The number of shares outstanding of the Registrant’s Common Stock as of April 21, 2011 was 465,566,072 shares.
Net Income – YUM! Brands, Inc.
Total Shareholders’ Equity – YUM! Brands, Inc.
We have prepared our accompanying unaudited Condensed Consolidated Financial Statements (“Financial Statements”) in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial information. Accordingly, they do not include all of the information and footnotes required by Generally Accepted Accounting Principles in the United States (“GAAP”) for complete financial statements. Therefore, we suggest that the accompanying Financial Statements be read in conjunction with the Consolidated Financial Statements and Notes thereto included in our annual report on Form 10-K for the fiscal year ended December 25, 2010 (“2010 Form 10-K”). Except as disclosed herein, there has been no material change in the information disclosed in the Notes to our Consolidated Financial Statements included in the 2010 Form 10-K.
YUM’s business consists of three reporting segments: YUM Restaurants China (“China” or “China Division”), YUM Restaurants International (“YRI” or “International Division”) and United States. The China Division includes mainland China and YRI includes the remainder of our international operations.
Our fiscal year ends on the last Saturday in December and, as a result, a 53rd week is added every five or six years. The first three quarters of each fiscal year consist of 12 weeks and the fourth quarter consists of 16 weeks in fiscal years with 52 weeks and 17 weeks in fiscal years with 53 weeks. The current fiscal year of 2011 has a 53rd week. Our subsidiaries operate on similar fiscal calendars except that certain international subsidiaries operate on a monthly calendar, with two months in the first quarter, three months in the second and third quarters and four months in the fourth quarter. Our international subsidiaries that operate on a monthly calendar, including China, are not impacted by the addition of a 53rd week. All of our international businesses except China close one period or one month earlier to facilitate consolidated reporting.
Our preparation of the accompanying Financial Statements in conformity with GAAP requires us to make estimates and assumptions that affect reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the Financial Statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from the estimates.
In our opinion, the accompanying Financial Statements include all normal and recurring adjustments considered necessary to present fairly, when read in conjunction with our 2010 Form 10-K, our financial position as of March 19, 2011, and the results of our operations for the quarters ended March 19, 2011 and March 20, 2010 and cash flows for the quarters ended March 19, 2011 and March 20, 2010. Our results of operations and cash flows for these interim periods are not necessarily indicative of the results to be expected for the full year.
Our significant interim accounting policies include the recognition of certain advertising and marketing costs, generally in proportion to revenue, and the recognition of income taxes using an estimated annual effective tax rate.
These unexercised employee stock options and stock appreciation rights were not included in the computation of diluted EPS because to do so would have been antidilutive for the periods presented.
Under the authority of our Board of Directors, we repurchased shares of our Common Stock during the quarters ended March 19, 2011 and March 20, 2010, as indicated below. All amounts exclude applicable transaction fees.
Amount excludes the effect of $19 million in share repurchases (0.4 million shares) with trade dates prior to the 2010 fiscal year end but cash settlement dates subsequent to the 2010 fiscal year end and includes the effect of $9 million in share repurchases (0.2 million shares) with trade dates prior to March 19, 2011 but with settlement dates subsequent to March 19, 2011.
Amount includes the effect of $5 million in share repurchases (0.1 million shares) with trade dates prior to March 20, 2010 but with settlement dates subsequent to March 20, 2010.
Total comprehensive income – YUM! Brands, Inc.
During the quarter ended March 19, 2011 we decided to sell our LJS and A&W brands. While the LJS and A&W asset groups comprising these brands did not meet the criteria for held for sale classification as of March 19, 2011, our decision to sell was considered an impairment indicator. As such, we reviewed the LJS and A&W asset groups for potential impairment and determined that their carrying values were not recoverable based on our estimates of holding period cash flows while we continue to own the brands and expected proceeds upon sale. Accordingly, we wrote the carrying values of the LJS and A&W asset groups down to our estimate of their fair values, which reflected the sales prices we would expect to receive from potential buyers. These fair value determinations considered current market conditions, trends in the businesses and prices for similar transactions in the restaurant industry, and resulted in a non-cash write down of the LJS and A&W asset groups’ carrying values totaling $66 million. The write down was allocated to definite-lived trademarks and franchise contract rights which we will continue to amortize until the LJS and A&W asset groups are considered held for sale. Additionally, we will continue to review the brands’ asset groups for any further necessary impairment through the date the brands are sold. The goodwill that was included in the LJS and A&W reporting unit was written off in a previous year.
Refranchising (gain) loss is not allocated to segments for performance reporting purposes.
Store closure (income) costs include the net gain or loss on sales of real estate on which we formerly operated a Company restaurant that was closed, lease reserves established when we cease using a property under an operating lease and subsequent adjustments to those reserves and other facility-related expenses from previously closed stores.
The impairment charge of $66 million resulting from the planned sale of the LJS and A&W businesses was not allocated to segments for performance reporting purposes and is not included in this table.
During the quarter ended March 20, 2010 we refranchised all of our remaining company restaurants in Taiwan, which consisted of 124 KFCs. We included in our March 20, 2010 financial statements a non-cash write-off of $7 million of goodwill in determining the loss on refranchising of Taiwan. This loss did not result in a related income tax benefit, and was not allocated to any segment for performance reporting purposes. The amount of goodwill write-off was based on the relative fair values of the Taiwan business disposed of and the portion of the business that was retained. The fair value of the business disposed of was determined by reference to the discounted value of the future cash flows expected to be generated by the restaurants and retained by the franchisee, which included a deduction for the anticipated royalties the franchisee will pay the Company associated with the franchise agreement entered into in connection with this refranchising transaction. The fair value of the Taiwan business retained consisted of expected net cash flows to be derived from royalties from franchisees, including the royalties associated with the franchise agreement entered into in connection with this refranchising transaction. We believed the terms of the franchise agreement entered into in connection with the Taiwan refranchising were substantially consistent with market. The remaining carrying value of goodwill related to our Taiwan business of $30 million, after the aforementioned write-off, was determined not to be impaired subsequent to the refranchising as the fair value of the Taiwan reporting unit exceeded its carrying amount.
U.S. refranchising loss for the quarter ended March 20, 2010 included $73 million in non-cash impairment charges related to our offer to refranchise a substantial portion of our Company operated KFCs in the U.S. We recorded an additional $12 million in non-cash impairment charges related to these restaurants in the quarter ended December 25, 2010. The majority of the restaurants offered for sale in 2010 continue to be Company operated at March 19, 2011. We believed in 2010 and continue to believe at March 19, 2011 that the restaurant groups for which we have not yet entered into agreements to sell do not meet the criteria to be classified as held for sale. Consistent with our historical policy, we are reviewing these restaurant groups for impairment on a held for use basis each quarter as a result of our intent to refranchise. To the extent the carrying value of these restaurant groups are not recoverable based upon our estimate of expected refranchising proceeds and holding period cash flows while we continue to operate the restaurants, they are written down to current estimates of their fair value. These fair value estimates, which are based on the sales price we would expect to receive for each restaurant group, consider current market conditions, real-estate values, trends in the KFC-U.S. business, prices for similar transactions in the restaurant industry and preliminary offers for any restaurant groups to date. No further impairment charges were recorded for these restaurant groups in the quarter ended March 19, 2011 as we currently estimate that the carrying values of all restaurant groups are recoverable. We continue to depreciate the carrying values of the restaurant assets, net of the aforementioned impairment charges, and will continue to do so through the date we believe the held for sale criteria for any restaurant groups are met. The $85 million in impairment charges recorded in 2010 does not include any allocation of the KFC reporting unit goodwill in the restaurant groups’ carrying values. This additional non-cash write down is being recorded, consistent with our historical policy, when a restaurant group ultimately meets the criteria to be classified as held for sale. We will also be required to record a charge for the fair value of our guarantee of future lease payments for leases we assign to the franchisee upon any sale.
Assets held for sale at March 19, 2011 and December 25, 2010 total $43 million and $23 million, respectively, of U.S. property, plant and equipment and are included in Prepaid expenses and other current assets on our Condensed Consolidated Balance Sheets.
In July 2010, the Financial Accounting Standards Board (“FASB”) issued accounting guidance that requires new disclosures about an entity’s allowance for credit losses and the credit quality of its financing receivables. Existing disclosures were amended to require an entity to provide certain disclosures on a disaggregated basis by portfolio segment or by class of financing receivables. The new disclosures as of the end of a reporting period were effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period were effective for interim and annual reporting periods beginning on or after December 15, 2010. All necessary disclosures have been complied with in this Form 10-Q.
The Company’s receivables are primarily generated as a result of ongoing business relationships with our franchisees and licensees as a result of royalty and lease agreements. Trade receivables consisting of royalties from franchisees and licensees are generally due within 30 days of the period in which the corresponding sales occur and are classified as Accounts and notes receivable on our Condensed Consolidated Balance Sheets. Our financing receivables primarily consist of notes receivable and direct financing leases with franchisees which we enter into from time to time. Balances of notes receivable and direct financing leases due within one year are included in Accounts and notes receivable while amounts due beyond one year are included in Other assets. The activity in the Allowance for doubtful accounts was not significant in the quarter ended March 19, 2011.
Our effective tax rates were lower than the expected U.S. federal statutory rate of 35% primarily due to the majority of our income being earned outside of the U.S. where tax rates are generally lower than the U.S. rate.
Our first quarter 2011 rate was higher than the prior year primarily due to lapping more favorable foreign and U.S. tax effects in 2010 attributable to foreign operations, including a foreign law change. This was partially offset by lapping 2010 unfavorable prior year adjustments.
On June 23, 2010, the Company received a Revenue Agent Report (“RAR”) from the Internal Revenue Service (the “IRS”) relating to its examination of our U.S. federal income tax returns for fiscal years 2004 through 2006. The IRS has proposed an adjustment to increase the taxable value of rights to intangibles used outside the U.S. that YUM transferred to certain of its foreign subsidiaries. The proposed adjustment would result in approximately $700 million of additional taxes plus net interest to date of approximately $155 million. Furthermore, if the IRS prevails it is likely to make similar claims for years subsequent to fiscal 2006. The potential additional taxes for these later years, through 2010, computed on a similar basis to the 2004-2006 additional taxes, would be approximately $320 million plus net interest of approximately $20 million.
We believe that the Company has properly reported taxable income and paid taxes in accordance with applicable laws and that the proposed adjustment is inconsistent with applicable income tax laws, Treasury Regulations and relevant case law. We intend to defend our position vigorously and have filed a protest with the IRS. As the final resolution of the proposed adjustment remains uncertain, the Company will continue to provide for its position in accordance with GAAP. There can be no assurance that payments due upon final resolution of this issue will not exceed our currently recorded reserve and such payments could have a material adverse effect on our financial position. Additionally, if increases to our reserves are deemed necessary due to future developments related to this issue, such increases could have a material, adverse effect on our results of operations as they are recorded. The Company does not expect resolution of this matter within twelve months and cannot predict with certainty the timing of such resolution.
We identify our operating segments based on management responsibility. The China Division includes mainland China and YRI includes the remainder of our international operations. In the U.S., we consider LJS and A&W to be a single operating segment. We consider our KFC-U.S., Pizza Hut-U.S., Taco Bell-U.S. and LJS/A&W-U.S. operating segments to be similar and therefore have aggregated them into a single reportable operating segment.
Amounts have not been allocated to the China Division, YRI or U.S. segments for performance reporting purposes.
Includes equity income from investments in unconsolidated affiliates of $16 million and $12 million for the quarters ended March 19, 2011 and March 20, 2010, respectively.
Amount represents an impairment charge resulting from the planned sale of the LJS and A&W businesses. See Note 4.
We sponsor noncontributory defined benefit pension plans covering certain full-time salaried and hourly U.S. employees. The most significant of these plans, the YUM Retirement Plan (the “Plan”), is funded while benefits from the other U.S. plan are paid by the Company as incurred. During 2001, the plans covering our U.S. salaried employees were amended such that any salaried employee hired or rehired by YUM after September 30, 2001 is not eligible to participate in those plans. We also sponsor various defined benefit pension plans covering certain of our non-U.S. employees, the most significant of which are in the United Kingdom (“U.K.”). Our plans in the U.K. have previously been amended such that new employees are not eligible to participate in those plans.
We made no contributions to the Plan during the quarter ended March 19, 2011 and no contributions to the Plan are anticipated in 2011. We will make contributions of approximately $6 million to a plan in the U.K. during the second quarter of 2011.
The Company is exposed to certain market risks relating to its ongoing business operations. The primary market risks managed by using derivative instruments are interest rate risk and cash flow volatility arising from foreign currency fluctuations.
We enter into interest rate swaps with the objective of reducing our exposure to interest rate risk and lowering interest expense for a portion of our fixed-rate debt. At March 19, 2011, our interest rate derivative instruments outstanding had notional amounts of $925 million and have been designated as fair value hedges of a portion of our debt. The critical terms of these swaps, including reset dates and floating rate indices match those of our underlying fixed-rate debt and no ineffectiveness has been recorded.
We enter into foreign currency forward contracts with the objective of reducing our exposure to cash flow volatility arising from foreign currency fluctuations associated with certain foreign currency denominated intercompany short-term receivables and payables. The notional amount, maturity date, and currency of these contracts match those of the underlying receivables or payables. For those foreign currency exchange forward contracts that we have designated as cash flow hedges, we measure ineffectiveness by comparing the cumulative change in the forward contract with the cumulative change in the hedged item. At March 19, 2011, foreign currency forward contracts outstanding had a total notional amount of $408 million.
The unrealized gains associated with our interest rate swaps that hedge the interest rate risk for a portion of our debt have been reported as an addition of $1 million and $26 million to Short-term borrowings and Long-term debt, respectively, at March 19, 2011. During the quarters ended March 19, 2011 and March 20, 2010, Interest expense, net was reduced by $8 million and $7 million, respectively, for recognized gains on these interest rate swaps.
The gains/losses reclassified from Accumulated OCI into income were recognized as Other income (expense) in our Condensed Consolidated Statement of Income, largely offsetting foreign currency transaction losses/gains recorded when the related intercompany receivables and payables were adjusted for foreign currency fluctuations. Changes in fair values of the foreign currency forwards recognized directly in our results of operations either from ineffectiveness or exclusion from effectiveness testing were insignificant in the quarters ended March 19, 2011 and March 20, 2010.
Additionally, we had a net deferred loss of $13 million, net of tax, as of March 19, 2011 within Accumulated OCI due to treasury locks and forward starting interest rate swaps that were cash settled in prior years, as well as outstanding foreign currency forward contracts. The majority of this loss arose from the 2007 settlement of forward starting interest rate swaps entered into prior to the issuance of our Senior Unsecured Notes due in 2037, and is being recognized in interest expense through 2037 consistent with interest payments made on the related Senior Unsecured Notes. In the quarters ended March 19, 2011 and March 20, 2010, an insignificant amount was reclassified from Accumulated OCI to Interest expense, net as a result of these previously settled cash flow hedges.
As a result of the use of derivative instruments, the Company is exposed to risk that the counterparties will fail to meet their contractual obligations. To mitigate the counterparty credit risk, we only enter into contracts with carefully selected major financial institutions based upon their credit ratings and other factors, and continually assess the creditworthiness of counterparties. At March 19, 2011, all of the counterparties to our interest rate swaps and foreign currency forwards had investment grade ratings. To date, all counterparties have performed in accordance with their contractual obligations.
The following table presents the fair values for those assets and liabilities measured at fair value on a recurring basis and the level within the fair value hierarchy in which the measurements fall. No transfers among the levels within the fair value hierarchy occurred during the quarter ended March 19, 2011.
The fair value of the Company’s foreign currency forwards and interest rate swaps were determined based on the present value of expected future cash flows considering the risks involved, including nonperformance risk, and using discount rates appropriate for the duration based upon observable inputs. The other investments include investments in mutual funds, which are used to offset fluctuations in deferred compensation liabilities where employees have chosen to invest in phantom shares of a Stock Index Fund or Bond Index Fund. The other investments are classified as trading securities and their fair value is determined based on the closing market prices of the respective mutual funds as of March 19, 2011 and December 25, 2010.
In the quarter ended March 19, 2011 we recorded a $66 million impairment charge in Closure and impairment (income) expense to write down the trademarks and franchise contract rights of A&W and LJS as a result of our decision, during the quarter, to sell those brands. The asset groups comprising these brands were deemed impaired on a held for use basis and the fair value measurements used in our impairment evaluations included an estimate of the sales prices we anticipate receiving from the sale of the brands.
During the quarter ended March 20, 2010 we recorded $77 million of impairment charges in Refranchising (gain) loss related to writing down the assets of restaurants or restaurant groups consisting of approximately 650 restaurants, offered for refranchising, and deemed to be impaired on a held for use basis. The fair value measurements used in our impairment evaluation were based on estimates of the sales prices we anticipated receiving from a franchisee for the restaurant or restaurant groups.
At March 19, 2011 the carrying values of cash and cash equivalents, accounts receivable and accounts payable approximated their fair values because of the short-term nature of these instruments. The fair value of notes receivable net of allowances and lease guarantees less subsequent amortization approximates their carrying value. The Company’s debt obligations, excluding capital leases, were estimated to have a fair value of $3.6 billion, compared to their carrying value of $3.3 billion. We estimated the fair value of debt using market quotes and calculations based on market rates.
As a result of (a) assigning our interest in obligations under real estate leases as a condition to the refranchising of certain Company restaurants; (b) contributing certain Company restaurants to unconsolidated affiliates; and (c) guaranteeing certain other leases, we are frequently contingently liable on lease agreements. These leases have varying terms, the latest of which expires in 2026. As of March 19, 2011, the potential amount of undiscounted payments we could be required to make in the event of non-payment by the primary lessee was approximately $500 million. The present value of these potential payments discounted at our pre-tax cost of debt at March 19, 2011 was approximately $450 million. Our franchisees are the primary lessees under the vast majority of these leases. We generally have cross-default provisions with these franchisees that would put them in default of their franchise agreement in the event of non-payment under the lease. We believe these cross-default provisions significantly reduce the risk that we will be required to make payments under these leases. Accordingly, the liability recorded for our probable exposure under such leases at March 19, 2011 was not material.
We have agreed to provide financial support, if required, to an entity that operates a franchisee lending program used primarily to assist franchisees in the development of new restaurants and, to a lesser extent, in connection with the Company’s historical refranchising programs. As part of this agreement, we have provided a partial guarantee of approximately $15 million and two letters of credit totaling approximately $23 million in support of the franchisee loan program at March 19, 2011. One such letter of credit could be used if we fail to meet our obligations under our guarantee. The other letter of credit could be used, in certain circumstances, to fund our participation in the funding of the franchisee loan program. The total loans outstanding under the loan pool were $68 million with an additional $32 million available for lending at March 19, 2011.
In addition to the guarantee described above, YUM has provided guarantees of $25 million on behalf of franchisees for several financing programs related to specific initiatives, the most significant of which was the purchase of ovens by KFC franchisees for the launch of Kentucky Grilled Chicken. The total nominal loans outstanding under these financing programs were approximately $29 million at March 19, 2011.
We are self-insured for a substantial portion of our current and prior years’ coverage including workers’ compensation, employment practices liability, general liability, automobile liability, product liability and property losses (collectively, “property and casualty losses”). To mitigate the cost of our exposures for certain property and casualty losses, we make annual decisions to self-insure the risks of loss up to defined maximum per occurrence retentions on a line by line basis or to combine certain lines of coverage into one loss pool with a single self-insured aggregate retention. The Company then purchases insurance coverage, up to a certain limit, for losses that exceed the self-insurance per occurrence or aggregate retention. The insurers’ maximum aggregate loss limits are significantly above our actuarially determined probable losses; therefore, we believe the likelihood of losses exceeding the insurers’ maximum aggregate loss limits is remote. As of March 19, 2011 and December 25, 2010, we had liabilities recorded for self-insured property and casualty losses of $149 million and $150 million, respectively.
In the U.S. and in certain other countries, we are also self-insured for healthcare claims and for long-term disability claims for eligible participating employees subject to certain deductibles and limitations. We have accounted for our retained liabilities for property and casualty losses, healthcare and long-term disability claims, including reported and incurred but not reported claims, based on information provided by independent actuaries.
Due to the inherent volatility of actuarially determined property and casualty loss estimates, it is reasonably possible that we could experience changes in estimated losses which could be material to our growth in quarterly and annual Net Income. We believe that we have recorded reserves for property and casualty losses at a level which has substantially mitigated the potential negative impact of adverse developments and/or volatility.
We are subject to various claims and contingencies related to lawsuits, real estate, environmental and other matters arising in the normal course of business. We provide reserves for such claims and contingencies when payment is probable and reasonably estimable.
On November 26, 2001, Kevin Johnson, a former Long John Silver’s (“LJS”) restaurant manager, filed a collective action against LJS in the United States District Court for the Middle District of Tennessee alleging violation of the Fair Labor Standards Act (“FLSA”) on behalf of himself and allegedly similarly-situated LJS general and assistant restaurant managers. Johnson alleged that LJS violated the FLSA by perpetrating a policy and practice of seeking monetary restitution from LJS employees, including Restaurant General Managers (“RGMs”) and Assistant Restaurant General Managers (“ARGMs”), when monetary or property losses occurred due to knowing and willful violations of LJS policies that resulted in losses of company funds or property, and that LJS had thus improperly classified its RGMs and ARGMs as exempt from overtime pay under the FLSA. Johnson sought overtime pay, liquidated damages, and attorneys’ fees for himself and his proposed class.
LJS moved the Tennessee district court to compel arbitration of Johnson’s suit. The district court granted LJS’s motion on June 7, 2004, and the United States Court of Appeals for the Sixth Circuit affirmed on July 5, 2005.
On December 19, 2003, while the arbitrability of Johnson’s claims was being litigated, former LJS managers Erin Cole and Nick Kaufman, represented by Johnson’s counsel, initiated arbitration with the American Arbitration Association (the “Cole Arbitration”). The Cole Claimants sought a collective arbitration on behalf of the same putative class as alleged in the Johnson lawsuit and alleged the same underlying claims.
On June 15, 2004, the arbitrator in the Cole Arbitration issued a Clause Construction Award, finding that LJS’s Dispute Resolution Policy did not prohibit Claimants from proceeding on a collective or class basis. LJS moved unsuccessfully to vacate the Clause Construction Award in federal district court in South Carolina. On September 19, 2005, the arbitrator issued a Class Determination Award, finding, inter alia, that a class would be certified in the Cole Arbitration on an “opt-out” basis, rather than as an “opt-in” collective action as specified by the FLSA.
On January 20, 2006, the district court denied LJS’s motion to vacate the Class Determination Award and the United States Court of Appeals for the Fourth Circuit affirmed the district court’s decision on January 28, 2008. A petition for a writ of certiorari filed in the United States Supreme Court seeking a review of the Fourth Circuit’s decision was denied on October 7, 2008. The parties participated in mediation on April 24, 2008, on February 28, 2009, and again on November 18, 2009 without reaching resolution. An arbitration hearing on liability with respect to the alleged restitution policy and practice for the period beginning in late 1998 through early 2002 concluded in June, 2010. On October 11, 2010, the arbitrator issued a partial interim award for the first phase of the three-phase arbitration finding that, for the period from late 1998 to early 2002, LJS had a policy and practice of making impermissible deductions from the salaries of its RGMs and ARGMs. Phase two of the arbitration has been scheduled for early October, 2011. Phase three, which would address damages, has not been scheduled.
Based on the rulings issued to date in this matter, the Cole Arbitration is proceeding as an “opt-out” class action, rather than as an “opt-in” collective action. LJS denies liability and is vigorously defending the claims in the Cole Arbitration. We have provided for a reasonable estimate of the cost of the Cole Arbitration, taking into account a number of factors, including our current projection of eligible claims, the estimated amount of each eligible claim, the estimated claim recovery rate, the estimated legal fees incurred by Claimants and a reasonable settlement value of Claimants’ claims. However, in light of the inherent uncertainties of litigation, the fact-specific nature of Claimants’ claims, and the novelty of proceeding in an FLSA lawsuit on an “opt-out” basis, there can be no assurance that the Cole Arbitration will not result in losses in excess of those currently provided for in our Condensed Consolidated Financial Statements.
On August 4, 2006, a putative class action lawsuit against Taco Bell Corp. styled Rajeev Chhibber vs. Taco Bell Corp. was filed in Orange County Superior Court. On August 7, 2006, another putative class action lawsuit styled Marina Puchalski v. Taco Bell Corp. was filed in San Diego County Superior Court. Both lawsuits were filed by a Taco Bell RGM purporting to represent all current and former RGMs who worked at corporate-owned restaurants in California since August 2002. The lawsuits allege violations of California’s wage and hour laws involving unpaid overtime and meal period violations and seek unspecified amounts in damages and penalties. The cases were consolidated in San Diego County as of September 7, 2006.
Based on plaintiffs’ revised class definition in their class certification motion, Taco Bell removed the case to federal court in San Diego on August 29, 2008. On March 17, 2009, the court granted plaintiffs’ motion to remand. On January 29, 2010, the court granted the plaintiffs’ class certification motion with respect to the unpaid overtime claims of RGMs and Market Training Managers but denied class certification on the meal period claims. The parties participated in mediation on May 26, 2010 without reaching resolution. The court has ruled that this case will be tried to the bench rather than a jury. That trial is scheduled to begin on February 6, 2012.
Taco Bell denies liability and intends to vigorously defend against all claims in this lawsuit. We have provided for a reasonable estimate of the cost of this lawsuit. However, in view of the inherent uncertainties of litigation, there can be no assurance that this lawsuit will not result in losses in excess of those currently provided for in our Condensed Consolidated Financial Statements.
On September 10, 2007, a putative class action against Taco Bell Corp., the Company and other related entities styled Sandrika Medlock v. Taco Bell Corp., was filed in United States District Court, Eastern District, Fresno, California. The case was filed on behalf of all hourly employees who have worked at corporate-owned restaurants in California since September 2003 and alleges numerous violations of California labor laws including unpaid overtime, failure to pay wages on termination, denial of meal and rest breaks, improper wage statements, unpaid business expenses and unfair or unlawful business practices in violation of California Business & Professions Code §17200. The Company was dismissed from the case without prejudice on January 10, 2008.
On April 11, 2008, Lisa Hardiman filed a Private Attorneys General Act (“PAGA”) complaint in the Superior Court of the State of California, County of Fresno against Taco Bell Corp., the Company and other related entities. This lawsuit, styled Lisa Hardiman vs. Taco Bell Corp., et al., was filed on behalf of Hardiman individually and all other aggrieved employees pursuant to PAGA. The complaint seeks penalties for alleged violations of California’s Labor Code. On June 25, 2008, Hardiman filed an amended complaint adding class action allegations on behalf of hourly employees in California very similar to the Medlock case, including allegations of unpaid overtime, missed meal and rest periods, improper wage statements, non-payment of wages upon termination, unreimbursed business expenses and unfair or unlawful business practices in violation of California Business & Professions Code §17200. On July 25, 2008, the case was removed to Federal Court in the Eastern District of California.
On June 16, 2008, a putative class action lawsuit against Taco Bell Corp. and the Company, styled Miriam Leyva vs. Taco Bell Corp., et al., was filed in Los Angeles Superior Court. The case was filed on behalf of Leyva and purportedly all other California hourly employees and alleges failure to pay overtime, failure to provide meal and rest periods, failure to pay wages upon discharge, failure to provide itemized wage statements, unfair business practices and wrongful termination and discrimination. The Company was dismissed from the case without prejudice on August 20, 2008.
On November 5, 2008, a putative class action lawsuit against Taco Bell Corp. and the Company styled Loraine Naranjo vs. Taco Bell Corp., et al., was filed in Orange County Superior Court. The case was filed on behalf of Naranjo and purportedly all other California employees and alleges failure to pay overtime, failure to reimburse for business related expenses, improper wage statements, failure to pay accrued vacation wages, failure to pay minimum wage and unfair business practices. The case was removed to District Court and subsequently transferred to the Eastern District of California. The Company filed a motion to dismiss on December 15, 2008, which was denied on January 20, 2009.
On March 26, 2009, Taco Bell was served with a putative class action lawsuit filed in Orange County Superior Court against Taco Bell and the Company styled Endang Widjaja vs. Taco Bell Corp., et al. The case was filed on behalf of Widjaja, a former California hourly assistant manager, and purportedly all other individuals employed in Taco Bell’s California restaurants as managers and alleges failure to reimburse for business related expenses, failure to provide rest periods, unfair business practices and conversion. Taco Bell removed the case to federal district court and filed a notice of related case. On June 18, 2009 the case was transferred to the Eastern District of California.
On December 1, 2010, a putative class action styled Teresa Nave v. Taco Bell Corp. and Taco Bell of America, Inc. was filed in the United States District Court for the Eastern District of California, Fresno division. The plaintiff seeks to represent a California state-wide class of hourly employees who allegedly were not timely paid all earned vacation at the end of their employment and were denied required rest breaks. Plaintiff additionally seeks statutory “waiting time” penalties and alleges violations of California’s Unfair Business Practices Act (B&P Code §17200 et. seq.). On December 9, 2010, the plaintiff filed a First Amended Complaint adding three individuals as named plaintiffs.
On May 19, 2009 the court granted Taco Bell’s motion to consolidate the Medlock, Hardiman, Leyva and Naranjo matters, and the consolidated case is styled In Re Taco Bell Wage and Hour Actions. On July 22, 2009, Taco Bell filed a motion to dismiss, stay or consolidate the Widjaja case with the In Re Taco Bell Wage and Hour Actions, and Taco Bell’s motion to consolidate was granted on October 19, 2009. On December 16, 2010, the court ordered the Nave matter consolidated with In Re Taco Bell Wage and Hour Actions.
The In Re Taco Bell Wage and Hour Actions plaintiffs filed a consolidated complaint on June 29, 2009, and on March 30, 2010 the court approved the parties’ stipulation to dismiss the Company from the action. The parties participated in mediation on August 5, 2010 without reaching resolution. Plaintiffs filed their motion for class certification on December 30, 2010, and the hearing on plaintiffs’ class certification motion has been scheduled for June 6, 2011. Plaintiffs have filed a motion to amend their class action complaint and to include an additional named plaintiff.
Taco Bell denies liability and intends to vigorously defend against all claims in this lawsuit. However, in view of the inherent uncertainties of litigation, the outcome of this case cannot be predicted at this time. Likewise, the amount of any potential loss cannot be reasonably estimated.
On September 28, 2009, a putative class action styled Marisela Rosales v. Taco Bell Corp. was filed in Orange County Superior Court. The plaintiff, a former Taco Bell crew member, alleges that Taco Bell failed to timely pay her final wages upon termination, and seeks restitution and late payment penalties on behalf of herself and similarly situated employees. This case appears to be duplicative of the In Re Taco Bell Wage and Hour Actions case described above. Taco Bell removed the case to federal court on November 5, 2009, and subsequently filed a motion to dismiss, stay or transfer the case to the same district court as the In Re Taco Bell Wage and Hour Actions case. The parties stipulated to remand of the case to Orange County Superior Court on March 18, 2010. The state court granted Taco Bell’s motion to stay the Rosales case on May 28, 2010, but required Taco Bell to give notice to Rosales’ counsel of the In Re Taco Bell Wage and Hour Actions mediation. The matter remains stayed.
On October 2, 2009, a putative class action, styled Domonique Hines v. KFC U.S. Properties, Inc., was filed in California state court on behalf of all California hourly employees alleging various California Labor Code violations, including rest and meal break violations, overtime violations, wage statement violations and waiting time penalties. Plaintiff is a former non-managerial KFC restaurant employee. KFC filed an answer on October 28, 2009, in which it denied plaintiff’s claims and allegations. KFC removed the action to the United States District Court for the Southern District of California on October 29, 2009. Plaintiff filed a motion for class certification on May 20, 2010 and KFC filed a brief in opposition. On October 22, 2010, the District Court granted Plaintiff’s motion to certify a class on the meal and rest break claims, but denied the motion to certify a class regarding alleged off-the-clock work. On November 1, 2010, KFC filed a motion requesting a stay of the case pending a decision from the California Supreme Court regarding the applicable standard for employer provision of meal and rest breaks. Plaintiff filed an opposition to that motion on November 19, 2010. On January 14, 2011, the District Court granted KFC’s motion and stayed the entire action pending a decision from the California Supreme Court. No trial date has been set.
KFC denies liability and intends to vigorously defend against all claims in this lawsuit. However, in view of the inherent uncertainties of litigation, the outcome of this case cannot be predicted at this time. Likewise, the amount of any potential loss cannot be reasonably estimated.
On August 18, 2010, a putative class action, styled Lisa Harrison and Noe Rivera v. KFC USA, Inc., KFC U.S. Properties, Inc., and KFC Corporation, was filed in California state court on behalf of all former California hourly employees alleging various California Labor Code violations, including failure to pay all vacation pay, failure to reimburse business expenses (mileage and uniforms), and waiting time penalties, as well as a claim of unfair competition. KFC removed the action to the United States District Court for the Northern District of California on October 4, 2010, and the case was transferred to the Central District of California on October 27, 2010. On December 14, 2010, the court granted KFC’s motion to dismiss Plaintiffs’ third cause of action (Plaintiffs’ claim for reimbursement of expenses). Plaintiffs filed a First Amended Complaint on December 28, 2010. The First Amended Complaint contained the same causes of action as the initial complaint, along with a request for penalties pursuant to the California Private Attorneys General Act. In response to KFC’s stated intention to file a motion to dismiss the First Amended Complaint, Plaintiffs filed a Second Amended Complaint on February 20, 2011. No trial date has been set.
On December 17, 2002, Taco Bell was named as the defendant in a class action lawsuit filed in the United States District Court for the Northern District of California styled Moeller, et al. v. Taco Bell Corp. On August 4, 2003, plaintiffs filed an amended complaint that alleges, among other things, that Taco Bell has discriminated against the class of people who use wheelchairs or scooters for mobility by failing to make its approximately 220 company-owned restaurants in California accessible to the class. Plaintiffs contend that queue rails and other architectural and structural elements of the Taco Bell restaurants relating to the path of travel and use of the facilities by persons with mobility-related disabilities do not comply with the U.S. Americans with Disabilities Act (the “ADA”), the Unruh Civil Rights Act (the “Unruh Act”), and the California Disabled Persons Act (the “CDPA”). Plaintiffs have requested: (a) an injunction from the District Court ordering Taco Bell to comply with the ADA and its implementing regulations; (b) that the District Court declare Taco Bell in violation of the ADA, the Unruh Act, and the CDPA; and (c) monetary relief under the Unruh Act or CDPA. Plaintiffs, on behalf of the class, are seeking the minimum statutory damages per offense of either $4,000 under the Unruh Act or $1,000 under the CDPA for each aggrieved member of the class. Plaintiffs contend that there may be in excess of 100,000 individuals in the class.
On February 23, 2004, the District Court granted plaintiffs’ motion for class certification. The class includes claims for injunctive relief and minimum statutory damages.
On May 17, 2007, a hearing was held on plaintiffs’ Motion for Partial Summary Judgment seeking judicial declaration that Taco Bell was in violation of accessibility laws as to three specific issues: indoor seating, queue rails and door opening force. On August 8, 2007, the court granted plaintiffs’ motion in part with regard to dining room seating. In addition, the court granted plaintiffs’ motion in part with regard to door opening force at some restaurants (but not all) and denied the motion with regard to queue lines.
The parties participated in mediation on March 25, 2008, and again on March 26, 2009, without reaching resolution. On December 16, 2009, the court denied Taco Bell’s motion for summary judgment on the ADA claims and ordered plaintiff to file a definitive list of remaining issues and to select one restaurant to be the subject of a trial. The court has ordered the exemplar trial to begin on June 6, 2011. The trial will be bifurcated and the first stage will address equitable relief and whether violations existed at the restaurant. Taco Bell will have the opportunity to renew its motion for summary judgment on those issues and the opportunity to move to decertify the class. A case currently pending before the U.S. Supreme Court, Dukes v. Wal-Mart Stores, Inc., may impact the issue of class certification. Depending on the findings in the first stage of the trial and the court’s rulings on motions for summary judgment or class de-certification, the court may address the issue of damages in a separate, second stage.
Taco Bell denies liability and intends to vigorously defend against all claims in this lawsuit. Taco Bell has taken steps to address potential architectural and structural compliance issues at the restaurants in accordance with applicable state and federal disability access laws. The costs associated with addressing these issues have not significantly impacted our results of operations. It is not possible at this time to reasonably estimate the probability or amount of liability for monetary damages on a class wide basis to Taco Bell.
On March 14, 2007, a lawsuit styled Boskovich Farms, Inc. v. Taco Bell Corp. and Does 1 through 100 was filed in the Superior Court of the State of California, Orange County. Boskovich Farms, a supplier of produce to Taco Bell, alleged in its complaint, among other things, that it suffered damage to its reputation and business as a result of publications and/or statements it claims were made by Taco Bell in connection with Taco Bell’s reporting of results of certain tests conducted during investigations on green onions used at Taco Bell restaurants. The parties participated in mediation on April 10, 2008, without reaching resolution. The arbitration panel heard the parties’ cross motions for summary judgment on August 12, 2009. On August 14, 2009, the arbitration panel issued an opinion granting Taco Bell’s motion for summary judgment and dismissing all of Boskovich’s claims with prejudice. On September 23, 2009, Boskovich filed a motion to vacate the arbitration award. On January 6, 2010 the court heard oral arguments on Boskovich’s motion to vacate and took the matter under submission. On March 24, 2010, the court denied plaintiff’s motion and confirmed the arbitration award. Boskovich appealed to the Kentucky Court of Appeals on April 23, 2010.
Taco Bell filed its response on May 19, 2010 and reserved the right to seek attorneys’ fees for the cost of the appeals. Taco Bell denies liability and intends to vigorously defend against all claims in any arbitration and the lawsuit. However, in view of the inherent uncertainties of litigation, the outcome of this case cannot be predicted at this time. Likewise, the amount of any potential loss cannot be reasonably estimated.
On July 9, 2009, a putative class action styled Mark Smith v. Pizza Hut, Inc. was filed in the United States District Court for the District of Colorado. The complaint alleges that Pizza Hut did not properly reimburse its delivery drivers for various automobile costs, uniforms costs, and other job-related expenses and seeks to represent a class of delivery drivers nationwide under the Fair Labor Standards Act (FLSA) and Colorado state law. On January 4, 2010, plaintiffs filed a motion for conditional certification of a nationwide class of current and former Pizza Hut, Inc. delivery drivers. However, on March 11, 2010, the court granted Pizza Hut’s pending motion to dismiss for failure to state a claim, with leave to amend. On March 31, 2010, plaintiffs filed an amended complaint, which dropped the uniform claims but, in addition to the federal FLSA claims, asserts state-law class action claims under the laws of 16 different states. Pizza Hut filed a motion to dismiss the amended complaint, and plaintiffs sought leave to amend their complaint a second time. On August 9, 2010, the court granted plaintiffs’ motion to amend. Pizza Hut has filed another motion to dismiss the Second Amended Complaint. The court has yet to rule on Pizza Hut’s motion.
Pizza Hut denies liability and intends to vigorously defend against all claims in this lawsuit. However, in view of the inherent uncertainties of litigation, the outcome of these cases cannot be predicted at this time. Likewise, the amount of any potential loss cannot be reasonably estimated.
On August 6, 2010, a putative class action styled Jacquelyn Whittington v. Yum Brands, Inc., Taco Bell of America, Inc. and Taco Bell Corp. was filed in the United States District Court for the District of Colorado. The plaintiff seeks to represent a nationwide class, with the exception of California, of salaried assistant managers who were allegedly misclassified and did not receive compensation for all hours worked and did not receive overtime pay after 40 hours in a week. The plaintiff also purports to represent a separate class of Colorado assistant managers under Colorado state law, which provides for daily overtime after 12 hours in a day. The Company has been dismissed from the case without prejudice. Taco Bell filed its answer on September 20, 2010, and the parties commenced class discovery, which is currently on-going. Taco Bell has moved to compel arbitration of certain employees in the Colorado class.
We are engaged in various other legal proceedings and have certain unresolved claims pending, the ultimate liability for which, if any, cannot be determined at this time. However, based upon consultation with legal counsel, we are of the opinion that such proceedings and claims are not expected to have a material adverse effect, individually or in the aggregate, on our consolidated financial condition or results of operations.
On April 15, 2011, we repaid $650 million of Senior Unsecured Notes upon their maturity with existing cash on hand.
We currently own 27% of the outstanding shares of Little Sheep Group Limited (“Little Sheep”), a Hot Pot concept headquartered in Baotou, Inner Mongolia, China. On April 26, 2011, we announced that we have submitted a preliminary proposal to Little Sheep under which we would offer to acquire all outstanding shares of Little Sheep, other than a minority interest to be held by the chairman and other founding shareholders of Little Sheep. No formal offer has been made at this stage and any such offer, should one be made, would be made only after we have obtained all necessary regulatory approvals for the transaction. There can be no assurance that the current discussions between YUM and Little Sheep regarding the proposal will ultimately lead to an offer being made or, if an offer is made, that it will result in a completed transaction.
The following Management’s Discussion and Analysis (“MD&A”) should be read in conjunction with the unaudited Condensed Consolidated Financial Statements (“Financial Statements”), the Cautionary Note Regarding Forward-Looking Statements and our annual report on Form 10-K for the fiscal year ended December 25, 2010 (“2010 Form 10-K”). Throughout the MD&A, YUM! Brands, Inc. (“YUM” or the “Company”) makes reference to certain performance measures as described below.
The Company provides the percentage changes excluding the impact of foreign currency translation (“FX” or “Forex”). These amounts are derived by translating current year results at prior year average exchange rates. We believe the elimination of the foreign currency translation impact provides better year-to-year comparability without the distortion of foreign currency fluctuations.
System sales growth includes the results of all restaurants regardless of ownership, including Company-owned, franchise, unconsolidated affiliate and license restaurants that operate our concepts. Sales of franchise, unconsolidated affiliate and license restaurants generate franchise and license fees for the Company (typically at a rate of 4% to 6% of sales). Franchise, unconsolidated affiliate and license restaurant sales are not included in Company sales on the Condensed Consolidated Statements of Income; however, the franchise and license fees are included in the Company’s revenues. We believe system sales growth is useful to investors as a significant indicator of the overall strength of our business as it incorporates all of our revenue drivers, Company and franchise same store sales as well as net unit development.
Same store sales is the estimated growth in sales of all restaurants that have been open one year or more.
Company restaurant profit is defined as Company sales less expenses incurred directly by our Company restaurants in generating Company sales. Company restaurant margin as a percentage of sales is defined as Company restaurant profit divided by Company sales.
Operating margin is defined as Operating Profit divided by Total revenues.
All Note references herein refer to the accompanying Notes to the Condensed Consolidated Financial Statements. Tabular amounts are displayed in millions except per share and unit count amounts, or as otherwise specifically identified.
YUM is the world’s largest restaurant company based on number of system units, with over 37,000 units in more than 110 countries and territories operating under the KFC, Pizza Hut, Taco Bell, Long John Silver’s (“LJS”) and A&W All-American Food Restaurants (“A&W”) brands. Four of the Company’s restaurant brands – KFC, Pizza Hut, Taco Bell and LJS – are the global leaders in the quick-service chicken, pizza, Mexican-style food and seafood categories, respectively. Of the over 37,000 restaurants, 19% are operated by the Company, 75% are operated by franchisees and unconsolidated affiliates and 6% are operated by licensees.
YUM’s business consists of three reporting segments: YUM Restaurants China (“China” or “China Division”), YUM Restaurants International (“YRI” or “International Division”) and United States (“U.S.”). The China Division includes mainland China and YRI includes the remainder of our international operations. The China Division, YRI and Taco Bell-U.S. now represent over 85% of the Company’s operating profits. Our KFC-U.S. and Pizza Hut-U.S. businesses operate in a highly competitive marketplace resulting in slower profit growth, but continue to produce strong cash flows.
Build Leading Brands in China in Every Significant Category – The Company has developed the KFC and Pizza Hut brands into the leading quick service and casual dining restaurants, respectively, in mainland China. The Company and its franchisees opened over 500 new restaurants in 2010 in the China Division. Additionally, the Company owns and operates the distribution system for its restaurants in mainland China which we believe provides a significant competitive advantage. Given this strong competitive position, a growing economy and a population of 1.3 billion in mainland China, the Company is rapidly adding KFC and Pizza Hut Casual Dining restaurants and testing the additional restaurant concepts of Pizza Hut Home Service (pizza delivery) and East Dawning (Chinese food). Our ongoing earnings growth model in China includes double digit unit growth, same store sales growth of at least 4% and leverage of our General and Administrative (“G&A”) infrastructure, which we expect to drive Operating Profit growth of 15%.
Drive Aggressive International Expansion and Build Strong Brands Everywhere – The Company and its franchisees opened nearly 900 new restaurants in 2010 in the Company’s International Division, representing 11 straight years of opening over 700 restaurants, and YRI is one of the leading international retail developers in terms of units opened. The Company expects to continue to experience strong growth by building out existing markets and growing in new markets including France, Russia and India. The International Division’s Operating Profit has experienced an 8 year compound annual growth rate of 11%. Our ongoing earnings growth model for YRI includes Operating Profit growth of 10% driven by 3-4% net unit growth, at least 2-3% same store sales growth, modest margin improvement and leverage of our G&A infrastructure.
Dramatically Improve U.S. Brand Positions, Consistency and Returns – The Company continues to focus on improving its U.S. position through differentiated products and marketing and an improved customer experience. The Company also strives to provide industry leading new product innovation which adds sales layers and expands day parts. We continue to evaluate our returns and ownership positions with an earn the right to own philosophy on Company owned restaurants. Our ongoing earnings growth model calls for Operating Profit growth of 5% in the U.S. As we near completion of our refranchising program in 2011, the Taco Bell operating segment will become an increasingly larger component of U.S. ongoing earnings growth. The U.S. ongoing earnings growth model includes Taco Bell Operating Profit growth of 6% driven by modest unit growth, same store sales growth of 3% and leverage of our G&A infrastructure.
Drive Industry-Leading, Long-Term Shareholder and Franchisee Value – The Company is focused on delivering high returns and returning substantial cash flows to its shareholders via dividends and share repurchases. The Company has one of the highest returns on invested capital in the Quick Service Restaurants (“QSR”) industry. The Company’s dividend and share repurchase programs have returned over $1.8 billion and $6 billion to shareholders, respectively, since 2004. The Company is targeting an annual dividend payout ratio of 35% to 40% of net income and has increased the quarterly dividend each year since inception in 2004. Shares are repurchased opportunistically as part of our regular capital structure decisions.
The ongoing earnings growth rates referenced above represent our average annual expectations for the foreseeable future. Details of our 2011 Guidance by division as presented on December 8, 2010 can be found online at http://www.yum.com.
Worldwide operating profit grew 5%, prior to foreign currency translation, including 18% in China and 8% in YRI, partially offset by a 13% decline in the U.S.
Worldwide system sales grew 5%, prior to foreign currency translation, including 24% in China and 6% in YRI. System sales in the U.S. were flat.
International development continued at a strong pace with 223 new restaurants, including 92 new units in China.
System same store sales grew 13% in China and 2% in YRI, with a 1% decline in the U.S.
Worldwide restaurant margin improved 0.6 percentage points to 17.6%.
Repurchased 2.9 million shares totaling $142 million at an average price of $49.41 per share.
The tax rate increased to 27.1% in 2011 from 25.7% in 2010.
All preceding comparisons are versus the same period a year ago and exclude the impact of Special Items. See the Significant Known Events, Trends or Uncertainties Impacting or Expected to Impact Comparisons of Reported or Future Results section of this MD&A for a description of Special Items.
See Note 2 for the number of shares used in this calculation.
The following factors impacted comparability of operating performance for the quarters ended March 19, 2011 and March 20, 2010 and/or could impact comparability with the remainder of our results in 2011 or beyond. Certain of these factors were previously discussed in our 2010 Form 10-K.
In addition to the results provided in accordance with Generally Accepted Accounting Principles (“GAAP”) above and throughout this document, the Company has provided non-GAAP measurements which present operating results for the quarters ended March 19, 2011 and March 20, 2010 on a basis before Special Items. Included in Special Items are the impact of measures we took to transform our U.S. business (“the U.S. business transformation measures”) including the U.S. refranchising gain (loss), the depreciation reduction arising from the impairment of KFC restaurants we offered to sell in 2010 that remained Company restaurants for some or all of the quarter ended March 19, 2011 and charges relating to U.S. G&A productivity initiatives and realignment of resources, as well as the losses recognized upon refranchising of our equity market in Taiwan and the impairment of intangibles and other costs relating to our planned sale of LJS and A&W. These amounts are further described below.
The Company uses earnings before Special Items as a key performance measure of results of operations for the purpose of evaluating performance internally and Special Items are not included in our China Division, YRI or U.S. segment results. This non-GAAP measurement is not intended to replace the presentation of our financial results in accordance with GAAP. Rather, the Company believes that the presentation of earnings before Special Items provides additional information to investors to facilitate the comparison of past and present operations, excluding items in the quarters ended March 19, 2011 and March 20, 2010 that the Company does not believe are indicative of our ongoing operations due to their size and/or nature.
Loss upon refranchising of an equity market outside the U.S.
The tax benefit (expense) was determined based upon the impact of the nature, as well as the jurisdiction of the respective individual components within Special Items.
The U.S. business transformation measures in 2011 and 2010 included: continuation of our U.S. refranchising and G&A productivity initiatives and realignment of resources (primarily severance and early retirement costs). We do not believe these measures are indicative of our ongoing operations and are not including the impacts of these U.S. business transformation measures in our U.S. segment for performance reporting purposes.
In the quarters ended March 19, 2011 and March 20, 2010, we recorded a pre-tax gain of $1 million and a pre-tax loss of $56 million, respectively, from refranchising in the U.S. The loss recorded in the quarter ended March 20, 2010 was the net result of gains from 46 restaurants sold and non-cash impairment charges related to our offers to refranchise restaurants in the U.S., principally a substantial portion of our Company operated KFC restaurants. The non-cash impairment charges related to our offers to refranchise a substantial portion of our Company operated KFC restaurants in the U.S. decreased depreciation expense versus what would have otherwise been recorded by $3 million in the quarter ended March 19, 2011 for those restaurants that remained company stores for some or all of the quarter ended March 19, 2011. This depreciation reduction was recorded as a Special Item, resulting in depreciation expense in the U.S. segment results continuing to be recorded at the rate at which it was prior to the impairment charge being recorded for these restaurants. The refranchising gains and losses are more fully discussed in Note 4 and the Store Portfolio Strategy Section of the MD&A.
In connection with our G&A productivity initiatives and realignment of resources (primarily severance and early retirement costs) we recorded pre-tax charges of $1 million and $3 million in the quarters ended March 19, 2011 and March 20, 2010, respectively.
Refranchising of an Equity Market Outside the U.S.
Operating Profit in the U.S. declined 13% in the quarter ended March 19, 2011 primarily due to a decline in restaurant margins of 1.6 percentage points. Restaurant margins decreased due to the impact of higher restaurant operating costs, including commodity inflation of $8 million, accompanied by a same store sales decline of 1%. Taco Bell’s operating profits were significantly impacted in the quarter by the publicity associated with a lawsuit filed in late January 2011 alleging a violation of consumer protection statutes and deceptive business practices by Taco Bell through its advertising that the beef served in its products is “seasoned beef”. Such claims were false and the lawsuit was voluntarily withdrawn on April 18, 2011. Nonetheless, Taco Bell experienced a significant reversal in sales trends immediately following the filing of the lawsuit. These negative sales trends have continued into the second quarter through the date of this filing and we do not know when they will reverse. We expect that the weak sales trends at Taco Bell and continued food inflation will have a significant negative impact on U.S. Operating Profit in our second quarter ending June 11, 2011.
Early in the YRI Division’s second quarter, a massive earthquake and tsunami impacted Japan. Our restaurants in Japan are 100% franchise-owned. Thus, while there have been some franchise store closures in the directly affected area and widespread interruptions to operations across the country, we do not expect that our results of operations will be materially impacted. We currently estimate the impact to Operating Profit to be $3 million in YRI’s second quarter up to a maximum of $6 million for the full year.
Changes in foreign currency exchange rates positively impacted the translation of our foreign currency denominated Operating Profit in our YRI Division and our China Division by $5 million and $7 million, respectively, for the quarter ended March 19, 2011.
From time to time we sell Company restaurants to existing and new franchisees where geographic synergies can be obtained or where franchisees’ expertise can generally be leveraged to improve our overall operating performance, while retaining Company ownership of strategic U.S. and international markets in which we choose to continue investing capital. In the U.S., we are targeting Company ownership of KFC, Pizza Hut and Taco Bell restaurants of about 12%, down from its current level of 15%. These U.S. ownership percentages no longer consider the impact of LJS and A&W restaurants, both of which are completely franchise operated, as we are pursuing a sale of these brands. Consistent with this strategy, 15 Company restaurants in the U.S. were sold to franchisees in the quarter ended March 19, 2011.
Refranchisings reduce our reported revenues and restaurant profits and increase the importance of system sales growth as a key performance measure. Additionally, G&A expenses will decline over time as a result of these refranchising activities. The timing of G&A declines will vary and often lag the actual refranchising activities as the synergies are typically dependent upon the size and geography of the respective deals. G&A expenses included in the tables below reflect only direct G&A that we no longer incurred as a result of stores that were operated by us for all or some portion of the first quarter in 2010 and were no longer operated by us as of the last day of the current first quarter.
The quarter ended March 20, 2010 includes a non-cash impairment charge of $73 million related to our offer to refranchise a substantial portion of our Company operated KFC restaurants in the U.S. See Note 4 for further discussion.
The impact on Operating Profit arising from refranchising is the net of (a) the estimated reductions in Restaurant profit, which reflects the decrease in Company sales, and G&A expenses and (b) the increase in franchise fees from the restaurants that have been refranchised. The tables presented below reflect the impacts on Total revenues and on Operating Profit from stores that were operated by us for all or some portion of the prior year period and were no longer operated by us as of the last day of the current quarter. In these tables, Decreased Company sales and Decreased Restaurant profit represents the amount of sales or Restaurant profit earned by the refranchised restaurants during the period we owned them in the prior year but did not own them in the current year. Increased Franchise and license fees and income represents the franchise and license fees from the refranchised restaurants that were recorded by the Company in the current year during periods in which the restaurants were Company stores in the prior year.
The Worldwide, YRI and U.S. totals exclude 2,171, 134 and 2,037 licensed units, respectively, at March 19, 2011. There are no licensed units in the China Division. Licensed units are generally units that offer limited menus and operate in non-traditional locations like malls, airports, gasoline service stations, convenience stores, stadiums and amusement parks where a full scale traditional outlet would not be practical or efficient. As licensed units have lower average unit sales volumes than our traditional units and our current strategy does not place a significant emphasis on expanding our licensed units, we do not believe that providing further detail of licensed unit activity provides significant or meaningful information.
The following table details the key drivers of system sales growth for each reportable segment for the quarter. Net unit growth and other represents the net impact of actual system sales growth due to new unit openings and historical system sales lost due to closures as well as any necessary rounding.


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In the United States, as in any democracy, the most important guarantee of government accountability is the right of citizens to control their government through elections. But elections are not the only way of holding public officials to account. Robert S. Barker, professor of law at Duquesne University School of Law, who has written and spoken widely about the subject, discusses the key components of accountability in this article on the U.S. system.
"The genius of republican liberty seems to demand...not only that all power should be derived from the people, but that those entrusted with it should be kept in dependence on the people...."
"...the concentration of power and the subjection of individuals will increase amongst democratic nations ... in the same proportion as their ignorance."
Governmental accountability -- that is, the duty of public officials to report their actions to the citizens, and the right of the citizens to take action against those officials whose conduct the citizens consider unsatisfactory -- is an essential element, perhaps the essential element of democracy. The purpose of this article is to review some aspects of governmental accountability as reflected in the constitutions, laws, history, and political traditions of the United States.
The Constitution of the United States contains a number of provisions which deal directly with governmental accountability. For example, Article I, Section 5, requires that each house of Congress "keep a Journal of its Proceedings, and from time to time publish the same, excepting such Parts as may in their Judgment require Secrecy; and the Yeas and Nays [that is, the votes "for" and "against"] of the members of either house on any question shall, at the Desire of one fifth of those Present, be entered on the Journal." The president is required, "from time to time" to give the Congress "Information of the State of the Union" and, whenever he vetoes any bill passed by Congress, he is required to state his objections and those objections must be published in the journal of the House in which the bill originated. The Constitution also requires that "a regular Statement and Account of the Receipts and Expenditures of all public Money...be published from time to time." The Sixth Amendment provides that the accused in a criminal case "shall enjoy the right to a...public trial." Importantly, all civil officers of the United States are subject to removal from office for misconduct, upon impeachment by the House of Representatives and conviction by the Senate. Finally, the Constitution guarantees accountability by imposing fixed terms of office on those who exercise federal legislative and executive power. All of these guarantees promote accountability by requiring government to disclose its activities, and by providing ordinary and extraordinary means of removing public officials. The constitutions of the 50 states contain various provisions comparable to those found in the national Constitution.
In addition to the aforementioned constitutional guarantees, there are many federal and state statutes and local ordinances which directly promote accountability by, for example, giving citizens the right to inspect public records, requiring public officials to disclose their sources of income, requiring candidates for public office to disclose the names of those who contribute to their campaigns, and requiring that legislative meetings be open to the public. (The term "statute" refers to a law enacted by the Congress of the United States or by the legislature of one of the states. The term "ordinance" refers to a law enacted by a city, county, or other local government.) These and other provisions promote accountability in a direct and obvious way. Such provisions are, of course, important; however, equally important are those indirect guarantees of accountability which flow from the structure of American government and the history of American politics.
Some years ago, a newspaper reporter asked the mayor of a large American city, "Which is more important, national politics or local politics?" The mayor, quoting Thomas P. "Tip" O'Neill, the late speaker of the House of Representatives, immediately answered, "All politics is local!" He was right, and his answer identified one of the characteristics of the American political tradition which promotes governmental accountability. Ever since colonial times, the basis of citizen participation in government has been local government. Everywhere in the 13 original colonies, the settlers organized themselves into boroughs and townships, which, in turn, were grouped into counties. When the colonists established their colonial legislatures, they generally followed the practice of having each borough, township, or county elect one representative to the lower house of the legislature of that colony.
The right to vote was in those days usually severely restricted -- slaves, women and those who did not own land were not permitted to vote. Many important questions were decided by the Crown rather than by the colonists, but the colonial systems of local government and legislative representation laid the foundation for ongoing accountability: local officials were known to, and dependent upon their neighbors, and accountability was thus natural. The practice of electing legislators by single-member districts meant that each legislator was chosen by, identified with, and responsible to a particular, defined community, again ensuring a high degree of accountability.
Although each state determines for itself, through its own constitution and laws, the precise extent of governmental power enjoyed by its local governments, the role of local government has always and everywhere been very important, both legally and politically.
"The concentration of [all the powers of government] in the same hands is precisely the definition of despotic government.... The government we fought for was one not only founded on free principles but in which the powers of government should be so divided and balanced among several bodies of magistracy...that no one could transcend their legal limits without being effectively checked and restrained by the others... For this reason...the legislative, executive, and judicial departments should be separate and distinct, so that no person should exercise the powers of more than one of them at the same time."
"We should ... marshal our government into (1) a general federal republic, for all concerns foreign and federal; (2) that of the State, for what relates to our own citizens exclusively; (3) the county republics, for the duties and concerns of the county; and (4) the ward republics, for the small and yet numerous and interesting concerns of the neighborhood. Thus in government, as well as in every other business of life, it is by division and subdivision of duties alone that all matters, great and small, can be managed to perfection."
The "separation of powers" described by Jefferson has at least three dimensions: First, the allocation of governmental power among separate branches of government (this is "separation of powers" in the strict sense); second, the division of that power in such a way that the authority of one branch in a given matter is limited by the authority of another branch over the same or a related matter. (This is usually called "checks and balances." It is, in essence, a system of intra-governmental accountability.) The third aspect of this arrangement is the vertical division of governmental power in such a way that each governmental task is assigned to the smallest, most local governmental unit able to perform it. This is the principle of subsidiarity, which of course, encompasses federalism.
All of these aspects of separation of powers are reflected in the U.S. Constitution drafted in Philadelphia in 1787. The Constitution gives to the federal (or "national") government certain powers, such as the power to conduct foreign relations, to decide questions of war and peace, and to regulate commerce among the states and with foreign countries. Those enumerated powers, and all powers implied therein, may be exercised by the federal government. All powers not delegated to the federal government by the Constitution are, in the words of the Constitution itself, "reserved to the states respectively, or to the people." This division of power, made explicit by the Tenth Amendment to the Constitution, establishes the principle of federalism.
Federal governmental power is divided among three branches, legislative, executive and judicial, thus establishing "separation of powers" in the strict sense. Moreover, the exercise of power by any one of the three branches of the federal government is limited in various ways by the powers given to the other branches, thus establishing the principle of checks and balances.
This approach to separation of powers has also been carried out within each state in its own state constitution through the division of power among three branches within the state government; the creation of a variety of checks and balances among the three branches of government; and the allocation of many governmental powers to two lower levels of local government, counties and municipalities.
In a very important way, governmental accountability is exercised and enforced by the tribunals through the process known as "judicial review," which began with the landmark decision of the United States Supreme Court in 1803 in the case of Marbury v. Madison. In that case, President John Adams, in the closing days of his presidency, nominated one William Marbury to be justice of the peace in the District of Columbia. However, Marbury's "commission" (that is, the document certifying his appointment) was not delivered to him, and Adam's presidential term expired. The new president, Thomas Jefferson, ordered that the commission not be delivered.
Marbury then brought suit in the U.S. Supreme Court, seeking an order directing the Secretary of State, James Madison, to deliver the commission to him. Marbury argued that a federal statute gave the Supreme Court power to exercise original jurisdiction in cases such as his. However, the Supreme Court concluded that the Constitution limits its original jurisdiction to certain categories of suits, and that Marbury's case was not within any of those categories. Thus, the Court said, there was a conflict between the federal statute, which purported to confer original jurisdiction, and the Constitution, which purported to deny original jurisdiction. Because, the Court continued, the Constitution is the "supreme law of the land," the Constitution must prevail over any other law, federal or state, which conflicts with it. Accordingly, the Court applied the Constitution, ignored the statute, and dismissed Marbury's claim for lack of jurisdiction.
Marbury v. Madison established the principle that all laws and other governmental actions must conform to the Constitution, and that any individual who believes that his or her constitutional rights are being violated by any level of government -- federal, state or local -- may obtain redress through appropriate litigation. As such, every year, U.S. federal and state courts decide hundreds of cases in which government officials are required to defend the constitutionality of their actions.
In 1952, during the Korean War, the steelworkers union announced its intention to go on strike against the major steel manufacturers in the United States. A few hours before the strike was to begin, President Harry Truman issued an executive order placing the steel mills under the control of the federal government, in order to keep them operating. The steel companies immediately brought suit against the federal government, arguing that the president had exceeded his powers under the Constitution. In its decision (Youngstown Sheet & Tube Co. v. Sawyer), the Supreme Court, by a vote of 6-to-3, concluded that the president had indeed exceeded his constitutional powers. The government immediately returned the steel mills to their owners, in accordance with the decision of the Court.
Perhaps the most famous exercise of judicial review in recent decades was the Supreme Court decision in the 1954 case of Brown v. Board of Education, in which the Court held that laws establishing racial segregation in public schools violate the constitutional guarantee of "equal protection of the laws." The Brown decision, and numerous other "equal protection" decisions which followed it, have established the principle that government is accountable to all the people, not just to those who constitute the "majority" at any given moment.
In 1974, the Supreme Court was faced with a case of great constitutional importance arising out of the Watergate scandal. Two years earlier, the headquarters of the Democratic National Committee, located in a building complex known as "Watergate," was burglarized. It soon became clear that the burglary had been organized by persons close to President Richard Nixon, and that after the burglary, a number of the president's advisors, and probably Nixon himself, had conspired to impede the investigation of the crime. Several former members of the president's staff were charged with crimes related to the Watergate burglary and "cover-up." In the course of their trial, the federal criminal court ordered the president to deliver to the court certain tapes of presidential conversations which were, allegedly, relevant to the case. The president refused, arguing that he had the right to preserve the secrecy of presidential communications.
The Supreme Court, by a unanimous vote in United States v. Nixon, decided against the president and ordered him to deliver the tapes to the criminal court. The Court reasoned that while the president does enjoy an "executive privilege," which enables him to maintain the confidentiality of presidential conversations, that privilege is not absolute, but rather must in each instance be weighed against the countervailing interest in disclosure. The Court concluded that since President Nixon had not asserted any particular need for secrecy, his interests were outweighed by the obvious need to maintain the integrity of the criminal process. The president promptly delivered the tapes to the criminal court.
The foregoing rules, practices and decisions ensuring governmental accountability would have been, and would now be, ineffective were it not for another set of principles deeply rooted in American history and law: freedom of speech, press, assembly, petition and association, which are guaranteed by the First Amendment to the Constitution and are often collectively referred to as "freedom of expression." The details of these First Amendment freedoms are beyond the scope of this brief article. Nevertheless, one case in particular serves to demonstrate the close connection between freedom of expression and government accountability.
In the early 1960's, the New York Times published a political advertisement which made certain accusations of misconduct about a city official in the state of Alabama. The official sued the New York Times for defamation. At trial, it was established that the accusations were false, and the court ordered the Times to pay damages to the defamed official. On appeal, the U.S. Supreme Court reversed the decision, holding that the right to criticize government is so important that even false accusations about public officials are constitutionally protected. Therefore, the Court concluded, a public official may recover damages for defamation only when the speaker (whether an individual or a newspaper) either knows that the defamatory statement is false, or acts with reckless disregard for the truth. This decision, New York Times v. Sullivan, established the principle that freedom of expression is most highly protected when one is criticizing the government and government officials, and, conversely, that public officials enjoy very little protection from criticism, even when that criticism is based on error.
Unless citizens can speak openly, publish and debate their ideas, and organize themselves into groups according to their own criteria and principles, they cannot possibly call public officials to account. Fortunately, the United States has a long tradition of respect for these freedoms.
Accountability has its limits. As the Supreme Court acknowledged in the Watergate case, the interest of the government in, for example, protecting national security or maintaining the confidentiality of diplomatic communications might, in any given situation, outweigh the reasons for disclosure. The Constitution itself, while requiring the Senate and the House of Representatives to keep and publish records of their proceedings, expressly excepts "such Parts as may in their judgment require Secrecy."
Further, the courts have decided that the constitutional obligation of the federal government to publish an "account of receipts and expenditures" does not require the publication of information which would compromise national security, and the constitutional guarantee of a public trial may in extreme cases be limited, if such limitation is necessary to ensure that the accused will receive a fair trial.
In the United States, as in any democracy, the most important guarantee of governmental accountability is the right of the citizens to control the direction of governmental policy and the identity of those who exercise governmental power, through the electoral process. All other constitutional and statutory provisions are but auxiliary measures. Accountable government depends ultimately on responsible citizens or, more precisely, responsible voters, who take public affairs seriously, inform themselves about the issues and the candidates, debate vigorously, vote regularly, and have the moral sense to distinguish right from wrong. Reporting and disclosure requirements and open-meeting laws have their place, but they are meaningless to a complacent, cynical or self-indulgent citizenry. Accountability, like liberty, requires eternal vigilance.

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