2004 Form 10-K


  
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
 

  
FORM 10-K

|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES 
  EXCHANGE ACT OF 1934  [FEE REQUIRED] for the fiscal year ended December 25, 2004
   
 OR
   
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
  EXCHANGE ACT OF 1934  [NO FEE REQUIRED]

For the transition period from ____________ to _________________

Commission file number 1-13163



YUM! BRANDS, INC.
(Exact name of registrant as specified in its charter)

North Carolina      13-3951308
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
   
1441 Gardiner Lane, Louisville, Kentucky      40213
(Address of principal executive offices)  (Zip Code)

Registrant’s telephone number, including area code: (502) 874-8300
 
Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class Name of Each Exchange on Which Registered
   
Common Stock, no par value New York Stock Exchange
   
Rights to purchase Series A New York Stock Exchange
Participating Preferred Stock, no par  
value of the Registrant  
   
Securities registered pursuant to Section 12(g) of the Act:
 
None
 

         Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_|  

         Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. |X|

         The aggregate market value of the voting stock (which consists solely of shares of Common Stock) held by non-affiliates of the registrant as of June 12, 2004 computed by reference to the closing price of the registrant’s Common Stock on the New York Stock Exchange Composite Tape on such date was $10,836,560,846. All executive officers and directors of the registrant have been deemed, solely for the purpose of the foregoing calculation, to be “affiliates” of the registrant.

         Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes |X| No |_|  

         The number of shares outstanding of the registrant’s Common Stock as of February 17, 2005 was 291,379,627 shares.

Documents Incorporated by Reference

         Portions of the definitive proxy statement furnished to shareholders of the registrant in connection with the annual meeting of shareholders to be held on May 19, 2005 are incorporated by reference into Part III.

  



PART I

Item 1.                    Business.

YUM! Brands, Inc. (referred to herein as “YUM” or the “Company”), was incorporated under the laws of the state of North Carolina in 1997. The principal executive offices of YUM are located at 1441 Gardiner Lane, Louisville, Kentucky 40213, and the telephone number at that location is (502) 874-8300.

YUM, the registrant, together with its restaurant operating companies and other subsidiaries, is referred to in this Form 10-K annual report (“Form 10-K”) as the Company. Prior to October 6, 1997, the business of the Company was conducted by PepsiCo, Inc. (“PepsiCo”) through various subsidiaries and divisions.

This Form 10-K should be read in conjunction with the Cautionary Statements on pages 43 and 44.

(a)              General Development of Business

In January 1997, PepsiCo announced its decision to spin-off its restaurant businesses to shareholders as an independent public company (the “Spin-off”). Effective October 6, 1997, PepsiCo disposed of its restaurant businesses by distributing all of the outstanding shares of common stock of YUM to its shareholders. YUM’s Common Stock began trading on the New York Stock Exchange on October 7, 1997 under the symbol “YUM.” Prior to that date, from September 17, 1997 through October 6, 1997, YUM’s Common Stock was traded on the New York Stock Exchange on a “when-issued” basis.

On May 7, 2002, YUM completed the acquisition of Yorkshire Global Restaurants, Inc. (“YGR”), the parent company and operator of Long John Silver’s (“LJS”) and A&W All-American Food Restaurants (“A&W”). Additionally, on May 16, 2002, following receipt of shareholder approval, the Company changed its name from TRICON Global Restaurants, Inc. to YUM! Brands, Inc.

Throughout this Form 10-K, the terms “restaurants,” “stores” and “units” are used interchangeably.

(b)              Financial Information about Operating Segments

YUM consists of five operating segments: KFC, Pizza Hut, Taco Bell, LJS/A&W and YUM Restaurants International (“YRI” or “International”). For financial reporting purposes, management considers the four U.S. operating segments to be similar and, therefore, has aggregated them into a single reportable operating segment. Operating segment information for the years ended December 25, 2004, December 27, 2003 and December 28, 2002 for the Company is included in Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) in Part II, Item 7, pages 21 through 44 and in the related Consolidated Financial Statements and footnotes in Part II, Item 8, pages 45 through 84.

(c)              Narrative Description of Business

General

YUM is the world’s largest quick service restaurant (“QSR”) company based on number of system units, with over 33,000 units in more than 100 countries and territories. The YUM organization is currently made up of six operating companies organized around the five restaurant concepts of KFC, Pizza Hut, Taco Bell, LJS and A&W (the “Concepts”). The six operating companies are KFC, Pizza Hut, Taco Bell, LJS, A&W and YRI.


2



Restaurant Concepts

Through its five Concepts, the Company develops, operates, franchises and licenses a worldwide system of restaurants which prepare, package and sell a menu of competitively priced food items. These restaurants are operated by the Company or, under the terms of franchise or license agreements, by franchisees or licensees who are independent third parties, or by affiliates in which we own a non-controlling equity interest (“Unconsolidated Affiliates”).

In each Concept, consumers can dine in and/or carry out food. In addition, Taco Bell, KFC, LJS and A&W offer a drive-thru option in many stores. Pizza Hut offers a drive-thru option on a much more limited basis. Pizza Hut and, on a much more limited basis, KFC offer delivery service.

Each Concept has proprietary menu items and emphasizes the preparation of food with high quality ingredients as well as unique recipes and special seasonings to provide appealing, tasty and attractive food at competitive prices.

The franchise program of the Company is designed to assure consistency and quality, and the Company is selective in granting franchises. Under the standard franchise agreement, franchisees supply capital – initially by paying a franchise fee to YUM, purchasing or leasing the land, building and equipment and purchasing signs, seating, inventories and supplies and, over the longer term, by reinvesting in the business. Franchisees then contribute to the Company’s revenues through the payment of royalties based on a percentage of sales.

The Company believes that it is important to maintain strong and open relationships with its franchisees and their representatives. To this end, the Company invests a significant amount of time working with the franchisee community and their representative organizations on all aspects of the business, including new products, equipment and management techniques.

The Company is actively pursuing the strategy of multibranding, where two or more of its Concepts are operated in a single unit. By combining two or more restaurant concepts, particularly those that have complementary daypart strengths in one location, the Company believes it can generate higher sales volumes from such units, significantly improve returns on per unit investment, and enhance its ability to penetrate a greater number of trade areas throughout the U.S.. Through market planning initiatives encompassing all of its Concepts, the Company has established, and annually updates, multi-year development plans by trade area to optimize franchise and company penetration of its Concepts and to improve returns on its existing asset base. The development of multibranded units may be limited, in some instances, by prior development and/or territory rights granted to franchisees.

At year-end 2004, there were 2,824 multibranded units in the worldwide system. These units were comprised of 2,431 units offering food products from two of the Concepts (a “2n1”), 49 units offering food products from three of the Concepts (a “3n1”), 331 units offering food products from Pizza Hut and WingStreet, a flavored chicken wings concept YUM has developed, and 13 units offering food products from one of the Concepts and either Pasta Bravo, a concept currently in development by the Company, or a restaurant concept not owned by or affiliated with YUM.

Restaurant Operations

Through its Concepts, YUM develops, operates, franchises and licenses a worldwide system of both traditional and non-traditional QSR restaurants. Traditional units feature dine-in, carryout and, in some instances, drive-thru or delivery services. Non-traditional units, which are typically licensed outlets, include express units and kiosks which have a more limited menu and operate in non-traditional locations like malls, airports, gasoline service stations, convenience stores, stadiums, amusement parks and colleges, where a full-scale traditional outlet would not be practical or efficient.


3



The Company’s restaurant management structure varies by concept and unit size. Generally, each Company restaurant is led by a restaurant general manager (“RGM”), together with one or more assistant managers, depending on the operating complexity and sales volume of the restaurant. In the U.S., the average restaurant has 25 to 30 employees, while internationally this figure can be significantly higher depending on the location and sales volume of the restaurant. Most of the employees work on a part-time basis. The Company’s six operating companies each issue detailed manuals covering all aspects of their respective operations, including food handling and product preparation procedures, safety and quality issues, equipment maintenance, facility standards and accounting control procedures. The restaurant management teams are responsible for the day-to-day operation of each unit and for ensuring compliance with operating standards. CHAMPS – which stands for Cleanliness, Hospitality, Accuracy, Maintenance, Product Quality and Speed of Service – is our core systemwide program for training, measuring and rewarding employee performance against key customer measures. CHAMPS is intended to align the operating processes of our entire system around one set of standards. RGMs’ efforts, including CHAMPS performance measures, are monitored by Area Managers or Market Coaches. Market Coaches typically work with approximately six to twelve restaurants. The Company’s restaurants are visited from time to time by various senior operators who help ensure adherence to system standards and mentor restaurant team members.

RGMs attend and complete their respective operating company’s required training programs. These programs consist of initial training, as well as additional continuing development and training programs that may be offered or required from time to time. Initial manager training programs generally last at least six weeks and emphasize leadership, business management, supervisory skills (including training, coaching, and recruiting), product preparation and production, safety, quality control, customer service, labor management, and equipment maintenance.

Following is a brief description of each operating company:

KFC

 
KFC was founded in Corbin, Kentucky by Colonel Harland D. Sanders, an early developer of the quick service food business and a pioneer of the restaurant franchise concept. The Colonel perfected his secret blend of 11 herbs and spices for Kentucky Fried Chicken in 1939 and signed up his first franchisee in 1952. KFC is based in Louisville, Kentucky.
 
As of year-end 2004, KFC was the leader in the U.S. chicken QSR segment among companies featuring chicken- on-the-bone as their primary product offering, with a 46 percent market share in that segment which is nearly four times that of its closest national competitor.
 
KFC operates in 89 countries and territories throughout the world. As of year-end 2004, KFC had 5,525 units in the U.S., and 7,741 units outside the U.S. Approximately 23 percent of both the U.S. and non-U.S. units are operated by the Company.
 
Traditional KFC restaurants in the U.S. offer fried chicken-on-the-bone products, primarily marketed under the names Original Recipe and Extra Tasty Crispy. Other principal entree items include chicken sandwiches (including the Twister), Colonel’s Crispy Strips, Popcorn Chicken and, seasonally, Chunky Chicken Pot Pies. KFC restaurants in the U.S. also offer a variety of side items, such as biscuits, mashed potatoes and gravy, coleslaw, corn, and potato wedges, as well as desserts. While many of these products are offered outside of the U.S., menus internationally are more focused on chicken sandwiches and Colonel’s Crispy Strips, and include side items that are suited to local preferences and tastes. Restaurant decor throughout the world is characterized by the image of the Colonel.

4



Pizza Hut

 
The first Pizza Hut restaurant was opened in 1958 in Wichita, Kansas, and within a year, the first franchise unit was opened. Today, Pizza Hut is the largest restaurant chain in the world specializing in the sale of ready-to-eat pizza products. Pizza Hut is based in Dallas, Texas.
 
As of year-end 2004, Pizza Hut was the leader in the U.S. pizza QSR segment, with a 16 percent market share in that segment.
 
Pizza Hut operates in 86 countries and territories throughout the world. As of year-end 2004, Pizza Hut had 7,500 units in the U.S., and 4,774 units outside of the U.S. Approximately 23 percent of the U.S. units and 21 percent of the non-U.S. units are operated by the Company.
 
Pizza Hut features a variety of pizzas, which may include Pan Pizza, Thin ’n Crispy, Hand Tossed, Sicilian, Stuffed Crust, Twisted Crust, The Big New Yorker, The Insider, The Chicago Dish and 4forALL. Each of these pizzas is offered with a variety of different toppings. In some restaurants, Pizza Hut also offers breadsticks, pasta, salads and sandwiches. Menu items outside of the U.S. are generally similar to those offered in the U.S., though pizza toppings are often suited to local preferences and tastes.
 

Taco Bell

 
The first Taco Bell restaurant was opened in 1962 by Glen Bell in Downey, California, and in 1964, the first Taco Bell franchise was sold. Taco Bell is based in Irvine, California.
 
As of year-end 2004, Taco Bell was the leader in the U.S. Mexican QSR segment, with a 64 percent market share in that segment.
 
Taco Bell operates in 11 countries and territories throughout the world. As of year-end 2004, there were 5,900 Taco Bell units in the U.S., and 238 units outside of the U.S. Approximately 22 percent of the U.S. units and 5 percent of the non-U.S. units are operated by the Company.
 
Taco Bell specializes in Mexican-style food products, including various types of tacos, burritos, gorditas, chalupas, quesadillas, salads, nachos and other related items. Additionally, proprietary entrée items include Grilled Stuft Burritos and Border Bowls. Taco Bell units feature a distinctive bell logo on their signage.
 

LJS

 
The first LJS restaurant opened in 1969 and the first LJS franchise unit opened later the same year. LJS is based in Louisville, Kentucky.
 
As of year-end 2004, LJS was the leader in the U.S. seafood QSR segment, with a 35 percent market share in that segment.
 
LJS operates in 4 countries and territories throughout the world. As of year-end 2004, there were 1,200 LJS units in the U.S., and 34 units outside the U.S. Approximately 58 percent of the U.S. units are operated by the Company. All non-U.S. units are operated by franchisees or licensees.
 
LJS features a variety of seafood items, including meals featuring batter-dipped fish, chicken, shrimp and hushpuppies. LJS units typically feature a distinctive seaside/nautical theme.

5



A&W

 
A&W was founded in Lodi, California by Roy Allen in 1919 and the first A&W franchise unit opened in 1925. A&W is based in Louisville, Kentucky.
 
A&W operates in 13 countries and territories throughout the world. As of year-end 2004, there were 485 A&W units in the U.S., and 210 units outside the U.S. Approximately 4 percent of the U.S. units are operated by the Company. All non-U.S. units are operated by franchisees or licensees.
   
A&W serves A&W draft Root Beer and a signature A&W Root Beer float, as well as all-American pure-beef hamburgers and hot dogs.
 

International

The international operations of the five Concepts are consolidated into a separate operating company (YRI), which has directed its focus toward franchise system growth and concentration of Company development in those markets in which the Company believes sufficient scale is achievable. YRI has developed global systems and tools designed to improve marketing, operations consistency, product delivery, market planning and development and franchise support capability. YRI is based in Dallas, Texas.

As of year-end 2004, YRI had 12,998 units. Approximately 21 percent of these units are operated by the Company. In 2004, YRI accounted for approximately 36 percent of the Company’s revenues.

Operating Structure

In all five of its Concepts, the Company either operates units or they are operated by independent franchisees or licensees. Franchisees can range in size from individuals owning just a few units to large publicly traded companies. In addition, the Company owns non-controlling interests in Unconsolidated Affiliates who operate similar to franchisees. As of year-end 2004, approximately 23 percent of YUM’s worldwide units were operated by the Company, approximately 65 percent by franchisees, approximately 7 percent by licensees and approximately 5 percent by Unconsolidated Affiliates.

Supply and Distribution

The Company is a substantial purchaser of a number of food and paper products, equipment and other restaurant supplies. The principal items purchased include chicken products, cheese, beef and pork products, paper and packaging materials, flour, produce, certain beverages, seafood, cooking oils, pinto beans, seasonings and tomato-based products.

The Company, along with the representatives of the Company’s KFC, Pizza Hut, Taco Bell, LJS and A&W franchisee groups, are members in the Unified FoodService Purchasing Co-op, LLC (the “Unified Co-op”) which was created for the purpose of purchasing certain restaurant products and equipment in the U.S. The core mission of the Unified Co-op is to provide the lowest possible sustainable store-delivered prices for restaurant products and equipment. This arrangement combines the purchasing power of the Company and franchisee restaurants in the U.S. which the Company believes will further leverage the system’s scale to drive cost savings and effectiveness in the purchasing function. The Company also believes that the Unified Co-op has resulted, and should continue to result, in closer alignment of interests and a stronger relationship with its franchisee community.


6



The Company is committed to conducting its business in an ethical, legal and socially responsible manner. To encourage compliance with all legal requirements and ethical business practices, YUM has a supplier code of conduct for all U.S. suppliers to our business. To ensure the wholesomeness of food products, suppliers are required to meet or exceed strict quality control standards. Long-term contracts and long-term vendor relationships are used to ensure availability of products. The Company has not experienced any significant continuous shortages of supplies, and alternative sources for most of these products are generally available. Prices paid for these supplies are subject to fluctuation. When prices increase, the Company may be able to pass on such increases to its customers, although there is no assurance this can be done in the future.

Most food products, paper and packaging supplies, and equipment used in the operation of the Company’s restaurants are distributed to individual restaurant units by third party distribution companies. Since November 30, 2000, McLane Company, Inc. (“McLane”) has been the exclusive distributor for Company-operated KFCs, Pizza Huts and Taco Bells in the U.S. and for a substantial number of franchisee and licensee stores. McLane became the distributor when it assumed all supply and distribution responsibilities under an existing agreement between AmeriServe Food Distribution, Inc. (“AmeriServe”) and the Company (the “AmeriServe Agreement”). McLane assumed the AmeriServe Agreement, as amended, as well as distribution agreements covering a substantial portion of the Pizza Hut and Taco Bell franchise system, and, to a lesser extent, the KFC franchise system simultaneously with its acquisition of the AmeriServe business. The AmeriServe business was acquired by McLane after AmeriServe filed for protection under Chapter 11 of the U.S. Bankruptcy Code and a plan of reorganization for AmeriServe (the “POR”) was approved by the U.S. Bankruptcy Court on November 28, 2000. A discussion of the impact of the AmeriServe bankruptcy reorganization process on the Company is contained in Note 7 to the Consolidated Financial Statements on page 60.

In connection with McLane’s acquisition and assumption of the AmeriServe Agreement, the Company agreed to certain amendments, including an extension of the AmeriServe Agreement through October 31, 2010. Under the terms of the Agreement with McLane, Company-operated KFC, Pizza Hut and Taco Bell restaurants in the U.S. generally cannot use alternative distributors. The Company stores within the LJS system are covered under a separate agreement with McLane.

YRI and its franchisees use decentralized sourcing and distribution systems involving many different global, regional, and local suppliers and distributors. In certain countries, including China, YRI owns all or a portion of the distribution system.

Trademarks and Patents

The Company and its Concepts own numerous registered trademarks and service marks. The Company believes that many of these marks, including its Kentucky Fried Chicken®, KFC®, Pizza Hut®, Taco Bell® and Long John Silver’s® marks, have significant value and are materially important to its business. The Company’s policy is to pursue registration of its important marks whenever feasible and to oppose vigorously any infringement of its marks. The Company also licenses certain A&W trademarks and service marks (the “A&W Marks”), which are owned by A&W Concentrate Company (formerly A&W Brands, Inc.). A&W Concentrate Company, which is not affiliated with the Company, has granted the Company an exclusive, worldwide (excluding Canada), perpetual, royalty-free license (with the right to sublicense) to use the A&W Marks for restaurant services.

The use of these marks by franchisees and licensees has been authorized in KFC, Pizza Hut, Taco Bell, LJS and A&W franchise and license agreements. Under current law and with proper use, the Company’s rights in its marks can generally last indefinitely. The Company also has certain patents on restaurant equipment which, while valuable, are not material to its business.

Working Capital

Information about the Company’s working capital is included in MD&A in Part II, Item 7, pages 21 through 44 and the Consolidated Statements of Cash Flows in Part II, Item 8, page 47.


7



Customers

The Company’s business is not dependent upon a single customer or small group of customers.

Seasonal Operations

The Company does not consider its operations to be seasonal to any material degree.

Backlog Orders

Company restaurants have no backlog orders.

Government Contracts

No material portion of the Company’s business is subject to renegotiation of profits or termination of contracts or subcontracts at the election of the U.S. government.

Competition

The retail food industry, in which the Company competes, is made up of supermarkets, supercenters, warehouse stores, convenience stores, coffee shops, snack bars, delicatessens and restaurants (including the QSR segment), and is intensely competitive with respect to food quality, price, service, convenience, location and concept. The industry is often affected by changes in consumer tastes; national, regional or local economic conditions; currency fluctuations; demographic trends; traffic patterns; the type, number and location of competing food retailers and products; and disposable purchasing power. Each of the Concepts compete with international, national and regional restaurant chains as well as locally-owned restaurants, not only for customers, but also for management and hourly personnel, suitable real estate sites and qualified franchisees. In 2004, the restaurant business in the U.S. consisted of about 878,000 restaurants representing approximately $440 billion in annual sales. Our Concepts accounted for about 2% of those restaurants and about 4% of those sales. There is currently no way to reasonably estimate the size of the competitive market outside the U.S.

Research and Development (“R&D”)

The Company operates R&D facilities in Louisville, Kentucky; Dallas, Texas; and Irvine, California and in several locations outside the U.S. The Company expensed $26 million in both 2004 and 2003 and $23 million in 2002 for R&D activities. From time to time, independent suppliers also conduct research and development activities for the benefit of the YUM system.

Environmental Matters

The Company is not aware of any federal, state or local environmental laws or regulations that will materially affect its earnings or competitive position, or result in material capital expenditures. However, the Company cannot predict the effect on its operations of possible future environmental legislation or regulations. During 2004, there were no material capital expenditures for environmental control facilities and no such material expenditures are anticipated.

Government Regulation

U.S .   The Company is subject to various federal, state and local laws affecting its business. Each of the Company’s restaurants must comply with licensing and regulation by a number of governmental authorities, which include health, sanitation, safety and fire agencies in the state or municipality in which the restaurant is located. In addition, each of the YUM operating companies must comply with various state laws that regulate the franchisor/franchisee relationship. To date, the Company has not been significantly affected by any difficulty, delay or failure to obtain required licenses or approvals.


8



A small portion of Pizza Hut’s and LJS’s sales are attributable to the sale of beer and wine. A license is required in most cases for each site that sells alcoholic beverages (in most cases, on an annual basis) and licenses may be revoked or suspended for cause at any time. Regulations governing the sale of alcoholic beverages relate to many aspects of restaurant operations, including the minimum age of patrons and employees, hours of operation, advertising, wholesale purchasing, inventory control and handling, storage and dispensing of alcoholic beverages.

The Company is also subject to federal and state laws governing such matters as employment and pay practices, overtime, tip credits and working conditions. The bulk of the Company’s employees are paid on an hourly basis at rates related to the federal and state minimum wages.

The Company is also subject to federal and state child labor laws which, among other things, prohibit the use of certain “hazardous equipment” by employees 18 years of age or younger. The Company has not to date been materially adversely affected by such laws.

The Company continues to monitor its facilities for compliance with the Americans with Disabilities Act (“ADA”) in order to conform to its requirements. Under the ADA, the Company could be required to expend funds to modify its restaurants to better provide service to, or make reasonable accommodation for the employment of, disabled persons. We believe that expenditures, if required, would not have a material adverse effect on the Company’s operations.

International.  Internationally, the Company’s restaurants are subject to national and local laws and regulations which are similar to those affecting the Company’s U.S. restaurants, including laws and regulations concerning labor, health, sanitation and safety. The international restaurants are also subject to tariffs and regulations on imported commodities and equipment and laws regulating foreign investment. International compliance with environmental requirements has not had a material adverse effect on the Company’s results of operations, capital expenditures or competitive position.

Employees

As of year-end 2004, the Company employed over 256,000 persons, approximately 77 percent of whom were part-time. Approximately 49 percent of the Company’s employees are employed in the U.S. The Company believes that it provides working conditions and compensation that compare favorably with those of its principal competitors. Most Company employees are paid on an hourly basis. Some of the Company’s non-U.S. employees are subject to labor council relationships that vary due to the diverse cultures in which the Company operates. The Company considers its employee relations to be good.

(d)              Financial Information about U.S. and International Operations

Financial information about International and U.S. markets is incorporated herein by reference from Selected Financial Data in Part II, Item 6, page 19; Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) in Part II, Item 7, pages 21 through 44; and in the related Consolidated Financial Statements and footnotes in Part II, Item 8, pages 45 through 84.

(e)              Available Information

The Company makes available through its internet website www.yum.com its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after electronically filing such material with the Securities and Exchange Commission. The reference to the Company’s website address does not constitute incorporation by reference of the information contained on the website and should not be considered part of this document.


9



Item 2.                    Properties.

As of year-end 2004, YUM Concepts owned over 1,800 units and leased land, building or both in over 3,100 units in the U.S.; and YRI owned over 300 units and leased land, building or both in over 2,300 units outside the U.S. Company restaurants in the U.S. which are not owned are generally leased for initial terms of 15 or 20 years and generally have renewal options; however, Pizza Hut delivery/carryout units in the U.S. generally are leased for significantly shorter initial terms with short renewal options. The Company generally does not lease or sub-lease units that it owns or leases to franchisees. Pizza Hut leases its and YRI’s corporate headquarters and a research facility in Dallas, Texas. Taco Bell leases its corporate headquarters and research facility in Irvine, California. KFC owns its and LJS’s, A&W’s and YUM’s corporate headquarters and a research facility in Louisville, Kentucky. In addition, YUM leases office facilities for certain support groups in Louisville, Kentucky. The former LJS and A&W corporate headquarters and research facility in Lexington, Kentucky continues to be under lease, though efforts to transition the property out of the YUM system are ongoing. Additional information about the Company’s properties is included in the Consolidated Financial Statements and footnotes in Part II, Item 8, pages 45 through 84.

The Company believes that its properties are generally in good operating condition and are suitable for the purposes for which they are being used.

Item 3.                    Legal Proceedings.  

The Company is subject to various claims and contingencies related to lawsuits, taxes, real estate, environmental and other matters arising in the normal course of business. The following is a brief description of the more significant of these categories of lawsuits and other matters. Except as stated below, the Company believes that the ultimate liability, if any, in excess of amounts already provided for these matters in the Consolidated Financial Statements, is not likely to have a material adverse effect on the Company’s annual results of operations, financial condition or cash flows.

Franchising

A substantial number of the restaurants of each of the Concepts are franchised to independent businesses operating under arrangements with the Concepts. In the course of the franchise relationship, occasional disputes arise between the Company and its franchisees relating to a broad range of subjects, including, without limitation, quality, service, and cleanliness issues, contentions regarding grants, transfers or terminations of franchises, territorial disputes and delinquent payments.

Suppliers

The Company, through approved distributors, purchases food, paper, equipment and other restaurant supplies from numerous independent suppliers throughout the world. These suppliers are required to meet and maintain compliance with the Company’s standards and specifications. On occasion, disputes arise between the Company and its suppliers on a number of issues, including, but not limited to, compliance with product specifications and terms of procurement and service requirements.


10



Employees

At any given time, the Company employs hundreds of thousands of persons, primarily in its restaurants. In addition, each year thousands of persons seek employment with the Company and its restaurants. From time to time, disputes arise regarding employee hiring, compensation, termination and promotion practices.

Like other retail employers, the Company has been faced in a few states with allegations of purported class-wide wage and hour violations.

On August 13, 2003, a class action lawsuit against Pizza Hut, Inc., entitled Coldiron v. Pizza Hut, Inc., was filed in the United States District Court, Central District of California. Plaintiff alleges that she and other current and former Pizza Hut Restaurant General Managers (“RGM’s”) were improperly classified as exempt employees under the U.S. Fair Labor Standards Act (“FLSA”). There is also a pendent state law claim, alleging that current and former RGM’s in California were misclassified under that state’s law. Plaintiff seeks unpaid overtime wages and penalties. On May 5, 2004, the District Court granted conditional certification of a nationwide class of RGM’s under the FLSA claim, providing notice to prospective class members and an opportunity to join the class. Approximately 10 percent of the eligible class members have joined the litigation. Once class certification discovery is completed, Pizza Hut intends to challenge the propriety of conditional class certification. On July 20, 2004, the District Court granted summary judgment on Ms. Coldiron’s individual FLSA claim. Pizza Hut believes that the District Court’s summary judgment ruling in favor of Ms. Coldiron is clearly erroneous under well-established legal precedent. As of February 23, 2005, Ms. Coldiron has also filed a motion to certify an additional class of current and former California RGM’s under California state law, a motion for summary judgment on her individual state law claims and a motion requesting that the District Court enter summary judgment on the damages that FLSA class members would be due upon successful prosecution of the class-wide litigation. Pizza Hut is opposing all three motions.

We continue to believe that Pizza Hut has properly classified its RGM’s as exempt under the FLSA and California law and accordingly intend 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.

Customers

The Company’s restaurants serve a large and diverse cross-section of the public and in the course of serving so many people, disputes arise regarding products, service, accidents and other matters typical of large restaurant systems such as those of the Company.

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 entitled 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 (the “California Restaurants”) 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 (including parking spaces, ramps, counters, restroom facilities and seating) 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. For themselves, the four named plaintiffs have claimed aggregate minimum statutory damages of no less than $16,000, but are expected to claim greater amounts based on the number of Taco Bell outlets they visited at which they claim to have suffered discrimination.


11



On February 23, 2004, the District Court granted Plaintiffs’ motion for class certification. The District Court certified a Rule 23(b)(2) mandatory injunctive relief class of all individuals with disabilities who use wheelchairs or electric scooters for mobility who, at any time on or after December 17, 2001, were denied, or are currently being denied, on the basis of disability, the full and equal enjoyment of the California Restaurants. The class includes claims for injunctive relief and minimum statutory damages.

Pursuant to the parties’ agreement, on or about August 31, 2004, the District Court ordered that the trial of this action be bifurcated so that stage one will resolve Plaintiffs’ claims for equitable relief and stage two will resolve Plaintiffs’ claims for damages. The parties are currently proceeding with the equitable relief stage of this action. During this stage, Taco Bell filed a motion to partially decertify the class to exclude from the Rule 23(b)(2) class claims for monetary damages. The District Court denied the motion. Plaintiffs filed their own motion for partial summary judgment as to liability relating to a subset of the California Restaurants. The District Court denied that motion as well.

Taco Bell has denied liability and intends to vigorously defend against all claims in this lawsuit. Although this lawsuit is at an early stage in the proceedings, it is likely that certain of the California Restaurants will be determined to be not fully compliant with accessibility laws and that Taco Bell will be required to take certain steps to make those restaurants fully compliant. However, at this time, it is not possible to estimate with reasonable certainty the potential costs to bring any non-compliant California Restaurants into compliance with applicable state and federal disability access laws. Nor is it possible at this time to reasonably estimate the probability or amount of liability for monetary damages on a class-wide basis to Taco Bell.

Intellectual Property

The Company has registered trademarks and service marks, many of which are of material importance to the Company’s business. From time to time, the Company may become involved in litigation to defend and protect its use of its registered marks.

Other Litigation

On January 16, 1998, a lawsuit against Taco Bell Corp., entitled Wrench LLC, Joseph Shields and Thomas Rinks v. Taco Bell Corp. (“Wrench”) was filed in the United States District Court for the Western District of Michigan. The lawsuit alleged that Taco Bell Corp. misappropriated certain ideas and concepts used in its advertising featuring a Chihuahua. The plaintiffs sought to recover monetary damages under several theories, including breach of implied-in-fact contract, idea misappropriation, conversion and unfair competition. On June 10, 1999, the District Court granted summary judgment in favor of Taco Bell Corp. Plaintiffs filed an appeal with the U.S. Court of Appeals for the Sixth Circuit and oral arguments were held on September 20, 2000. On July 6, 2001, the Sixth Circuit Court of Appeals reversed the District Court’s judgment in favor of Taco Bell Corp. and remanded the case to the District Court. Taco Bell Corp. unsuccessfully petitioned the Sixth Circuit Court of Appeals for rehearing en banc, and its petition for writ of certiorari to the United States Supreme Court was denied on January 21, 2002. The case was returned to District Court for trial which began on May 14, 2003 and on June 4, 2003 the jury awarded $30 million to the plaintiffs. Subsequently, the plaintiffs’ moved to amend the judgment to include pre-judgment interest and post-judgment interest and Taco Bell filed its post-trial motion for judgment as a matter of law or a new trial. On September 9, 2003, the District Court denied Taco Bell’s motion and granted the plaintiff’s motion to amend the judgment.

In view of the jury verdict and subsequent District Court ruling, we recorded a charge of $42 million in 2003. We appealed the verdict to the Sixth Circuit Court of Appeals and interest continued to accrue during the appeal process. Prior to a ruling from the Sixth Circuit Court of Appeals, we settled this matter with the Wrench plaintiffs on January 15, 2005. Concurrent with the settlement with the plaintiffs, we also settled the matter with certain of our insurance carriers. As a result of these settlements, reversals of previously recorded expense of $14 million were recorded in the year ended December 25, 2004.


12



We intend to continue to seek additional recoveries from our other insurance carriers during the periods in question. We have also filed suit against Taco Bell’s former advertising agency in the United States District Court for the Central District of California seeking reimbursement for the settlement amount as well as any costs that we have incurred in defending this matter. Any additional recoveries will be recorded as they are realized.


13



Item 4.                    Submission of Matters to a Vote of Security Holders.

None.

Executive Officers of the Registrant   

The executive officers of the Company as of February 17, 2005, and their ages and current positions as of that date are as follows:


Name   Age   Position

  
  
David C. Novak   52   Chairman of the Board, Chief Executive Officer and President
 
David J. Deno   47   Chief Financial Officer and Chief Operating Officer
 
Christian L. Campbell   54   Senior Vice President, General Counsel, Secretary and Chief Franchise Policy Officer
 
Jonathan D. Blum   46   Senior Vice President – Public Affairs
 
Charles E. Rawley, III   54   Chief Development Officer
 
Anne P. Byerlein   46   Chief People Officer
 
Gregory N. Moore   55   Senior Vice President and Controller
 
Richard T. Carucci   47   Senior Vice President, Finance and Chief Financial Officer – Designate
 
Gregg R. Dedrick   45   President and Chief Concept Officer, KFC
 
Peter R. Hearl   53   President and Chief Concept Officer, Pizza Hut
 
Emil J. Brolick   57   President and Chief Concept Officer, Taco Bell
 
Graham D. Allan   49   President, YUM! Restaurants International
 
Samuel Su   52   President, YUM! Restaurants China

David C. Novak  is Chairman of the Board, Chief Executive Officer and President of YUM. He has served in this position since January 2001. From December 1999 to January 2001, Mr. Novak served as Vice Chairman of the Board, Chief Executive Officer and President of YUM. From October 1997 to December 1999, he served as Vice Chairman and President of YUM. Mr. Novak previously served as Group President and Chief Executive Officer, KFC and Pizza Hut from August 1996 to July 1997. Mr. Novak joined Pizza Hut in 1986 as Senior Vice President, Marketing. In 1990, he became Executive Vice President, Marketing and National Sales, for Pepsi-Cola Company. In 1992, he became Chief Operating Officer, Pepsi-Cola North America, and in 1994 he became President and Chief Executive Officer of KFC North America. Mr. Novak is also a director of J.P. Morgan Chase.

David J. Deno is Chief Financial Officer and Chief Operating Officer of YUM. He has served as Chief Financial Officer since November 1999 and as Chief Operating Officer since October 2004. From August 1997 to November 1999, Mr. Deno served as Senior Vice President and Chief Financial Officer of YRI. From August 1996 to August 1997, Mr. Deno served as Senior Vice President and Chief Financial Officer for Pizza Hut. From 1994 to August 1996, Mr. Deno was Division Vice President for the Florida Division of Pizza Hut. Mr. Deno joined Pizza Hut in 1991 as Vice President and Controller.


14



Christian L. Campbell is Senior Vice President, General Counsel, Secretary and Chief Franchise Policy Officer of YUM. He has served as Senior Vice President, General Counsel and Secretary since September 1997. In January 2003, his title and job responsibilities were expanded to include Chief Franchise Policy Officer. From 1995 to September 1997, Mr. Campbell served as Senior Vice President, General Counsel and Secretary of Owens Corning, a building products company. Before joining Owens Corning, Mr. Campbell served as Vice President, General Counsel and Secretary of Nalco Chemical Company in Naperville, Illinois, from 1990 through 1994.

Jonathan D. Blum  is Senior Vice President – Public Affairs for YUM. He has served in this position since July 1997. Mr. Blum previously served as Vice President of Public Affairs for Taco Bell, a position that he held since joining Taco Bell in 1993.

Charles E. Rawley, III  is Chief Development Officer of YUM, a position he assumed in January of 2001. Prior to that, he served as President and Chief Operating Officer of KFC. Mr. Rawley assumed his position of Chief Operating Officer in 1995 and President in 1998. Mr. Rawley joined KFC in 1985 as a Director of Operations. He served as Vice President of Operations for the Southwest, West, Northeast, and Mid-Atlantic Divisions from 1988 to 1994, when he became Senior Vice President, Concept Development for KFC.

Anne P. Byerlein  is Chief People Officer of YUM. She has served in this position since December 2002. From October 1997 to December 2002, she was Vice President of Human Resources of YUM. From October 2000 to December 2002, she also served as KFC’s Chief People Officer. Ms. Byerlein has also served as Vice President of Corporate Human Resources of PepsiCo. From 1988 to 1996, Ms. Byerlein served in a variety of human resources positions within the restaurant divisions of PepsiCo.

Gregory N. Moore is Senior Vice President and Controller of YUM. He has served in this position since September 2003. Prior to that, he was Vice President, Audit and General Auditor of YUM from October 1997 to September 2003. He was Vice President and Controller at Taco Bell from May 1989 to October 1997 and Assistant Corporate Controller at Taco Bell from February 1986 to May 1989. He held management positions in PepsiCola International from May 1983 to February 1986.

Richard T. Carucci  is Senior Vice President, Finance and Chief Financial Officer – Designate of YUM. He has served in this position since October 2004. From May 2003 to October 2004, he served as Executive Vice President and Chief Development Officer of YRI. From November 2002 to May 2003, he served as Senior Vice President for YRI and also assisted Pizza Hut in asset strategy development. From November 1999 to July 2002, he was Chief Financial Officer of YRI.

Gregg R. Dedrick is President and Chief Concept Officer of KFC. He has served in this position since September 2003. From January 2002 to September 2003, Mr. Dedrick acted as a Strategic Advisor to YUM while serving as Chief Administrative Officer of his church, which is one of the ten largest churches in the United States. From July 1997 to January 2002, he served as Chief People Officer of YUM. Mr. Dedrick also served as Senior Vice President, Human Resources for Pizza Hut and KFC, a position he assumed in 1996. He served as Senior Vice President, Human Resources of KFC in 1995 and Vice President, Human Resources of Pizza Hut in 1994. Mr. Dedrick joined the Pepsi-Cola Company in 1981 and held various positions from 1981 to 1994.

Peter R. Hearl  is President and Chief Concept Officer of Pizza Hut. Prior to this position, he was Chief People Officer and Executive Vice President of YUM, a position he held from January 2002 until November 2002. From December 1998 to January 2002, he served as Executive Vice President of YRI. Prior to that, he was Regional Vice President for YRI in Asia Pacific, a position he assumed in October 1997. From March 1996 to September 1997, Mr. Hearl was Regional Vice President for YRI with responsibility for Australia, New Zealand and South Africa. Prior to that, he was Regional Vice President for KFC with responsibility for the United Kingdom, Ireland and South Africa, a position he assumed in January 1995. From September 1993 to December 1994, Mr. Hearl was Regional Vice President for KFC Europe.


15



Emil J. Brolick  is President and Chief Concept Officer of Taco Bell. He has served in this position since July 2000. Prior to joining Taco Bell, Mr. Brolick served as Senior Vice President of New Product Marketing, Research & Strategic Planning for Wendy’s International, Inc. from August 1995 to July 2000. From March 1988 to August 1995, he held various positions at Wendy’s including Manager, Planning and Evaluation and Vice President, Strategic Planning and Research.

Graham D. Allan is the President of YRI. He has served in this position since November 2003. Immediately prior to this position he served as Executive Vice President of YRI. From December 2000 to January 2003 Mr. Allan was the Managing Director of YRI. Prior to that, he was Managing Director of KFC in the United Kingdom from 1996 until November 2000.

Samuel Su  is the President of YUM! Restaurants China. He has served in this position since 1997. Prior to this he was the Vice President of North Asia for both KFC and Pizza Hut. Mr. Su started his career with YUM in 1989 as KFC International’s Director of Marketing for the North Pacific area.

Executive officers are elected by and serve at the discretion of the Board of Directors.


16



PART II

Item 5.                    Market for the Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchases of Equity Securities.

The Company’s common stock trades under the symbol YUM and is listed on the New York Stock Exchange (“NYSE”). The following sets forth the high and low NYSE composite closing sale prices by quarter for the Company’s common stock and dividends per common share.


  2004  
   
 
Quarter   High   Low   Dividends
Declared
  Dividends
Paid
 

 
 
 
 
 
First   $ 38.28   $ 32.56   $   $  
Second     39.50     35.72     0.10      
Third     40.13     35.88         0.10  
Fourth     46.95     39.33     0.20     0.10  
   
 
 
 
 

  2003  
   
 
Quarter   High   Low   Dividends
Declared
  Dividends
Paid
 

 
 
 
 
 
First   $ 25.75   $ 22.06   $   $  
Second     28.54     23.40          
Third     30.82     28.55          
Fourth     35.13     29.40          
   
 
 
 
 

We initiated the payment of quarterly dividends to our stockholders in 2004. Three cash dividends of $0.10 per share of common stock, $87 million in total, were declared. The dividend declared late in 2004 had a distribution date of February 4, 2005. Going forward, the Company is targeting dividend payments equating to a payout ratio of 15% to 20% of net income.

As of February 17, 2005, there were approximately 100,500 registered holders of record of the Company’s common stock.

The Company had no sales of unregistered securities during 2004, 2003 or 2002.


17



Issuer Purchases of Equity Securities

The following table provides information as of December 25, 2004 with respect to shares of Common Stock repurchased by the Company during the quarter then ended:


Fiscal Periods   Total number
of shares
purchased
  Average
price paid per
share
  Total number of
shares purchased as
part of publicly
announced plans or
programs
  Approximate dollar
value of shares that
may yet be purchased
under the plans or
programs
 

 
 
 
 
 
Period 10                  
9/5/04 - 10/2/04               $ 300,048,827  
                           
Period 11  
10/3/04 - 10/30/04     566,000   $ 42.70     566,000   $ 275,879,162  
                           
Period 12  
10/31/04 - 11/27/04     21,000   $ 43.44     21,000   $ 274,966,892  
                           
Period 13  
11/28/04 - 12/25/04     5,367,110   $ 46.58     5,367,110   $ 24,966,909  
                           
Total     5,954,110   $ 46.20     5,954,110   $ 24,966,909  

In November 2003, our Board of Directors authorized a share repurchase program. This program authorized us to repurchase, through May 21, 2005, up to $300 million of our outstanding Common Stock (excluding applicable transaction fees). During the quarter ended December 25, 2004, this share repurchase program was completed.

In May 2004, our Board of Directors authorized a share repurchase program. This program authorized us to repurchase through November 21, 2005, up to $300 million of our outstanding Common Stock (excluding applicable transaction fees). During the quarter ended December 25, 2004, the majority of our share repurchases were made under this program.


18



Item 6.                    Selected Financial Data.

Selected Financial Data
YUM! Brands, Inc. and Subsidiaries
(in millions, except per share and unit amounts)


Fiscal Year  
 
 
2004   2003   2002   2001   2000  
 
 
 
 
 
 
Summary of Operations                      
Revenues  
   Company sales   $ 7,992   $ 7,441   $ 6,891   $ 6,138   $ 6,305  
   Franchise and license fees     1,019     939     866     815     788  
 
 
 
 
 
 
   Total     9,011     8,380     7,757     6,953     7,093  
 
 
 
 
 
 
Facility actions(a)     (26 )   (36 )   (32 )   (1 )   176  
Wrench litigation income (expense)(b)     14     (42 )            
AmeriServe and other (charges) credits(c)     16     26     27     3     (204 )
 
 
 
 
 
 
Operating profit     1,155     1,059     1,030     891     860  
Interest expense, net     129     173     172     158     176  
 
 
 
 
 
 
Income before income taxes and cumulative effective  
  of accounting change     1,026     886     858     733     684  
 
 
 
 
 
 
Income before cumulative effect of accounting change     740     618     583     492     413  
Cumulative effect of accounting change, net of tax(d)         (1 )            
 
 
 
 
 
 
Net income     740     617     583     492     413  
Basic earnings per common share(e)     2.54     2.10     1.97     1.68     1.41  
Diluted earnings per common share(e)     2.42     2.02     1.88     1.62     1.39  
 
 
 
 
 
 
Cash Flow Data  
Provided by operating activities   $ 1,131   $ 1,053   $ 1,088   $ 832   $ 491  
Capital spending, excluding acquisitions     645     663     760     636     572  
Proceeds from refranchising of restaurants     140     92     81     111     381  
 
 
 
 
 
 
Balance Sheet  
Total assets   $ 5,696   $ 5,620   $ 5,400   $ 4,425   $ 4,149  
Long-term debt     1,731     2,056     2,299     1,552     2,397  
Total debt     1,742     2,066     2,445     2,248     2,487  
 
 
 
 
 
 
Other Data  
Number of stores at year end  
   Company     7,743     7,854     7,526     6,435     6,123  
   Unconsolidated Affiliates     1,662     1,512     2,148     2,000     1,844  
   Franchisees     21,858     21,471     20,724     19,263     19,287  
   Licensees     2,345     2,362     2,526     2,791     3,163  
 
 
 
 
 
 
   System     33,608     33,199     32,924     30,489     30,417  
U.S. Company blended same store sales growth(f)     3 %       2 %   1 %   (2 )%
International system sales growth(g)  
   Reported     15 %   14 %   8 %   1 %   6 %
   Local currency(h)     9 %   7 %   9 %   8 %   8 %
Shares outstanding at year end(e)     290     292     294     293     293  
Cash dividends declared per common share   $ 0.30                  
 
 
 
 
 
 
Market price per share at year end (e)   $ 46.27   $ 33.64   $ 24.12   $ 24.62   $ 16.50  
 
 
 
 
 
 

Fiscal years 2004, 2003, 2002 and 2001 include 52 weeks and fiscal year 2000 includes 53 weeks. From May 7, 2002, results include Long John Silver’s (“LJS”) and A&W All-American Food Restaurants (“A&W”), which were added when we acquired Yorkshire Global Restaurants, Inc. Fiscal year 2002 includes the impact of the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). As a result we ceased amortization of goodwill and indefinite-lived assets beginning December 30, 2001. If SFAS 142 had been effective for 2001 and 2000, reported net income would have increased $26 million and $24 million, respectively. Both basic earnings per share and diluted earnings per share would have increased $0.09 and $0.08 in 2001 and 2000, respectively. The selected financial data should be read in conjunction with the Consolidated Financial Statements and the Notes thereto.

 
(a) See Note 7 to the Consolidated Financial Statements for a description of Facility actions in 2004, 2003 and 2002.
 
(b) See Note 24 to the Consolidated Financial Statements for a description of Wrench litigation in 2004 and 2003.
 
(c) See Note 7 to the Consolidated Financial Statements for a description of AmeriServe and other charges (credits) in 2004, 2003 and 2002.
 
(d) Fiscal year 2003 includes the impact of the adoption of SFAS No. 143, “Accounting for Asset Retirement Obligations”. See Note 2 to the Consolidated Financial Statements for further discussion.
 
(e) Per share and share amounts have been adjusted to reflect the two-for-one stock split distributed on June 17, 2002.
 
(f) U.S. Company blended same-store sales growth includes the results of Company owned KFC, Pizza Hut and Taco Bell restaurants that have been open one year or more. LJS and A&W are not included.
 
(g) International system sales growth includes the results of all international restaurants regardless of ownership, including Company owned, franchise, unconsolidated affiliate and license restaurants. 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 we present on the Consolidated Statements of Income; however, the 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 our revenue drivers, Company and franchise same store sales as well as net unit development.

19



(h) Local currency represents the percentage change excluding the impact of foreign currency translation. 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.

20



Item 7.                    Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Introduction and Overview

YUM! Brands, Inc. and Subsidiaries (collectively referred to as “YUM” or the “Company”) comprises the worldwide operations of KFC, Pizza Hut, Taco Bell, Long John Silver’s (“LJS”) and A&W All-American Food Restaurants (“A&W”) (collectively “the Concepts”) and is the world’s largest quick service restaurant (“QSR”) company based on the number of system units. LJS and A&W were added when YUM acquired Yorkshire Global Restaurants, Inc. (“YGR”) on May 7, 2002. With 12,998 international units, YUM is the second largest QSR company outside the U.S. YUM became an independent, publicly-owned company on October 6, 1997 (the “Spin-off Date”) via a tax-free distribution of our Common Stock (the “Distribution” or “Spin-off”) to the shareholders of our former parent, PepsiCo, Inc. (“PepsiCo”).

Through its Concepts, YUM develops, operates, franchises and licenses a system of both traditional and non-traditional QSR restaurants. Traditional units feature dine-in, carryout and, in some instances, drive-thru or delivery services. Non-traditional units, which are typically licensed outlets, include express units and kiosks which have a more limited menu and operate in non-traditional locations like malls, airports, gasoline service stations, convenience stores, stadiums, amusement parks and colleges, where a full-scale traditional outlet would not be practical or efficient.

The retail food industry, in which the Company competes, is made up of supermarkets, supercenters, warehouse stores, convenience stores, coffee shops, snack bars, delicatessens and restaurants (including the QSR segment), and is intensely competitive with respect to food quality, price, service, convenience, location and concept. The industry is often affected by changes in consumer tastes; national, regional or local economic conditions; currency fluctuations; demographic trends; traffic patterns; the type, number and location of competing food retailers and products; and disposable purchasing power. Each of the Concepts compete with international, national and regional restaurant chains as well as locally-owned restaurants, not only for customers, but also for management and hourly personnel, suitable real estate sites and qualified franchisees.

The Company’s key strategies are:

 
Building dominant restaurant brands in China
 
Driving profitable international expansion
 
Improving restaurant operations
 
Multibranding category-leading brands
 

The Company is focused on five long-term measures identified as essential to our growth and progress. These five measures and related key performance indicators are as follows:

 
International expansion
 
   International system-sales growth (local currency)
 
   Number of new international restaurant openings
 
   Net international unit growth  

21



Multibrand innovation and expansion
 
     Number of multibrand restaurant locations
 
     Number of multibrand units added
 
     Number of franchise multibrand units added
 
Portfolio of category-leading U.S. brands
 
     U.S. blended same store sales growth
 
     U.S. system sales growth
 
Global franchise fees
 
     New restaurant openings by franchisees
 
     Franchise fee growth
 
Strong cash generation and returns
 
   Cash generated from all sources
 
      Cash generated from all sources after capital spending
 
      Restaurant margins
 

Our progress against these measures is discussed throughout the Management’s Discussion and Analysis (“MD&A”).

Throughout the MD&A, the Company provides the percentage change excluding the impact of foreign currency translation. 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.

This MD&A should be read in conjunction with our Consolidated Financial Statements on pages 46 through 49 and the Cautionary Statements on pages 43 and 44. All Note references herein refer to the Notes to the Consolidated Financial Statements on pages 50 through 84. Tabular amounts are displayed in millions except per share and unit count amounts, or as otherwise specifically identified.

Factors Affecting Comparability of 2004 Results to 2003 Results and 2003 Results to 2002 Results

Lease Accounting Adjustments

In late 2004 and early 2005, a number of companies within the QSR industry announced adjustments to their accounting for leases and the depreciation of leasehold improvements. In consultation with our external auditors, we also determined that an adjustment was necessary to modify our accounting in these areas. Accordingly, in the fourth quarter of 2004, we recorded an adjustment such that all of our leasehold improvements are now being depreciated over the shorter of their useful lives or the term of the lease, including options in some instances, over which we are recording rent expense, including escalations, on a straight-line basis.

The cumulative adjustment, primarily through increased U.S. depreciation expense, totaled $11.5 million ($7 million after tax). The portions of this adjustment that related to 2004 full year and 2004 fourth quarter were approximately $3 million and $1 million, respectively. As the portion of our adjustment recorded that was a correction of errors of amounts reported in our prior period financial statements was not material to any of those prior period financial statements, the entire adjustment was recorded in the 2004 Consolidated Financial Statements and no adjustment was made to any prior period financial statements. We anticipate that the impact of this accounting change will result in additional expense of $3 million in 2005.


22



YGR Acquisition

On May 7, 2002, the Company completed its acquisition of YGR, the parent company of LJS and A&W. See Note 4 for a discussion of the acquisition.

As of the date of the acquisition, YGR consisted of 742 and 496 company and franchise LJS units, respectively, and 127 and 742 company and franchise A&W units, respectively. In addition, 133 multibranded LJS/A&W restaurants were included in the LJS unit totals. Except as discussed in certain sections of the MD&A, the impact of the acquisition on our results of operations in 2003 was not significant relative to 2002.

Amendment of Sale-Leaseback Agreements

As discussed in Note 14, on August 15, 2003 we amended two sale-leaseback agreements assumed in our 2002 acquisition of YGR such that the agreements now qualify for sale-leaseback accounting. Restaurant profit decreased by $5 million and by $3 million in 2004 and 2003, respectively, as a result of the two amended agreements being accounted for as operating leases subsequent to the amendment. The decrease in restaurant profit was largely offset by a similar decrease in interest expense.

Canada Unconsolidated Affiliate Dissolution

On November 10, 2003, we dissolved our unconsolidated affiliate that previously operated 733 restaurants in Canada. We owned 50% of this unconsolidated affiliate prior to its dissolution and accounted for our interest under the equity method. Of the restaurants previously operated by the unconsolidated affiliate, we now operate the vast majority of Pizza Huts and Taco Bells, while almost all KFCs are operated by franchisees. As a result of operating certain restaurants that were previously operated by the unconsolidated affiliate, our Company sales, restaurant profit and general and administrative expenses increased and our franchise fees decreased. Additionally, on a full year basis other income increased as we recorded a loss from our investment in the Canadian unconsolidated affiliate in 2003.

As a result of the dissolution of our Canadian unconsolidated affiliate, Company sales increased $147 million, franchise fees decreased $9 million, restaurant profit increased $8 million, general and administrative expenses increased $11 million and other income increased $4 million for the year ended December 25, 2004 compared to the year ended December 27, 2003. The impact on 2004 net income was not significant. The impact of the dissolution on our 2003 results was also not significant.

Sale of Puerto Rico Business

Our Puerto Rico business was held for sale since the fourth quarter of 2002 and was sold on October 4, 2004 for an amount approximating its then carrying value. Company sales and restaurant profit decreased $27 million and $4 million, respectively, franchise fees increased $1 million and general and administrative expenses decreased $1 million for the year ended December 25, 2004 as compared to the year ended December 27, 2003.

Commodity Inflation

The increased cost of certain commodities negatively impacted our U.S. margins for the year ended December 25, 2004. Higher commodity costs, particularly in cheese and meat prices, negatively impacted U.S. restaurant margins as a percentage of sales by approximately 160 basis points for the year ended December 25, 2004.


23



Wrench Litigation

We recorded income of $14 million in 2004 and expense of $42 million in 2003. See Note 24 for a discussion of the Wrench litigation.

AmeriServe and Other Charges (Credits)

We recorded income of $16 million in 2004, $26 million in 2003 and $27 million in 2002. See Note 7 for a detailed discussion of AmeriServe and other charges (credits).

Store Portfolio Strategy

From time to time we sell Company restaurants to existing and new franchisees where geographic synergies can be obtained or where their expertise can generally be leveraged to improve our overall operating performance, while retaining Company ownership of key U.S. and International markets. Such refranchisings reduce our reported revenues and restaurant profits and increase the importance of system sales growth as a key performance measure.

The following table summarizes our refranchising activities:


2004   2003   2002  
 
 
 
 
Number of units refranchised     317     228     174  
Refranchising proceeds, pre-tax   $ 140   $ 92   $ 81  
Refranchising net gains, pre-tax(a)   $ 12   $ 4   $ 19  

(a) Refranchising net gains for the year ended December 25, 2004 include charges to write down our Puerto Rico business to our then estimate of its fair value and charges to write down certain U.S. restaurants we currently own but we have offered to sell at amounts lower than their carrying values. Refranchising net gains for the year ended December 27, 2003 also include charges to write down our Puerto Rico business to our then estimate of its fair value. As previously noted, we sold our Puerto Rico business effective October 4, 2004 for an amount approximating its then carrying value.
 

In addition to our refranchising program, from time to time we close restaurants that are poor performing, we relocate restaurants to a new site within the same trade area or we consolidate two or more of our existing units into a single unit (collectively “store closures”).

The following table summarizes Company store closure activities:


2004   2003   2002  
 
 
 
 
Number of units closed     319     287     224  
Store closure costs (income)(a)   $ (3 ) $ 6   $ 15  
Impairment charges for stores to be closed   $ 5   $ 12   $ 9  

(a) Store closure income in 2004 is primarily the result of gains from the sale of properties on which we formerly operated restaurants.

24



The impact on operating profit arising from refranchising and Company store closures is the net of (a) the estimated reductions in restaurant profit, which reflects the decrease in Company sales, and general and administrative expenses and (b) the estimated increase in franchise fees from the stores refranchised. The amounts presented below reflect the estimated impact from stores that were operated by us for all or some portion of the respective previous year and were no longer operated by us as of the last day of the respective year. The amounts do not include results from new restaurants that we opened in connection with a relocation of an existing unit or any incremental impact upon consolidation of two or more of our existing units into a single unit.

The following table summarizes the estimated impact on revenue of refranchising and Company store closures:


2004  
 
 
U.S.   International   Worldwide  
 
 
 
 
Decreased sales   $ (241 ) $ (131 ) $ (372 )
Increased franchise fees     7     5     12  
 
 
 
Decrease in total revenues   $ (234 ) $ (126 ) $ (360 )
 
 
 
 

2003  
 
 
U.S.   International   Worldwide  
 
 
 
 
Decreased sales   $ (148 ) $ (120 ) $ (268 )
Increased franchise fees     1     5     6  
 
 
 
Decrease in total revenues   $ (147 ) $ (115 ) $ (262 )
 
 
 

The following table summarizes the estimated impact on operating profit of refranchising and Company store closures:

 
2004  
 
 
U.S.   International   Worldwide  
 
 
 
 
Decreased restaurant profit   $ (18 ) $ (11 ) $ (29 )
Increased franchise fees     7     5     12  
Decreased general and administrative expenses         6     6  
 
 
 
Decrease in operating profit   $ (11 ) $   $ (11 )
 
 
 
 
     
2003  
 
 
U.S.   International   Worldwide  
 
 
 
 
Decreased restaurant profit   $ (18 ) $ (15 ) $ (33 )
Increased franchise fees     1     5     6  
Decreased general and administrative expenses         6     6  
 
 
 
Decrease in operating profit   $ (17 ) $ (4 ) $ (21 )
 
 
 
 

25



Results of Operations


2004   % B/(W)
vs. 2003
  2003   % B/(W)
vs. 2002
 
 
 
 
 
 
Company sales   $ 7,992     7   $ 7,441     8  
Franchise and license fees     1,019     8     939     9  
 
     
   
Revenues   $ 9,011     8   $ 8,380     8  
 
     
   
Company restaurant profit   $ 1,159     5   $ 1,104      
 
     
   
                           
% of Company sales     14.5 %   (0.3 ) ppts.   14.8 %   (1.2 ) ppts.
 
     
   
                           
Operating profit     1,155     9     1,059     3  
Interest expense, net     129     25     173     (1 )
Income tax provision     286     (7 )   268     3  
 
     
 
               
Income before cumulative effect of  
accounting change     740     20     618     6  
                           
Cumulative effect of accounting change,  
net of tax             (1 )   NM  
 
     
   
Net income   $ 740     20   $ 617     6  
 
     
   
Diluted earnings per share(a)   $ 2.42     20   $ 2.02     7  
 
     
   

(a)       See Note 6 for the number of shares used in this calculation.

Restaurant Unit Activity


Worldwide   Company   Unconsolidated
Affiliates
  Franchisees   Total
Excluding
Licensees
 

 
 
 
 
 
Balance at end of 2002     7,526     2,148     20,724     30,398  
New Builds     454     176     868     1,498  
Acquisitions     389     (736 )   345     (2 )
Refranchising     (228 )   (1 )   227     (2 )
Closures     (287 )   (75 )   (691 )   (1,053 )
Other             (2 )   (2 )
   
 
 
 
Balance at end of 2003     7,854     1,512     21,471     30,837  
New Builds     457     178     815     1,450  
Acquisitions     72     11     (83 )    
Refranchising     (317 )       316     (1 )
Closures     (319 )   (31 )   (651 )   (1,001 )
Other     (4 )   (8 )   (10 )   (22 )
   
 
 
 
Balance at end of 2004     7,743     1,662     21,858     31,263  
   
 
 
 
% of Total     25 %   5 %   70 %   100 %

The above total excludes 2,345 and 2,362 licensed units at the end of 2004 and 2003, respectively.


26



United States   Company   Unconsolidated
Affiliates
  Franchisees   Total
Excluding
Licensees
 

 
 
 
 
 
Balance at end of 2002     5,193     4     13,663     18,860  
New Builds     142     3     245     390  
Acquisitions     106         (108 )   (2 )
Refranchising     (150 )       148     (2 )
Closures     (197 )   (1 )   (386 )   (584 )
Other             4     4  
   
 
 
 
 
Balance at end of 2003     5,094     6     13,566     18,666  
New Builds     146         227     373  
Acquisitions     61         (61 )    
Refranchising     (113 )       112     (1 )
Closures     (199 )   (6 )   (365 )   (570 )
Other             3     3  
   
 
 
 
Balance at end of 2004     4,989         13,482     18,471  
   
 
 
 
% of Total     27 %       73 %   100 %
 

The above total excludes 2,139 and 2,156 licensed units at the end of 2004 and 2003, respectively.

 
International Company   Unconsolidated
Affiliates
  Franchisees   Total
Excluding
Licensees
 

 
 
 
 
 
 Balance at end of 2002     2,333     2,144     7,061     11,538  
 New Builds     312     173     623     1,108  
 Acquisitions     283     (736 )   453      
 Refranchising     (78 )   (1 )   79      
 Closures     (90 )   (74 )   (305 )   (469 )
 Other(a)             (6 )   (6 )
   
 
 
 
 Balance at end of 2003     2,760     1,506     7,905     12,171  
 New Builds     311     178     588     1,077  
 Acquisitions     11     11     (22 )    
 Refranchising     (204 )       204      
 Closures     (120 )   (25 )   (286 )   (431 )
 Other(a)     (4 )   (8 )   (13 )   (25 )
   
 
 
 
 Balance at end of 2004     2,754     1,662     8,376     12,792  
   
 
 
 
 % of Total     22 %   13 %   65 %   100 %

(a)             Represents an adjustment of previously reported amounts.

The above totals exclude 206 licensed units at both the end of 2004 and 2003.


27



Included in the above totals are multibrand restaurants. Multibrand conversions increase the sales and points of distribution for the second brand added to a restaurant but do not result in an additional unit count. Similarly, a new multibrand restaurant, while increasing sales and points of distribution for two brands, results in just one additional unit count. Franchise unit counts include both franchisee and unconsolidated affiliate multibrand units. Multibrand restaurant totals were as follows:


2004 Company   Franchise   Total  


 
 
 
United States   1,391   1,250   2,641  
International   28   155   183  
 
 
 
Worldwide   1,419   1,405   2,824  



           
2003 Company   Franchise   Total


 
 
United States   1,032   1,116   2,148  
International   52   127   179  
 
 
 
Worldwide   1,084   1,243   2,327  




For 2004 and 2003, Company multibrand unit gross additions were 384 and 235, respectively. For 2004 and 2003, franchise multibrand unit gross additions were 169 and 194, respectively.

System Sales Growth


Increase
Increase excluding currency
translation

2004
2003
2004
2003
United States   3 % 3 % N/ A N/ A
International   15 % 14 % 9 % 7 %
Worldwide   8 % 7 % 5 % 5 %

System sales growth includes the results of all restaurants regardless of ownership, including Company-owned, franchise, unconsolidated affiliate and license restaurants. 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 restaurants sales are not included in Company sales on the 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.

In 2004, the increase in Worldwide system sales was driven by new unit development and same store sales growth, partially offset by store closures. Excluding the favorable impact from both foreign currency translation and the YGR acquisition, Worldwide system sales increased 3% in 2003. The increase was driven by new unit development, partially offset by store closures.

In 2004, the increase in U.S. system sales was driven by new unit development and same store sales growth, partially offset by store closures. Excluding the favorable impact of the YGR acquisition, U.S. system sales increased 1% in 2003. The increase was driven by new unit development, partially offset by store closures.

In 2004, the increase in International system sales was driven by new unit development and same store sales growth, partially offset by store closures. In 2003, the increase in International system sales was driven by new unit development, partially offset by store closures.


28



Revenues


Amount   % Increase   % Increase excluding
currency translation
 
 
 
 
 
2004   2003   2004   2003   2004   2003  
 
 
 
 
 
 
 
Company sales                
  United States $ 5,163   $ 5,081   2   6   N/A   N/A  
  International   2,829     2,360   20   12   16   8  
 
 
               
  Worldwide   7,992     7,441   7   8   6   7  
                             
Franchise and license fees
  United States   600     574   4   1   N/A   N/A  
  International   419     365   15   23   8   14  
 
 
               
  Worldwide   1,019     939   8   9   6   6  
                             
Total revenues
  United States   5,763     5,655   2   6   N/A   N/A  
  International   3,248     2,725   19   13   15   8  
 
 
               
  Worldwide $ 9,011   $ 8,380   8   8   6   7  
 
 
               

In 2004, the increase in Worldwide Company sales was driven by new unit development, acquisitions of franchisee restaurants (primarily certain units in Canada which we now operate), and same store sales growth, partially offset by refranchising and store closures. Excluding the favorable impact of both foreign currency translation and the YGR acquisition, Worldwide Company sales increased 4% in 2003. The increase was driven by new unit development, partially offset by store closures and refranchising.

In 2004, the increase in Worldwide franchise and license fees was driven by new unit development, same store sales growth, and refranchising, partially offset by store closures and acquisitions of franchisee restaurants (primarily certain units in Canada which we now operate). Excluding the favorable impact of both foreign currency translation and the YGR acquisition, Worldwide franchise and license fees increased 5% in 2003. The increase was driven by new unit development, royalty rate increases and same store sales growth, partially offset by store closures.

In 2004, the increase in U.S. Company sales was driven by new unit development and same store sales growth, partially offset by refranchising and store closures. Excluding the favorable impact of the YGR acquisition, U.S. Company sales increased 2% in 2003. The increase was driven by new unit development, partially offset by store closures and refranchising.


29



U.S same store sales includes only Company restaurants that have been open one year or more. U.S. blended same store sales includes KFC, Pizza Hut and Taco Bell Company-owned restaurants only. U.S. same store sales for Long John Silver’s and A&W restaurants are not included. Following are the same store sales growth results by brand:


    2004
 
    Same Store
Sales

  Transactions
  Average Guest
Check

 
KFC   (2 )%   (4 )%   2 %
Pizza Hut   5 %   2 %   3 %
Taco Bell   5 %   3 %   2 %

    2003
 
    Same Store
Sales

  Transactions
  Average Guest
Check

 
KFC   (2 )%   (4 )%   2 %
Pizza Hut   (1 )%   (4 )%   3 %
Taco Bell   2 %   1 %   1 %

In 2004, blended Company same store sales increased 3% due to increases in average guest check and transactions. In 2003, blended Company same store sales were flat due to a decrease in transactions offset by an increase in average guest check.

In 2004, the increase in U.S. franchise and license fees was driven by same store sales growth, new unit development and refranchising, partially offset by store closures. Excluding the favorable impact of the YGR acquisition, U.S. franchise and license fees remained essentially flat in 2003 as a decrease primarily driven by store closures was largely offset by new unit development.

In 2004, the increase in International Company sales was driven by new unit development, acquisitions of franchisee restaurants (primarily certain units in Canada which we now operate), and same store sales growth, partially offset by refranchising and store closures. In 2003, the increase in International Company sales was driven by new unit development, partially offset by refranchising, same store sales declines and store closures.

In 2004, the increase in International franchise and license fees was driven by new unit development, same store sales growth and refranchising, partially offset by store closures and our acquisitions of franchisee restaurants (primarily certain units in Canada which we now operate). In 2003, the increase in International franchise and license fees was driven by new unit development, royalty rate increases and same store sales growth, partially offset by store closures.

Company Restaurant Margins


2004
United States
  International
  Worldwide
 
Company sales   100.0 %   100.0 %   100.0 %
Food and paper   29.9     35.1     31.8  
Payroll and employee benefits   30.5     19.1     26.4  
Occupancy and other operating expenses   25.8     30.0     27.3  
 
 
 
 
Company restaurant margin   13.8 %   15.8 %   14.5 %
 
 
 
 

30



2003
United States
  International
  Worldwide
 
Company sales   100.0 %   100.0 %   100.0 %
Food and paper   28.8     35.5     30.9  
Payroll and employee benefits   31.0     19.0     27.2  
Occupancy and other operating expenses   25.6     30.0     27.1  
 
 
 
 
Company restaurant margin   14.6 %   15.5 %   14.8 %
 
 
 
 

2002
United States
  International
  Worldwide
 
Company sales   100.0 %   100.0 %   100.0 %
Food and paper   28.2     36.1     30.6  
Payroll and employee benefits   30.9     18.7     27.2  
Occupancy and other operating expenses   24.9     29.2     26.2  
 
 
 
 
Company restaurant margin   16.0 %   16.0 %   16.0 %
 
 
 
 

In 2004, the decrease in U.S. restaurant margins as a percentage of sales was driven by higher food and paper costs and higher occupancy and other costs, partially offset by the impact of same store sales increases on restaurant margin. Higher food and paper costs were primarily driven by increased commodity costs (principally cheese and meats) and higher occupancy and other costs were primarily driven by increased expense resulting from the adjustment related to our accounting for leases and the depreciation of leasehold improvements. In 2003, the decrease in U.S. restaurant margin as a percentage of sales was primarily driven by the increased occupancy expenses due to higher rent, primarily due to additional rent expense associated with the amended YGR sale-leaseback agreements, and utilities. The higher food and paper costs were primarily due to the impact of unfavorable discounting and product mix. Also contributing to the decrease was higher labor costs, primarily driven by low single-digit increases in wage rates.

In 2004, the increase in International restaurant margins as a percentage of sales was driven by the impact of same store sales increases on restaurant margin and lower food and paper costs (principally due to supply chain savings). The increase was partially offset by a 60 basis point unfavorable impact of operating certain restaurants in Canada, which is a market with below average margins, that were previously operated by our unconsolidated affiliate, increased labor costs in certain markets and a 10 basis point unfavorable impact from foreign currency translation. In 2003, the decrease in International restaurant margins as a percentage of sales was driven by the impact on margin of same store sales declines and a 20 basis point unfavorable impact from foreign currency translation. The decrease was partially offset by the impact of supply chain savings on the cost of food and paper (principally in China), and the cessation of depreciation expense of approximately $9 million for the Puerto Rico business while it was held for sale.

The impact from foreign currency translation on margins as a percentage of sales is a result of the portfolio of markets effect. International margin percentages in total are impacted unfavorably when currencies strengthen in markets with below average margins. Those markets contributing to the unfavorable impacts of foreign currency translation on margin have below average margins largely due to their higher labor costs.

Worldwide General and Administrative Expenses

General and administrative expenses increased $111 million or 12% in 2004, including a 2% unfavorable impact from foreign currency translation. The increase was driven by higher compensation related costs, including incentive compensation, amounts associated with investments in strategic initiatives in China and other international growth markets and pension costs. Also contributing to the increase were higher professional fees and increased reserves related to potential development sites and surplus facilities. The increase was also partially attributable to expenses of $11 million associated with operating the restaurants we now own in Canada that were previously operated by our unconsolidated affiliate. These increases were partially offset by decreases in expenses due to the favorable impact of refranchising certain restaurants.


31



General and administrative expenses increased $32 million or 3% in 2003, including a 1% unfavorable impact from foreign currency translation. Excluding the unfavorable impact from both foreign currency translation and the YGR acquisition, general and administrative expenses were flat for 2003. Lower management incentive compensation costs were offset by increases in expenses associated with international restaurant expansion and pension expense.

Worldwide Franchise and License Expenses

Franchise and license expenses decreased $2 million or 8% in 2004. The decrease was primarily driven by the favorable impact of lapping the biennial International franchise convention held in 2003.

Franchise and license expenses decreased $21 million or 42% in 2003. The decrease was primarily attributable to lower allowances for doubtful franchise and license fee receivables, principally at Taco Bell.

Worldwide Other (Income) Expense


2004
  2003
  2002
 
Equity income from investments in unconsolidated affiliates $ (54 ) $ (39 ) $ (29 )
Foreign exchange net (gain) loss   (1 )   (2 )   (1 )



Other (income) expense $ (55 ) $ (41 ) $ (30 )




Other income increased $14 million or 34% in 2004, including a 7% favorable impact from foreign currency translation. The increase was driven by an increase in equity income from our unconsolidated affiliates, principally in China, and the dissolution of our unconsolidated affiliate in Canada which recorded a loss for the year ended December 27, 2003.

Other income increased $11 million or 39% in 2003, including a 6% favorable impact from foreign currency translation. The increase was primarily driven by an increase in equity income from our unconsolidated affiliates, particularly in China.

Worldwide Facility Actions

We recorded a net loss from facility actions of $26 million, $36 million and $32 million in 2004, 2003 and 2002, respectively. See the Store Portfolio Strategy section for more detail of our refranchising and closure activities and Note 7 for a summary of the components of facility actions by reportable operating segment.


32



Operating Profit


% Increase/(decrease)
 
2004
  2003
  2004
  2003
 
United States $ 777   $ 812     (4 )   1  
International   542     441     23     22  
Unallocated and corporate expenses   (204 )   (179 )   (14 )    
Unallocated other income (expense)   (2 )   (3 )   NM     NM  
Unallocated facility actions   12     4     NM     NM  
Wrench litigation income (expense)   14     (42 )   NM     NM  
AmeriServe and other (charges) credits   16     26     NM     NM  
 
 
             
Operating profit $ 1,155   $ 1,059     9     3  
 
 
             

In 2004, the decrease in U.S. operating profit was driven by the impact on restaurant profit of higher commodity costs (primarily cheese and meat) and the adjustment recorded related to our accounting for leases and the depreciation of leasehold improvements, as well as higher general and administrative expenses. The decrease was partially offset by the impact of same store sales increases on restaurant profit and franchise and license fees. Excluding the favorable impact of the YGR acquisition, U.S. operating profit in 2003 was flat compared to 2002. Decreases driven by lower restaurant profit as a result of increased occupancy expenses and the impact of unfavorable discounting and product mix shift on food and paper costs were offset by lower franchise and license and general and administrative expenses.

Excluding the favorable impact from foreign currency translation, International operating profit increased 17% in 2004. The increase was driven by new unit development, the impact of same store sales increases on restaurant profit and franchise and license fees and higher income from our investments in unconsolidated affiliates, partially offset by higher general and administrative costs. Excluding the favorable impact from foreign currency translation, International operating profit increased 15% in 2003. The increase was driven by new unit development and the impact of supply chain savings initiatives on the cost of food and paper, partially offset by the impact of same store sales declines on restaurant profit and higher general and administrative expenses.

Unallocated and corporate expenses comprise general and administrative expenses and unallocated facility actions comprise refranchising gains (losses), neither of which are allocated to the U.S. or International segments for performance reporting purposes.

Interest Expense, Net


2004
  2003
  2002
 
Interest expense $ 145   $ 185   $ 180  
Interest income   (16 )   (12 )   (8 )



Interest expense, net $ 129   $ 173   $ 172  




Interest expense decreased $40 million or 22% in 2004. The decrease was primarily driven by a decrease in our average interest rates primarily attributable to pay-variable interest rate swaps entered into during 2004. Also contributing to the decrease was a reduction in our average debt outstanding primarily as a result of the amended YGR sale-leaseback agreement and lower International short-term borrowings.

Interest expense increased $5 million or 3% in 2003. Excluding the impact of the YGR acquisition, interest expense decreased 6%. The decrease was primarily due to a decrease in our average debt outstanding.


33



Income Taxes


2004
  2003
  2002
 
Reported            
  Income taxes $ 286   $ 268   $ 275  
  Effective tax rate   27.9 %   30.2 %   32.1 %

The reconciliation of income taxes calculated at the U.S. federal tax statutory rate to our effective tax rate is set forth below:


2004
  2003
  2002
 
U.S. federal statutory tax rate   35.0 %   35.0 %   35.0 %
State income tax, net of federal tax benefit   1.3     1.8     2.0  
Foreign and U.S. tax effects attributable to foreign operations   (5.8 )   (3.6 )   (2.8 )
Adjustments to reserves and prior years   (6.7 )   (1.7 )   (1.8 )
Foreign tax credit amended return benefit       (4.1 )    
Valuation allowance additions (reversals)   4.2     2.8      
Other, net   (0.1 )       (0.3 )



Effective tax rate   27.9 %   30.2 %   32.1 %




Income taxes and the effective tax rate as shown above reflect tax on all amounts included in our results of operations except for the income tax benefit of approximately $1 million on the $2 million cumulative effect adjustment recorded in the year ended December 27, 2003 due to the adoption of SFAS 143.

The 2004 effective tax rate decreased 2.3 percentage points to 27.9%. The decrease in the effective tax rate was driven by a number of factors, including the reversal of reserves in the current year associated with audits that were settled as well as the effects of certain international tax planning strategies implemented in 2004. The decrease was partially offset by the impact of lapping the benefit in 2003 of amending certain prior U.S. income tax returns to claim credit for foreign taxes paid in prior years as well as the recognition in 2004 of valuation allowances for certain deferred tax assets whose realization is no longer considered more likely than not.

The 2003 effective tax rate decreased 1.9 percentage points to 30.2%. The decrease in the effective tax rate was primarily due to a 4.1 percentage point benefit of amending certain prior U.S. income tax returns to claim credit for foreign taxes paid in prior years. The returns were amended upon our determination that it was more beneficial to claim credit for such taxes than to deduct such taxes, as had been done when the returns were originally filed. In future years, we anticipate continuing to claim credit for foreign taxes paid in the then current year, as we have done in 2004, 2003 and 2002. However, the amended return benefit recognized in 2003 was non-recurring. The decrease in the 2003 effective tax rate was partially offset by the recognition of valuation allowances for certain deferred tax assets whose realization is no longer considered more likely than not. See Note 22 for a discussion of valuation allowances.

Adjustments to reserves and prior years include the effects of the reconciliation of income tax amounts recorded in our Consolidated Statements of Income to amounts reflected on our tax returns, including any adjustments to the Consolidated Balance Sheets. Adjustments to reserves and prior years also includes changes in tax reserves established for potential exposure we may incur if a taxing authority takes a position on a matter contrary to our position. We evaluate these reserves, including interest thereon, on a quarterly basis to insure that they have been appropriately adjusted for events, including audit settlements, that we believe may impact our exposure.


34



Consolidated Cash Flows

Net cash provided by operating activities  was $1,131 million compared to $1,053 million in 2003. The increase was primarily driven by an increase in net income and a decrease in the amount of voluntary contributions to our funded pension plan compared to 2003, partially offset by higher income tax payments in 2004.

In 2003, net cash provided by operating activities was $1,053 million compared to $1,088 million in 2002. The decrease was primarily driven by $130 million in voluntary contributions to our funded pension plan in 2003, partially offset by higher net income.

Net cash used in investing activities  was $486 million versus $519 million in 2003. The decrease was primarily driven by higher proceeds from refranchising of restaurants and lower capital spending compared to 2003, partially offset by the impact of the timing of purchases and sales of short-term investments.

In 2003, net cash used in investing activities was $519 million versus $885 million in 2002. The decrease in cash used was primarily driven by the $275 million acquisition of YGR in 2002 and lower capital spending in 2003.

Net cash used in financing activities was $779 million versus $475 million in 2003. The increase in 2004 was primarily driven by higher share repurchases, higher net debt repayments and the payment of two quarterly dividends, partially offset by higher proceeds from stock option exercises.

In 2003, net cash used in financing activities was $475 million versus $187 million in 2002. The increase was primarily driven by higher net debt repayments and higher shares repurchased in 2003.

Consolidated Financial Condition

Assets  increased $76 million or 1% to $5.7 billion primarily due to an increase in property, plant and equipment driven by capital expenditures in excess of depreciation. The increase was also partially driven by the existence of a federal income tax receivable at December 25, 2004 recorded in prepaid expenses and other current assets and the timing of the collection of certain accounts receivable. The increase was partially offset by the impact of higher spending for financing activities compared to 2003, as described above, and a decrease in other assets as a result of the utilization of deferred income tax assets in 2004.

Liabilities  decreased $399 million or 9% to $4.1 billion primarily due to lower long-term debt as a result of the early redemption of our 2005 Senior Unsecured Notes of $350 million in 2004 and lower income taxes payable due to the excess of current year tax payments made over the current year provision.

Liquidity and Capital Resources

Operating in the QSR industry allows us to generate substantial cash flows from the operations of our company stores and from our franchise operations, which require a limited YUM investment. In each of the last three fiscal years, net cash provided by operating activities has exceeded $1 billion. These cash flows have allowed us to fund our discretionary spending, while at the same time reducing our long-term debt balances. We expect these levels of net cash provided by operating activities to continue in the foreseeable future. Our discretionary spending includes capital spending for new restaurants, acquisitions of restaurants from franchisees, repurchases of shares of our common stock and dividends paid to our shareholders. Though a decline in revenues could adversely impact our cash flows from operations, we believe our operating cash flows, our ability to reduce discretionary spending, and our borrowing capacity will allow us to meet our cash requirements in 2005 and beyond.


35



We initiated the payment of quarterly dividends in 2004 with two quarterly dividends paid totaling $58 million. Additionally, on November 12, 2004 our Board of Directors approved a cash dividend of $0.10 per share of common stock to be distributed on February 4, 2005 to shareholders of record at the close of business on January 14, 2005. On an annual basis, the Company is targeting a payout ratio of 15% to 20% of net income.

On September 7, 2004, the Company executed an amended and restated five-year senior unsecured Revolving Credit Facility (the “Credit Facility”) totaling $1.0 billion which replaced a $1.0 billion senior unsecured Revolving Credit Facility (the “Old Facility”) with a maturity date of June 25, 2005. Under the terms of the Credit Facility, the Company may borrow up to the maximum borrowing limit less outstanding letters of credit. At December 25, 2004, our unused Credit Facility totaled $776 million, net of outstanding letters of credit of $205 million. There were borrowings of $19 million outstanding under the Credit Facility at December 25, 2004. The interest rate for borrowings under the Credit Facility ranges from 0.35% to 1.625% over the London Interbank Offered Rate (“LIBOR”) or 0.00% to 0.20% over an Alternate Base Rate, which is the greater of the Prime Rate or the Federal Funds Effective Rate plus 0.50%. The exact spread over LIBOR or the Alternate Base Rate, as applicable, will depend upon our performance under specified financial criteria. Interest on any outstanding borrowings under the Credit Facility is payable at least quarterly.

The Credit Facility is unconditionally guaranteed by our principal domestic subsidiaries and contains financial covenants relating to maintenance of leverage and fixed charge coverage ratios. The Credit Facility also contains affirmative and negative covenants including, among other things, limitations on certain additional indebtedness, guarantees of indebtedness, level of cash dividends, aggregate non-U.S. investment and certain other transactions as defined in the agreement. These covenants are substantially similar to those contained in the Old Facility. We were in compliance with all covenants at December 25, 2004, and do not anticipate that the covenants will impact our ability to borrow under our Credit Facility for its remaining term.

The remainder of our long-term debt primarily comprises Senior Unsecured Notes. Amounts outstanding under Senior Unsecured Notes were $1.5 billion at December 25, 2004. On November 15, 2004, we voluntarily redeemed all of our 7.45% Senior Unsecured Notes due in May 2005 (the “2005 Notes”) in accordance with their original terms. The 2005 Notes, which had a face value of $350 million, were redeemed for an amount of approximately $358 million using primarily cash on hand as well as some borrowings under our Credit Facility. The redemption amount approximated the carrying value of the 2005 Notes resulting in no significant impact on net income.

We estimate that in 2005 capital spending, including acquisitions of our restaurants from franchisees, will be approximately $780 million. We also estimate that in 2005 refranchising proceeds, prior to taxes, will be approximately $100 million, employee stock options proceeds, prior to taxes, will be approximately $150 million and sales of property, plant and equipment will be approximately $80 million. A share repurchase program authorized by our Board of Directors in May 2004 is expected to be completed during the first half of 2005. At December 25, 2004, we had remaining capacity to repurchase, through November 2005, up to approximately $25 million of our outstanding Common Stock (excluding applicable transaction fees) under this program. In January 2005, the Board of Directors authorized a new share repurchase program for up to $500 million of the Company’s outstanding common stock to be purchased through January 2006.


36



In addition to any discretionary spending we may choose to make, significant contractual obligations and payments as of December 25, 2004 included:


Total
  Less than
1 Year

  1-3 Years
  3-5 Years
  More than
5 Years

 
Long-term debt(a) $ 1,598   $ 1   $ 204   $ 275   $ 1,118  
Capital leases(b)   184     18     32     28     106  
Operating leases(b)   2,511     342     564     442     1,163  
Purchase obligations(c)   233     138     39     30     26  
Other long-term liabilities reflected
   on our Consolidated Balance
   Sheet under GAAP   30         18     4     8  





Total contractual obligations $ 4,556   $ 499   $ 857   $ 779   $ 2,421  






(a) Excludes a fair value adjustment of $21 million included in debt related to interest rate swaps that hedge the fair value of a portion of our debt. See Note 14.
 
(b) These obligations, which are shown on a nominal basis, relate to approximately 5,500 restaurants. See Note 15.
 
(c) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. We have excluded agreements that are cancelable without penalty. Purchase obligations relate primarily to information technology and commodity agreements, purchases of property, plant and equipment as well as marketing, maintenance, consulting and other agreements.
 

We have not included obligations under our pension and postretirement medical benefit plans in the contractual obligations table. Our funding policy regarding our funded pension plan is to contribute amounts necessary to satisfy minimum pension funding requirements plus such additional amounts from time to time as are determined to be appropriate to improve the plan’s funded status. The pension plan’s funded status is affected by many factors including discount rates and the performance of plan assets. We are not required to make minimum pension funding payments in 2005, but we may make discretionary contributions during the year based on our estimate of the plan’s expected September 30, 2005 funded status. During 2004, we made a $50 million discretionary contribution to our funded plan, none of which represented minimum funding requirements. Our postretirement plan is not required to be funded in advance, but is pay as you go. We made postretirement benefit payments of $4 million in 2004.

Also excluded from the contractual obligations table are payments we may make for workers’ compensation, employment practices liability, general liability, automobile liability and property losses (collectively “property and casualty losses”) as well as employee healthcare claims for which we are self-insured. The majority of our recorded liability for self-insured employee health and property and casualty losses represents estimated reserves for incurred claims that have yet to be filed or settled.

Off-Balance Sheet Arrangements

We had provided approximately $16 million of partial guarantees of two franchisee loan pools related primarily to the Company’s historical refranchising programs and, to a lesser extent, franchisee development of new restaurants, at December 25, 2004. In support of these guarantees, we posted $4 million of letters of credit at December 25, 2004. We also provided a standby letter of credit of $18 million at December 25, 2004, under which we could potentially be required to fund a portion of one of the franchisee loan pools. The total loans outstanding under these loan pools were approximately $90 million at December 25, 2004.


37



Any funding under the guarantees or letters of credit would be secured by the franchisee loans and any related collateral. We believe that we have appropriately provided for our estimated probable exposures under these contingent liabilities. These provisions were primarily charged to net refranchising loss (gain). New loans are not currently being added to either loan pool.

We have guaranteed certain lines of credit and loans of unconsolidated affiliates totaling $34 million at December 25, 2004. Our unconsolidated affiliates had total revenues of over $1.7 billion for the year ended December 25, 2004 and assets and debt of approximately $884 million and $49 million, respectively, at December 25, 2004.

Other Significant Known Events, Trends or Uncertainties Expected to Impact 2005 Operating Profit Comparisons with 2004

New Accounting Pronouncements Not Yet Adopted

Upon the adoption of Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”) in 2005, we will be required to recognize compensation cost in the financial statements for all share-based payments to our employees, including grants of stock options, based on the fair value of the share-based awards on the date of grant. The fair value of the share-based awards will be determined using option pricing models and assumptions that appropriately reflect the specific circumstances of the awards. Compensation cost will be recognized over the vesting period based on the fair value of awards that actually vest.

SFAS 123R is effective at the beginning of the first interim or annual period beginning after June 15, 2005 (the quarter ending December 31, 2005 for the Company) and early adoption is encouraged. We are in the process of evaluating the use of certain option-pricing models as well as the assumptions to be used in such models. When such evaluation is complete, we will determine the transition method to use and the timing of adoption. We currently do not anticipate that the impact on net income on a full year basis of the adoption of SFAS 123R will be significantly different from the historical pro forma impacts as previously disclosed.

See Note 2.

Sale of Puerto Rico Business

As a result of the sale of our Puerto Rico business on October 4, 2004, Company sales, restaurant profit and general and administrative expenses will decrease by $159 million, $29 million and $8 million, respectively, and we estimate franchise fees will increase by $10 million for the year ended December 31, 2005 compared to the year ended December 25, 2004.

Extra Week in 2005

Our fiscal calendar results in a fifty-third week every five or six years. Fiscal year 2005 will include a fifty-third week in the fourth quarter for the majority of our U.S. businesses as well as our International businesses that report on a period, as opposed to a monthly, basis. In the U.S., we anticipate permanently accelerating the timing of the KFC business closing by one week in December 2005, and thus, there will be no fifty-third week benefit for this business in 2005. We estimate the fifty-third week will increase revenues and operating profit in 2005 by approximately $80 million and $15 million, respectively. While the impact of the fifty-third week adds a potential incremental benefit of $0.04 to diluted earnings per share, we believe this benefit will be offset by expense associated with strategic asset actions and refranchising KFC restaurants in the U.S.


38



International Reporting Changes

In the first quarter of 2005 we will begin reporting information for our international business in two separate operating segments as a result of changes to our management reporting structure. The China Division will include the People’s Republic of China (“China”), Thailand and KFC Taiwan, and the International Division will include the remainder of our international operations. This reporting change will not impact our consolidated results.

In the first quarter of 2005 we will also change the China business reporting calendar to more closely align the timing of the reporting of its results of operations with our U.S. business. Previously our China business, like the rest of our international businesses, closed one month (or one period for certain of our international businesses) earlier than YUM’s period end date to facilitate consolidated reporting. As a result, the operations of the China business for the one month period ending December 31, 2004 will be recognized as an adjustment to consolidated retained earnings in the first quarter of 2005, as opposed to being recorded in our Consolidated Statement of Income, to maintain comparability of our consolidated results of operations. Our consolidated results of operations for the first quarter of 2005 will thus include the results of operations of the China business for the months of January and February and the months included in each quarterly reporting period thereafter will begin one month later in 2005 than in previous years.

Critical Accounting Policies and Estimates

Our reported results are impacted by the application of certain accounting policies that require us to make subjective or complex judgments. These judgments involve estimations of the effect of matters that are inherently uncertain and may significantly impact our quarterly or annual results of operations or financial condition. Changes in the estimates and judgments could significantly affect our results of operations, financial condition and cash flows in future years. A description of what we consider to be our most significant critical accounting policies follows.

Impairment or Disposal of Long-Lived Assets

We evaluate our long-lived assets for impairment at the individual restaurant level except when there is an expectation that we will refranchise restaurants as a group. Restaurants held and used are evaluated for impairment on a semi-annual basis or whenever events or circumstances indicate that the carrying amount of a restaurant may not be recoverable (including a decision to close a restaurant or an offer to refranchise a restaurant or group of restaurants for less than the carrying value). Our semi-annual test includes those restaurants that have experienced two consecutive years of operating losses. These impairment evaluations require an estimation of cash flows over the remaining useful life of the primary asset of the restaurant, which can be for a period of over 20 years, and any terminal value. We limit assumptions about important factors such as sales growth and margin improvement to those that are supportable based upon our plans for the unit and actual results at comparable restaurants.

If the long-lived assets of a restaurant on a held and used basis are not recoverable based upon forecasted, undiscounted cash flows, we write the assets down to their fair value. This fair value is determined by discounting the forecasted cash flows, including terminal value, of the restaurant at an appropriate rate. The discount rate used is our cost of capital, adjusted upward when a higher risk is believed to exist.

When it is probable that we will sell a restaurant within one year, we write down the restaurant to its fair value. We often refranchise restaurants in groups and, therefore, perform such impairment evaluations at the group level. Fair value is based on the expected sales proceeds less applicable transaction costs. Estimated sales proceeds are based on the most relevant of historical sales multiples or bids from buyers, and have historically been reasonably accurate estimations of the proceeds ultimately received.

See Note 2 for a further discussion of our policy regarding the impairment or disposal of long-lived assets.


39



Impairment of Investments in Unconsolidated Affiliates

We record impairment charges related to an investment in an unconsolidated affiliate whenever events or circumstances indicate that a decrease in the value of an investment has occurred which is other than temporary. In addition, we evaluate our investments in unconsolidated affiliates for impairment when they have experienced two consecutive years of operating losses. Our impairment measurement test for an investment in an unconsolidated affiliate is similar to that for our restaurants except that we use discounted cash flows after interest and taxes instead of discounted cash flows before interest and taxes as used for our restaurants. The fair values of our investments in unconsolidated affiliates are generally significantly in excess of their carrying value.

See Note 2 for a further discussion of our policy regarding the impairment of investments in unconsolidated affiliates.

Impairment of Goodwill and Indefinite-Lived Intangible Assets  

We evaluate goodwill and indefinite-lived intangible assets for impairment on an annual basis or more often if an event occurs or circumstances change that indicates impairment might exist. Goodwill is evaluated for impairment through the comparison of fair value of our reporting units to their carrying values. Our reporting units are our operating segments in the U.S. and our business management units internationally (typically individual countries). Fair value is the price a willing buyer would pay for the reporting unit, and is generally estimated by discounting expected future cash flows from the reporting unit over twenty years plus an expected terminal value. We limit assumptions about important factors such as sales growth and margin improvement to those that are supportable based upon our plans for the reporting unit. For 2004, there was no impairment of goodwill identified during our annual impairment testing.

Our impairment test for indefinite-lived intangible assets consists of a comparison of the fair value of the asset with its carrying amount. Our indefinite-lived intangible assets consist of values assigned to certain trademarks/brands of which we have acquired ownership. We believe the value of these trademarks/brands is derived from the royalty we avoid, in the case of Company stores, or receive, in the case of franchise stores, due to our ownership of the trademarks/brands. Thus, anticipated sales are the most important assumption in valuing trademarks/brands. We limit assumptions about sales growth, as well as other factors impacting the fair value calculation, to those that are supportable based on our plans for the applicable Concept.

The most significant indefinite-lived trademark/brand asset we have recorded is the LJS trademark/brand in the amount of $140 million. The fair value of this trademark/brand is currently in excess of its carrying value as are the fair values of all other recorded trademarks/brands with an indefinite life. While we believe the sales assumptions used in our determinations of fair value for our trademarks/brands are consistent with our operating plans and forecasts, fluctuations in the assumptions would have impacted our impairment calculation. If the long-term rate of sales growth used in each of our fair value determinations for our trademarks/brands had been one percentage point lower, such fair values would have continued to exceed carrying value in all instances.

See Note 2 for a further discussion of our policies regarding goodwill and indefinite-lived intangible assets.

Allowances for Franchise and License Receivables and Contingent Liabilities

We reserve a franchisee’s or licensee’s entire receivable balance based upon pre-defined aging criteria and upon the occurrence of other events that indicate that we may not collect the balance due. As a result of reserving using this methodology, we have an immaterial amount of receivables that are past due that have not been reserved for at December 25, 2004. See Note 2 for a further discussion of our policies regarding franchise and license operations.


40



Primarily as a result of our refranchising efforts, we remain liable for certain lease assignments and guarantees. We record a liability for our exposure under these lease assignments and guarantees when such exposure is probable and estimable. At December 25, 2004, we have recorded an immaterial liability for our exposure which we consider to be probable and estimable. The potential total exposure under such leases is significant, with $306 million representing the present value, discounted at our pre-tax cost of debt, of the minimum payments of the assigned leases at December 25, 2004. Current 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 and, historically, we have not been required to make such payments in significant amounts. See Note 24 for a further discussion of our lease guarantees.

Self-Insured Property and Casualty Losses

We record our best estimate of the remaining cost to settle incurred self-insured property and casualty claims. The estimate is based on the results of an independent actuarial study and considers historical claim frequency and severity as well as changes in factors such as our business environment, benefit levels, medical costs and the regulatory environment that could impact overall self-insurance costs. Additionally, a risk margin to cover unforeseen events that may occur over the several years it takes for claims to settle is included in our reserve, increasing our confidence level that the recorded reserve is adequate.

See Note 24 for a further discussion of our insurance programs.

Pension Plans

Certain of our employees are covered under noncontributory defined benefit pension plans. The most significant of these plans was amended in 2001 such that employees hired after September 30, 2001 are not eligible to participate. As of our September 30, 2004 measurement date, these plans had a projected benefit obligation (“PBO”) of $700 million, an accumulated benefit obligation (“ABO”) of $629 million and a fair value of plan assets of $518 million. As a result of the $111 million underfunded status of the plans relative to the ABO at September 30, 2004, we have recorded a cumulative $95 million charge to accumulated other comprehensive loss (net of tax of $58 million) as of December 25, 2004.

The PBO and ABO reflect the actuarial present value of all benefits earned to date by employees. The PBO incorporates assumptions as to future compensation levels while the ABO reflects only current compensation levels. Due to the relatively long time frame over which benefits earned to date are expected to be paid, our PBO and ABO are highly sensitive to changes in discount rates. We measured our PBO and ABO using a discount rate of 6.15% at September 30, 2004. This discount rate was determined using a hypothetical portfolio of high-quality debt instruments with maturities that mirror our expected benefit obligations under the plans. A 50 basis point increase in this discount rate would have decreased our PBO by approximately $63 million at September 30, 2004. Conversely, a 50 basis point decrease in this discount rate would have increased our PBO by approximately $65 million at September 30, 2004.

The pension expense we will record in 2005 is also impacted by the discount rate we selected at September 30, 2004. In total, we expect pension expense to increase approximately $3 million to $56 million in 2005. The increase is primarily driven by an increase in interest cost because of the higher PBO. Service cost will also increase as a result of the lower discount rate, though, as previously mentioned, the plans are closed to new participants. A 50 basis point change in our discount rate assumption of 6.15% at September 30, 2004 would impact our 2005 pension expense by approximately $12 million.

The assumption we make regarding our expected long-term rate of return on plan assets also impacts our pension expense. Our expected long-term rate of return on plan assets at both September 30, 2004 and September 30, 2003 was 8.5%. We believe that this assumption is appropriate given the composition of our plan assets and historical market returns thereon. Given no change to the market-related value of our plan assets as of September 30, 2004, a one percentage point increase or decrease in our expected rate of return on plan assets assumption would decrease or increase, respectively, our 2005 pension plan expense by approximately $5 million.


41



The losses our plan assets have experienced, along with the decrease in discount rates, have largely contributed to an unrecognized actuarial loss of $225 million in our plans as of September 30, 2004. For purposes of determining 2004 expense, our funded status was such that we recognized $19 million of unrecognized actuarial loss in 2004. We will recognize approximately $22 million of unrecognized actuarial loss in 2005. Given no change to the assumptions at our September 30, 2004 measurement date, actuarial loss recognition will remain at an amount near that to be recognized in 2005 over the next few years before it begins to gradually decline.

Income Tax Valuation Allowances and Tax Reserves

At December 25, 2004, we have a valuation allowance of $351 million primarily to reduce our net operating loss and tax credit carryforwards of $231 million and our other deferred tax assets to amounts that will more likely than not be realized. The net operating loss and tax credit carryforwards exist in many state and foreign jurisdictions and have varying carryforward periods and restrictions on usage. The estimation of future taxable income in these state and foreign jurisdictions and our resulting ability to utilize net operating loss and tax credit carryforwards can significantly change based on future events, including our determinations as to the feasibility of certain tax planning strategies. Thus, recorded valuation allowances may be subject to material future changes.

As a matter of course, we are regularly audited by federal, state and foreign tax authorities. We provide reserves for potential exposures when we consider it probable that a taxing authority may take a sustainable position on a matter contrary to our position. We evaluate these reserves, including interest thereon, on a quarterly basis to insure that they have been appropriately adjusted for events, including audit settlements, that may impact our ultimate payment for such exposures.

See Note 22 for a further discussion of our income taxes.

Item 7A.                    Quantitative and Qualitative Disclosures About Market Risk.

The Company is exposed to financial market risks associated with interest rates, foreign currency exchange rates and commodity prices. In the normal course of business and in accordance with our policies, we manage these risks through a variety of strategies, which may include the use of derivative financial and commodity instruments to hedge our underlying exposures. Our policies prohibit the use of derivative instruments for trading purposes, and we have procedures in place to monitor and control their use.

Interest Rate Risk

We have a market risk exposure to changes in interest rates, principally in the United States. We attempt to minimize this risk and lower our overall borrowing costs through the utilization of derivative financial instruments, primarily interest rate swaps. These swaps are entered into with financial institutions and have reset dates and critical terms that match those of the underlying debt. Accordingly, any change in market value associated with interest rate swaps is offset by the opposite market impact on the related debt.

At December 25, 2004 and December 27, 2003, a hypothetical 100 basis point increase in short-term interest rates would result, over the following twelve-month period, in a reduction of approximately $6 million and $3 million, respectively, in income before income taxes. The estimated reductions are based upon the level of variable rate debt and assume no changes in the volume or composition of debt. In addition, the fair value of our derivative financial instruments at December 25, 2004 and December 27, 2003 would decrease approximately $51 million and $5 million, respectively. The fair value of our Senior Unsecured Notes at December 25, 2004 and December 27, 2003 would decrease approximately $76 million and $87 million, respectively. Fair value was determined by discounting the projected cash flows.


42



Foreign Currency Exchange Rate Risk

International operating profit constitutes approximately 41% of our operating profit in 2004, excluding unallocated income (expenses). In addition, the Company’s net asset exposure (defined as foreign currency assets less foreign currency liabilities) totaled approximately $1.5 billion as of December 25, 2004. Operating in international markets exposes the Company to movements in foreign currency exchange rates. The Company’s primary exposures result from our operations in Asia-Pacific, the Americas and Europe. Changes in foreign currency exchange rates would impact the translation of our investments in foreign operations, the fair value of our foreign currency denominated financial instruments and our reported foreign currency denominated earnings and cash flows. For the fiscal year ended December 25, 2004, operating profit would have decreased $59 million if all foreign currencies had uniformly weakened 10% relative to the U.S. dollar. The estimated reduction assumes no changes in sales volumes or local currency sales or input prices.

We attempt to minimize the exposure related to our investments in foreign operations by financing those investments with local currency debt when practical and holding cash in local currencies when possible. In addition, we attempt to minimize the exposure related to foreign currency denominated financial instruments by purchasing goods and services from third parties in local currencies when practical. Consequently, foreign currency denominated financial instruments consist primarily of intercompany short-term receivables and payables. At times, we utilize forward contracts to reduce our exposure related to these intercompany short-term receivables and payables. The notional amount and maturity dates of these contracts match those of the underlying receivables or payables such that our foreign currency exchange risk related to these instruments is eliminated.

Commodity Price Risk

We are subject to volatility in food costs as a result of market risk associated with commodity prices. Our ability to recover increased costs through higher pricing is, at times, limited by the competitive environment in which we operate. We manage our exposure to this risk primarily through pricing agreements as well as, on a limited basis, commodity future and option contracts. Commodity future and option contracts entered into for the fiscal years ended December 25, 2004, and December 27, 2003, did not significantly impact our financial position, results of operations or cash flows.

Cautionary Statements

From time to time, in both written reports and oral statements, we present “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The statements include those identified by such words as “may,” “will,” “expect,” “project,” “anticipate,” “believe,” “plan” and other similar terminology. These “forward-looking statements” reflect our current expectations regarding future events and operating and financial performance and are based upon data available at the time of the statements. Actual results involve risks and uncertainties, including both those specific to the Company and those specific to the industry, and could differ materially from expectations.

Company risks and uncertainties include, but are not limited to, potentially substantial tax contingencies related to the Spin-off, which, if they occur, require us to indemnify PepsiCo, Inc.; changes in effective tax rates; our debt leverage and the attendant potential restriction on our ability to borrow in the future; potential unfavorable variances between estimated and actual liabilities; our ability to secure distribution of products and equipment to our restaurants on favorable economic terms and our ability to ensure adequate supply of restaurant products and equipment in our stores; effects and outcomes of legal claims involving the Company; the effectiveness of operating initiatives and advertising and promotional efforts; the ongoing financial viability of our franchisees and licensees; the success of our refranchising strategy; volatility of actuarially determined losses and loss estimates; and adoption of new or changes in accounting policies and practices including pronouncements promulgated by standard setting bodies.


43



Industry risks and uncertainties include, but are not limited to, economic and political conditions in the countries and territories where we operate, including effects of war and terrorist activities; changes in legislation and governmental regulation; new product and concept development by us and/or our food industry competitors; changes in commodity, labor, and other operating costs; changes in competition in the food industry; publicity which may impact our business and/or industry; severe weather conditions; volatility of commodity costs; increases in minimum wage and other operating costs; availability and cost of land and construction; consumer preferences or perceptions concerning the products of the Company and/or our competitors, spending patterns and demographic trends; political or economic instability in local markets and changes in currency exchange and interest rates; and the impact that any widespread illness or general health concern may have on our business and/or the economy of the countries in which we operate.


44



Item 8.                    Financial Statements and Supplementary Data.

INDEX TO FINANCIAL INFORMATION


  Page
Reference

Consolidated Financial Statements  
     
Consolidated Statements of Income for the fiscal years ended
   December 25, 2004, December 27, 2003 and December 28, 2002
46
     
Consolidated Statements of Cash Flows for the fiscal years ended December 25, 2004,
   December 27, 2003 and December 28, 2002
47
     
Consolidated Balance Sheets at December 25, 2004 and December 27, 2003 48
     
Consolidated Statements of Shareholders’ Equity and Comprehensive Income for the
   fiscal years ended December 25, 2004, December 27, 2003 and December 28, 2002
49
     
Notes to Consolidated Financial Statements 50
     
Management’s Responsibility for Financial Statements 85
     
Reports of Independent Auditors 86

Financial Statement Schedules

No schedules are required because either the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the above listed financial statements or notes thereto.

  


45



Consolidated Statements of Income
YUM! Brands, Inc. and Subsidiaries
Fiscal years ended December 25, 2004, December 27, 2003 and December 28, 2002
(in millions, except per share data)


2004
  2003
  2002
 
Revenues            
Company sales $ 7,992   $ 7,441   $ 6,891  
Franchise and license fees   1,019     939     866  



    9,011     8,380     7,757  



 
Costs and Expenses, net
Company restaurants
  Food and paper   2,538     2,300     2,109  
  Payroll and employee benefits   2,112     2,024     1,875  
  Occupancy and other operating expenses   2,183     2,013     1,806  



    6,833     6,337     5,790  
                   
General and administrative expenses   1,056     945     913  
Franchise and license expenses   26     28     49  
Facility actions   26     36     32  
Other (income) expense   (55 )   (41 )   (30 )
Wrench litigation (income) expense   (14 )   42      
AmeriServe and other charges (credits)   (16 )   (26 )   (27 )



Total costs and expenses, net   7,856     7,321     6,727  



                   
Operating Profit   1,155     1,059     1,030  
                   
Interest expense, net   129     173     172  



Income Before Income Taxes and Cumulative Effect of
   Accounting Change
  1,026     886     858  
                   
Income tax provision   286     268     275  



Income before Cumulative Effect of Accounting Change   740     618     583  
                   
Cumulative effect of accounting change, net of tax       (1 )    



                    
Net Income $ 740   $ 617   $ 583  



Basic Earnings Per Common Share $ 2.54   $ 2.10   $ 1.97  



Diluted Earnings Per Common Share $ 2.42   $ 2.02   $ 1.88  



Dividends Declared Per Common Share $ 0.30   $   $  



             

See accompanying Notes to Consolidated Financial Statements.



46




Consolidated Statements of Cash Flows
YUM! Brands, Inc. and Subsidiaries
Fiscal years ended December 25, 2004, December 27, 2003 and December 28, 2002
(in millions)


2004
  2003
  2002
 
Cash Flows – Operating Activities            
Net income $ 740   $ 617   $ 583  
Adjustments to reconcile net income to net cash provided by
   operating activities:
    Cumulative effect of accounting change, net of tax       1      
    Depreciation and amortization   448     401     370  
    Facility actions   26     36     32  
    Wrench litigation (income) expense   (14 )   42      
    AmeriServe and other charges (credits)       (3 )    
    Contributions to defined benefit pension plans   (55 )   (132 )   (26 )
    Other liabilities and deferred credits   21     17     (12 )
    Deferred income taxes   142     (23 )   21  
    Other non-cash charges and credits, net   25     32     36  
Changes in operating working capital, excluding effects of
   acquisitions and dispositions:
    Accounts and notes receivable   (39 )   2     32  
    Inventories   (7 )   (1 )   11  
    Prepaid expenses and other current assets   (5 )       19  
    Accounts payable and other current liabilities   (20 )   (32 )   (37 )
    Income taxes payable   (131 )   96     59  



    Net change in operating working capital   (202 )   65     84  



Net Cash Provided by Operating Activities   1,131     1,053     1,088  



Cash Flows – Investing Activities
Capital spending   (645 )   (663 )   (760 )
Proceeds from refranchising of restaurants   140     92     81  
Acquisition of Yorkshire Global Restaurants, Inc.           (275 )
Acquisition of restaurants from franchisees   (38 )   (41 )   (13 )
Short-term investments   (36 )   13     9  
Sales of property, plant and equipment   52     46     58  
Other, net   41     34     15  



Net Cash Used in Investing Activities   (486 )   (519 )   (885 )



Cash Flows – Financing Activities
Proceeds from Senior Unsecured Notes           398  
Revolving Credit Facility activity, by original maturity
  Three months or less, net   19     (153 )   59  
Repayments of long-term debt   (371 )   (17 )   (511 )
Short-term borrowings-three months or less, net       (137 )   (15 )
Repurchase shares of common stock   (569 )   (278 )   (228 )
Employee stock option proceeds   200     110     125  
Dividends paid on common shares   (58 )        
Other, net           (15 )



Net Cash Used in Financing Activities   (779 )   (475 )   (187 )



Effect of Exchange Rate on Cash and Cash Equivalents   4     3     4  



Net (Decrease) Increase in Cash and Cash Equivalents   (130 )   62     20  
Cash and Cash Equivalents – Beginning of Year   192     130     110  



Cash and Cash Equivalents – End of Year $ 62   $ 192   $ 130  



             

See accompanying Notes to Consolidated Financial Statements.



47



Consolidated Balance Sheets
YUM! Brands, Inc. and Subsidiaries
December 25, 2004 and December 27, 2003
(in millions)


2004
  2003
 
ASSETS        
Current Assets
Cash and cash equivalents $ 62   $ 192  
Short-term investments, at cost   54     15  
Accounts and notes receivable, less allowance: $22 in 2004 and $25 in 2003   192     150  
Inventories   76     67  
Assets classified as held for sale   7     96  
Prepaid expenses and other current assets   135     65  
Deferred income taxes   156     165  
Advertising cooperative assets, restricted   65     56  


   Total Current Assets   747     806  
             
Property, plant and equipment, net   3,439     3,280  
Goodwill   553     521  
Intangible assets, net   347     357  
Investments in unconsolidated affiliates   194     184  
Other assets   416     472  


   Total Assets $ 5,696   $ 5,620  


 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities
Accounts payable and other current liabilities $ 1,160   $ 1,157  
Dividends payable   29      
Income taxes payable   111     238  
Short-term borrowings   11     10  
Advertising cooperative liabilities   65     56  


   Total Current Liabilities   1,376     1,461  
             
Long-term debt   1,731     2,056  
Other liabilities and deferred credits   994     983  


   Total Liabilities   4,101     4,500  


 
Shareholders’ Equity
Preferred stock, no par value, 250 shares authorized; no shares issued        
Common stock, no par value, 750 shares authorized; 290 shares and 292
  shares issued in 2004 and 2003, respectively
  659     916  
Retained earnings   1,067     414  
Accumulated other comprehensive income (loss)   (131 )   (210 )


   Total Shareholders’ Equity   1,595     1,120  


   Total Liabilities and Shareholders’ Equity $ 5,696   $ 5,620  


         

See accompanying Notes to Consolidated Financial Statements.



48



Consolidated Statements of Shareholders’ Equity and Comprehensive Income 
YUM! Brands, Inc. and Subsidiaries
Fiscal years ended December 25, 2004, December 27, 2003 and December 28, 2002
(in millions)


  Issued
Common Stock
  Retained
Earnings
(Accumulated

Deficit)
Accumulated
Other
Comprehensive

Income (Loss)
Total
 
 
Shares Amount





Balance at December 29, 2001 293   $ 1,097   $ (786 )   $ (207 )   $ 104
                         
Net income           583         583
Foreign currency translation adjustment
    arising during the period
                6   6
Net unrealized loss on derivative instruments
   (net of tax impact of $1 million)
                (1 )   (1 )
Minimum pension liability adjustment
   (net of tax impact of $29 million)
                (47 )   (47 )

Comprehensive Income                       541
Repurchase of shares of common stock (8 )   (228 )               (228 )
Employee stock option exercises (includes tax
    impact of $49 million)
9   174               174
Compensation-related events     3               3





Balance at December 28, 2002 294   $ 1,046   $ (203 )   $ (249 )   $ 594





Net income           617         617
Foreign currency translation adjustment
   arising during the period
                67   67
Foreign currency translation adjustment
   included in net income
                2   2
Minimum pension liability adjustment
   (net of tax impact of $18 million)
                (30 )   (30 )

Comprehensive Income                       656
Repurchase of shares of common stock (9 )   (278 )               (278 )
Employee stock option exercises (includes tax
    impact of $26 million)
7   136               136
Compensation-related events     12               12





Balance at December 27, 2003 292   $ 916   $ 414   $ (210 )   $ 1,120





Net income           740         740
Foreign currency translation adjustment
   arising during the period
                73   73
Minimum pension liability adjustment
   (net of tax impact of $3 million)
                6   6
                               
 
Comprehensive Income                       819
Dividends declared on common shares ($0.30
    per common share)
          (87 )         (87 )
Repurchase of shares of common stock (14 )   (569 )               (569 )
Employee stock option exercises (includes tax
    impact of $102 million)
12   302               302
Compensation-related events     10               10





Balance at December 25, 2004 290   $ 659   $ 1,067   $ (131 )   $ 1,595





                             

See accompanying Notes to Consolidated Financial Statements.



49



Notes to Consolidated Financial Statements
(Tabular amounts in millions, except share data)

Note 1 – Description of Business

YUM! Brands, Inc. and Subsidiaries (collectively referred to as “YUM” or the “Company”) comprises the worldwide operations of KFC, Pizza Hut, Taco Bell and since May 7, 2002, Long John Silver’s (“LJS”) and A&W All-American Food Restaurants (“A&W”) (collectively the “Concepts”), which were added when we acquired Yorkshire Global Restaurants, Inc. (“YGR”). YUM is the world’s largest quick service restaurant company based on the number of system units, with over 33,000 units of which approximately 39% are located outside the U.S. in more than 100 countries and territories. YUM was created as an independent, publicly-owned company on October 6, 1997 (the “Spin-off Date”) via a tax-free distribution by our former parent, PepsiCo, Inc. (“PepsiCo”), of our Common Stock (the “Distribution” or “Spin-off”) to its shareholders. References to YUM throughout these Consolidated Financial Statements are made using the first person notations of “we,” “us ” or “our.” 

Through our widely-recognized Concepts, we develop, operate, franchise and license a system of both traditional and non-traditional quick service restaurants. Each Concept has proprietary menu items and emphasizes the preparation of food with high quality ingredients as well as unique recipes and special seasonings to provide appealing, tasty and attractive food at competitive prices. Our traditional restaurants feature dine-in, carryout and, in some instances, drive-thru or delivery service. Non-traditional units, which are principally licensed outlets, include express units and kiosks which have a more limited menu and operate in non-traditional locations like airports, gasoline service stations, convenience stores, stadiums, amusement parks and colleges, where a full-scale traditional outlet would not be practical or efficient. We are actively pursuing the strategy of multibranding, where two or more of our Concepts are operated in a single unit. In addition, we are pursuing the multibrand combination of Pizza Hut and WingStreet, a flavored chicken wings concept we have developed. We are also testing multibranding options involving one of our Concepts and either a concept in development, such as Pasta Bravo, or a concept not owned or affiliated with YUM.

Note 2 - Summary of Significant Accounting Policies

Our preparation of the accompanying Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America 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 these estimates.

Principles of Consolidation and Basis of Preparation.  Intercompany accounts and transactions have been eliminated. Certain investments in businesses that operate our Concepts are accounted for by the equity method. Generally, we possess 50% ownership of and 50% voting rights over these affiliates. Our lack of majority voting rights precludes us from controlling these affiliates, and thus we do not consolidate these affiliates. Our share of the net income or loss of those unconsolidated affiliates is included in other (income) expense.

We participate in various advertising cooperatives with our franchisees and licensees. In certain of these cooperatives we possess majority voting rights, and thus control the cooperatives. At December 27, 2003, we reported the related assets and liabilities of those advertising cooperatives we control in accounts and notes receivable, prepaid expenses and other current assets and accounts payable and other current liabilities, as appropriate. We have now summed all assets and liabilities of these advertising cooperatives and reported the amounts as advertising cooperative assets, restricted and advertising cooperative liabilities in the Consolidated Balance Sheet as of December 25, 2004. We have reclassified those amounts in the Consolidated Balance Sheet as of December 27, 2003 for comparative purposes. As the contributions to these cooperatives are designated and segregated for advertising, we act as an agent for the franchisees and licensees with regard to these contributions. Thus, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 45, “Accounting for Franchise Fee Revenue,” we do not reflect, and have not reflected in the past, franchisee and licensee contributions to these cooperatives in our Consolidated Statements of Income.


50



In 2004, we adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (“FIN 46R”). FIN 46R addresses the consolidation of an entity whose equity holders either (a) have not provided sufficient equity at risk to allow the entity to finance its own activities or (b) do not possess certain characteristics of a controlling financial interest. FIN 46R requires the consolidation of such an entity, known as a variable interest entity (“VIE”), by the primary beneficiary of the entity. The primary beneficiary is the entity, if any, that is obligated to absorb a majority of the risk of loss from the VIE’s activities, entitled to receive a majority of the VIE’s residual returns, or both. FIN 46R excludes from its scope businesses (as defined by FIN 46R) unless certain conditions exist.

The principal entities in which we possess a variable interest include franchise entities, including our unconsolidated affiliates described above. We do not possess any ownership interests in franchise entities except for our investments in various unconsolidated affiliates accounted for under the equity method. Additionally, we generally do not provide financial support to franchise entities in a typical franchise relationship.

We also possess variable interests in certain purchasing cooperatives we have formed along with representatives of the franchisee groups of each of our Concepts. These purchasing cooperatives were formed for the purpose of purchasing certain restaurant products and equipment in the U.S. Our equity ownership in each cooperative is generally proportional to our percentage ownership of the U.S. system units for the Concept. We account for our investments in these purchasing cooperatives using the cost method, under which our recorded balances were not significant at December 25, 2004 or December 27, 2003.

As a result of the adoption of FIN 46R, we have not consolidated any franchise entities, purchasing cooperatives or other entities.

Fiscal Year.  Our fiscal year ends on the last Saturday in December and, as a result, a fifty-third week is added every five or six years. Fiscal year 2000 included 53 weeks. The Company’s next fiscal year with 53 weeks will be 2005. 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. Our subsidiaries operate on similar fiscal calendars with period or month end dates suited to their businesses. The subsidiaries’ period end dates are within one week of YUM’s period end date with the exception of our international businesses, which close one period or one month earlier to facilitate consolidated reporting.

Reclassifications.  We have reclassified certain items in the accompanying Consolidated Financial Statements and Notes thereto for prior periods to be comparable with the classification for the fiscal year ended December 25, 2004. These reclassifications had no effect on previously reported net income.

Franchise and License Operations.  We execute franchise or license agreements for each unit which set out the terms of our arrangement with the franchisee or licensee. Our franchise and license agreements typically require the franchisee or licensee to pay an initial, non-refundable fee and continuing fees based upon a percentage of sales. Subject to our approval and their payment of a renewal fee, a franchisee may generally renew the franchise agreement upon its expiration.

We incur expenses that benefit both our franchise and license communities and their representative organizations and our Company operated restaurants. These expenses, along with other costs of servicing of franchise and license agreements are charged to general and administrative (“G&A”) expenses as incurred. Certain direct costs of our franchise and license operations are charged to franchise and license expenses. These costs include provisions for estimated uncollectible fees, franchise and license marketing funding, amortization expense for franchise related intangible assets and certain other direct incremental franchise and license support costs. Franchise and license expenses also include occupancy costs associated with restaurants we sublease to franchisees, net of any rental income we receive.


51



We monitor the financial condition of our franchisees and licensees and record provisions for estimated losses on receivables when we believe that our franchisees or licensees are unable to make their required payments. While we use the best information available in making our determination, the ultimate recovery of recorded receivables is also dependent upon future economic events and other conditions that may be beyond our control. Net provisions for uncollectible franchise and license receivables of $1 million and $15 million were included in franchise and license expense in 2004 and 2002, respectively. Included in franchise and license expense in 2003 was a net benefit for uncollectible franchise and license receivables of $3 million, as we were able to recover previously reserved receivables in excess of current provisions.

Revenue Recognition. The Company’s revenues consist of sales by Company operated restaurants and fees from our franchisees and licensees. Revenues from Company operated restaurants are recognized when payment is tendered at the time of sale. We recognize initial fees received from a franchisee or licensee as revenue when we have performed substantially all initial services required by the franchise or license agreement, which is generally upon the opening of a store. We recognize continuing fees based upon a percentage of franchisee and licensee sales as earned. We recognize renewal fees when a renewal agreement with a franchisee or licensee becomes effective. We include initial fees collected upon the sale of a restaurant to a franchisee in refranchising gains (losses).

Direct Marketing Costs.  We report substantially all of our direct marketing costs in occupancy and other operating expenses. We charge direct marketing costs to expense ratably in relation to revenues over the year in which incurred and, in the case of advertising production costs, in the year the advertisement is first shown. Deferred direct marketing costs, which are classified as prepaid expenses, consist of media and related advertising production costs which will generally be used for the first time in the next fiscal year and have historically not been significant. To the extent we participate in advertising cooperatives, we expense our contributions as incurred. Our advertising expenses were $458 million, $419 million and $384 million in 2004, 2003 and 2002, respectively.

Research and Development Expenses.  Research and development expenses, which we expense as incurred, are reported in G&A expenses. Research and development expenses were $26 million in both 2004 and 2003 and $23 million in 2002.

Impairment or Disposal of Long-Lived Assets. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), we review our long-lived assets related to each restaurant to be held and used in the business, including any allocated intangible assets subject to amortization, semi-annually for impairment, or whenever events or changes in circumstances indicate that the carrying amount of a restaurant may not be recoverable. We evaluate restaurants using a “two-year history of operating losses” as our primary indicator of potential impairment. Based on the best information available, we write down an impaired restaurant to its estimated fair market value, which becomes its new cost basis. We generally measure estimated fair market value by discounting estimated future cash flows. In addition, when we decide to close a restaurant it is reviewed for impairment and depreciable lives are adjusted based on the expected disposal date. The impairment evaluation is based on the estimated cash flows from continuing use through the expected disposal date plus the expected terminal value.

The Company has adopted SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”), effective for exit or disposal activities that were initiated after December 31, 2002. Costs addressed by SFAS 146 include costs to terminate a contract that is not a capital lease, costs of involuntary employee termination benefits pursuant to a one-time benefit arrangement, costs to consolidate facilities and costs to relocate employees. SFAS 146 changes the timing of expense recognition for certain costs we incur while closing restaurants or undertaking other exit or disposal activities; however, the timing difference is not typically significant in length. Adoption of SFAS 146 did not have a material impact on our Consolidated Financial Statements for the years ended December 25, 2004 or December 27, 2003.

Store closure costs include costs of disposing of the assets as well as other facility-related expenses from previously closed stores. These store closure costs are generally expensed as incurred. Additionally, at the date we cease using a property under an operating lease, we record a liability for the net present value of any remaining lease obligations, net of estimated sublease income, if any. To the extent we sell assets, primarily land, associated with a closed store, any gain or loss upon that sale is recorded in store closure costs.


52



Refranchising gains (losses) includes the gains or losses from the sales of our restaurants to new and existing franchisees and the related initial franchise fees, reduced by transaction costs. In executing our refranchising initiatives, we most often offer groups of restaurants. We classify restaurants as held for sale and suspend depreciation and amortization when (a) we make a decision to refranchise; (b) the stores can be immediately removed from operations; (c) we have begun an active program to locate a buyer; (d) significant changes to the plan of sale are not likely; and (e) the sale is probable within one year. We recognize estimated losses on refranchisings when the restaurants are classified as held for sale. We also recognize as refranchising losses impairment associated with stores we have offered to refranchise for a price less than their carrying value, but do not believe have met the criteria to be classified as held for sale. We recognize gains on restaurant refranchisings when the sale transaction closes, the franchisee has a minimum amount of the purchase price in at-risk equity, and we are satisfied that the franchisee can meet its financial obligations. If the criteria for gain recognition are not met, we defer the gain to the extent we have a remaining financial exposure in connection with the sales transaction. Deferred gains are recognized when the gain recognition criteria are met or as our financial exposure is reduced. When we make a decision to retain a store previously held for sale, we revalue the store at the lower of its (a) net book value at our original sale decision date less normal depreciation and amortization that would have been recorded during the period held for sale or (b) its current fair market value. This value becomes the store’s new cost basis. We record any difference between the store’s carrying amount and its new cost basis to refranchising gains (losses). When we make a decision to close a store previously held for sale, we reverse any previously recognized refranchising loss and then record impairment and store closure costs as described above. Refranchising gains (losses) also include charges for estimated exposures related to those partial guarantees of franchisee loan pools and contingent lease liabilities which arose from refranchising activities. These exposures are more fully discussed in Note 24.

Considerable management judgment is necessary to estimate future cash flows, including cash flows from continuing use, terminal value, closure costs, sublease income and refranchising proceeds. Accordingly, actual results could vary significantly from our estimates.

Impairment of Investments in Unconsolidated Affiliates. We record impairment charges related to an investment in an unconsolidated affiliate whenever events or circumstances indicate that a decrease in the value of an investment has occurred which is other than temporary. In addition, we evaluate our investments in unconsolidated affiliates for impairment when they have experienced two consecutive years of operating losses. Our impairment measurement test for an investment in an unconsolidated affiliate is similar to that for our restaurants except that we use discounted cash flows after interest and taxes instead of discounted cash flows before interest and taxes as used for our restaurants.

Considerable management judgment is necessary to estimate future cash flows. Accordingly, actual results could vary significantly from our estimates.

Asset Retirement Obligations. Effective December 29, 2002, the Company adopted SFAS No. 143, “Accounting for Asset Retirement Obligations” (“SFAS 143”). SFAS 143 addresses the financial accounting and reporting for legal obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. As a result of obligations under certain leases that are within the scope of SFAS 143, the Company recorded a cumulative effect adjustment of $2 million ($1 million after tax) which did not have a material effect on diluted earnings per common share. The adoption of SFAS 143 also did not have a material impact on our Consolidated Financial Statements for the years ended December 25, 2004 or December 27, 2003. If SFAS 143 had been adopted as of the beginning of 2002, the cumulative effect adjustment would not have been materially different from that recorded on December 29, 2002.

Guarantees.  The Company has adopted FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34” (“FIN 45”). FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. FIN 45 also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of certain obligations undertaken. The initial recognition and measurement provisions were applicable to certain guarantees issued or modified after December 31, 2002. While the nature of our business results in the issuance of certain guarantees from time to time, the adoption of FIN 45 did not have a material impact on our Consolidated Financial Statements for the years ended December 25, 2004 or December 27, 2003.


53



We have also issued guarantees as a result of assigning our interest in obligations under operating leases as a condition to the refranchising of certain Company restaurants. Such guarantees are subject to the requirements of SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections” (“SFAS 145”). We recognize a liability for the fair value of such lease guarantees under SFAS 145 at their inception, with the related expense being included in refranchising gains (losses).

Cash and Cash Equivalents.  Cash equivalents represent funds we have temporarily invested (with original maturities not exceeding three months) as part of managing our day-to-day operating cash receipts and disbursements.

Inventories.   We value our inventories at the lower of cost (computed on the first-in, first-out method) or net realizable value.

Property, Plant and Equipment.  We state property, plant and equipment at cost less accumulated depreciation and amortization, impairment writedowns and valuation allowances. We calculate depreciation and amortization on a straight-line basis over the estimated useful lives of the assets as follows: 5 to 25 years for buildings and improvements, 3 to 20 years for machinery and equipment and 3 to 7 years for capitalized software costs. As discussed above, we suspend depreciation and amortization on assets related to restaurants that are held for sale.

Leases and Leasehold Improvements.  We account for our leases in accordance with SFAS No. 13, “Accounting for Leases” and other related authoritative guidance. When determining the lease term, we often include option periods for which failure to renew the lease imposes a penalty on the Company in such an amount that a renewal appears, at the inception of the lease, to be reasonably assured. The primary penalty to which we are subject is the economic detriment associated with the existence of leasehold improvements which might be impaired if we choose not to continue the use of the leased property.

In 2004, we recorded an adjustment, similar to that recorded by many other companies within our industry, such that all of our leasehold improvements are now being depreciated over the shorter of their useful lives or the underlying lease term. The cumulative adjustment necessary, primarily through increased U.S. depreciation expense, totaled $11.5 million ($7 million after tax). The portion of this adjustment that related to the current year was approximately $3 million. As the portion of the adjustment recorded that was a correction of errors in our prior period financial statements was not material to any of those prior period financial statements, we recorded the entire adjustment in our 2004 Consolidated Financial Statements as increased occupancy and other operating expenses.

We record rent expense for leases that contain scheduled rent increases on a straight-line basis over the lease term, including any option periods considered in the determination of that lease term. Contingent rentals are generally based on sales levels in excess of stipulated amounts, and thus are not considered minimum lease payments and are included in rent expense as they accrue. We capitalize rent associated with land that we are leasing while we are constructing a restaurant. Such capitalized rent is then expensed on a straight-line basis over the remaining term of the lease upon opening of the restaurant. We generally do not receive rent holidays, rent concessions or leasehold improvement incentives upon opening a store that is subject to a lease.

Internal Development Costs and Abandoned Site Costs. We capitalize direct costs associated with the site acquisition and construction of a Company unit on that site, including direct internal payroll and payroll-related costs. Only those site-specific costs incurred subsequent to the time that the site acquisition is considered probable are capitalized. If we subsequently make a determination that a site for which internal development costs have been capitalized will not be acquired or developed, any previously capitalized internal development costs are expensed and included in G&A expenses.


54



Goodwill and Intangible Assets. The Company accounts for acquisitions of restaurants from franchisees and other acquisitions of business that may occur from time to time in accordance with SFAS No. 141, “Business Combinations” (“SFAS 141”). Goodwill in such acquisitions represents the excess of the cost of a business acquired over the net of the amounts assigned to assets acquired, including identifiable intangible assets, and liabilities assumed. SFAS 141 specifies criteria to be used in determining whether intangible assets acquired in a business combination must be recognized and reported separately from goodwill. We base amounts assigned to goodwill and other identifiable intangible assets on independent appraisals or internal estimates.

The Company accounts for recorded goodwill and other intangible assets in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). In accordance with SFAS 142, we do not amortize goodwill and indefinite-lived intangible assets. We evaluate the remaining useful life of an intangible asset that is not being amortized each reporting period to determine whether events and circumstances continue to support an indefinite useful life. If an intangible asset that is not being amortized is subsequently determined to have a finite useful life, we amortize the intangible asset prospectively over its estimated remaining useful life. Amortizable intangible assets are amortized on a straight-line basis over 3 to 40 years. As discussed above, we suspend amortization on those intangible assets with a defined life that are allocated to restaurants that are held for sale.

In accordance with the requirements of SFAS 142, goodwill has been assigned to reporting units for purposes of impairment testing. Our reporting units are our operating segments in the U.S. (see Note 23) and our business management units internationally (typically individual countries). Goodwill impairment tests consist of a comparison of each reporting unit’s fair value with its carrying value. The fair value of a reporting unit is an estimate of the amount for which the unit as a whole could be sold in a current transaction between willing parties. We generally estimate fair value based on discounted cash flows. If the carrying value of a reporting unit exceeds its fair value, goodwill is written down to its implied fair value. We have selected the beginning of our fourth quarter as the date on which to perform our ongoing annual impairment test for goodwill. For 2004 and 2003, there was no impairment of goodwill identified during our annual impairment testing. For 2002, goodwill assigned to the Pizza Hut France reporting unit was deemed impaired and written off. The charge of $5 million was recorded in facility actions.

For indefinite-lived intangible assets, our impairment test consists of a comparison of the fair value of an intangible asset with its carrying amount. Fair value is an estimate of the price a willing buyer would pay for the intangible asset and is generally estimated by discounting the expected future cash flows associated with the intangible asset. We also perform our annual test for impairment of our indefinite-lived intangible assets at the beginning of our fourth quarter. Our indefinite-lived intangible assets consist of values assigned to certain trademarks/brands we have acquired. When determining the fair value, we limit assumptions about important factors such as sales growth to those that are supportable based on our plans for the trademark/brand. As discussed in Note 12, we recorded a $5 million charge in 2003 as a result of the impairment of an indefinite-lived intangible asset. This charge was recorded in facility actions. No impairment of indefinite-lived intangibles was recorded in 2004 or 2002.

Stock-Based Employee Compensation.  At December 25, 2004, the Company had four stock-based employee compensation plans in effect, which are described more fully in Note 18. The Company accounts for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related Interpretations. No stock-based employee compensation cost is reflected in net income for options granted under these plans, as all such options had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 “Accounting for Stock-Based Compensation” (“SFAS 123”), to stock-based employee compensation.


55



2004
  2003
  2002
 
Net Income, as reported $ 740   $ 617   $ 583  
Deduct: Total stock-based employee
compensation expense determined under fair
value based method for all awards, net of
related tax effects   (34 )   (36 )   (39 )



Net income, pro forma   706     581     544  
  
Basic Earnings per Common Share
  As reported $ 2.54   $ 2.10   $ 1.97  
  Pro forma   2.42     1.98     1.84  
 
Diluted Earnings per Common Share
  As reported $ 2.42   $ 2.02   $ 1.88  
  Pro forma   2.31     1.91     1.76  
 

Derivative Financial Instruments. We do not use derivative instruments for trading purposes and we have procedures in place to monitor and control their use. Our use of derivative instruments has included interest rate swaps and collars, treasury locks and foreign currency forward contracts. In addition, on a limited basis we utilize commodity futures and options contracts. Our interest rate and foreign currency derivative contracts are entered into with financial institutions while our commodity derivative contracts are exchange traded.

We account for these derivative financial instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) as amended by SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 133 requires that all derivative instruments be recorded on the Consolidated Balance Sheet at fair value. The accounting for changes in the fair value (i.e., gains or losses) of a derivative instrument is dependent upon whether the derivative has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship. For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in the results of operations. For derivative instruments that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income (loss) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Any ineffective portion of the gain or loss on the derivative instrument is recorded in the results of operations immediately. For derivative instruments not designated as hedging instruments, the gain or loss is recognized in the results of operations immediately. See Note 16 for a discussion of our use of derivative instruments, management of credit risk inherent in derivative instruments and fair value information.

New Accounting Pronouncements Not Yet Adopted

In October 2004, the FASB ratified the consensus reached by the Emerging Issues Task Force (“EITF”) on Issue 04-1 “Accounting for Preexisting Relationships between the Parties to a Business Combination” (“EITF 04-1”). EITF 04-1 requires that a business combination between two parties that have a preexisting relationship be evaluated to determine if a settlement of a preexisting relationship exists. EITF 04-1 also requires that certain reacquired rights (including the rights to the acquirer’s trade name under a franchise agreement) be recognized as intangible assets apart from goodwill. However, if a contract giving rise to the reacquired rights includes terms that are favorable or unfavorable when compared to pricing for current market transactions for the same or similar items, EITF 04-1 requires that a settlement gain or loss should be measured as the lesser of a) the amount by which the contract is favorable or unfavorable to market terms from the perspective of the acquirer or b) the stated settlement provisions of the contract available to the counterparty to which the contract is unfavorable.


56



EITF 04-1 is effective prospectively for business combinations consummated in reporting periods beginning after October 13, 2004 (the fiscal year beginning December 26, 2004 for the Company). When effective, EITF 04-01 will apply to acquisitions of restaurants we may make from our franchisees or licensees. We currently attempt to have our franchisees or licensees enter into standard franchise or license agreements for the applicable Concept and/or market when renewing or entering into a new agreement. However, in certain instances franchisees or licensees have existing agreements that possess terms, including royalty rates, that differ from our current standard agreements for the applicable Concept and/or market. If in the future we were to acquire a franchisee or licensee with such an existing agreement, we would be required to record a settlement gain or loss at the date of acquisition. The amount and timing of any such gains or losses we might record is dependent upon which franchisees or licensees we might acquire and when they are acquired. Accordingly, any impact cannot be currently determined.

In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”), which replaces SFAS 123, supersedes APB 25 and related interpretations and amends SFAS No. 95, “Statement of Cash Flows.” The provisions of SFAS 123R are similar to those of SFAS 123, however, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements as compensation cost based on their fair value on the date of grant. Fair value of share-based awards will be determined using option-pricing models (e.g. Black-Scholes or binomial models) and assumptions that appropriately reflect the specific circumstances of the awards. Compensation cost will be recognized over the vesting period based on the fair value of awards that actually vest.

We will be required to choose between the modified-prospective and modified-retrospective transition alternatives in adopting SFAS 123R. Under the modified-prospective-transition method, compensation cost will be recognized in financial statements issued subsequent to the date of adoption for all shared-based payments granted, modified or settled after the date of adoption, as well as for any unvested awards that were granted prior to the date of adoption. As we previously adopted only the pro forma disclosure provisions of SFAS 123, we will recognize compensation cost relating to the unvested portion of awards granted prior to the date of adoption using the same estimate of the grant-date fair value and the same attribution method used to determine the pro forma disclosures under SFAS 123. Under the modified-retrospective-transition method compensation cost will be recognized in a manner consistent with the modified-prospective-transition method, however, prior period financial statements will also be restated by recognizing compensation cost as previously reported in the pro forma disclosures under SFAS 123. The restatement provisions can be applied to either a) all periods presented or b) to the beginning of the fiscal year in which SFAS 123R is adopted.

SFAS 123R is effective at the beginning of the first interim or annual period beginning after June 15, 2005 (the quarter ending December 31, 2005 for the Company) and early adoption is encouraged. The Company is in the process of evaluating the use of certain option-pricing models as well as the assumptions to be used in such models. When such evaluation is complete, we will determine the transition method to use and the timing of adoption. We do not currently anticipate that the impact on net income on a full year basis of the adoption of SFAS 123R will be significantly different from the historical pro forma impacts as disclosed in accordance with SFAS 123.

 Note 3 - Two-for-One Common Stock Split

On May 7, 2002, the Company announced that its Board of Directors approved a two-for-one split of the Company’s outstanding shares of Common Stock. The stock split was effected in the form of a stock dividend and entitled each shareholder of record at the close of business on June 6, 2002 to receive one additional share for every outstanding share of Common Stock held on the record date. The stock dividend was distributed on June 17, 2002, with approximately 149 million shares of common stock distributed. All per share and share amounts in the accompanying Consolidated Financial Statements and Notes to the Financial Statements have been adjusted to reflect the stock split.


57



Note 4 – YGR Acquisition

On May 7, 2002, YUM completed the acquisition of YGR. The results of operations for YGR have been included in our Consolidated Financial Statements since that date. If the acquisition had been completed as of the beginning of the year ended December 28, 2002, pro forma Company sales and franchise and license fees would have been as follows:

 
2002
 
Company sales $ 7,139  
Franchise and license fees   877  
 

The impact of the acquisition, including interest expense on debt incurred to finance the acquisition, on net income and diluted earnings per share would not have been significant in 2002. The pro forma information is not necessarily indicative of the results of operations had the acquisition actually occurred at the beginning of this period.

As of the date of acquisition, we recorded approximately $49 million of reserves (“exit liabilities”) related to our plans to consolidate certain support functions, and exit certain markets through store refranchisings and closures. The consolidation of certain support functions included the termination of approximately 100 employees. The remaining exit liabilities, which totaled approximately $17 million and $27 million at December 25, 2004 and December 27, 2003, respectively, consist of reserves related to the lease of the former YGR headquarters and certain reserves associated with store refranchising and closures. With the exception of these remaining exit liabilities, the vast majority of the other reserves established at the date of acquisition have been extinguished through cash payments.

Note 5 –  Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) includes:

 
2004
  2003
 
Foreign currency translation adjustment $ (34 ) $ (107 )
Minimum pension liability adjustment, net of tax   (95 )   (101 )
Unrealized losses on derivative instruments, net of tax   (2 )   (2 )


Total accumulated other comprehensive loss $ (131 ) $ (210 )


 

Note 6 - Earnings Per Common Share (“EPS”)

 
2004
  2003
  2002
 
Net income $ 740   $ 617   $ 583  



 
Basic EPS:
Weighted-average common shares outstanding   291     293     296  



Basic EPS $ 2.54   $ 2.10   $ 1.97  



 
Diluted EPS:
Weighted-average common shares outstanding   291     293     296  
Shares assumed issued on exercise of dilutive share equivalents   47     52     56  
Shares assumed purchased with proceeds of dilutive share equivalents   (33 )   (39 )   (42 )



Shares applicable to diluted earnings   305     306     310  



Diluted EPS $ 2.42   $ 2.02   $ 1.88  



 

Unexercised employee stock options to purchase approximately 0.4 million, 4 million and 1.4 million shares of our Common Stock for the years ended December 25, 2004, December 27, 2003 and December 28, 2002, respectively, were not included in the computation of diluted EPS because their exercise prices were greater than the average market price of our Common Stock during the year.


58



Note 7 – Items Affecting Comparability of Net Income

Facility Actions

Facility actions consists of the following components:

 
Refranchising net (gains) losses;
 
Store closure costs;
 
Impairment of long-lived assets for stores we intend to close and stores we intend to continue to use in the business;
 
Impairment of goodwill and indefinite-lived intangible assets.
 
2004
  2003
  2002
 
                   
U.S.            
Refranchising net (gains) losses(a) (b) $ (14 ) $ (20 ) $ (4 )
Store closure costs(c)   (3 )   1     8  
Store impairment charges   17     10     15  
SFAS 142 impairment charges(d)       5      



Facility actions       (4 )   19  



 
International
Refranchising net (gains) losses(a) (d)   2     16     (15 )
Store closure costs       5     7  
Store impairment charges   24     19     16  
SFAS 142 impairment charges(e)           5  



Facility actions   26     40     13  



 
Worldwide
Refranchising net (gains) losses(a) (b) (d)   (12 )   (4 )   (19 )
Store closure costs(c)   (3 )   6     15  
Store impairment charges   41     29     31  
SFAS 142 impairment charges(e)       5     5  



Facility actions $ 26   $ 36   $ 32  




(a) Includes initial franchise fees in the U.S. of $2 million in 2004, $3 million in 2003 and $1 million in 2002 and in International of $8 million in 2004, $2 million in 2003 and $5 million in 2002. See Note 9.
 
(b) U.S. includes a $7 million write down in 2004 on restaurants we currently own but have offered to sell at amounts lower than their carrying amounts.
 
(c) Income in store closure costs results primarily from gains from the sale of properties on which we formerly operated restaurants.
 
(d) International includes write downs of $6 million and $16 million for the years ended December 25, 2004 and December 27, 2003, respectively, related to our Puerto Rico business, which was sold on October 4, 2004.
 
(e) In 2003, we recorded a $5 million charge in the U.S. related to the impairment of the A&W trademark/brand (see further discussion at Note 12). In 2002, we recorded a $5 million charge in International related to the impairment of the goodwill of the Pizza Hut France reporting unit.

59



The following table summarizes the 2004 and 2003 activity related to reserves for remaining lease obligations for stores closed or stores we intend to close.


Beginning
Balance

  Amounts
Used

  New
Decisions

  Estimate/Decision
Changes

  Other(a)
  Ending
Balance

 
                                     
2003 Activity $ 41     (13 )   6     2     4   $ 40  
                                     
2004 Activity $ 40     (17 )   8     (1 )   13   $ 43  
 

(a)      Primarily reserves established upon acquisitions of franchisee restaurants.

The following table summarizes the carrying values of the major classes of assets held for sale at December 25, 2004 and December 27, 2003. U.S. amounts primarily represent land on which we previously operated restaurants and are net of impairment charges of $2 million at both December 25, 2004 and December 27, 2003. International amounts in 2003 relate primarily to our Puerto Rico business. The Puerto Rico business was sold on October 4, 2004 for an amount approximating its then carrying value.

 
December 25, 2004
 
   U.S.
   International
   Worldwide
  
Property, plant and equipment, net $ 7   $   $ 7  
Goodwill            
Other assets            



  Assets classified as held for sale $ 7   $   $ 7  




December 27, 2003
 
U.S.
  International
  Worldwide
 
Property, plant and equipment, net $ 9   $ 73   $ 82  
Goodwill       12     12  
Other assets       2     2  



  Assets classified as held for sale $ 9   $ 87   $ 96  




Wrench Litigation

Income of $14 million was recorded for 2004 reflecting settlements associated with the Wrench litigation for amounts less than previously accrued as well as related insurance recoveries. Expense of $42 million was recorded as Wrench litigation for 2003 reflecting the amounts awarded to the plaintiff and interest thereon. See Note 24 for a discussion of Wrench litigation.

AmeriServe and Other Charges (Credits)

AmeriServe Food Distribution Inc. (“AmeriServe”) was the primary distributor of food and paper supplies to our U.S. stores when it filed for protection under Chapter 11 of the U.S. Bankruptcy Code on January 31, 2000. A plan of reorganization for AmeriServe (the “POR”) was approved on November 28, 2000, which resulted in, among other things, the assumption of our distribution agreement, subject to certain amendments, by McLane Company, Inc. During the AmeriServe bankruptcy reorganization process, we took a number of actions to ensure continued supply to our system. Those actions resulted in significant expense for the Company, primarily recorded in 2000. Under the POR, we are entitled to proceeds from certain residual assets, preference claims and other legal recoveries of the estate.


60



We classify expenses and recoveries related to AmeriServe, as well as integration costs related to our acquisition of YGR, costs to defend certain wage and hour litigation and certain other items, as AmeriServe and other charges (credits). These amounts were classified as unusual items in 2002.

Income of $16 million and $26 million was recorded as AmeriServe and other charges (credits) for 2004 and 2003, respectively. These amounts primarily resulted from cash recoveries related to the AmeriServe bankruptcy reorganization process. Income of $27 million was recorded as AmeriServe and other charges (credits) for 2002, primarily resulting from recoveries related to the AmeriServe bankruptcy reorganization process, partially offset by integration costs related to our acquisition of YGR and costs to defend certain wage and hour litigation.

Note 8 – Supplemental Cash Flow Data

 
  2004
  2003
  2002
 
Cash Paid for:            
   Interest $ 146   $ 178   $ 153  
   Income taxes   276     196     200  
                   
Significant Non-Cash Investing and Financing Activities:                  
Assumption of debt and capital leases related to the                  
   acquisition of YGR $   $   $ 227  
Assumption of capital leases related to the acquisition                  
   of restaurants from franchisees   8          
Capital lease obligations incurred to acquire assets   13     9     23  
Debt reduction due to amendment of sale-leaseback                  
   agreements (see Note 14)       88      
 

On November 10, 2003, our unconsolidated affiliate in Canada was dissolved. Upon dissolution, the Company assumed operation of certain units that were previously operated by the unconsolidated affiliate. The Company also assumed ownership of the assets related to the units that it now operates, as well as the real estate associated with certain units previously owned and operated by the unconsolidated affiliate that are now operated by franchisees (either our former partner in the unconsolidated affiliate or a publicly-held Income Trust in Canada). The acquired real estate associated with the units that are not operated by the Company is being leased to the franchisees. The resulting reduction in our investments in unconsolidated affiliates ($56 million at November 10, 2003) was primarily offset by increases in property, plant and equipment, net and capital lease receivables (included in other assets). The Company realized an insignificant gain upon the dissolution of the unconsolidated affiliate. This gain was realized as the fair value of our increased ownership in the assets received was greater than our carrying value in those assets, and was net of expenses associated with the dissolution.

Note 9 – Franchise and License Fees

 
  2004
  2003
  2002
 
Initial fees, including renewal fees $ 43   $ 36   $ 33  
Initial franchise fees included in refranchising gains   (10 )   (5 )   (6 )



    33     31     27  
Continuing fees   986     908     839  



  $ 1,019   $ 939   $ 866  




61



Note 10 – Other (Income) Expense

 
  2004
  2003
  2002
 
Equity income from investments in unconsolidated affiliates $ (54 ) $ (39 ) $ (29 )
Foreign exchange net (gain) loss   (1 )   (2 )   (1 )



  $ (55 ) $ (41 ) $ (30 )



 

Note 11 – Property, Plant and Equipment, net

 
  2004
  2003
 
Land $ 617   $ 662  
Buildings and improvements   2,957     2,861  
Capital leases, primarily buildings   146     119  
Machinery and equipment   2,337     1,964  


    6,057     5,606  
Accumulated depreciation and amortization   (2,618 )   (2,326 )


  $ 3,439   $ 3,280  


 

Depreciation and amortization expense related to property, plant and equipment was $434 million, $388 million and $357 million in 2004, 2003 and 2002, respectively.

Note 12 – Goodwill and Intangible Assets

The changes in the carrying amount of goodwill are as follows:

 
  U.S.
  International
  Worldwide
 
Balance as of December 28, 2002 $ 372   $ 113   $ 485  
Acquisitions   21     15     36  
Disposals and other, net(a)   (7 )   7      



Balance as of December 27, 2003 $ 386   $ 135   $ 521  
Acquisitions   19     14     33  
Disposals and other, net(a)   (10 )   9     (1 )



Balance as of December 25, 2004 $ 395   $ 158   $ 553  



   
(a) Disposals and other, net for International primarily reflects the impact of foreign currency translation on existing balances.

62



Intangible assets, net for the years ended 2004 and 2003 are as follows:

 
2004
  2003
 
Gross
Carrying
Amount

  Accumulated
Amortization

  Gross
Carrying
Amount

  Accumulated
Amortization

 
Amortized intangible assets                
   Franchise contract rights $ 146   $ (55 ) $ 141   $ (49 )
   Trademarks/brands   67     (3 )   67     (1 )
   Favorable operating leases   22     (16 )   27     (18 )
   Pension-related intangible   11         14      
   Other   5     (1 )   5      




  $ 251   $ (75 ) $ 254   $ (68 )




                 
Unamortized intangible assets
   Trademarks/brands $ 171       $ 171        
 
       
       
 

The most significant recorded trademark/brand assets resulted when we acquired YGR in 2002. At the date of acquisition, we assigned value to both the LJS and A&W trademark/brand assets and determined both had indefinite lives. The fair value of a trademark/brand is determined based upon the value derived from the royalty we avoid, in the case of Company stores, or receive, in the case of franchise and licensee stores, for the use of the trademark/brand. This fair value determination is thus largely dependent upon our estimation of sales attributable to the trademark/brand.

The fair value of the LJS trademark/brand was determined to be in excess of its carrying value during our 2004 and 2003 annual impairment tests. The estimates of sales attributable to the LJS trademark/brand at the dates of these tests reflect the opportunities we believe exist with regard to increased penetration of LJS, for both stand-alone units and as a multibrand partner.

As a result of the decision in 2003 to focus short-term development largely on increased penetration of LJS and our discretionary capital spending limits, less development of A&W was assumed in the near term than forecasted at the date of acquisition. Additionally, while we continued to view A&W as a viable multibrand partner, subsequent to acquisition we decided to close or refranchise substantially all Company-owned A&W restaurants that we had acquired. These restaurants were low-volume, mall-based units that were inconsistent with the remainder of our Company-owned portfolio. Both the decision to close these Company-owned A&W units and the decision to focus on short-term development opportunities at LJS negatively impacted the fair value of the A&W trademark/brand. Accordingly, we recorded a $5 million charge in 2003 to facility actions to write the value of the A&W trademark/brand down to its fair value.

Historically, we have considered the assets acquired representing trademark/brand to have indefinite useful lives due to our expected use of the asset and the lack of legal, regulatory, contractual, competitive, economic or other factors that may limit their useful lives. As required by SFAS 142, we reconsider the remaining useful life of indefinite-life intangible assets each reporting period. Subsequent to the recording of the impairment of the A&W trademark/brand in 2003, we began amortizing its remaining balance over a period of thirty years. While we continue to incorporate development of the A&W trademark/brand into our multibranding plans, our decision to no longer operate the acquired stand-alone Company-owned A&W restaurants is considered a factor that limits its useful life. Accordingly, we are amortizing the remaining balance of the A&W trademark/brand over a period of thirty years, the typical term of our multibrand franchise agreements including renewals. We continue to believe that all of our other recorded trademark/brand assets, including the LJS trademark/brand, have indefinite lives.


63



Amortization expense for definite-lived intangible assets was $8 million in 2004, $7 million in 2003 and $6 million in 2002. Amortization expense for definite-lived intangible assets will approximate $8 million in 2005 and 2006 and $7 million in 2007 through 2009.

Note 13 – Accounts Payable and Other Current Liabilities

 
2004
2003
Accounts payable $ 414   $ 393  
Accrued compensation and benefits   263     257  
Other current liabilities   483     507  
 
 
 
  $ 1,160   $ 1,157  


 

Note 14 – Short-term Borrowings and Long-term Debt

 
2004
  2003
 
Short-term Borrowings        
Current maturities of long-term debt $ 11   $ 10  
             
Long-term Debt            
Senior, Unsecured Revolving Credit Facility, expires September 2009   19      
Senior, Unsecured Notes, due May 2005       351  
Senior, Unsecured Notes, due April 2006   200     200  
Senior, Unsecured Notes, due May 2008   251     251  
Senior, Unsecured Notes, due April 2011   646     645  
Senior, Unsecured Notes, due July 2012   398     398  
Capital lease obligations (See Note 15)   128     112  
Other, due through 2019 (6% - 12%)   79     80  


    1,721     2,037  
Less current maturities of long-term debt   (11 )   (10 )


Long-term debt excluding SFAS 133 adjustment   1,710     2,027  
Derivative instrument adjustment under SFAS 133 (See Note 16)   21     29  


Long-term debt including SFAS 133 adjustment $ 1,731   $ 2,056  


 

On September 7, 2004, we executed an amended and restated five-year senior unsecured Revolving Credit Facility totaling $1.0 billion which matures on September 7, 2009 (the “Credit Facility”). The Credit Facility serves as our primary bank credit agreement and replaced the $1.0 billion Senior Unsecured Revolving Credit Facility that was scheduled to mature on June 25, 2005 (the “Old Credit Facility”). The Credit Facility is unconditionally guaranteed by our principal domestic subsidiaries and contains financial covenants relating to maintenance of leverage and fixed charge coverage ratios. The Credit Facility also contains affirmative and negative covenants including, among other things, limitations on certain additional indebtedness, guarantees of indebtedness, level of cash dividends, aggregate non-U.S. investment and certain other transactions as defined in the agreement. These covenants are substantially similar to those contained in the Old Credit Facility. We were in compliance with all debt covenants at December 25, 2004.

Under the terms of the Credit Facility, we may borrow up to the maximum borrowing limit less outstanding letters of credit. At December 25, 2004, our unused Credit Facility totaled $776 million, net of outstanding letters of credit of $205 million. There were borrowings of $19 million outstanding under the Credit Facility at the end of 2004. The interest rate for borrowings under the Credit Facility ranges from 0.35% to 1.625% over the London Interbank Offered Rate (“LIBOR”) or 0.00% to 0.20% over an Alternate Base Rate, which is the greater of the Prime Rate or the Federal Funds Effective Rate plus 0.50%. The exact spread over LIBOR or the Alternate Base Rate, as applicable, will depend upon our performance under specified financial criteria. Interest on any outstanding borrowings under the Credit Facility is payable at least quarterly. In 2004, 2003 and 2002, we expensed facility fees of approximately $4 million, $6 million and $5 million, respectively. At December 25, 2004, the weighted average contractual interest rate on borrowings outstanding under the Credit Facility was 2.72%.


64



On November 15, 2004, we voluntarily redeemed all of our 7.45% Senior Unsecured Notes that were due in May 2005 (the “2005 Notes”) in accordance with their original terms. The 2005 Notes, which had a total face value of $350 million, were redeemed for approximately $358 million using primarily cash on hand as well as some borrowings under our Credit Facility. The redemption amount approximated the carrying value of the 2005 Notes, including a derivative instrument adjustment under SFAS 133, resulting in no significant impact on net income upon redemption.

In 1997, we filed a shelf registration statement with the Securities and Exchange Commission for offerings of up to $2 billion of senior unsecured debt. The following table summarizes all Senior Unsecured Notes issued under this shelf registration that remain outstanding at December 25, 2004:

 
            Interest Rate
Issuance Date
  Maturity Date
  Principal Amount
  Stated
  Effective(d)
May 1998   May 2008(a)   $     250   7.65%   7.81%
April 2001   April 2006(b)         200   8.50%   9.04%
April 2001   April 2011(b)         650   8.88%   9.20%
June 2002   July 2012(c)        400   7.70%   8.04%

(a) Interest payments commenced on November 15, 1998 and are payable semi-annually thereafter.
   
(b) Interest payments commenced on October 15, 2001 and are payable semi-annually thereafter.
   
(c) Interest payments commenced on January 1, 2003 and are payable semi-annually thereafter.
   
(d) Includes the effects of the amortization of any (1) premium or discount; (2) debt issuance costs; and (3) gain or loss upon settlement of related treasury locks. Excludes the effect of any interest rate swaps as described in Note 16.
 

We have $150 million remaining for issuance under the $2 billion shelf registration.

In connection with our acquisition of YGR in 2002, we assumed approximately $168 million in present value of future rent obligations related to three existing sale-leaseback agreements entered into by YGR involving approximately 350 LJS units. As a result of liens held by the buyer/lessor on certain personal property within the units, the sale-leaseback agreements were accounted for as financings upon acquisition. On August 15, 2003, we amended two of these sale-leaseback agreements to remove the liens on the personal property within the units. As the two amended agreements qualify for sale-leaseback accounting, they are accounted for as operating leases. Accordingly, the future rent obligations associated with the two amended agreements, previously recorded as long-term debt of $88 million, were no longer reflected on our Consolidated Balance Sheets at December 25, 2004 or December 27, 2003. There was no gain or loss recorded as a result of this transaction.

The annual maturities of long-term debt as of December 25, 2004, excluding capital lease obligations of $128 million and derivative instrument adjustments of $21 million, are as follows:

 
Year ended:
2005 $ 1  
2006   202  
2007   2  
2008   253  
2009   22  
Thereafter   1,118  

Total $ 1,598  


65



Interest expense on short-term borrowings and long-term debt was $145 million, $185 million and $180 million in 2004, 2003 and 2002, respectively.

Note 15 – Leases

At December 25, 2004 we operated over 7,700 restaurants, leasing the underlying land and/or building in over 5,500 of those restaurants with our commitments expiring at various dates through 2087. We also lease office space for headquarters and support functions, as well as certain office and restaurant equipment. We do not consider any of these individual leases material to our operations. Most leases require us to pay related executory costs, which include property taxes, maintenance and insurance.

Future minimum commitments and amounts to be received as lessor or sublessor under non-cancelable leases are set forth below:

 
Commitments
  Lease Receivables
 
Capital
  Operating
  Direct
Financing

  Operating
 
2005 $ 18   $ 342   $ 7   $ 21  
2006   17     298     7     18  
2007   15     266     6     15  
2008   14     234     7     12  
2009   14     208     7     11  
Thereafter   106     1,163     67     80  




  $ 184   $ 2,511   $ 101   $ 157  




 

At December 25, 2004 and December 27, 2003, the present value of minimum payments under capital leases was $128 million and $112 million, respectively. At December 25, 2004 and December 27, 2003, unearned income associated with direct financing lease receivables was $48 million and $41 million, respectively.

The details of rental expense and income are set forth below:

 
2004
  2003
  2002
 
Rental expense            
   Minimum $ 376   $ 329   $ 303  
   Contingent   49     44     40  



  $ 425   $ 373   $ 343  



Minimum rental income $ 13   $ 14   $ 11  



 

Note 16 – Financial Instruments

Interest Rate Derivative Instruments - 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 debt. Under the contracts, we agree with other parties to exchange, at specified intervals, the difference between variable rate and fixed rate amounts calculated on a notional principal amount. At December 25, 2004, interest rate derivative instruments outstanding included pay-variable interest rate swaps with notional amounts of $850 million. These swaps have reset dates and floating rate indices which match those of our underlying fixed-rate debt and have been designated as fair value hedges of a portion of that debt. As the swaps qualify for the short-cut method under SFAS 133, no ineffectiveness has been recorded. The net fair value of these swaps as of December 25, 2004 was approximately $29 million, of which $30 million and $1 million have been included in other assets and other liabilities and deferred credits, respectively. The portion of this fair value which has not yet been recognized as a reduction to interest expense at December 25, 2004 (approximately $21 million) has been included in long-term debt.


66



Due to early redemption of the underlying 7.45% Senior Unsecured Notes on November 15, 2004 (see Note 14), pay-variable interest rate swaps with notional amounts of $350 million that qualified for hedge accounting at December 27, 2003, no longer qualify for hedge accounting at December 25, 2004. As we elected to hold these swaps until their May 2005 maturity, we entered into new pay-fixed interest rate swaps with offsetting notional amounts and terms. Gains or losses due to changes in the fair value of the pay-variable swaps will be recognized in the results of operations through May 2005 but these gains or losses are expected to be almost entirely offset by changes in fair value of the pay-fixed swaps. The fair value of both of these swaps were in an asset position as of December 25, 2004 with a fair value totaling approximately $9 million. This fair value has been included in prepaid expenses and other current assets. The fair value of the swaps that previously qualified for hedge accounting was $31 million at December 27, 2003, which was included in other assets. The portion of this fair value which had not been recognized as a reduction to interest expense at December 27, 2003 (approximately $29 million) was included in long-term debt.

Foreign Exchange Derivative Instruments  - 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 financial instruments, the majority of which are 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. No ineffectiveness was recognized in 2004, 2003 or 2002 for those foreign currency forward contracts designated as cash flow hedges.

Equity Derivative Instruments  - On December 3, 2004, we entered into an accelerated share repurchase program (the “Program”). In connection with the Program, a third-party investment bank borrowed approximately 5.4 million shares of our common stock from shareholders. We then repurchased those shares at their then market value ($46.58) from the investment bank for approximately $250 million. The repurchase of the 5.4 million shares was made pursuant to a $300 million share repurchase program authorized by our Board of Directors in May 2004.

Simultaneously, we entered into a forward contract with the investment bank that was indexed to the number of shares repurchased. Under the terms of the forward contract we will receive or be required to pay a price adjustment based on the difference between the weighted average price of our common stock over the duration of the Program and the initial purchase price of $46.58 per share. We expect the Program to be completed by the end of our first fiscal quarter in 2005. At our election, any payments we are obligated to make will either be in cash or in shares of our common stock (not to exceed 15 million shares as specified in the forward contract). Therefore, in accordance with EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled In, a Company’s Own Stock”, any changes in the fair value of the forward contract will be recognized as an adjustment to Shareholders’ Equity at the end of the Program. Through December 25, 2004, the difference between the weighted average price of our common stock and the initial purchase price was insignificant.

Commodity Derivative Instruments  - We also utilize, on a limited basis, commodity futures and options contracts to mitigate our exposure to commodity price fluctuations over the next twelve months. Those contracts have not been designated as hedges under SFAS 133. Commodity future and options contracts did not significantly impact the Consolidated Financial Statements in 2004, 2003 or 2002.

Deferred Amounts in Accumulated Other Comprehensive Income (Loss) - As of December 25, 2004, we had a net deferred loss associated with cash flow hedges of approximately $2 million, net of tax. The loss, which primarily arose from the settlement of treasury locks entered into prior to the issuance of certain amounts of our fixed-rate debt, will be reclassified into earnings from January 1, 2005 through 2012 as an increase to interest expense on this debt.


67



Credit Risks

Credit risk from interest rate swaps and foreign exchange contracts is dependent both on movement in interest and currency rates and the possibility of non-payment by counterparties. We mitigate credit risk by entering into these agreements with high-quality counterparties, and settle swap and forward rate payments on a net basis.

Accounts receivable consists primarily of amounts due from franchisees and licensees for initial and continuing fees. In addition, we have notes and lease receivables from certain of our franchisees. The financial condition of these franchisees and licensees is largely dependent upon the underlying business trends of our Concepts. This concentration of credit risk is mitigated, in part, by the large number of franchisees and licensees of each Concept and the short-term nature of the franchise and license fee receivables.

Fair Value

At December 25, 2004 and December 27, 2003, the fair values of cash and cash equivalents, short-term investments, accounts receivable and accounts payable approximated the carrying values because of the short-term nature of these instruments. The fair value of notes receivable approximates the carrying value after consideration of recorded allowances.

The carrying amounts and fair values of our other financial instruments subject to fair value disclosures are as follows:

 
2004
  2003
 
Carrying
Amount

  Fair Value
  Carrying
Amount

  Fair Value
 
Debt                
   Short-term borrowings and long-term debt,
      excluding capital leases and the derivative
      instrument adjustments $ 1,593   $ 1,900   $ 1,925   $ 2,181  




Debt-related derivative instruments:
   Open contracts in a net asset position   38     38     31     31  




Foreign currency-related derivative
   instruments:
   Open contracts in a net asset (liability) position   (2 )   (2 )        




Lease guarantees   10     27     8     28  




Guarantees supporting financial arrangements
   of certain franchisees, unconsolidated
   affiliates and other third parties   7     8     8     10  




Letters of credit       2         3  




 

We estimated the fair value of debt, debt-related derivative instruments, foreign currency-related derivative instruments, guarantees and letters of credit using market quotes and calculations based on market rates.

Note 17 – Pension and Postretirement Medical Benefits

Pension Benefits

We sponsor noncontributory defined benefit pension plans covering substantially all full-time U.S. salaried employees, certain U.S. hourly employees and certain international employees. The most significant of these plans, the YUM Retirement Plan (the “Plan”), is funded while benefits from the other plans 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. Benefits are based on years of service and earnings or stated amounts for each year of service.


68



Postretirement Medical Benefits

Our postretirement plan provides health care benefits, principally to U.S. salaried retirees and their dependents. This plan includes retiree cost sharing provisions. During 2001, the plan was amended such that any salaried employee hired or rehired by YUM after September 30, 2001 is not eligible to participate in this plan. Employees hired prior to September 30, 2001 are eligible for benefits if they meet age and service requirements and qualify for retirement benefits.

We use a measurement date of September 30 for our pension and postretirement medical plans described above.

Obligation and Funded status at September 30:

 
Pension Benefits   Postretirement
Medical Benefits
 
2004
  2003
  2004
  2003
 
Change in benefit obligation                
  Benefit obligation at beginning of year $ 629   $ 501   $ 81   $ 68  
    Service cost   32     26     2     2  
    Interest cost   39     34     5     5  
    Plan amendments   1              
    Curtailment gain   (2 )   (1 )        
    Benefits and expenses paid   (26 )   (21 )   (4 )   (4 )
    Actuarial (gain) loss   27     90     (3 )   10  




  Benefit obligation at end of year $ 700   $ 629   $ 81   $ 81  




Change in plan assets
  Fair value of plan assets at beginning of year $ 438   $ 251  
    Actual return on plan assets   53     52  
    Employer contributions   54     157  
    Benefits paid   (26 )   (21 )
    Administrative expenses   (1 )   (1 )


   
  Fair value of plan assets at end of year $ 518   $ 438  


   
  Funded status $ (182 ) $ (191 ) $ (81 ) $ (81 )
  Employer contributions(a)   1              
  Unrecognized actuarial loss   225     230     23     28  
  Unrecognized prior service cost   9     12          




  Net amount recognized at year-end $ 53   $ 51   $ (58 ) $ (53 )




                         
(a)  Reflects contributions made between the September 30, 2004 measurement date and December 25, 2004.
 
Amounts recognized in the statement of financial
   position consist of:
  Accrued benefit liability $ (111 ) $ (125 ) $ (58 ) $ (53 )
  Intangible asset   11     14          
  Accumulated other comprehensive loss   153     162          




  $ 53   $ 51   $ (58 ) $ (53 )





69


Additional Information        
  Other comprehensive (income) loss attributable to
     change in additional minimum liability
     recognition $ (9 ) $ 48  
             
Additional year-end information for pension plans with            
  accumulated benefit obligations in excess of plan assets
  Projected benefit obligation $ 700   $ 629  
  Accumulated benefit obligation   629     563  
  Fair value of plan assets   518     438  
   

While we are not required to make contributions to the Plan in 2005, we may make discretionary contributions during the year based on our estimate of the Plan’s expected September 30, 2005 funded status.

Components of Net Periodic Benefit Cost

   
Pension Benefits
 
2004
  2003
  2002
 
Service cost $ 32   $ 26   $ 22  
Interest cost   39     34     31  
Amortization of prior service cost   3     4     1  
Expected return on plan assets   (40 )   (30 )   (28 )
Recognized actuarial loss   19     6     1  



Net periodic benefit cost $ 53   $ 40   $ 27  



Additional loss recognized due to:
   Curtailment $   $   $ 1  
   
Postretirement Medical Benefits
 
2004
  2003
  2002
 
Service cost $ 2   $ 2   $ 2  
Interest cost   5     5     4  
Amortization of prior service cost            
Recognized actuarial loss   1     1     1  



Net periodic benefit cost $ 8   $ 8   $ 7  



 

Prior service costs are amortized on a straight-line basis over the average remaining service period of employees expected to receive benefits. Curtailment gains and losses have been recognized in facility actions as they have resulted primarily from refranchising and closure activities.

Weighted-average assumptions used to determine benefit obligations at September 30:

 
Pension Benefits
  Postretirement Medical
Benefits

 
2004
  2003
  2004
  2003
 
Discount rate   6.15 %   6.25 %   6.15 %   6.25 %
Rate of compensation increase   3.75 %   3.75 %   3.75 %   3.75 %

70



Weighted-average assumptions used to determine the net periodic benefit cost for fiscal years:

 
  Pension Benefits   Postretirement Medical Benefits  
 
 
 
2004   2003   2002   2004   2003   2002  

 
 
 
 
 
 
Discount rate   6.25 % 6.85 % 7.60 % 6.25 % 6.85 % 7.58 %
Long-term rate of return on plan  
   assets   8.50 % 8.50 % 10.00 %      
Rate of compensation increase   3.75 % 3.85 % 4.60 % 3.75 % 3.85 % 4.60 %
 

Our estimated long-term rate of return on plan assets represents the weighted-average of expected future returns on the asset categories included in our target investment allocation based primarily on the historical returns for each asset category, adjusted for an assessment of current market conditions.

Assumed health care cost trend rates at September 30:

 
Postretirement Medical
Benefits
 
 
 
2004     2003  
   
   
 
Health care cost trend rate assumed for next year   11 %   12 %
Rate to which the cost trend rate is assumed to  
   decline (the ultimate trend rate)   5.5 %   5.5 %
Year that the rate reaches the ultimate trend rate   2012     2012  
 

There is a cap on our medical liability for certain retirees. The cap for Medicare eligible retirees was reached in 2000 and the cap for non-Medicare eligible retirees is expected to be reached between the years 2007-2008; once the cap is reached, our annual cost per retiree will not increase.

Assumed health care cost trend rates have a significant effect on the amounts reported for our postretirement health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:

 

 
1-Percentage-Point
Increase
  1-Percentage-Point
Decrease
 

 
 
Effect on total of service and interest cost   $   $  
Effect on postretirement benefit obligation   $ 2   $ (2 )
 

Plan Assets

Our pension plan weighted-average asset allocations at September 30, by asset category are set forth below:

 
Asset Category 2004     2003  

   
 
Equity securities   70 %   65 %
Debt securities   28 %   30 %
Cash   2 %   5 %


   Total   100 %   100 %


 

Our primary objectives regarding the pension assets are to optimize return on assets subject to acceptable risk and to maintain liquidity, meet minimum funding requirements and minimize plan expenses. To achieve these objectives, we have adopted a passive investment strategy in which the asset performance is driven primarily by the investment allocation. Our target investment allocation is 70% equity securities and 30% debt securities, consisting primarily of low cost index mutual funds that track several sub-categories of equity and debt security performance. The investment strategy is primarily driven by our Plan’s participants’ ages and reflects a long-term investment horizon favoring a higher equity component in the investment allocation.


71



A mutual fund held as an investment by the Plan includes YUM stock in the amount of $0.2 million at both September 30, 2004 and 2003 (less than 1% of total plan assets in each instance).

Benefit Payments

The benefits expected to be paid in each of the next five years and in the aggregate for the five years thereafter are set forth below:

 
Year ended: Pension
Benefits
  Postretirement
Medical Benefits
 

 
 
 
2005   $ 17   $ 5  
2006     22     5  
2007     25     6  
2008     28     6  
2009     32     6  
2010 - 2014     242     35  
 

Expected benefits are estimated based on the same assumptions used to measure our benefit obligation on our measurement date of September 30, 2004 and include benefits attributable to estimated further employee service.

Note 18 –Stock-Based Employee Compensation  

At year-end 2004, we had four stock option plans in effect: the YUM! Brands, Inc. Long-Term Incentive Plan (“1999 LTIP”), the 1997 Long-Term Incentive Plan (“1997 LTIP”), the YUM! Brands, Inc. Restaurant General Manager Stock Option Plan (“RGM Plan”) and the YUM! Brands, Inc. SharePower Plan (“SharePower”). During 2003, the 1999 LTIP was amended, subsequent to shareholder approval, to increase the total number of shares available for issuance and to make certain other technical and clarifying changes.

We may grant awards of up to 29.8 million shares and 45.0 million shares of stock under the 1999 LTIP, as amended, and 1997 LTIP, respectively. Potential awards to employees and non-employee directors under the 1999 LTIP include stock options, incentive stock options, stock appreciation rights, restricted stock, stock units, restricted stock units, performance shares and performance units. Potential awards to employees and non-employee directors under the 1997 LTIP include stock appreciation rights, restricted stock and performance restricted stock units. Prior to January 1, 2002, we also could grant stock options and incentive stock options under the 1997 LTIP. We have issued only stock options and performance restricted stock units under the 1997 LTIP and have issued only stock options under the 1999 LTIP.

We may grant stock options under the 1999 LTIP to purchase shares at a price equal to or greater than the average market price of the stock on the date of grant. New option grants under the 1999 LTIP can have varying vesting provisions and exercise periods. Previously granted options under the 1997 LTIP and 1999 LTIP vest in periods ranging from immediate to 2008 and expire ten to fifteen years after grant.

We may grant options to purchase up to 15.0 million shares of stock under the RGM Plan at a price equal to or greater than the average market price of the stock on the date of grant. RGM Plan options granted have a four year vesting period and expire ten years after grant. We may grant options to purchase up to 14.0 million shares of stock at a price equal to or greater than the average market price of the stock on the date of grant under SharePower. Previously granted SharePower options have expirations through 2014.


72



At the Spin-off Date, we converted certain of the unvested options to purchase PepsiCo stock that were held by our employees to YUM stock options under either the 1997 LTIP or SharePower. We converted the options at amounts and exercise prices that maintained the amount of unrealized stock appreciation that existed immediately prior to the Spin-off. The vesting dates and exercise periods of the options were not affected by the conversion. Based on their original PepsiCo grant date, these converted options vest in periods ranging from one to ten years and expire ten to fifteen years after grant.

We estimated the fair value of each option grant made during 2004, 2003 and 2002 as of the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:

 
2004     2003     2002  

   
   
 
Risk-free interest rate 3.2 %   3.0 %   4.3 %
Expected life (years) 6.0     6.0     6.0  
Expected volatility 40.0 %   33.6 %   33.9 %
Expected dividend yield 0.1 %(a)   0.0 %   0.0 %
   
(a) The weighted-average assumption for the expected dividend yield reflects an assumption of 0% for stock options granted prior to the initiation of our quarterly stock dividend in 2004 and 1% thereafter.
 

A summary of the status of all options granted to employees and non-employee directors as of December 25, 2004, December 27, 2003 and December 28, 2002, and changes during the years then ended is presented below (tabular options in thousands):

 
December 25, 2004   December 27, 2003   December 28, 2002  
 
 
 
 
Options   Wtd. Avg.
Exercise
Price
  Options   Wtd. Avg.
Exercise
Price
  Options   Wtd. Avg.
Exercise
Price
 
 
 
 
 
 
 
 
Outstanding at beginning of year   46,971   $ 18.77     49,630   $ 17.54     54,452   $ 16.04  
Granted at price equal to average
  market price
  5,223     35.17     7,344     24.78     6,974     25.52  
Exercised   (12,306 )   16.27     (6,902 )   16.18     (8,876 )   14.06  
Forfeited   (2,780 )   23.75     (3,101 )   19.18     (2,920 )   19.07  






Outstanding at end of year   37,108   $ 21.53     46,971   $ 18.77     49,630   $ 17.54  






Exercisable at end of year   21,033   $ 17.64     19,875   $ 17.22     17,762   $ 13.74  






Weighted-average fair value of options
  granted during the year
$ 15.11         $ 9.43         $ 10.44        

 
 
 

73



The following table summarizes information about stock options outstanding and exercisable at December 25, 2004 (tabular options in thousands):

 
Options Outstanding   Options Exercisable  
   
 
 
Range of
Exercise Prices
  Options   Wtd. Avg.
Remaining
Contractual
Life
  Wtd. Avg.
Exercise
Price
  Options   Wtd. Avg.
Exercise
Price
 

 
 
 
 
 
 
$ 0 - 10   338   0.51   $ 8.87   338   $ 8.87  
  10 - 15   4,418   2.46     12.96   4,258     13.01
  15 -20   13,536   5.17     16.21   10,392     15.76  
  20 - 30   13,172   6.85     24.46   5,625     23.75
  30 - 40   5,500   8.76     34.75   408     36.17
  40 - 50   144   9.79     41.41   12     43.52


 
      37,108         21,033    


 
 

In November 1997, we granted performance restricted stock units of YUM’s Common Stock in the amount of $3.6 million to our Chief Executive Officer (“CEO”). The award was made under the 1997 LTIP and may be paid in Common Stock or cash at the discretion of the Compensation Committee of the Board of Directors. Payment of the award is contingent upon his employment through January 25, 2006 and our attainment of certain pre-established earnings thresholds. The annual expense related to this award included in earnings was $0.4 million for 2004, 2003 and 2002.

Note 19 – Other Compensation and Benefit Programs

We sponsor two deferred compensation benefit programs, the Restaurant Deferred Compensation Plan and the Executive Income Deferral Program (the “RDC Plan” and the “EID Plan,” respectively) for eligible employees and non-employee directors.

Effective October 1, 2001, participants can no longer defer funds into the RDC Plan. Prior to that date, the RDC Plan allowed participants to defer a portion of their annual salary. The participant’s balances will remain in the RDC Plan until their scheduled distribution dates. As defined by the RDC Plan, we credit the amounts deferred with earnings based on the investment options selected by the participants. Investment options in the RDC Plan consist of phantom shares of various mutual funds and YUM Common Stock. We recognize compensation expense for the appreciation or depreciation, if any, attributable to all investments in the RDC Plan. Our obligations under the RDC program as of both year-end 2004 and 2003 were $11 million. We recognized compensation expense of $2 million in 2004, $3 million in 2003 and less than $1 million in 2002 for the RDC Plan.

The EID Plan allows participants to defer receipt of a portion of their annual salary and all or a portion of their incentive compensation. As defined by the EID Plan, we credit the amounts deferred with earnings based on the investment options selected by the participants. These investment options are limited to cash and phantom shares of our Common Stock. The EID Plan allows participants to defer incentive compensation to purchase phantom shares of our Common Stock at a 25% discount from the average market price at the date of deferral (the “Discount Stock Account”). Participants bear the risk of forfeiture of both the discount and any amounts deferred to the Discount Stock Account if they voluntarily separate from employment during the two year vesting period. We expense the intrinsic value of the discount over the vesting period. As investments in the phantom shares of our Common Stock can only be settled in shares of our Common Stock, we do not recognize compensation expense for the appreciation or the depreciation, if any, of these investments. Deferrals into the phantom shares of our Common Stock are credited to the Common Stock Account.


74



Our cash obligations under the EID Plan as of the end of 2004 and 2003 were $23 million and $25 million, respectively. We recognized compensation expense of $4 million in 2004, $3 million in 2003 and $2 million in 2002 for the EID Plan.

We sponsor a contributory plan to provide retirement benefits under the provisions of Section 401(k) of the Internal Revenue Code (the “401(k) Plan”) for eligible U.S. salaried and hourly employees. During 2004, participants were able to elect to contribute up to 25% of eligible compensation on a pre-tax basis (the maximum participant contribution increased from 15% to 25% effective January 1, 2003). Participants may allocate their contributions to one or any combination of 10 investment options within the 401(k) Plan. The Company matches 100% of the participant’s contribution to the 401(k) Plan up to 3% of eligible compensation and 50% of the participant’s contribution on the next 2% of eligible compensation. All matching contributions are made to the YUM Common Stock Fund. We recognized as compensation expense our total matching contribution of $11 million in 2004, $10 million in 2003 and $8 million in 2002.

Note 20 – Shareholders’ Rights Plan

In July 1998, our Board of Directors declared a dividend distribution of one right for each share of Common Stock outstanding as of August 3, 1998 (the “Record Date”). As a result of the two-for-one stock split distributed on June 17, 2002, each holder of Common Stock is entitled to one right for every two shares of Common Stock (one-half right per share). Each right initially entitles the registered holder to purchase a unit consisting of one one-thousandth of a share (a “Unit”) of Series A Junior Participating Preferred Stock, without par value, at a purchase price of $130 per Unit, subject to adjustment. The rights, which do not have voting rights, will become exercisable for our Common Stock ten business days following a public announcement that a person or group has acquired, or has commenced or intends to commence a tender offer for, 15% or more, or 20% or more if such person or group owned 10% or more on the adoption date of this plan, of our Common Stock. In the event the rights become exercisable for Common Stock, each right will entitle its holder (other than the Acquiring Person as defined in the Agreement) to purchase, at the right’s then-current exercise price, YUM Common Stock having a value of twice the exercise price of the right. In the event the rights become exercisable for Common Stock and thereafter we are acquired in a merger or other business combination, each right will entitle its holder to purchase, at the right’s then-current exercise price, common stock of the acquiring company having a value of twice the exercise price of the right.

We can redeem the rights in their entirety, prior to becoming exercisable, at $0.01 per right under certain specified conditions. The rights expire on July 21, 2008, unless we extend that date or we have earlier redeemed or exchanged the rights as provided in the Agreement.

This description of the rights is qualified in its entirety by reference to the original Rights Agreement, dated July 21, 1998, and the Agreement of Substitution and Amendment of Common Share Rights Agreement, dated August 28, 2003, between YUM and American Stock Transfer and Trust Company, the Rights Agent (both including the exhibits thereto).

Note 21 - Share Repurchase Program

In May 2004, our Board of Directors authorized a share repurchase program. This program authorized us to repurchase, through November 2005, up to $300 million (excluding applicable transaction fees) of our outstanding Common Stock. During the year ended December 25, 2004, we repurchased approximately 5.9 million shares for approximately $275 million at an average price per share of approximately $46 under this program. Based on market conditions and other factors, additional repurchases may be made from time to time in the open market or through privately negotiated transactions at the discretion of the Company.

In November 2003, our Board of Directors authorized a share repurchase program. This program authorized us to repurchase, through May 21, 2005, up to $300 million of our outstanding Common Stock (excluding applicable transaction fees). This share repurchase program was completed in 2004. During 2004, we repurchased approximately 8.1 million shares for approximately $294 million at an average price per share of approximately $36 under this program. During 2003, we repurchased approximately 169,000 shares for approximately $6 million at an average price per share of approximately $34 under this program.


75



In November 2002, our Board of Directors authorized a share repurchase program. This program authorized us to repurchase up to $300 million (excluding applicable transaction fees) of our outstanding Common Stock. This share repurchase program was completed in 2003. During 2003, we repurchased approximately 9.2 million shares for approximately $272 million at an average price per share of approximately $30 under this program. During 2002, we repurchased approximately 1.2 million shares for approximately $28 million at an average price per share of approximately $24 under this program.

In February 2001, our Board of Directors authorized a share repurchase program. This program authorized us to repurchase up to $300 million (excluding applicable transaction fees) of our outstanding Common Stock. This share repurchase program was completed in 2002. During 2002, we repurchased approximately 7.0 million shares for approximately $200 million at an average price per share of approximately $29 under this program.

Note 22 - Income Taxes

The details of our income tax provision (benefit) are set forth below. Amounts do not include the income tax benefit of approximately $1 million on the $2 million cumulative effect adjustment recorded on December 29, 2002 due to the adoption of SFAS 143.

 
2004     2003     2002    

   
   
   
Current: Federal $ 78   $ 181   $ 137  
  Foreign 79   114   93  
  State (13 )   (4 )   24  



  144   291   254  



       
Deferred: Federal 41   (23 )   29  
  Foreign 67   (16 )   (6 )  
  State 34   16   (2 )  



  142   (23 )   21  



  $ 286   $ 268   $ 275  



 

Included in the federal deferred tax provision above is approximately $6 million in tax provided on undistributed earnings in one of our foreign investments which we intend to repatriate to the U.S. We have made the determination to repatriate such earnings as the result of The American Jobs Creation Act of 2004 which became law on October 22, 2004 (the “Act”). The Act allows a dividends received deduction of 85% of repatriated qualified foreign earnings in fiscal year 2005. The $6 million in tax is being provided as a result of our determination to repatriate approximately $110 million at December 25, 2004. In accordance with FASB Staff Position 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provisions within the American Jobs Creation Act of 2004," we continue to evaluate whether we will now repatriate other undistributed earnings from foreign investments as a result of the Act. The range of additional amounts that we might repatriate through the Act’s effective date is $0 to approximately $400 million. The associated tax if such amounts were repatriated in accordance with the Act would range from $0 to $20 million. We will complete the evaluation of which of these earnings we will repatriate, if any, during 2005.

Taxes payable were reduced by $102 million, $26 million and $49 million in 2004, 2003 and 2002, respectively, as a result of stock option exercises.

Valuation allowances related to deferred tax assets in foreign countries increased by $45 million, $19 million and $6 million in 2004, 2003 and 2002, respectively. Valuation allowances in certain states increased by $6 million ($4 million, net of federal tax) and $1 million ($1 million, net of federal tax) in 2003 and 2002, respectively. These increases were as a result of determining that it is more likely than not that certain loss carryforwards will not be utilized prior to expiration.


76



In 2004, the deferred foreign tax provision included a $1 million credit to reflect the impact of changes in statutory tax rates in various countries. The deferred foreign tax provision for 2002 included a $2 million credit to reflect the impact of changes in statutory tax rates in various countries.

U.S. and foreign income before income taxes are set forth below:

 
2004   2003   2002  

 
 
 
U.S. $ 704   $ 669   $ 665  
Foreign 322   217   193  



$ 1,026   $ 886   $ 858  



 

The reconciliation of income taxes calculated at the U.S. federal tax statutory rate to our effective tax rate is set forth below:

 
2004     2003     2002  

   
   
 
U.S. federal statutory rate 35.0 %   35.0 %   35.0 %
State income tax, net of federal tax benefit 1.3   1.8   2.0
Foreign and U.S. tax effects attributable to foreign operations (5.8 )   (3.6 )   (2.8 )
Adjustments to reserves and prior years (6.7 )   (1.7 )   (1.8 )
Foreign tax credit amended return benefit   (4.1 )  
Valuation allowance additions (reversals) 4.2   2.8  
Other, net (0.1 )     (0.3 )



Effective income tax rate 27.9 %   30.2 %   32.1 %



 

The adjustments to reserves and prior years in 2004 was primarily driven by the reversal of reserves associated with audits that were settled.

We amended certain prior year returns in 2003 upon our determination that it was more beneficial to claim credit on our U.S. tax returns for foreign taxes paid than to deduct such taxes, as had been done when the returns were originally filed. The benefit for amending such returns will be non-recurring.

The details of 2004 and 2003 deferred tax liabilities (assets) are set forth below:

 
2004     2003    

   
   
Intangible assets and property, plant and equipment $ 153   $ 131  
Other 209   126  


Gross deferred tax liabilities $ 362   $ 257  


   
Net operating loss and tax credit carryforwards $ (231 )   $ (231 )  
Employee benefits (111 )   (105 )  
Self-insured casualty claims (46 )   (52 )  
Capital leases and future rent obligations related to sale-leaseback agreements (25 )   (20 )  
Various liabilities and other (479 )   (362 )  


Gross deferred tax assets (892 )   (770 )  
Deferred tax asset valuation allowances 351   183  


Net deferred tax assets (541 )   (587 )  


Net deferred tax (assets) liabilities $ (179 )   $ (330 )  



77



Reported in Consolidated Balance Sheets as:    
     Deferred income taxes $ (156 )   $ (165 )  
     Other assets (89 )   (178 )  
     Other liabilities and deferred credits 52    
     Accounts payable and other current liabilities 14   13  


$ (179 )   $ (330 )  


 

Federal income tax receivables of $59 million were included in prepaid expenses and other current assets at December 25, 2004.

We have previously not provided deferred tax on the undistributed earnings from our foreign investments, except for amounts to be repatriated as a result of the Act, as we believed they were permanent in nature. We estimate that our total net undistributed earnings upon which we have not provided deferred tax total approximately $300 million at December 25, 2004. A determination of the deferred tax liability on such earnings is not practicable.

We have available net operating loss and tax credit carryforwards totaling approximately $1.7 billion at December 25, 2004 to reduce future tax of YUM and certain subsidiaries. The carryforwards are related to a number of foreign and state jurisdictions. Of these carryforwards, $30 million expire in 2005 and $1.3 billion expire at various times between 2006 and 2023. The remaining carryforwards of approximately $400 million do not expire.

Note 23 – Reportable Operating Segments

We are principally engaged in developing, operating, franchising and licensing the worldwide KFC, Pizza Hut and Taco Bell concepts, and since May 7, 2002, the LJS and A&W concepts, which were added when we acquired YGR. KFC, Pizza Hut, Taco Bell, LJS and A&W operate throughout the U.S. and in 88, 85, 10, 3 and 12 countries and territories outside the U.S., respectively. Our five largest international markets based on operating profit in 2004 are China, United Kingdom, Australia, Asia Franchise and Korea. At December 25, 2004, we had investments in nine unconsolidated affiliates outside the U.S. which operate principally KFC and/or Pizza Hut restaurants. These unconsolidated affiliates operate in China, Japan, Poland and the United Kingdom.

We identify our operating segments based on management responsibility within the U.S. and International. For purposes of applying SFAS No. 131, “Disclosure About Segments of An Enterprise and Related Information” (“SFAS 131”) in the U.S., we consider LJS and A&W to be a single segment. We consider our KFC, Pizza Hut, Taco Bell and LJS/A&W operating segments in the U.S. to be similar and therefore have aggregated them into a single reportable operating segment.

 
Revenues  

 
2004   2003