that we understand what we have to do in the Pizza category and Scott Bergren and the Pizza Hut team are working hand-in-hand with our franchisees to come up with an enduring way to provide value.

Jeff Omohundro

Thank you.

Tim Jerzyk

Thanks, Jeff. Next question, please, Jasper.

Operator

Your next question comes from the line of David Palmer.

David Palmer – UBS

Congrats on the first half. Yum! delivered, I think, it was 20% profit growth for the first half of the year and China drove 70% of that growth and in the meanwhile the U.S. was flat. Thinking about the second half and as we think about and try to model the second half, it does seem ridiculous I guess to expect 20% profit growth all the time. However, your guidance implies something closer to 10% profit growth in the second half. Could you help us think about why the profit growth would slow so significantly or why it might flow significantly? And I have a quick follow-up.

Richard Carucci

Let me explain some of the dynamics, David, in the second half of the year. First was a follow-up to the question that Jeff raised. We talked about forex. Forex in the first half of the year, we had about $28 million upside and we just said in the second half of the year that will slow to about $5 million net upside. The cost dynamics in China are interesting when you look at it on a first half, second half of the year basis and that’s probably the biggest shift that we will see is in the first half of the year we had about $30 million of commodity deflation. In the second half we expect about $15 million of inflation, most of that in the fourth quarter.

The second turnaround is labor. We expected labor inflation coming into the year. However, the labor inflation, some of the rates that have occurred were higher than our initial expectations and so in the first half of the year we had about $12 million year-over-year increase in labor. In the back half we expect that to be about $32 million. So, that’s an extra $20 million of labor in the second half versus the first half. So if you add that up, it is a $45 million swing on commodities, $20 million swing on labor. And so that is what sort of driving less profit growth in China in the second half than the first half.

The last thing, which is just a hard thing to know, and as I said in my speech will more rely on sales in the second half of the year and this is just obviously an environment where sales are still fairly hard to come by. So, that is sort of our expectations when we look at the balance of the year.

David Palmer – UBS

I guess the follow-up would be on the pricing power in China and how that would have a sort of lags and leads impact to your business. You mentioned food and labor inflation in China, but for instance, if labor costs go up 8%, you should be able to offset that with one point of price given that labor is a relatively low percent of your sales. Meanwhile, that labor inflation theoretically is your consumers making more money. So you just had some pricing roll off in the second quarter here in China. I am thinking about your pricing how that will come into play. Maybe you are thinking pricing might come back late in the year not enough to help you but sets you up well for calendar 2011. How should we think about that?

Richard Carucci

That is exactly the way we are thinking about it, David. Obviously, we know that we need to cover these inflation increases at some point with pricing. We still expect this to back up. We expect for the full year to have very healthy margins in China, growth on last year, which were also very healthy margin.

So, overall, we like where we stand. Regarding the ebbs and flows to your point, we had an unbelievable position in the second quarter, where we had sort of relatively low labor costs, negative commodities and obviously solid same-store sales growth. In the later part of this year, we are having the inflation we talked about.

Clearly though, we believe we have the pricing ability in China. We have arguably the strongest consumer brand in China. We have to take in pricing before and if everybody has got labor inflation, I expect it would be pricing throughout the market, right? So I think the timing of that, to your point, is likely to be sort of late this year that won’t benefit this year but should cover us in 2011.

David Palmer – UBS

Thanks, thanks very much.

Tim Jerzyk

Thanks, David. Next question please, Jasper.

Operator

Your next question comes from the line of John Glass.

John Glass

Hi, thanks very much. Could you talk a little bit about sales trends during the quarter? I think coming out of the first quarter, there was some excitement about the 4% comp, because it was against a relatively difficult comparison relative to the rest of this year. This quarter, if you just use that two-year math, it wasn’t quite as robust and maybe two-year comparisons just don’t work anymore. So how do you think about ex-pricing the back half of the year in same-store sales in China? Have there been any material acceleration/deceleration patterns or is the 4% just a good number to plug in as we think about the back half of the year and if you want to talk about the last six weeks since the quarter ended in China that would always be helpful as well?

Richard Carucci

We don’t really have anything to say about trends within the quarter or since the quarter. Short answer to your question, 5%-4% is good as anything out there, but that is your judgment to make. It is really hard. We have looked at this in a bunch of different ways internally, John, in terms of last year, two-year. In this case, you almost have to go back three years, because if you remember, the earthquake hit in the middle of 2008. So you had very strong growth in the first half of that year.

So what we said at the end of the first quarter was, I actually feel better now than I did at the end of the first quarter. First quarter we had the same number, 4% growth. At that point, we actually said that is probably a good number to use as any in the second quarter. But the first quarter was really just based on two months, because the way our calendar is set up in China and some of that was a holiday period. So it is hard to get a read on it. At this point, we have three more months of information. We have three more months where the consumer confidence in China is higher than a year ago and it is not off the charts yet, but it is slowly coming back. So I think that the Chinese consumer is improving sort of slowly but steadily, isn’t all the way back yet, but better than last year.

John Glass

So your profit forecast would assume a 4% comp in China in the back half of the year?

Richard Carucci

I am not going to be that precise in that neighborhood.

John Glass

Okay, and then on the U.S. margins, how much of the improvement at KFC and may be just overall the U.S. margins, was temporary or held by something you did, cutting labor, reducing labor, whatever? How much of this is sustainable? And also the profits improvement we are seeing at KFC, is that something we ought to read through to the back half of the year?

David Novak

Yes. There are obviously a lot of moving factors when you look at margins. Just sort of two pieces that I think are harder to duplicate. One we talked about which were commodities. We have had modest commodity deflation in the first half of the year. It was $5 million in the first quarter, a little less than that in the second quarter, and we also benefit in the second quarter by a small reduction in discounting when you add it all across the businesses. That I don’t know, whether that will repeat as well. But on the flip side, we have done, we have gone hard after cost improvements and I think some of those will continue in the back half. When we put it all together, we are assuming slightly positive margin improvement for the full year in the U.S.

John Glass

Thank you.

Tim Jerzyk

Thanks, John. Next question, please, Jasper.

Operator

Your next question comes from the line of Joe Buckley.

Tim Jerzyk

Hey, Joe.

Joe Buckley

Thank you. Good morning. A couple more questions on China, talking about wage inflation, not your specific wage inflation, but wage inflation across the country and does the China team expects that to reach the better sales?

Richard Carucci

Yes. Again, just to review for people, we did expect labor inflation in the back half. It always happens with the consistent labor inflation. The piece that we were surprised at the level of is last year, labor inflation was maybe a little less than typical and we had thought this year it would be back to normal. What really happened is that this year sort of they made up for last year being a light year, right? So you had higher than normal labor inflation. You would think that that is going to help consumers, hard to tell the timing of that.

So on the one way, obviously, if more people have money in their pockets, they are going to spend some of that, but it is really hard for us to quantify, but obviously, the growing middle class in China is a benefit to us from a sales perspective, but also from a development perspective as more trades come in. So it is not necessarily a bad overall development, it is just sort of impacts our profit from quarter-to-quarter.

Joe Buckley

Okay, and then are you positioning the brands in any way to take advantage of what presumably will be higher income levels for your consumers?

Richard Carucci

Well, I will let David talk a little bit about that, but I think we are already well positioned to that. KFC has always had a very strong image in China. So I think we have always positioned ourselves even though, a quick service restaurant is somewhat aspirational, Pizza Hut even more so. So as the consumers have more money, I think, we are actually positioned pretty well.

David Novak

I think people are going to have more money to spend throughout the day and I think what we are doing now is with breakfast, with 24-hour service, with the home delivery basically, we are positioning ourselves to make our brand, which is clearly one of the strongest consumer brand, it is now the strongest consumer brand in China available to customers anytime they want.

So I think the team is doing a great job of positioning ourselves to take advantage of what is going to inevitably be growing buying power. I know you have followed us for a long time. The number of middle class consumers, the estimates just keep going up by the millions every year and we don’t see that getting any smaller and then the average per capita income is getting higher and higher of that group. So this is all good news for us.

We are very well positioned at KFC. Also Pizza Hut Casual Dining, remember now we have 464 casual dining units and we are doing the same thing. We have made our products more affordable. We are leveraging assets with tea time. We actually, during the tea time period, have a higher market share of beverage consumption than Starbucks would have in China.

So I think all of the things that we are doing are positioning us to take advantage of the growing buying power in this country and separately, one of the big markets, there is no question that there isn’t anybody that doesn’t think the Pizza Hut Home Delivery isn’t going to be a viable brand or category in China and we are there.

We also see the Chinese fast food category emerging and we continue to make progress for East Dawning. So our strategy is to have the leading brands in every significant category. What we are trying to do is build every one of our brands into power brand, so we can compete effectively and as the buying power of the consumer increases, which it will inevitably do, we will be able to take advantage of it.

One thing is kind of interesting, I think you guys were all in the call in the fourth quarter of last year, even the second quarter call last year, there was a big concern as to whether we would ever be able to grow our same-store sales again. So, we are pretty pleased with the fact that we have actually grown our same-store sales this year 4%.

We are feeling very good that we have had two straight quarters of 15% system sales growth and all of that, Joe, has been transaction driven with no pricing, even though we obviously have with our brand pricing power and as you know, our profits target for China is 15%, our profits year-to-date are up 35%. So, we are pretty happy that we are ahead of schedule and we are really happy that each one of our brand are stronger today than they were yesterday from a consumer perspective.

So, I think when you step back and look at where we are at with China, it is pretty difficult to imagine a better scenario. We couldn’t be happier and we just keep growing talent like you can’t believe there and that is one of those intangibles that you can’t see, but our talent level is better. Our operations continue to be best-in-class. We are leveraging the asset throughout the day.

We are in 1000 stores in home delivery, 1000 stores in 24-hour service. We are just getting started. We expect to have at least 14000 KFCs someday. So, it is just a matter of time. I always say we will have ebbs and flows in China as well, ups and downs and all that kind of good stuff, but we are really glad we are there. We are really glad we are there with the team we have. We are really glad that we have the brands that we have and this is a long-term proposition and it is really great to get the short-term growth along the way.

Joe Buckley

Can I just ask one more on YRI, the confidence that second half would be better? Can you talk a little bit about the Pizza Hut versus KFC performance at YRI and why the confidence in the second half?

David Novak

Well again, we mentioned YRI has been a pretty steady performer over the year. We are going to continue to have the development growth that we always have. You saw that the second quarter results were little bit better than the first quarter. We start lapping easier numbers as we get into the back half of the year. So, we are lapping negative same-store sales in the back half of 2009 as well. So we feel good about our ability to do that.

On your pizza question, Pizza Hut has been several points behind KFC on a year-to-date basis, which isn’t surprising given the environment. It is more casual dining and therefore premium price. So, that difference is there. I am not sure if that would change much in the balance of the year. We have also struggled with Pizza Hut results in the U.K. year-to-date and that were some of the reason for the margin decline that you saw in the second quarter. We are working to make that better and hopefully that will be better in the second half of the year. So, we expect margins to get a little bit better in the second half as well.

Joe Buckley

Thank you.

Tim Jerzyk

Thanks, Joe. Next question, please, Jasper.

Operator

Your next question comes from the line of Rachael Rothman.

Jake Bartlett

This is Jake Bartlett in for Rachael. I had a question about the franchising and essentially you affirmed your 500 store target in the U.S. I think you have about 71 done to-date. Can you just talk about the process, where you are in the process, maybe what obstacles you are seeing, whether it is financing on the part of the franchises; also maybe give us an idea of where you think they are going to fall mostly in the 4Q versus 3Q and just kind of your level of confidence in hitting that target, thanks?

David Novak

Again, we have made quite a bit of progress over the years on this and I think we have re-franchised about 1,300 restaurants since we put this in place. However, one of the things we did is we waited really until the first quarter of this year, the end of the first quarter, before we really marketed all of the KFC. So the good news at least from the re-franchising teams respected this. Pretty much everything that we plan to re-franchise is now in the market.

So, as I said in my speech, we are really actively pursuing that, so we have got a lot of discussions on various size transactions. So it is really hard to predict when they will fall. So it is really hard. Even an annual estimate on this is tough, which is why I said it in both our release and the speech that we plan to finish sometime in 2011, but I do feel still confident in that target and I can’t just really discuss specific areas, but I do expect that you will see clearly more numbers in the second half of the year than in the first half.

Jake Bartlett

Okay, but the 500 store target is more in 2011 than 2010?

David Novak

Well, 500 was our estimate for 2010. We really didn’t comment further on that target today, because as I said before, it is really hard to predict the timing. I doubt it will be exactly 500, because they are lumpy some of these transactions that we are working on. What we said is, we originally wanted to finish at the end of the 2010, what we said now is we will finish sometime during 2011.

Jake Bartlett

And just a quick follow-up. On the proceeds per unit, looks like they spiked churn, was there anything abnormal in this quarter and the ones you did in 2Q?

David Novak

In the second quarter we happened to have a few Taco Bells. Most of our re-franchising is Pizza Hut and KFC, but we had some re-franchising of Taco Bells. They are sort of the typical level that we have been doing each year but they fell in the second quarter and those command a higher price.

Jake Bartlett

Thank you.

Tim Jerzyk

Thanks. Next question, please, Jasper.

Operator

Your next question comes from the line of Jeffrey Bernstein.

Jeffrey Bernstein

Great. Thank you. A couple of questions on the U.S. business. One, just in terms of, you mentioned obviously greater focus on value continues. Just wondering whether you can give us an update both at Taco Bell and Pizza Hut in terms of whether it be the $2 meal or the $10 promotion, in terms of what type of mix you are getting off of that? I mean is it more just advertising that is bringing people in but not necessarily as many orders as you would expect. I am wondering you can size up the mix, perhaps the average check, the profit contribution, whatever metrics on each of those two promotions that seem to be working for you and then I had a follow-up question.

Richard Carucci

Well, David really talked about the strategy on value. Pizza Hut, most of our sales are in the $10 pizza, so it is a predominant part of our business. On the $2 menu, that has been in about 5% of our mix so far. Obviously, one of the things we are keeping our eye on, Jeffery, is where that mix comes from and where that changes over time. So far it is pretty similar to the test. Some of it is come from the ‘Why Pay More’ menu, a fair chunk of it has come from there, but we will keep an eye on that as we go forward and that has helped drive transactions up at Taco Bell.

Jeffrey Bernstein

Then in terms of on the margin side in the U.S. it looks like you mentioned kind of commodity changes most of the year, but would you see some pretty large swings in both labor and occupancy in terms of driving a large pressure on the margin in the first half to meaningful expansion of margin, actually the first quarter versus meaningful expansion in the second quarter? Just wondering whether those types of swings in labor and occupancy are sustainable? It seems like the comps are relatively similar first and second quarter, but there was pretty drastic swing on the margin side, I was just wondering about those labor and occupancy components?

Richard Carucci

Yes. We have benefited from re-franchising, as we have done re-franchising. That has helped the margins. That should be sustainable. And then we probably got a little higher swing than normal in some of our insurance costs. That is sustainable, but the headwind in the second quarter was higher than normal. The benefit in the second quarter was higher than normal.

David Novak

Jeff, that benefits both labor and occupancy as you have got workers comp, insurance in labor and then you got casualty and all the other general insurance in the other occupancy line.

Jeffrey Bernstein

Is there a way to size up of the 150, well, maybe it was even more than that in terms of swing versus the first quarter, but just how much insurance relates to that?

David Novak

No, I mean basically, we generally, on the comment in the release we put it in order of magnitude. So that is generally our direction of that kind of thing.

Jeffrey Bernstein

Just lastly, in terms of the cash usage, it looks like obviously the shift to share repurchase was on in the second quarter with a $115 million and debt pay down remains fairly modest. I am just wondering any update both in terms of the balance of either holding cash versus how you think about repurchase versus for the dividend boost to debt pay down, whether there is any kind of swing in that or we should assume continued share repurchase like we saw in this quarter?

Richard Carucci

Well, I think first of all, the cash went up a little bit really just because of the timing of repatriating some money, driven largely by China, that you will see swing from quarter-to-quarter on that piece of it. So don’t read too much into that. The repurchase side, there were probably no change versus what we said previously, we are going to repurchase stock. The debt piece of it, we have a large pay out, but that was really in 2011. That was a $600 million payout. We don’t believe we will touch any of that and we will have the opportunity to profitably pay that off in 2010. So I don’t expect anything significant on that front.

Jeffrey Bernstein

Great, thank you.

Tim Jerzyk

Thanks, Jeff. Next question, please, Jasper.

Operator

Your next question comes from the line of Jonathan Komp.

Jonathan Komp

Hi, thanks. It is Jonathan Komp calling in for David. Just a quick follow-up question on trends in YRI. Specifically, I am wondering if you can give a little bit more color on why you didn’t see an even bigger sequential improvement during the second quarter given that comparisons were much easier and you also did benefit from the Chinese New Year shift? Then secondly, as a follow-up to that, if there is anything unique about the comparisons in YRI during the back half that really give you confidence that trends will improve?

David Novak

We have pretty much covered most of the points so far, but let me sort of just put them together. One is, we have sort of said before, we are lapping easier numbers in the second half of the year. So we did have some improvement. Even if you factor out the Chinese New Year, we had some improvement from the second quarter to the first quarter. It has been sticky though for us in some of our developed markets.

So we have seen, if you look at our splits, you see in the franchise business is doing well in a lot of those emerging markets we talked about. We haven’t performed as well in some of our developed countries. So we have been a little slow in Australia, which you saw in the release as well as Pizza Hut U.K. I don’t see necessarily those changing a lot, but should get a little bit better again as we get into the easier comparisons.

Tim Jerzyk

Thanks for the question. Jasper, next question, please.

Operator

Your next question comes from the line of Larry Miller.

Larry Miller

Thanks. Most of my questions have been asked, but I did want to follow up on that re-franchising question. Have you guys talked about at what ownership level you would be at, at the end in 2011 for the KFC and Pizza Hut business? Then I have one other question about returns in China.

David Novak

What we have said is overall for the U.S. about 10% and that we would approach close to 5% at KFC and Pizza Hut.

Larry Miller

Then could you just give us a sense, because I think you reaccelerated growth in Pizza Hut in China, it is about a year ago and now you have had a pretty good sense of gauging returns, you said clearly things are better. Can you give us a sense of how those returns are stacking up just in absolute terms and then relative to the KFC? Then not a lot of mention of East Dawning, I know it is something you have been working on for quite a long period of time. How far off are you, you think, from figuring out the unit economics at that division?

David Novak

Just, Larry, to make sure I understand the question, you are talking about new unit returns for Pizza Hut?

Larry Miller

Casual dining in China?

Richard Carucci

Just to backup what Larry is referring to for the rest of the folks is that we said that we last year slowed down development of Pizza Hut and what was driving that is we were seeing two instances such where we weren’t getting the types of returns that we looked to get. One was, what we called, infill returns in Tier 1 cities, so not a new trade area, but sort of trying to put when closer to an existing unit.

And then the second was in some Tier 3 cities, the second units that we are putting in Tier 3 cities weren’t performing as well. The good news is that, we are still being pretty cautious on some of the Tier 1 cities. The Tier 3 are actually the results we have had are looking better. So, we feel more confident in going into more and more Tier 3 cities and we slowly started to ramp back up the development in Tier 1. The returns on Pizza Hut are not significantly different than the KFC type of return, so we are talking cash pay backs in less than three years.

Larry Miller

Then East Dawning, where you guys stand in terms of the unit economics?

Richard Carucci

I will talk a little bit about the economics. I will let David talk about the concept. We are very hopeful about East Dawning because it is a big idea. The consumer side keeps getting better each year. The cooking platform, we get more and more confidence. Having said that, we are a long way away from having unit economics that will allow us to expand rapidly, so don’t expect large increases in the near future.

David Novak

At the same time, I think we feel good about the progress that we have made. We have gone through a Central Kitchen, which is helping our unit economics. We have improved our everyday value proposition. We have got a beverage platform that we feel really good about, that will help us leverage the asset even more throughout the day. We continue to be confident that we will have a concept. We don’t want to get the cart ahead of the horse here and we have got enough great things to really tell very definitively when we talk about KFC and Pizza Hut.

Larry Miller

Thanks very much. Appreciate that.

Tim Jerzyk

Thanks, Larry. Next question, please, Jasper.

Operator

Your next question comes from the line of John Ivankoe.

John Ivankoe

Hi, thank you. A question on KFC and I am just going to ask you to step back a little bit and talk about kind of the success of Grilled Chicken, now that it has been in the system for a little bit over a year and what you would have done differently for that product, to more sustained sales and if there are any lessons that you have learned there across all off your U.S. brands. I am going to ask that in the context of the financial health of your franchisees and their willingness to participate in other initiatives that may actually cost the money upfront, whether it would be operational or other physical asset investment just to keep that brand healthy so it can participate on the upswing in the next cycle.

David Novak

Right. Well, I think Kentucky Grilled Chicken, if you look at all the brand majors has done nothing but improve our position in the marketplaces. I mentioned to you earlier, the American Customer Satisfaction Index, we had a eight point swing, which is the highest of any major brand. So clearly the Kentucky Grilled Chicken has made KFC in the U.S. much more relevant than it would have otherwise have been.

I think as you look at the current performance, we have about 10% to 15% mix of Kentucky Grilled Chicken. I was just reading the KFC quarterly, which is the franchise magazine that the franchisees publish and they tab it as a success and feel good about it and we have got a base that we can build from.

So, I think that we are very pleased that we launched it. I think some challenges that we have is we are working on better consistency just in P side and we have got a project that help us work on that with our suppliers. I think that is one thing that we think will help us get even more sustainability over the long-term just from a product perspective.

This product, John, as you know and I am sure you have read has had rave reviews from food critics. I mean, it is an outstanding product. There is no question about it. It is five-star taste and it has been named product of the year. People have recognized our people who developed the product. So, I think it was a huge win.

When I look at KFC’s prospects here in the U.S., I think we are working on the things that will really matter. Improving our chicken on the bone with a better balance between the fried and the grilled, introducing portable products, we now have outstanding filet, grilled filet and fried filet that is allowing us to do products like the Double Down and also move into the sandwich arena. So that has been a big move forward for the brand.

One of our big challenges is that our pricing approaches casual dining pricing, because we are a high-end business. And when you have pricing that gets into that casual dining arena or close to it, there aren’t too many concepts that are growing robustly today. So our value proposition is a major challenge for us as we go forward. I think as it relates to investment that is one of the challenges that I think we do have with the KFC system. It is tough time right now. Future investments, we need to get the business healthier, but we have an operating platform, an equipment package that gives us more variety than we have ever had from an opportunity, from an innovation perspective.

If you recall, KFC in the U.S. is the only place in the world where we have invested in back-of-the house capability for the franchisees, because we felt it was so important for us to get into grilled chicken. We helped fund and finance the ovens. I think this shows how committed we are to growing the business here in the U.S., because this is the origin of the brand. So I think the team here we have is outstanding and working hard in a difficult situation and we think we will have slow but steady progress as we go forward.

The great news is that KFC outside the United States is something for the U.S. franchise system to aspire towards being. We have got a team here very dedicated to making that happen and we are going to be relentless in terms of making that happen, because we think we can be much more proud of the KFC brand here in the U.S. Even though we are very proud of it, very proud of the origin, we think we can be even better and our job is to push the franchise system into doing the things that need to be done; improving ops, improving assets, improving our value proposition.

John Ivankoe

I know there is a lot of concern and it showed up in your P&L in the fourth quarter of 2009 in franchise expense. I mean, do you think that the overall financial health of the KFC franchise system in the U.S. is stable or I mean are you concerned that there might be significant store closures in the future if things don’t improve from a comp perspective?

Richard Carucci

In terms of the franchise stability, obviously we have gone through a couple of linear on sales and so we are always taking a closer look on that. Things have actually improved over the last few quarters, so we are in better shape from a franchise health perspective in terms of that piece of it. So I would say that we are stable. In terms of closures overtime, to David’s point, we are going to have to keep reinvesting in assets. To the extent that people are unable to do that that could lead to closures. At the time we are not as focused on the store count in the U.S. the way we are in international.

David Novak

We want to have a quality system. If we can have 4,500 fantastic great looking KFCs, I would rather have 4,500 great looking KFCs than 5,000 with 500 looking and being drawn by asset. So we are totally prepared to do whatever it takes to get this system to look like a leader, be a leader and get where we need to go and it will take time. But make no mistake about it. We are totally committed to doing that and its upside for us. It is literally very difficult. About 3% of our total profits, my God, this is upside for us and that is what we are really going after, working with our good franchise partners to make that happen.

John Ivankoe

That is very helpful, thank you.

Tim Jerzyk

Thanks, John. Next question, please, Jasper.

Operator

Your next question comes from the line of Tom Forte with Telsey Advisory Group.

Tom Forte - Telsey Advisory Group

I got two questions. So the first was on the Taco Bell tested breakfast. I want to know if you feel any differently given that since you first launched the test, you have seen Subway come into the space with kind of a value message and the rollout of the Dollar Menu at McDonalds for breakfast. And then second just from my own curiosity, any comment on for Kentucky Fried Chicken, either margin impact or the mix from the Double Down?

David Novak

The Taco Bell breakfast program, we are continuing to be very optimistic. Tucson was our original test market. McDonalds threw everything in the kitchen sink at us in terms of price discounting and we are already a breakeven in Tucson. We are also in three other markets that we are working towards that same goal. I just met with the franchisees two weeks ago, meeting with Greg Creed. We all know that the single biggest thing we can do at Taco Bell is to develop another $100,000 to $300,000 sales layer, because we have got the best unit economics outside of McDonalds that I think are in the industry second most profitable brand.

So, in our mind, breakfast is not a question of whether. It is a question of when and we feel like we are making more and more progress and we know how we can get even better. The other thing that we are very excited about is we have a beverage platform at Taco Bell that we will be going into a complete market launching and right now when you just upgrade our assets with our new bold assets, you get a 7% to 8% increase in sales.

We are hoping that will take it to 15% to 16% increase which will help fund more reinvestment into Taco Bell. So the breakfast and beverage platforms we think are really very positive developments for us and the only thing I can say is we are further along now than we were when I talked to you about it last time.

We continue to make progress, where we are committed to these sales layers, because this is what is going to really invigorate the brand. We think we should have 8,000 Taco Bell in the U.S. I mean, why not? Burger King does and you can’t tell me that Burger King has a more charismatic brand, more loved brand than Taco Bell. Taco Bell is a brand that everybody talks about. So we have got a great franchise, but we need $100,000 to $300,000 more in sales. So these big platforms are what we are really committed to getting after.

The other thing even with our existing equipment, we can get into home meal replacement. So we are bundling up our home meal replacement ideas, Taco meals, Tuesday Tacos, things like that that we are working on that also give us a chance to give some may be lower hanging fruit easier to do with significant sales growth as we go forward. So I am very optimistic. I think you can tell about the Taco Bell brand. Right now, we have got transaction growth, slightly positive sales, but when I think of the future, it is really bright.

Richard Carucci

And Tom, regarding your other question, the mix Double Down is immaterial to our margins. KFC margin will be driven more like sales, commodities and things we have already talked about.

David Novak

It wasn’t talked about product. There is no doubt about that. It is one biggie, so if you haven’t had it, give it a try.

Tom Forte - Telsey Advisory Group

Thank you.

Tim Jerzyk

Thanks, Tom. Next question, please, Jasper.

Operator

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

Keith Siegner - Credit Suisse

Thanks. Just a question for Rick and I just wanted to follow-up on the margin trends in the U.S. by concept. For example like Pizza Hut, since the launch of ‘$10 any’ and some of these other things, are restaurant level margins, not op margins, but restaurant level margins, are they up year-on-year? Taco Bell was in the mid-18s last year. How is it trending? Is it up year-on-year? I mean it has to be some portion of those two in order to get to the totals, it can’t just KFC. So if you could help me a little bit understand the margins trends at Pizza Hut and Taco Bell that will be great?

Richard Carucci

The Pizza Hut margins are down slightly. Overall, the business proposition works with the $10 pizza because it is growing transactions. We are working very hard to work on the cost side to make that sustainable and affordable on a long-term basis. Nothing really major to report on the mix, something happening within the Taco Bell portfolio, so we are going to keep an eye on the sales and sales will probably be the biggest driver. The only thing that