Yum! Brands, Inc. (NYSE:YUM) Q3 2013 Earnings Conference Call Transcript

Yum! Brands, Inc. (NYSE:YUM)

Q3 2013 Earnings Conference Call Transcript

Event Held on October 9, 2013, 9:15 AM Eastern Time

 Section I: Management Presentation

 

Operator

Good morning. My name is Angela and I will be your conference operator today. At this time, I would like to welcome everyone to the Yum! Brands third quarter 2013 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) Thank you.

I would now like to turn the call over to Mr. Steve Schmitt, VP of Investor Relations. Sir, you may begin.

Steve Schmitt – VP, IR

Thanks, Angela. Good morning everyone and thank you for joining us. On our call today are David Novak, Chairman and CEO; Rick Carucci, President and Pat Grismer, our CFO. Following remarks from David and Pat, we will 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 on 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 www.yum.com to find disclosures and reconciliations of non-GAAP financial measures that may be used on today’s call. We’re broadcasting this conference call via our website. This call is also being recorded and will be available 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 you to be aware of a couple of upcoming Yum! investor events. First, our 2013 New York investor and analyst conference will be Wednesday, December 4 in Midtown Manhattan. Second, our 2013 fourth quarter earnings release will be Monday, February 3.

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

David Novak – Chairman and CEO

All right. Steve, thank you very much and good morning to everyone. There are three key messages I want you to take away from our call this morning. Number one, we are very disappointed with our overall third-quarter results and the fact we now believe China same-store sales will unlikely be positive for the fourth quarter. Frankly, these results were well below the high expectations we have for our business.

Number two, there were some bright spots in the quarter and we are pleased with Pizza Hut Casual Dining in China, overall China restaurant margin, international development momentum and Taco Bell. And number three, despite current challenges, we remain as confident as ever in our ability to deliver strong sustainable growth in the years to come.

For the third quarter, earnings per share, excluding special items, declined 15% versus prior year. This included a 10 point adverse impact from a higher tax rate, driven by an increase in our tax reserves. Additionally, based on KFC China sales for September, which is part of China division’s fourth quarter and a less than expected sales lift from the launch of our new beef burger, it’s now unlikely that China division’s same-store sales will be positive for Q4, although we do expect to show improvement. Obviously, we are falling short of our Q4 guidance of positive same-store sales growth. We are now estimating a high single to low-double-digit percentage decline in full year EPS, excluding special items.

We also recorded a significant non-cash special item charge in the third quarter for the write-down of Little Sheep intangibles. While we are deeply disappointed with our Little Sheep results so far, the team is taking steps to strengthen the concept and improve operations. And we remain confident that we will create a significant value over the long term through new unit development in China’s large and extremely popular hot pot restaurant category.

If you followed us over the years, you know that our target has always been consistent dynasty-like performance growing at least 10% year after year. And in fact, the business accomplishment we’re most proud of is that prior to this year we delivered double-digit EPS growth for 11 consecutive years. This places Yum! Brands among an elite group of companies to deliver this track record of performance.

Now we’ve certainly been humbled by this year’s performance. But I want you to know that we are confident and determined to reestablish our track record of sustainable growth in the years to come. I also want to assure you that we’re working very hard right now to recover from the one-two punch of China poultry supply incident in December and the unexpected bout of avian flu in the spring.

Let me share with you some of the actions we’re taking over the next few months to continue to rebuild consumer trust at KFC China and gain more sales and profit momentum as we enter 2014, which we expect will be a bounce-back year for Yum! Brands.

Our number one priority at KFC China is to build and reinforce positive consumer perceptions around the safety of our food. And while our key brand attributes have improved significantly from where they were in the first few months following the December incident, the fact is, is that they remain below 2012 levels. The KFC brand is showing its resilience and we are confident that a full recovery is in store but more time and effort are required.

So in November, our plans are to launch what we are calling our [I Commit] campaign. We expect this to be a powerful new quality assurance campaign featuring actual representatives of our over 300,000 KFC employees, suppliers and poultry farmers in China. Our quality assurance message will be delivered in an authentic manner and will be centered on the theme that KFC is safe for my family, friends and me and hence, safe for you.

We are also leveraging our massive network of employees and suppliers through social media. The goal is to leverage the fact that KFC brand is part of the of fabric of China and of course, all of this is on top of the Operation Thunder actions we initiated earlier this year to strengthen our poultry supply chain.

On the marketing calendar front, we’ll be following up the recent new product introduction of our beef burger with promotions featuring chicken on the bone, wings and beverages. At the same time, our China team will remain very focused on operating efficiency. We were really pleased to see a nearly 20% restaurant margin despite the decline in sales. I want to recognize the team for really buffing down at the store level. Pat will share more details on this in his remarks.

In short, I’m confident we’re doing the right things to rebuild consumer trust at KFC China and we expect to have momentum heading into 2014. The good news is we’ll begin overlapping very weak same-store sales in December and we’ll have this unfortunate benefit across most of next year. And we plan a number of major menu and value innovations to ignite the sales growth in 2014. Sam Su will share more details of our initiatives during our December meeting in New York.

Now the obvious question is why do you think sales momentum stalled in China? I’ve always said that no two crises are the same. And we always said that we would need to get to time and that it would take at least nine to 12 months. So far, it’s nine months and counting and not happening as fast as we had hoped.

Now, as I just mentioned trust scores are improving significantly, but still below 2012 levels. We believe this is because KFC’s leadership in size has grown exponentially over the years, and our customers’ expectations of the KFC brand have grown along with it. Social media has also exacerbated the issue and kept the dialogue alive. And macros haven’t helped.

While we’ve announced process improvements, communicated a trust message, and we’ve had value promotions, frankly, we haven’t had the kind of major innovation that could turn the tide. And like I said, we are working hard to get back on track, and we are confident that we will.

On the China development front, we continue to expect at least 700 new units in 2013. This means we will have opened around 1,600 new units in a two-year period, and we expect another strong year of development in 2014, all of which will provide substantial momentum for our China division as sales continue to recover at KFC.

Whether it was Sudan Red, avian flu, or SARS, we experienced temporary setbacks to sales and profits, but we stayed the course and kept building units, and I’m glad we did. KFC is a power brand in China today and will be for many, many years to come. In fact, even with our recent challenges at KFCs, we wouldn’t trade places with anyone else in China.

Today, we have nearly 4,500 KFC restaurants in over 900 cities in China. That’s more than twice the size of our nearest competitor in the QSR category. Additionally, we serve about 60 million customers at KFC every week or so, which is almost the entire population of the UK. That may be one reason why the BBC recently published a report naming KFC as the number one foreign brand in China. Any way you look at it, our KFC brand is deeply ingrained in the hearts, minds, and lives of the Chinese customer.

Additionally, China is undeniably the number one retail opportunity in the world. The country continues to experience the fastest pace of urbanization the world has ever seen, and the macro trend we remain most enthusiastic about is the growing consuming class, which is expected to increase from 300 million people today to over 600 million people by 2020.

So, with the number one brand in the restaurant category situated in what will soon be the largest consumer economy in the world, and supported by the people capabilities that are the envy of our industry, we believe KFC is undoubtedly in a very powerful position to bounce back strongly. Clearly, we still have work to do, but we know we’re doing the right things to regain consumer trust, and we remain confident that our best days for KFC in China are yet to come.

Moving to our second brand in China, Pizza Hut Casual Dining clearly has momentum, delivering solid same-store sales growth in the quarter, up 5% on top of 8% in the third quarter of last year. So far this year, we’ve grown same-store sales at Pizza Hut Casual Dining by 4% and unit growth of 29%. That’s pretty good performance by any standard.

Pizza Hut Casual Dining goes well beyond pizza and is unquestionably the leading western casual dining concept in China. Pizza Hut continues to lead with menu innovation and everyday affordable value. 20% of Pizza Hut’s menu is revamped twice a year, and we recently launched a major new product with Stone Pan Sizzling Steak that we know our customers love.

We’re also continuing to leverage our assets by expanding our breakfast menu into more and more cities. With this new sales layer, our long-term goal is to create and own the mid-scale 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’re very well-positioned to capture it.

In the third quarter, we opened 38 new Pizza Hut Casual Dining units and now have over 950 units in 242 cities, compared to the over 900 cities where KFC currently operates. Importantly, we have a strong economic model, leading to less than three-year cash paybacks on new units. With the terrific performance we’re seeing, we’re continuing to accelerate our new unit development and are aggressively expanding into lower-tier cities. We expect to have around 1,000 units by the end of the year, which would be up from about 500 units only three years ago. And we’re just getting started.

We’re also continuing to invest behind the development of our emerging brands. Pizza Hut Home Service, which is in the home delivery category, has 185 units in 22 cities. We have strong unit economics driven by best-in-class technology and everyday affordable value, and we’ll ultimately scale this brand across the country. We’re already a leader in ecommerce with over 60% of our Pizza Hut delivery sales now sourced through online channels. So with the strong foundation already in place, and with the enormous consumer demand for home meal replacement in China that will only grow, we expect our Pizza Hut Home Service business will contribute more meaningfully in the years ahead.

We also continue to make slow but steady progress with East Dawning, our Chinese fast food concept, but still have work to do before we have a scalable business model. And as I said before on Little Sheep, we’re committed to making this the number one casual dining restaurant chain in China and showing the true potential of the brand. We’ve had a clear setback, but our belief in what we can ultimately do with this brand remains intact.

So let me wrap up the China business. I’ve always said that our China business will have its ups and downs, and this year is clearly proving to be one of those downs. At the same time, I’ve also said there’s no market we’d rather lead in and invest in. Make no mistake, we love our overall position in China. We have complete confidence in a full recovery and long-term impressive growth at KFC. Pizza Hut Casual Dining is a growing powerhouse, and we have future growth engines with Pizza Hut Home Service and ultimately with Little Sheep and East Dawning.

Outside of China, we expect generally on-target performance for Yum! Brands this year, and we’re well-positioned to deliver against our ongoing operating profit targets in 2014 and beyond.

At Yum! Restaurants International, 2013 is basically on track. We have an outstanding business portfolio with nearly 15,000 restaurants in over 120 countries and territories. We have tremendous development opportunities in emerging markets, and over 90% of our restaurants at YRI are franchised. This combination creates a steady stream of franchise fees and strong growth.

Now as you probably know, Yum! is a clear restaurant leader in emerging markets, and we expect to build upon this position in the years to come. Importantly, the bulk of our emerging market business will continue to be led by franchisees. The reasons our franchisees continue to accelerate development and invest their own capital behind our iconic brands is pretty clear. Payback periods for franchisees in many of these emerging markets are around three years, and we’re attacking our cost structure across the board to improve our overall investment model so that the pace of development will increase over time.

On the subject of international development, I’m pleased to report that we remain on track to open at least 1,000 new units in YRI this year, which is above the 950 units we were expecting at the beginning of the year and represents a new record for the division. Additionally, our development pipeline for new units in 2014 is very robust.

In summary, our international franchise base of about 1,000 franchisees has proven to be a high growth and extremely reliable source, and we expect growth will accelerate over time as more and more of our development occurs in emerging markets which benefit from faster growing local economies and more favorable cost structures.

Additionally, we expect our relatively new equity base in select emerging markets, such as Russia, South Africa, and most recently Turkey, will begin to deliver more profit growth in the future. We initially invested ahead of the growth curve in these markets, but are now positioned to leverage our early investments to achieve higher growth and higher returns in the years to come.

In the United States, we’re having another solid year. With the completion of our refranchising program this year, and the second consecutive year of net new unit growth, we expect to continue consistent 5% profit growth in the years ahead.

Taco Bell, which represents about 60% of our U.S. profit, is set up for another solid year. In recognition of the extraordinary success of the Doritos Locos Tacos and Cantina Bell product platforms introduced in 2012, as well as leading the way with social media along with the launch of the much talked about LIVE MÁS advertising campaign earlier this year, Taco Bell was recently named by Advertising Age as Marketer of the Year for the entire consumer goods industry. The brand definitely has mojo, and congratulations to Greg Creed and the team.

Building on this brand strength, we now know we have a winning proposition with our breakfast platform. We have three destination products, great value, and an attractive investment proposition for our franchisees. And the good news is that based upon our extensive market test, 90% of the breakfast sales are incremental. And it looks like the breakfast advertising is also driving total brand sales.

I was in Orlando on Monday for the Taco Bell annual franchise convention, and I was pleased that the franchise leadership stood up on stage and enthusiastically endorsed the national breakfast launch. And it’s clear to me we have a unity of purpose across the entire franchise system to win.

The franchisees are also excited about the significant innovation we have planned for our core business. We know that for the U.S. to have a successful year, it’s important for our most profitable U.S. brand to do well, and we certainly have a lot going in our favor at Taco Bell.

We also expect 2014 to be a better year at Pizza Hut with the most significant news being our plan to nationally advertise WingStreet for the first time, which includes chicken strips and our award-winning wings. Virtually all the stores in our system are putting in the chicken operating platform so we can use network television next year to feature home delivery chicken products.

The industry-leading pizza innovation, consistent everyday value, and the chicken sales layer will be our focus throughout 2014. We’ve also changed advertising agencies to help us break through more aggressively in the category and leverage the power of our leading brand.

And finally, while the country macros and our recent results haven’t been as strong as we’d like, we’re continuing to invest in and develop a great business in India. We currently have 613 restaurants and we are full steam ahead with development as we expect to open up 150 new units this year. Although it’s still early days, we expect our India division will drive substantial growth for Yum! in the years ahead, and we are making the required investments to build a powerhouse there.

So, to sum things up, in spite of our short-term sales issue with KFC in China, the fundamentals of the Yum! growth model remain extremely compelling. As you know better than I, there are three keys to driving shareholder value in retail: New unit development, same-store sales growth, and high returns.

In terms of development, our new unit opportunity in emerging markets, including China, remains the best in the retail, and our opportunity to expand is huge. We have three iconic brands, and while we have 58 restaurants per million people in the United States today, we only have two restaurants per million in the emerging markets. That’s a long runway for growth and gives us tremendous confidence in our ability to continue our aggressive expansion for many years to come.

Furthermore, we have nearly 40,000 restaurants around the world that have all kinds of capacity to grow. This represents a huge opportunity for same-store sales growth. In addition to our ongoing efforts to drive sales through improved product innovation, marketing, and operations, we’re developing major new sales layers, broadening our menu variety, expanding our day-parts, and opening new channels with digital.

I’ve mentioned our breakfast rollouts at Pizza Hut Casual Dining in China and at Taco Bell, but we’re also doing this at KFC in many of our emerging markets. Pizza Hut WingStreet in the U.S. is another example of what we’re doing to leverage our home delivery capabilities and drive higher levels of asset utilization.

Meanwhile, our returns on invested capital have consistently been among the best in the retail industry. We love the virtually capital free franchise model, which will generate over $1.8 billion in franchise fees this year. 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 meaningful cash to our shareholders.

Speaking of shareholder cash payouts, I’m pleased to note that we recently increased our dividend by 10%, marking our ninth consecutive annual double-digit percentage increase. Since 2004, the year we instituted a dividend payment, we’ve returned over $11 billion to shareholders in the form of dividends and share repurchases, all while also continuing to invest in future growth. The mere fact that we’ve increased our dividend in a down year demonstrates the power of our operating cash flow and the confidence we have that our investment model will deliver strong shareholder returns for many years to come.

In summary, after over a decade of growth, 2013 is clearly proving to be a setback. However, we are confident we will restore our track record of double-digit EPS growth in 2014 and well into the future. We have an established track record. In fact, our compound annual growth rate in EPS is above 10% over the past 12 years, and that includes this year. I want to emphasize that we know these results are yesterday’s news, but we firmly believe that Yum! is a company on the ground floor of global growth, and recognize that it’s “show me” not “tell me” going forward.

Having said this, we have every belief and enormous intentionality that we’ll begin to get back on track in 2014. We expect to have a strong bounce-back year, driving EPS growth of at least 20%, which is admittedly now off a lower base than we had hoped for. And as always, if we can do better, we will.

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

Pat Grismer – CFO

Thank you, David. As David said, 2013 is a very challenging year for Yum! Brands, and our third quarter results were certainly below expectations. I’ll cover the details in a couple of minutes, but I first want to echo David’s view that we don’t consider these results indicative of Yum!’s ongoing performance or future growth potential. We’re confident that our global brands, competitive position, and investment opportunities remain compelling, and we’ll deliver double-digit EPS growth for many years to come.

One of the first things I want to do is to explain the timing of our revised guidance for fourth quarter same-store sales growth in China. We had very high expectations for the month of September with an exciting new product introduction at KFC, the beef burger, and with a much easier comparison from last year. The fact is that we expected a much better result and in hindsight, we were wrong.

When you step back and look at our business this year, there’s no doubt that the unprecedented decline in EPS before special items has been led by the temporary issues at KFC China, with the balance of our portfolio generally meeting full year plan.

Remember, Pizza Hut has continued to deliver outstanding results in China, and our other major divisions, Yum! Restaurants International in the U.S., are generally on track to achieve their full year ongoing growth targets, generating significant cash flow. Importantly, we’ve been able to sustain high rates of investment and have even been able to raise our dividend despite the challenges in China. It takes a company of considerable strength and confidence to do that.

Today I’ll provide some additional perspective on our third quarter results, our full year outlook, and Yum! shareholder cash payouts. I’ll then share some initial thoughts on 2014.

For the third quarter, we recorded a 15% decline in EPS, before special items, which is obviously disappointing. This decline was led by sales and profit declines in our China division, as well as a higher tax rate. Our third quarter tax rate increased from 25% to 33%, driven primarily by a tax reserve adjustment, which negatively impacted EPS growth by 10 percentage points in the quarter. This increase relates to the continuing dispute with the IRS regarding a valuation of intangible assets, which has been disclosed in our prior SEC filings. For the full year 2013, we now expect our global effective tax rate to be approximately 28%.

Reported EPS declined 67%, primarily due to a non-cash special item charge of $258 million to reflect the partial impairment of Little Sheep intangible assets. Partially offsetting this is the non-cash $74 million special item gain that we were required to recognize last year upon our acquisition of Little Sheep to write up our previously owned interest to fair value at the time.

As I mentioned on our second quarter earnings call, Little Sheep results were trending below our expectations, due in part to a longer than expected approval process and ownership transition. Our efforts to regain sales momentum were then thwarted by negative publicity surrounding quality issues linked to the hot pot category in China, even though Little Sheep was not involved. This has further delayed our expansion plans, which were a key component of our initial valuation. Although we remain confident in the long term prospects of the Little Sheep brand, we determined that it was appropriate to write down our investment in the quarter because of the sustained negative sales performance.

Now I’d like to dig a little deeper on each division’s third quarter results. In China, operating profit declined 14% in Q3, prior to foreign currency translation, driven by an 11% decline in same-store sales. This decline in same-store sales included a 14% decline at KFC and 5% growth at Pizza Hut Casual Dining. Overall, China division restaurant margin was above 20%, excluding the negative impact of Little Sheep, or 19.5%, including Little Sheep. And while restaurant margin declined 1.9 percentage points in the quarter, this is a remarkable achievement when you consider the extent of our same-store sales decline.

It’s clear that our China team has worked very hard to capture restaurant operating efficiencies, delivering sequential improvement in margin performance versus prior year in the last two quarters. As evidence of this, an important restaurant productivity measure that we track, number of transactions per labor hour, was very impressive for the third quarter. And importantly, the team has done this, without sacrificing customer service levels. We’re optimistic that these productivity improvements will sustain as sales continue to recover, and we’ll share more about this at our December meeting in New York.

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On the development front, we opened 132 new units in China during the quarter. For the first three quarters, which includes the first eight months of the year, we opened a total of 458 new units in China, or almost 60 units per month. This is in line with our expectations of at least 700 new units in China in 2013.

So to summarize our performance in China. KFC is coming back, although it’s taking longer than we had originally estimated. Pizza Hut Casual Dining is continuing to have an outstanding year. The team is doing a very good job of managing restaurant margin, and we’re continuing to invest for the future.

At Yum! Restaurants International, operating profit increased 1%, excluding foreign currency translation and the cost of our biannual franchise convention. Including the convention costs, operating profit declined 2% in the quarter. Year to date, operating profit increased 9%.

Importantly, YRI continued to accelerate its pace of development throughout the year, opening 215 new units in the quarter, including 139 units in high-growth emerging markets. YRI same-store sales grew 1% in the quarter. This was softer than we would have liked, as continued weak performance in Japan and our Pizza Hut UK business adversely impacted YRI’s same store sales growth by about 2 percentage points.

In emerging markets, even though broad economic growth continued to moderate, we generated same store sales growth of 4% in the quarter. It’s also important to note that YRI’s third quarter same store sales growth was adversely impacted by 1 percentage point due to the timing of Ramadan holidays. This impact will reverse in Q4, delivering a one-point benefit to YRI’s same store sales growth in the coming quarter.

YRI operating margin increased 0.6 percentage points for the quarter, driven by new unit development and same store sales growth and in spite of a 0.5 percentage point decline in company restaurant margin. This restaurant margin decrease included the benefit from refranchising our Pizza Hut UK dine-in business. Offsetting this benefit was weak margin performance at our KFC UK business, which is YRI’s second largest equity market. Restaurant margin was also negatively impacted by underperformance in Turkey.

Moving to the U.S., third quarter operating profit grew 1% versus prior year. Excluding the impact of refranchising, operating profit grew a very respectable 6%. Taco Bell once again led the way in the U.S., delivering same store sales growth of 2% in the quarter, successfully overlapping last year’s growth of 7% and marking the seventh consecutive quarter of positive same store sales growth at Taco Bell. As Taco Bell represents about 60% of the U.S. division’s operating profit, we’re especially pleased to see these sustained results.

For the U.S. division overall, operating margin increased 3.3 percentage points in the quarter, driven by refranchising. This was in spite of a 0.7 percentage point decline in company restaurant margin. U.S. company restaurant margin was 16% for the quarter, and 17% year to date, which we consider healthy.

Now I’m going to talk about our expectations for the full year. As you’d expect, our fourth quarter results remain heavily dependent on our sales recovery at KFC in China. Unfortunately, with disappointing results for the month of September, it’s now unlikely that China division same-store sales will be positive for the fourth quarter, although we do expect to show improvement over the third quarter.

It’s because of this lower than expected sales recovery at KFC China and a higher than expected tax rate that we’re revising our full year EPS forecast to a high single to low double-digit percentage decline versus prior year before special items.

We’ll continue to keep you informed of our progress by temporarily providing monthly updates on China same-store sales until sales have recovered. Our next update will be for the month of October, which we’ll report on November 12, after market hours.

Moving to YRI, we expect another solid year of system sales growth, driven by new unit development of at least 1,000 stores in 2013. This is an increase from the 950 units we were expecting at the beginning of the year and would represent another new record. This will also be the second consecutive year we’ve achieved 4% unit growth at YRI, giving us strong momentum going forward.

And in the U.S., we’re expecting solid profit growth, driven by continued same-store sales strength at Taco Bell and the second consecutive year of positive net unit growth, led by attractive investment models at both Pizza Hut and Taco Bell. So while our overall results for 2013 will be clouded by the temporary sales issues at our KFC business in China and higher than expected tax rate, the balance of our portfolio remains on track to deliver operating profit growth that is generally in line with our ongoing EPS growth model.

This brings me to my third topic — Yum! shareholder cash payout. I’m extremely pleased to note that we recently increased our dividend by 10%, marking the ninth consecutive year that we’ve increased our dividend payment at a double-digit percentage rate — one of only 10 companies in the S&P 500 to do so. With this rate of growth, we’ve nearly doubled our dividend in the past five years while continuing to return significant cash to share repurchases.

When you consider the impact the temporary KFC China issues have had on this year’s operating cash flow, our dividend increase is yet another reflection of our confidence in future years’ earnings potential. Through the third quarter, we repurchased shares totaling almost $500 million, and we continue to expect over $700 million in repurchases for the year. Adding it up, we expect to return over $1.3 billion to shareholders in the form of dividends and share repurchases this year, all while continuing to invest over $1 billion behind new store development and other engines of future growth.

As we typically do on our third quarter call, I’ll now share our initial thoughts on 2014. We’re still in the process of developing detailed plans for our businesses next year. In fact, I’ll be traveling with David and Rick as we review each division’s 2014 operating plans over the next few weeks. And as usual, we’ll provide additional perspective at our December meeting in New York. However, I do want to share some initial thoughts.

First, we expect our YRI and U.S. divisions to continue to grow operating profit generally in line with our ongoing growth model, or 10% and 5% respectively. At YRI, our portfolio has continued to shift to emerging markets, which has delivered consistently strong results. Our international franchise revenue stream has proven to be well-diversified and steadily growing. We expect this growth will accelerate over time, as an increasing proportion of our new unit development will occur in high growth emerging markets, where unit penetration levels remain very low, where same-store sales growth is fueled by the broad development of booming economies, and where unit level economics are helped by lower cost structures.

Record level development at YRI in 2013 will also provide a strong tailwind for earnings growth in 2014. In the U.S., we expect that another year of net unit growth, coupled with core product innovation and our new breakfast layer at Taco Bell, along with national advertising of WingStreet at Pizza Hut, will support on-target performance next year. We also have some tailwinds on the expense side, primarily related to pension, which will benefit our U.S. business.

Now, on to our China division. As we’ve mentioned, sales are recovering more slowly than we had anticipated, and admittedly have been difficult to call. Because of this, it’s more challenging to estimate next year’s performance compared to previous years. However, we do expect 2014 to be a bounce-back year for China.

Considering the extent of our new unit development over the last two years, the strong momentum we’re seeing with Pizza Hut Casual Dining, and the restaurant margin improvements we expect will materialize as KFC sales continue to recover, we believe that China division is well positioned to deliver total profit that will at least equal what the division achieved in 2012 or just over $1 billion. Given this year’s significant profit decline in China, that amounts to year-over-year growth of at least 40% for China division in 2014.

Adding it all up, we expect that 2014 will be a strong bounce-back year for Yum! Brands, and we’re targeting EPS growth of at least 20% next year. We look forward to providing a more detailed perspective on this at our December 4 meeting in New York.

So to wrap things up, we take accountability for this year’s results but view 2013 as a temporary setback, and remain as bullish as ever on our long-term growth prospects. As evidence of that, we’re committed to staying the course and investing behind our growth strategies, even in a difficult year. Given these investments and the demonstrated growth potential of our businesses, I’m confident that we’ll bounce back strongly in 2014 and restore our track record of double-digit EPS growth in the years to come.

And with that, we’ll be happy to take your questions.

Section II: Q&A Session

 

Operator

(Operator instructions) And your first question comes from John Glass with Morgan Stanley.

John Glass – Analyst, Morgan Stanley

Thanks. Pat, just on your commentary on China and the recovery, what’s the underlying comp assumption that would get you there? In other words, I can see a couple of paths. One, you could say margins are going to improve dramatically, and we expect this moderate comp recovery and then the upside is upside. Or you could say we’re going to – we’re banking on at least double-digit comp improvements to get there. So how do you frame how you think you’re going to get to that 40% profit improvement in China, comps versus margin?

Pat Grismer – CFO

John, at this stage of the process, we wouldn’t provide a roadmap like that as to how we expect to realize growth. The fact is that there are many different ways we can get to that number. In the current context given where we’re at with our sales recovery, I think it’s fair to say that we’re very balanced in our sales expectations for next year. And we’re focusing on continuing to realize the productivity improvements that have given us the nice lift to margins this year.

John Glass – Analyst, Morgan Stanley

Can you describe the sales productivity a little bit more detail in China? It’s been phenomenal. We look at it on a per-store basis. You’re looking at it on transactions per labor hour. But how is this — are there any one-time elements to it in this quarter that may not recur? And then maybe when you think about transactions coming back, have you permanently reduced the labor hours per transaction, or transactions per labor hour, so you don’t have to add that incremental labor back?

Pat Grismer – CFO

Well, as you can imagine, there are a number of things that we’re doing to drive restaurant level productivity. The fact is that the team is learning to operate very efficiently under unprecedented conditions. Bear in mind this is the third consecutive quarter of same-store sales decline, and when you think about that, we’re very pleased with the team’s focus to drive profitability. One of the ways that they’ve been able to be more efficient is that they’ve improved the way that they’ve forecasted sales and their labor requirements at the store level. They’ve become increasingly sophisticated in this area, and they’re developing new tools and techniques to deliver optimal service levels with relatively low labor. So we remain confident they’re going to be able to sustain these results into next year. And on top of that, they’re continuing to work through new ways of delivering productivity.

The other thing I want to point out – I am sorry, John, I just want to clarify is that clearly we’re very pleased with our performance with China restaurant margin in the third quarter. But I do want to set the right expectations for Q4, because there are some things that are a bit different in Q4 compared to Q3. The first is that we’re going to lose one point of margin benefit from rollover pricing when you compare Q4 to Q3. The other is that AMP will be a full point higher — that’s our advertising spending — a full point higher versus last year, whereas in Q3 we’re relatively flat versus prior year. And we do expect there to be some moderate amounts of food inflation, whereas commodities were flat in the third quarter.

So you add up these three things, and that’s about 3 points of margin headwind in the fourth quarter that we didn’t have in Q3. However, we do expect that same-store sales and same-store transactions will be better in Q4 than in Q3 and that will help to mitigate those impacts. So when we look at the full year for China margin, we’re 16% year to date through Q3. Given that we’re moving into a lower seasonality period, it’s reasonable to expect that we’ll be in the mid-teens on a full year basis. I think it is important just to understand what the near term outlook is for China margin. But I also want to reinforce that we couldn’t be happier with the effort of the China team to drive productivity at the store level, and we expect those efforts will sustain into 2014.

John Glass – Analyst, Morgan Stanley

If I can just one broad question, which is how convinced are you that you know the answer to why sales declines in China have been related specifically to the incidents you talked about? November last year you saw some sales declines. It’s never really been fully addressed at least in my mind, that those were occurring prior to this. And as we’ve gotten further away from these incidents, things haven’t gotten better. They’ve gotten stable, maybe worse, on a month-over-month basis. So what evidence do you have to offer that says it’s not cannibalization, it wasn’t pricing, it’s not competition, and that you’re convinced that it’s just the supplier and avian flu issue that lingers?

David Novak – Chairman and CEO

I think the biggest evidence we have, John, is just the fact that our overall trust and reliability and safety measures are below what they were the previous year. And we think we really need to get those back at least level, and build from that point.

Operator

Your next question comes from David Tarantino with Robert W. Baird.

David Tarantino – Analyst, Robert W. Baird

Just a follow up on that last question, David. I think there were some metrics shared at the China investor day that showed that the brand reliability scores had improved very dramatically from earlier in the year and are almost at levels that you saw in 2012. Yet the sales recovery seems to be lagging the recovery in the brand scores. So just wondering how you reconcile those, and do you normally see the brand reliability scores as more of a leading indicator, or a coincident indicator when you’re looking at your sales trends?

David Novak – Chairman and CEO

We really haven’t looked at reliability scores or trust as leading indicators. I think what we always look at is what perceptions [have us] do we have to change, build, or reinforce to grow the business. And what we see is that the perceptions, biggest issues that we have from a perception standpoint lie in the area of the safety, reliability, trust. And so I think that’s what we see as the biggest problem we have. The trend is moving in the right direction. We’re just not all the way back, and I think what we have to do is get all the way back.

And also, I think what we think we need is we need more innovation. We need more innovation. We’ve done, I think, a very good job on the value front, but frankly we haven’t really presented the concept as innovatively as I think we’re going to need to, to really take the business to the next level. And Sam Su and the team are working very hard on that, and I’m sure we’ll have something that we can be much more excited about next year.

David Tarantino – Analyst, Robert W. Baird

I know you had talked about in the past, kind of time will heal the recovery process, I guess. And I’m wondering if your thinking has changed on that at all, and whether you think you might need to invest some of the productivity savings you have, maybe in a more aggressive marketing approach to get the sales moving?

David Novak – Chairman and CEO

I think we have plenty of marketing to spend. And we have a leadership position, which gives us leadership advertising budgets. And so I don’t think that’s a real issue for us as we go forward. I think I always tell our people it depends on what we’re talking about, okay and I think what we have to do now is we’ve got this I Commit campaign to really drive home the reliability and trust issues. But as we move into 2014 next year, we think we’ve got a tremendous brand that we can glorify, magnify the role that we have in people’s lives, take the offense by being extremely positive, to bring forward the kind of news that we think will excite our customers more. And that’s what the team’s been working on.

And I think to me, it’s taken us longer than what we’d hoped, but we always said that we would need time, and I think we still need the gift of time. But I think historically, if you look back at our brand, or at any other powerful brand, they come back. And we’re going to come back.

Rick Carucci – President

This is Rick, David. As an example of that, if you go back a couple of years and look at Taco Bell, we had issues there a while back that were really fake issues – fake consumer issues on a bogus lawsuit. And some news that would have normally propelled the brand forward, right after that, really didn’t do it. And a) some time had to pass. We got a little bit of momentum, and then when we really hit new products like Cantina Bell and Doritos Locos Tacos is really when the brand took off. And now we’ve been able to sustain that performance as David said for now seven quarters. So I think we need something similar to that progression in China.

Operator

Your next question comes from John Ivankoe with JPMorgan.

John Ivankoe – Analyst, JPMorgan

Just a couple of follow-ups, if I may. First, Pat, you kind of gave a lot of different moving pieces for the margin in the fourth quarter. Would you mind spoon feeding us exactly like what you’re trying to communicate, not just necessarily for the full year, but the fourth quarter whether it’s just like a data point or like a range, just to make sure we’re all in the right place?

Pat Grismer – CFO

We typically don’t provide margin guidance on the quarter. What I wanted to do, though, was indicate that Q4 will look different from Q3, because there are those moving pieces that I outlined. But we do expect the productivity benefits to sustain, and we expect the impact from sales to be less in Q4 than we experienced in Q3. So the full year number, as I mentioned, is in that mid-teen range, which is pretty consistent with where we’re at year to date, through the end of Q3.

John Ivankoe – Analyst, JPMorgan

And then secondly, it happens a lot, not necessarily with you guys, that a focus on cost actually becomes a circular reference and actually influences transaction sales, ability to serve the customer, especially during peak day-parts. So could you just kind of talk about this focus on labor in the third quarter that just happened to correspond with sales being weaker than you thought in the third quarter, just to make sure those two are not related in some way?

Pat Grismer – CFO

There’s absolutely no relationship between those two things. We consider our best operators in the world to be in China, and as you would expect, they remain very much focused on customer service metrics, and they do not do things with their labor scheduling that would in any way compromise the customer experience. We don’t see that as at all related to sales performance.

David Novak – Chairman and CEO

I think if there’s one characteristic that I would give the Chinese team the most kudos for, we have one group that thinks long term — more long term than them, I don’t know what group it is. We do things on behalf of the customer, we think about the brand for the long term. We went into this year knowing we were going to have a difficult year. Our direction to the China team was do the right thing. And that’s what we’ve been doing.

John Ivankoe – Analyst, JPMorgan

And the final question from me, if I may, is on occupancy costs, especially as rent renewals and other things come up in the market. How much of a negative, if it is one, is occupancy cost potentially to the model over the next couple of years? How big of a headwind could it be? Or might there be other offsets to keep that line in check?

David Novak – Chairman and CEO

John, we don’t see anything really changing going forward from what we’ve seen in the past. We do see some rent increases, particularly in tier-one cities that have been larger. But fortunately for us we’re a country-wide business with lower rental costs in lower tier cities, and that’s where we’re skewing our development. So we don’t see that as moving significantly going forward.

Operator

Your next question comes from Sara Senatore with Sanford Bernstein.

Sara Senatore – Analyst, Sanford C. Bernstein

I just have a couple of follow-up questions. One on China, and I wanted to ask, are you still seeing wide gaps in performance between the lower tier and the higher tier cities with respect to comp? And the reason I ask is sometimes when you look at businesses in this industry, that’s one of the kind of harbingers of maybe a need to slow growth, is what you’re seeing in new units or performance. And I know in lower tier cities, new unit productivity and performance has been very good, but especially now with the pressure on your top line, does that gap persist? And is there a signal there that maybe you do need to slow at least KFC unit growth in China? And then I had a follow-up question on YRI.

Pat Grismer – CFO

Okay, Sara. With respect to same-store sales growth of city tiers, unlike the first half of the year, what we saw in Q3 was pretty comparable performance across the cities. So you’ll remember that the Shanghai region and other large cities were more severely impacted in the first quarter, and then avian flu cases being concentrated in Shanghai in the second quarter, we saw that disparity between city tiers. But that has not persisted into the third quarter.

Sara Senatore – Analyst, Sanford C. Bernstein

And then in terms of the unit growth, is there any kind of signal here that maybe that needs to slow, given that presumably new unit volumes have come down along with the rest of the system?

Rick Carucci – President

No, not at this stage. We remain committed to opening at least 700 new units this year. We’re not providing detailed guidance on next year at this stage, but I’ll tell you it’s hard to imagine that we would open fewer units in 2014 than we opened in 2013. As you know, we have world-class real estate development capability in China. We’re very disciplined in the way that we make those new unit decisions, and those openings are decided one at a time.

The one thing we’re doing, consistent with what we articulated in December, is that we are shifting our development focus. So yes, we are shifting more over to Pizza Hut Casual Dining from KFC, and within KFC, we’re shifting from the tier one, tier two coastal cities to tier three and below cities. And we’re seeing that with the development activity even in Q3 versus prior years.

Sara Senatore – Analyst, Sanford C. Bernstein

And then if I may – thank you. On YRI, you talked about investing ahead of growth, but expecting to see emerging markets really drive performance. You talked about how India, maybe the macro wasn’t as good as you expect, but you’re not generating a lot of profit there. I think Turkey was mentioned as one where maybe the environment hasn’t been as good. Can you just talk a little bit in broad strokes when emerging markets, upside of China really will start to drive performance? Do you need to refranchise the rest of the UK before we can see that? Or just is this kind of a one or two year, or is this more like a five plus year timeline?

Rick Carucci – President

Sara, why don’t I start and Pat may want to chime in. I think if you look at the emerging markets, clearly we have the franchise — the bulk of that business, again, is a franchise business. And overall, the economies in emerging markets are slowed a little bit from what they were a year ago, but are still pretty healthy. And you see that in the results we posted in the third quarter, where we saw system sales growth of 11%.

If you look at the profitability we get from the equity markets, it will build over time. And most of those markets, the Russias, South Africas, and Turkeys as examples, they’re still sub-scale businesses from an equity standpoint. However, even I think in 2014, I’d expect us to make more money in those markets collectively than we did in 2013. So I’d expect that to be a little bit of a benefit in 2014 and that becoming an increasing benefit over time.

Pat Grismer – CFO

What I would add to Rick’s comments is that we’re continuing to invest aggressively behind our equity positions in emerging markets, because we love the unit-level economics that we see there, what we call home-run economics. We know that there’s enormous growth potential, and we believe that it’s important to maintain a leadership position to lead the system, if you will, to capture the potential.

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With respect to your question around KFC UK, we have always had a very strong discipline to earn the right to own mentality. We are always evaluating our ownership positions and making adjustments as we go. It’s not necessary that we reduce our ownership position there before we move more aggressively with our equity investment in emerging markets.

Operator

Your next question comes from Diane Geissler with CLSA.

Diane Geissler – Analyst, CLSA

Pat, I wanted to ask you about your commentary about new store openings next year. And I appreciate you’re not giving details on that, but in an environment where you expect to open at least as many next year as you did this year, do you think the supply chain in China is ready for that? Here I’m really concerned about the poultry industry and your ability to secure safe supply. I know you cut a thousand producers from your supply chain this year, but could you talk about that? Is the supply chain ready in China for this continued ramp of new store openings?

Pat Grismer – CFO

We are optimistic that the supply chain is there. We have developed very strong relationships with the large poultry suppliers in China, as we’ve over the last year tightened our quality assurance protocols. And based on the fact that we’re looking at a year when volumes are significantly down versus last year, there is capacity in the system today, and our poultry suppliers are partners with us to plan for the growth in the category. So we are confident that, that capacity exists.

Diane Geissler – Analyst, CLSA

And how should we think about the — you said you were shifting more toward Pizza Hut and more toward KFC in lower tiers. Is there a way to think about maybe the number of KFCs versus the number of Pizza Huts, if you’re opening 700 units on an annual basis?

Pat Grismer – CFO

Well, just to give you a sense for how we are shifting, I’ll just give you a couple of data points and maybe that will give you some indication of the types of changes we’re making in the shape of our development program. When you look at the units we’ve opened year to date in China, 31% of those were Pizza Hut Casual Dining. Last year, it was 24%. So there’s a clear shift toward Pizza Hut Casual Dining given the very strong unit level economics we see, the very compelling investment proposition.

Another data point is with our KFC brand. Year to date, this year we opened – or 13% of our new unit openings were in tier one cities. Last year, that number was 19%. So again, this is what we’re doing. We’re shifting our development activity. We’re shifting our capital investment towards the opportunities that offer the stronger returns.

Operator

Your next question comes from Michael Kelter with Goldman Sachs.

Michael Kelter – Analyst, Goldman Sachs

I guess first, I just want to ask — you talked about food inflation in China starting to show up again. How much of that is from the increased cost of an evolving supply chain in China versus pure food inflation? And the reason I ask is because China food PPI is very muted right now while you’re talking about inflation.

Pat Grismer – CFO

Yes, we don’t see the changes to our supply chain having a perceptible impact to food costs. And as I talked about, the food cost inflation changing from what we saw in Q3, it’s a moderate change. We saw basically flat commodity costs in Q3, and we expect modestly positive in Q4. It’s not a dramatic swing. And it’s unrelated to the changes we’ve made to our supply chain.

Michael Kelter – Analyst, Goldman Sachs

And then could you maybe elaborate more on the payroll expenses in China, and how we should think about separating out what might be a new re-based lower level of expenses with efficiencies you’ve found versus what’s going to need to bounce back in ’14 when sales presumably return?

Pat Grismer – CFO

There’s no doubt that labor inflation has been much lower in China than we had anticipated. You’ll recall that we had guided mid-teens labor inflation, and what we now expect for 2013 is high single digit. Now, that has come through a favorable mix shift in our restaurant level employees and some restaurant level wage control. But I do want to stress that we don’t necessarily see that continuing into next year. The fact is that wage growth had moderated across China, but the central government’s objective remains to double disposable per capita income by 2020.

And as you know, that ultimately works to our advantage from the standpoint of growing our customer base. And it’s really on that basis that we are expecting China labor inflation in 2014 to move back to what we’ve traditionally guided, which is that low to mid double digit range.

Operator

Your next question comes from Joe Buckley with Bank of America.

Joe Buckley – Analyst, Bank of America Merrill Lynch

Curious on the sales issue if you have a sense of what the industry in China is doing. And I guess the direction of my question is how much of this is macro-related versus tied to the chicken issues?

David Novak – Chairman and CEO

I don’t think we have any new category information to share. I think that first of all, the macros, we don’t think it’s really healthy. But when we look at the Pizza Hut business, Pizza Hut, because it’s had the innovation, because it’s had the value, because it’s had the operational excellence, it’s performing well. So we think that regardless of what’s going on in the category, or with competition or whatever, with the strength of our brands, when we get things right we can move the needle. And that’s what we’re working on at KFC. We’re working on keeping Pizza Hut right, and we’re excited about everything we’re doing there on the innovation front, expanding breakfast, and then we’re working on revamping KFC to come at the market in a fresher perspective.

Joe Buckley – Analyst, Bank of America Merrill Lynch

So the slower than expected recovery really is around the trust issues and sort of KFC brand perception issues as opposed to —

David Novak – Chairman and CEO

If you look at the consumer research, that’s what our take is. This is not a precise science, you know, I mean I can’t tell you 100% for sure. But when we look at what do we have to target at KFC, what do we need to do at KFC to really get the business moving forward, we think it’s continuing to make progress on regaining the trust. We have made steady progress. We’re getting closer to where we want to be from an overall research standpoint, but we’re still behind.

We like to do problem detection studies and the food safety and trust issue remains our biggest problem that we need to deal with. And what I ask all of our divisions to do, wherever I go around the world, we want to know what perceptions (inaudible), do we have to change, build, or reinforce to grow the business? And we think that the perception that we had to change at KFC, and enhance, and get it back to where it was, is the whole reliability and trust issue.

But we’re not going to do that forever, okay? This is what – I mean we’ve got this “I Commit” campaign, we’re going to get the message out there, and then it’s time to move on. It’s time to move on and tell people what we’ve got, and get people excited about our brands, and that’s my message to the China team. We’re going to deal with this, stay after it, keep building trust, do everything we can to earn that trust back. But we really think that we need to excite our customers with more innovation and more excitement about the brand. And that’s the real marketing focus for the future.

Operator

Your next question comes from Andy Barish with Jefferies.

Andy Barish – Analyst, Jefferies & Company

Hey guys, just one other expense question on China. Can you help me understand kind of the occupancy sort of variable versus fixed just on broad brushstrokes? And then one other question on the U.S. after that.

Steve Schmitt – VP, IR

Andy, this is Steve. Just on the occupancy cost line, as you know we do have variable rents, which is unique to the China business in our system. And we have a variable component and at least are actually more than half of our leases in China. So that is a variable component that’s unique to China. And now in the quarter we did have, as you might imagine, the restaurants are looking at ways to control costs. So from a semi-variable standpoint, the team’s definitely doing what they can to guard profits in this environment without impacting services.

Andy Barish – Analyst, Jefferies & Company

And then on U.S. restaurant level margins, you pointed to inflation as well picking up a little bit. Where did you see that in the third quarter in the U.S. business?

Pat Grismer – CFO

Generally very moderate, Andy. For the U.S. it’s relatively flat for the year on a commodity standpoint, and labor is in the low single digits.

Operator

Your next question comes from Jason West with Deutsche Bank.

Jason West – Analyst, Deutsche Bank

Just one more on China. Looking back at the September number that you guys talked about kind of surprised you, can you talk a little bit more about what happened there? We don’t actually have the monthlies from last year, so I don’t know what the comparison was in August versus September maybe. That would be helpful. And then was it just a promotional misfire that was a big issue in the month? Or were there other specific one-offs that maybe caused the weakness in September?

Pat Grismer – CFO

Well, Jason, as I mentioned we had very high expectations for the month of September, not only because of the launch of this new product, but because we were lapping softer performance in September versus August. And I’m not going to get into the extent of that difference, but we were anticipating that that was going to provide a lift to the month. And frankly, we weren’t going to call the month and the quarter, bearing in mind that September is the first month of China division’s fourth quarter, until we had read the full month. It was a big disappointment to us, to such an extent that we revised our guidance for Q4 same-store sales.

Jason West – Analyst, Deutsche Bank

But can you talk a little bit about what was disappointing about it other than just sales were under plan —

David Novak – Chairman and CEO

Well, we launched the beef burger, which is a product innovation that we had some high hopes for. And while we had good success rate in the sense that the mix was good, we didn’t get the incrementality, which we think also gives us the belief that we’ve got to keep working on the trust side of the equation. So that’s basically what we had in September.

I think that we always have – we always will call it like we see it, when we see it. And that’s what we’ll continue to do. We definitely missed on the fourth quarter, and that’s just the way it is. I wish we had a 1000% batting average. It’s a hell of a lot more fun to have these calls when you do, I can tell you that. But we missed, okay?

Operator

Your next question comes from Mitch Speiser with Buckingham Research.

Mitch Speiser – Analyst, Buckingham Research

Just following up on a comment that you made about the comps in tier one, tier two cities versus tier three to tier six, and how it seems like they’re now comparable on the weakness versus earlier in the year where it seemed like the larger cities, which had more of the food safety issues, had weaker comps. That seems interesting to me. Can you maybe try to explain that? Why would the tier three to tier six cities start to soften? Is it the perception of the chicken supply moving into that area? Is it the macros, competition? Because that seems to be the stronghold, the lower-tier cities, and now that seems to be more emulating the tier one, tier two cities.

Pat Grismer – CFO

Mitch, that’s actually not the right way to think about it. What happened was that the tier one, tier two cities were more significantly impacted in Q1 and Q2. All city tiers have shown significant improvement in Q3 versus the first half of the year, but there were significantly greater improvement in the higher tier cities off of their very low position in the first half of the year. So all of them are getting better, it’s just that given how very weak, by comparison to what the tier one, tier two cities were, that we’re now seeing that they’re all more or less coalescing around the same extent of same-store sales climate in the third quarter.

I just want to clarity it’s not that the lower tier cities are now getting worse, or that they’re underperforming the tier one.

Mitch Speiser – Analyst, Buckingham Research

Okay, then maybe could you explain why the tier three, tier six cities are in line with the tier one, tier two cities? You have just a lot less competition. It does seem like the food safety issues were more concentrated in the tier one, tier two cities. It just seems like tier three to tier six is where the strength has been, and it seems like it’s more in line with the overall system, even though you’re much less saturated. And if the economy is the issue, that’s fine. It just seems like you’re playing down just the macros, and it’s more company specific and food safety related issues. So it’s just a little more –

David Novak – Chairman and CEO

We never have blamed the macros for anything. We don’t talk about macros, or weather, or anything like that. We just don’t. We just don’t believe in it. If I start, and I hear myself say that, I think everybody’s kind of going to look at me funny. So that’s one thing.

I think what we really have here is a countrywide issue of trust. And it’s in tier four, five, six cities, tiers one, two, three cities. That’s what we really think we have to address. That’s what our marketing folks have determined by listening to our customers, and that’s what we’re getting after. So I think that’s the issue that we’re really trying to deal with.

Mitch Speiser – Analyst, Buckingham Research

If I could just slip in another question on the U.S. business. With Taco Bell gearing up for breakfast going national in 2014, any sense of the timetable? Should we expect that beginning of the year, mid-year? And maybe the same with Pizza Hut and WingStreet, when should we expect these national initiatives?

Rick Carucci – President

This is Rick, Mitch. Breakfast, we don’t know the exact timing, but I’d say roughly middle of the year next year. On WingStreet, we expect that to start at the beginning of the year.

David Novak – Chairman and CEO

Breakfast will be in the first half of the year for Taco Bell. We’re working on the details. It’s a competitive category.

Operator

Your next question comes from Jeffrey Bernstein with Barclays.

Jeffrey Bernstein – Analyst, Barclays Capital

Two questions. The first one is a follow up on China. Having been there, I guess a month ago, there seems to be some confidence perhaps in pricing power in ’14 to offset labor costs, which it sounds like are going to be double digits. It sounds like food might be a lot more modest, but that there would be pricing power to insulate or drive the margin. And you said you’re lapping one point of price going to the fourth quarter. So can you give us an update on where we are now in pricing, and perhaps qualitatively how do you assess pricing power, whether you might be more cautious now and therefore we shouldn’t expect any kind of meaningful price increase next year, how you think about that?

Pat Grismer – CFO

Our expectation is that we will take pricing to offset inflation. Naturally, given current circumstances of the KFC brand, we’re very sensitive to how consumers perceive our value. But we believe that we can do both. That we can offer strong value and that we can take the amount of pricing necessary to offset inflation, because we are very much focused on the profitability of our restaurants. We believe it’s critical to achieve the new unit returns that are essential to accelerating the pace of development over time. When we meet in December, we can share with you some more insights into how we might be looking at pricing for next year, but I would say generally speaking, going forward, it would be to offset inflation.

Jeffrey Bernstein – Analyst, Barclays Capital

But the pricing for the fourth quarter, or I should say, for the fourth quarter should we expect that to be relatively flat for full year?

Pat Grismer – CFO

No, no new pricing actions. We’ll have about a point of benefit or so. And that’s strictly from rollover actions.

Jeffrey Bernstein – Analyst, Barclays Capital

Okay and the follow up question is just on the U.S. segment. With three big brands, you’re a great proxy for broader U.S. QSR. You addressed that inflation was relatively modest, but in the press release you also talked about promotional activities perhaps pressuring margins. I’m just wondering, on the promotional activity, is that more your own promotional activity, in which case what might it have been that would have pressured margin, or perhaps any kind of color on broader QSR, where you might be seeing some outsized pressure? Just wondering if maybe the competition is getting more or less rational with more modest food cost and a challenging traffic environment?

Pat Grismer – CFO

The short answer is I don’t think that Q3 is a trend or something that’s different than what’s been occurring in the category. The category the last month has been pretty flat in the U.S. So it is a competitive category and there’s not a lot of total growth out there. I would say that always in our category, value is key and we’re always playing it at the key brand. If you look at it on a year to date basis, we’re obviously very happy with the overall margins, and there’s nothing out there from a promotional standpoint that I think is going to dramatically change those margins in any way. I think it was almost just the timing of what we were running in Q3 this year versus Q3 last year.

Operator

Your next question comes from Howard Penney with Hedgeye Risk Management.

Howard Penney – Analyst, Hedgeye Risk Management

I have two questions. My first one is about the asset light model. You bought two assets in the last year. You bought the assets in China, and then you bought Turkey, which kind of moves you away from the asset light model. And I understand that the returns are high in the emerging markets, but the returns are even greater in an asset light model. Is there a slight shift towards, away from the asset light model, with your acquiring Little Sheep in Turkey in particular? And then I have another question.

Pat Grismer – CFO

Not at all. We believe that one of the strengths of our business is that we are as heavily franchised as we are, which drives extraordinary return on invested capital for us. So we’re not moving away from that strategy. What we are doing is we’re shifting where we place our equity. So don’t forget that we’ve done some significant refranchisings in recent years, and we’ve taken that capital and we’ve put it into the high-growth emerging markets where we know we can get much stronger returns.

Howard Penney – Analyst, Hedgeye Risk Management

And then the second question is you alluded to, David, in the beginning, that each crisis is different. And Taco Bell’s recovery in the United States was not an easy one, but you didn’t have the capacity increases in the store base that you had, so you were just fixing existing assets.

And then in China, each situation is different, or each crisis has been different, and each year you’re facing increased capacity as you’re adding 700 stores this year. So you’re trying to turn around a base when your capacity is increasing significantly, and I know you were asked about the growth rate in China, but I was hoping you could maybe reiterate your confidence in the growth rate in China and that you’re actually seeing the returns in the tier one cities. And you don’t know what you don’t know, but is 13% the right number of what your unit growth should be in those tier one cities? So there’s a lot of questions around sort of development and growth, and I would just, I guess, like to hear you, again, say with confidence that your growth rate is appropriate, and that we’re not going to be hearing in December or six months or 12 months from now that you’re going to be slowing it down.

David Novak – Chairman and CEO

Well, I think the exact growth rate we’ll need to get to you on, get back to you on, and we’ll be able to talk, I think, more about that in December. We’re always evaluating our growth rate. We have our new unit tracking model, and making adjustments where we need to make adjustments. And Pat’s already talked about many of those. I think when we look at China, we think the big macro that is a positive is the 300 million to 600 million consuming class. And so when you look at the long term and what we think we can do in China, I think that nothing has really changed. We’re going to grow at the right rate to take advantage of the fact that we have the leading position in the dominant consumer market in the world, soon to be the fastest growing economy. So that’s really our strategy. We’ll only grow as fast as our people allow us to do it, and our returns justify it.

And as we look to next year, we see opening up at least 700 more restaurants next year. And we think that the investments we’re making in our restaurants and restaurant development will pay off for us as we go forward. Because we still only have a thousand Pizza Huts and 4,500 KFCs, in a business where we think you could take it times four or five. So we’ll get there the right way. That’s what I would tell our shareholders.

Howard Penney – Analyst, Hedgeye Risk Management

So I understand that you have a huge opportunity in China, and it’s a 10-year, 20-year, 30-year opportunity, but it’s the return on the incremental capital that you’re putting in the ground. And how do we know that 700 is the right number, and it shouldn’t be 500, or maybe it should be 900? And I guess I’m spinning my wheels here, but I just want to push a little bit harder on the rate of growth versus the absolute opportunity.

Pat Grismer – CFO

Well, Howard, as I mentioned before, we make these investment decisions one at a time. And we bring to bear unparalleled expertise and intelligence around retail development in China. We’re not chasing a number per se. We’re capturing an opportunity where we know we can create a lot of value for our shareholders.

Operator

And your final question comes from Paul Westra with Stifel.

Paul Westra – Analyst, Stifel Financial Corp.

One more time on China. I was wondering if you could share any further insights into the maybe dispersion of the recovery in the comps beyond the tiers one and two versus three and six. In other words, is there any day part that has maybe rebounded almost fully now, that maybe gives you confidence, or maybe you expected business lunch to recover and maybe the family dinner weekends has not. Or is there anything that has any consumer, any location, any day part mix that you can see that maybe gives you some green shoots that the leading occasion has recovered and the lagging occasion that you expected is going to take more time?

Pat Grismer – CFO

Paul, no real meaningful variances across the city tiers by day parts, or any other occasions. Pretty consistent, pretty balanced across the market.

Paul Westra – Analyst, Stifel Financial Corp.

And is that what happened in other comparable crises? Is that what you expected? Or is this —

Pat Grismer – CFO

Well, as I mentioned, the picture was very different in Q1 and Q2, because there were structural differences, if you will, between what was happening relative to social media, news stories, and so forth. So that’s why the tier one cities were more heavily impacted in the first half of the year. But as we mentioned earlier, what we now have is more of a countrywide issue, if you will. It’s pretty much a level playing field in that regard. And so we’re not seeing meaningful differences across the city tiers.

Paul Westra – Analyst, Stifel Financial Corp.

And on weekend versus weekday business?

Pat Grismer – CFO

No.

David Novak – Chairman and CEO

Okay, let me wrap this up. First of all, thank you for being on the call. We appreciate it. Obviously we’re disappointed with our overall third quarter results. But I’d just like to close by saying that we will be back, and we think 2014 will be a strong bounce back year, and we remain as confident as ever in our ability to deliver sustainable and strong growth in the years to come. So thanks again.

Operator

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

 

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