1997 ANNUAL REPORT
Table of Contents
On October 6, 1997 (the "Spin-off Date"), the worldwide operations of KFC, Pizza Hut and Taco Bell (the "Core Business(es)") became an independent, publicly owned restaurant company known as TRICON Global Restaurants, Inc. through a spin-off from our former parent, PepsiCo, Inc. (the "Spin-off"). See Notes 2, 3 and 4. The Spin-off marked the beginning of a company focused solely on the restaurant business and our three well-recognized brands which together have more outlets worldwide than any other single quick service restaurant ("QSR") company. Separately, each brand ranks in the top ten among QSR chains with regard to U.S. system sales and units. Internationally, our 9,000 plus units make us the second largest QSR company outside the United States.
This Management's Analysis is structured in four major sections. The first section provides an overview and focuses on items that either significantly impact comparability or are anticipated to significantly impact future operating results. The second analyzes results of operations; first on a consolidated basis and then separately for our U.S. and international businesses. The final sections address consolidated cash flows and financial condition. Discussion of certain market risks and our cautionary statements follow these major sections.
This Management's Analysis should be read in conjunction with the Consolidated Financial Statements on pages 31-49 and the Cautionary Statements on page 30.All note references herein refer to the Notes to the Consolidated Financial Statements on pages 35-49. Tabular amounts are displayed in millions except per share and unit count amounts, or as specifically identified. All pro forma earnings per share calculations assume that the 152 million shares issued at Spin-off had been outstanding for all periods presented.
Our worldwide businesses operate in highly competitive markets that are subject to both global and local economic conditions, including the effects of inflation, commodity price and currency fluctuations, governmental actions and political instability and its related dislocations. Our operating and investing strategies are designed, where possible, to mitigate these factors through focused actions on several fronts,including: (a) enhancing the appeal and value of our products through brand promotion, product innovation, quality improvement and prudent pricing actions; (b) providing excellent service to customers; (c) increasing worldwide availability of our products; (d) forming alliances to increase market presence and utilize resources more efficiently; and (e) containing costs through efficient and effective purchasing, distribution and administrative processes.
In 1997, as a percentage of our Core Businesses, our international business accounted for 34% of system sales, almost 25% of Company revenues, and 22% of operating profit before unallocated expenses, foreign exchange losses, facility actions and unusual charges. We believe that, despite the inherent risks and generally higher general and administrative costs of operations, key international markets will continue to be high priority investment targets due to their substantial growth potential. It is, therefore, important to consider that movements in currency exchange rates not only result in a related translation impact on our earnings, but also can result in significant economic impacts that affect operating results. Changes in exchange rates are often linked to variability in real growth, inflation, interest rates, governmental actions and other factors. In addition, material changes may cause us to adjust our financing, investing and operating strategies; for example, promotions and product strategies, pricing and decisions concerning capital spending, sourcing of raw materials and packaging (see discussion on Asia below). The following paragraphs describe the effect of currency exchange rate movements on our reported results.
As currency exchange rates change, translation of the income statements of our international businesses into U.S. dollars affects year-over-year comparability of operating results. Material effects on comparability of sales and operating profit arising from translation are identified in Management's Analysis of operating results. By definition, these translation effects exclude the impact of businesses in highly inflationary countries, where the accounting functional currency is the U.S. dollar.
Changes in currency exchange rates can also
result in reported foreign exchange gains and losses, which are included as a component of
general, administrative and other expenses. We reported a net foreign exchange loss of $16
million in 1997, $5 million in 1996 and
$1 million in 1995. These reported amounts include translation gains and losses arising from re-measurement into U.S. dollars of the monetary assets and liabilities of businesses in highly inflationary countries as well as transaction gains and losses. Transaction gains and losses arise from monetary assets such as receivables and short-term interest-bearing investments as well as payables (including debt) denominated in currencies other than a business unit's functional currency.
Asian Economic Events
Asian operations in such countries as China, Japan, Korea, Singapore and Thailand, among others, comprised approximately 37% of our international system sales for 1997. The economic turmoil and weakening of currencies throughout much of Asia against the U.S. dollar during 1997 has created a difficult retail environment and has had an adverse effect on our operating results beginning late in 1997. Despite this, we will continue to seek out investment opportunities in certain parts of Asia.Lessons learned, in the recent past, in other countries such as Mexico in 1996 and 1995 have helped us identify opportunities to mitigate the impact of these economic events.These include working with our suppliers to reduce costs and increasing the value of our product offerings. The complexities of the international environment in which we operate make it difficult to accurately predict the ongoing effect of foreign currency movements on results of operations. Related effects will be reported in our financial statements as they become known and are estimable.
Selected highlights of our recent operating results in Asia are as follows:
|% of Total International||22%||18%|
|Operating Profit||$ 92||6||$ 87|
|% of Total International(b)||54%||57%|
(a) % B(W) as used above and throughout
Management's Analysis means % Better (Worse).
(b) Exclusive of facility actions net loss and unusual charges.
We have established an enterprise-wide program to prepare our computer systems and applications for the Year 2000. We are utilizing both internal and external resources to identify, correct and test the systems for Year 2000 issues. We anticipate that the majority of domestic reprogramming will be complete by December 1998, and testing efforts will be concluded in the first quarter of 1999. TRICON Restaurants International has initiated a program to assess and correct computer systems for the Year 2000 in five major international markets. We intend to distribute this program to all other international markets in early 1998. We anticipate that business-critical international systems will be reprogrammed and tested by June 1999.
Because third party failures could have a material impact on our ability to conduct business, confirmations are being requested from our processing vendors and suppliers to certify that plans are being developed to address the Year 2000 issues. An assessment of our franchisee readiness is also in process. We anticipate that in the second quarter of 1998, information will be provided to all franchisees regarding the potential business risks associated with the Year 2000 issues.
Testing and conversion of systems and applications is expected to cost $40-$45 million from 1997 through 1999.Of these costs, approximately $4 million had been incurred by year-end 1997 and approximately $35 million is expected to be incurred in 1998. All costs are expected to be funded by cash flows from operations.
Though the benefits of the fourth quarter unusual charge, discussed below, are expected to be significant, we expect that they will be offset in the near term by the negative impact of fluctuations in Asian currencies and incremental spending related to Year 2000 issues.
Other Factors Affecting Comparability
In addition to the above identified near-term risks in our Asian businesses and costs related to Year 2000 issues, we believe that certain items included in 1997 results of operations are either unlikely to recur in 1998 or are expected to recur in significantly different magnitudes, thereby affecting future comparability of results. These items, more fully described in the appropriate sections of Management's Analysis, include the $24 million in special KFC franchise contract renewal fees primarily from renewals in the first half of 1997 which will not recur in 1998. In addition, 1998 total facility actions after-tax net gain is expected to be approximately half of the level of the after-tax net gain recognized in 1997, excluding the fourth quarter charge, due to the inclusion in the second quarter of 1997 of the tax-free gain of $100 million related to the refranchising of our restaurants in New Zealand through an initial public offering. During 1997, the non-core businesses, defined below, generated approximately $10 million ($8 million after-tax) of income before unusual charges through their dates of disposal in 1997 which will not recur.
As more fully discussed in Notes 3 and 16, we believe that our ongoing corporate unallocated annual general and administrative expenses as an independent, publicly owned entity will exceed the annualized amount of the PepsiCo allocation by approximately $20 million. This expected increase will be partially offset by non-recurring TRICON start-up costs of approximately $14 million which were incurred in the last three quarters of 1997.Our net interest expense is expected to be $40 million to $50 million higher in 1998, driven by the higher outstanding debt levels and higher expected weighted average interest rates. The increased general and administrative and interest expenses will primarily be incurred over the first three quarters of 1998.
Subsequent to year-end, we agreed to sell our shared services facility in Wichita, Kansas. We will relocate most of our Wichita operations to Dallas, Texas, and Louisville, Kentucky. Although we anticipate a gain on the sale when the transaction closes, currently scheduled for the fourth quarter of 1998, the majority of the relocation and other costs related to the decision will be incurred in earlier quarters of 1998. The full year net impact of the sale and relocation is expected to be immaterial.
Store Portfolio Perspectives
In the fourth quarter, we announced a $530 million unusual charge ($425 million after-tax). See Note 4.The charge included (1) costs of closing underperforming stores during 1998, primarily at Pizza Hut and internationally; (2) reduction to fair market value, less costs to sell, of the carrying amounts of restaurants we intend to refranchise in 1998; (3) impairment of certain restaurants intended to be used in the business; (4) impairment of certain joint venture investments; and (5) related personnel reductions. The components of the charge were as follows:
|Store closure costs||$213|
|Impairment charges for stores
to be used in the business
|Total facility actions net loss||410|
|Impairment of investment in
|Severance and other||41|
|Total unusual charges||120|
|Total fourth quarter charges||$530|
The charge is largely non-cash and is expected to have a favorable impact on future cash flows and operating profits.We believe our worldwide business, upon completion of the actions covered by the charge, will be significantly more focused and better positioned to deliver consistent growth in operating earnings before facility actions.
For more than two years, we have been working to reduce our share of total system units by selling Company restaurants to existing and new franchisees where their expertise can be leveraged to improve our concepts' overall operational performance, while retaining Company ownership of key markets. This portfolio-balancing activity has, and will continue to, reduce our reported revenues and increase the importance of system sales as a key performance measure. Refranchising frees up invested capital while continuing to generate franchise fees, thereby improving returns. We have also actively closed underperforming units. Restaurant margins and cash flows benefit from the one-time impact of refranchising gains and the ongoing impact of closing underperforming Company units. The impact of refranchising gains is expected to decrease over time.
As a result of our initiatives, coupled with new points of distribution added by our franchisees and licensees, our overall Company percentage (including joint venture units) of our Core Businesses' total system units declined by 6 percentage points from 44% at year-end 1996 to 38% at year-end 1997. We refranchised 1,418 and 659 Company units in 1997 and 1996, respectively. In addition, we closed 661 and 352 Company units in 1997 and 1996, respectively, and have approved for closure an additional 697 units at year-end 1997. Total system units grew 2% and 4% in 1997 and 1996, respectively, driven by new points of distribution added by our franchisees and licensees. As we approach a Company/franchise balance more consistent with our major competition, refranchising activity is expected to substantially decrease.
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