DEAR  PARTNERS  We’re pleased to report that 1998 was an outstanding year for Tricon, with solid progress made against every operational and financial goal we set for ourselves. Perhaps this is best reflected in your Tricon stock price, which soared 73 percent by year’s end, making it an excellent investment by any standard. More importantly, we’ve set the stage for 1999 and beyond, and are confident we are executing against the key growth drivers that we believe will differentiate us from every other restaurant company in the world.

We clearly ended 1998 with tremendous momentum. For the first time in nearly a decade, all three of our brands in the U.S. delivered positive same store sales growth for the full year. We believe this important achievement is the result of our focus on both operational excellence at the store level and marketing innovation with new products and promotions. Despite the financial crisis in Asia, our international business posted strong results, with an 11 percent increase in operating profit. The growth was driven by our focus on key markets, which allows us to build scale and rationalize General and Administrative expenses, while expanding franchise opportunities elsewhere. Recognizing that two-thirds of our international profit comes from just seven countries, we decided to substantially reduce our equity markets from 27 to about 16 by the end of 1999, well on the way to our goal of about ten equity markets.

This solid performance drove our store level margins up nearly 200 basis points to 13.5 percent. About one-third of the improvement in margins came from our base stores, while the balance of the improvement came from the benefits of our portfolio actions and the strategic charge we took in the fourth quarter of 1997.  Our ongoing operating profit jumped 14 percent to $768 million, driven by strong same store sales, the powerful growth in margins and higher franchise fees. Importantly, our ongoing operating earnings per share grew 29 percent for the year.

We also forged ahead on our refranchising and debt reduction targets. Strong demand in the market led to the refranchising of nearly 1,400 units — almost equaling the record number of units we sold in 1997. As a result, we made significant progress against our strategy to reduce our ownership to 20–25 percent of the system. The units refranchised, together with the closure of 661 units, drove our company ownership to 32 percent by year’s end, six points below our 1997 ownership level. The $600 million we received from the sale of these units, plus cash from our ongoing operations, enabled us to pay down over $1 billion of debt last year, almost two years ahead of our original target. As expected, worldwide revenues from company sales and franchise fees declined by 13 percent due to our refranchising efforts and unit closures.

In terms of marketing and innovation, KFC had great success in the U.S. with Popcorn Chicken and Colonel’s Crispy Strips, giving customers “food on the go” options in addition to the Colonel’s Original Recipe and Extra Crispy chicken. KFC also re-introduced the Colonel in an animated advertising campaign, raising awareness to a whole new level for chicken lovers. Taco Bell hit a home run with its successful launch of Gorditas, reinventing the taco for the first time since Taco Bell’s founder, Glenn Bell, introduced them over 35 years ago … not to mention Taco Bell’s little Chihuahua featured in its advertising and on the cover of this Report. Meanwhile, Pizza Hut had a turnaround year,after introducing The Sicilian Pizza to rave reviews. Along with Pan Pizza, the most popular pizza in the world, Stuffed Crust and Thin ’n Crispy pizzas, Pizza Hut is delivering on its commitment to serve “The Best Pizzas Under One Roof.” Internationally, we had strong same store sales growth in major markets like Mexico and the United Kingdom, and we built nearly 900 new units outside of the U.S., primarily through our franchisees and licensees.

1999 PERSPECTIVE  We believe we’ve laid the groundwork in 1998 for another powerful year in 1999. We expect system sales to grow four to five percent, with the addition of 1,500 units, mostly by our franchisees and licensees. Our company revenues will continue to decline, reflecting the loss of sales from the units we sold or closed in 1998 and an additional 800–900 units we expect to refranchise in 1999. Franchise fees, however, should grow in the low teens as a result of franchisees building new units and acquiring former company-owned stores. We anticipate paying down about $400–500 million of debt, reducing our balance to just over $3 billion by year’s end.

With cost savings, productivity enhancements and volume leverage, we expect to generate about a 100 basis point margin improvement, about half coming from our base stores and the other half coming from our portfolio actions. We also anticipate reducing our G&A by about $50 million in 1999, despite continued spending on necessary Y2K initiatives and other system enhancements. In total, we expect our operating profit to grow in the mid-teen range, and when coupled with about an eight percent expected decline in net interest, operating earnings should be up just over 20 percent.

Our pipeline of new products and marketing in 1999 is far more exciting than it was at this time in 1998, beginning with the recent successful launch of Pizza Hut’s “Big New Yorker” pizza. This new pizza, introduced in time for the Super Bowl, drove all-time record sales at Pizza Hut and we anticipate even greater results throughout the year. In the second half of 1999, KFC will launch a delicious new line of chicken sandwiches, providing our U.S. entry into this $4 billion category in which we essentially have a zero share today, while strengthening our lunchtime business. Taco Bell also will introduce a dinner-time value meal which will enhance our after-5:00 pm business, complementing our strong lunch business. Overlaying these new products will be an exciting, exclusive global restaurant tie-in with the new Star Wars movie, Episode 1 — The Phantom Menace, scheduled to premiere on May 21 in the U.S. We’ll be encouraging our customers to visit all three of our restaurant concepts with one blockbuster promotion.

So as you can see, we’re very enthusiastic about our growth and financial prospects for 1999.

SET THE STAGE FOR FUTURE GROWTH  While we’ve given you our perspective on the company’s positive performance in 1998 and our outlook for 1999, we want you to know we’re focused on six “Bold Goals” to continue to drive our business results well into the future. These bold goals will help shape our management efforts:

First, we want to become renowned for an ownership and recognition culture that drives the best results in the industry. Let’s face it: high employee turnover in the food service business is a reality, often exceeding 200 percent per year at the crew level. We believe the key to reducing this problem is highly motivated, qualified Restaurant General Managers (RGMs), since they’re the ones leading the customer-focused teams. Our RGMs are our Number One leaders. So last year we began giving each of our RGMs a one-time, $20,000 stock option grant called YUMBUCKs, with the opportunity to earn even more options based on their restaurant’s performance. Like you, our RGMs now have an ownership stake in our company and that’s helping improve our business and reduce turnover.

Each of our restaurant companies has its own unique program to recognize outstanding restaurant teamwork across its system. And we’re pleased to tell you that our recognition culture knows no geographic boundaries. From Bangkok to Boston, and London to Los Angeles, we’re having fun recognizing our people who are driving customer satisfaction and getting financial results. In Puerto Rico, for example, we dramatically reduced annual crew turnover by establishing a recognition culture that rewards employees for delivering customer satisfaction.

We’re also pleased that nearly 100 percent of Tricon’s top 500 leaders have met or exceeded our internal stock ownership guidelines, demonstrating their confidence in our growth potential and helping us achieve leadership continuity across the system. You can bet we’re going to continue to do all we can to build an organization where every tool — from training and recognition, to compensation systems — recognizes winning performance, promotes ownership and establishes continuity. This improves retention, drives performance and generates profits.

Our second goal is to drive superior same store sales growth through differentiated brand positioning and innovation. We have the dominant share of the chicken, pizza and Mexican quick service restaurant (QSR) categories and have the three most recognizable restaurant brands in those categories in the world. Our strategy to enhance that position is to capitalize on the uniqueness of each brand through more product innovation, memorable retail advertising and promotions, and service so good it drives sales. We also have a unique opportunity to combine any of our three powerful brands into a single restaurant to give our customers more choice and drive sales — an advantage no other restaurant company in our peer group enjoys.

Third, we are working to improve the economics of our restaurants enough to drive shareholder value. We recognize we need to run each restaurant like it’s our only one. This means we’re going to continue to sweat the details and exploit every opportunity we can find to drive margin improvement the hard way, by being smarter and doing things better. One way we won’t achieve margin improvement is by shortchanging our customers.

To do all of that, we’ve been working closely with our top-performing franchisees and company operators to find more effective ways of attacking cost pressures. For example, we formed a unified food service purchasing cooperative with our U.S. franchisees. This new $4 billion co-op is intended to leverage system scale to drive down costs by purchasing food, paper goods and equipment for all our U.S. restaurants across the Tricon system. We’re also introducing new technologies to simplify operations and improve service time. And we’re intensifying team training and RGM coaching across the system.

On the store level, we’re committed to a new program called CHAMPS (Cleanliness, Hospitality, Accuracy, Maintenance, Product quality and Speed of service), developed by our international team and being introduced in the U.S. in 1999 at our company-owned and many franchised restaurants. With CHAMPS, we’ll now train, measure and reward outstanding employee performance against a common customer standard at all of our restaurants, enabling us to run our restaurants more efficiently and effectively.

Our fourth Bold Goal is to develop the most competitive, leveragable above-the-store cost structure in the industry. Rather than duplicate effort across each of our companies, we’re focused on a “one-time, one-way” execution wherever possible, leveraging our enormous scale to weed out complexity and redundancy. We reduced our general and administrative expenses by over $50 million in 1998, and plan to reduce them by about $50 million in 1999, by doing things one-time, one-way.

As an example, we consolidated most of our Kansas support facility into our existing operations in Kentucky and Texas. We also completed the consolidation of our television network media buying for all three brands, making Tricon one of the dominant network advertisers in the U.S. and leveraging our clout.

Another goal is to expand the system aggressively and profitably by becoming a superior franchise company. Over the next few years, we plan to take our company ownership down to 20–25 percent of the system by selling more of our restaurants to franchisees who are good, experienced operators; and by strategically expanding our
system. Of the 1,500 units we expect to add in 1999, about 1,300 will be opened by our franchisees and licensees. Although we already have more restaurants than any other company, we still have tremendous growth potential in the U.S. and abroad.

This past August we held our first-ever U.S. Franchise Leadership Summit, where company leaders and franchisees from all three brands met to discuss our “one-system” approach, share best practices, and explore cross-branded expansion opportunities. Our franchisees are as excited about our growth potential as we are.

Our last Bold Goal is to build a capital and asset structure that dramatically enhances shareholder value — what we also call YUM Value. YUM Value is the sum of three things: 1) we intend to get more out of our existing businesses; 2) invest in high return businesses; and 3) exit persistently low return businesses. We’ll continue to create YUM Value with a sharpened focus on sales growth, margin improvement, strategic system expansion and elimination of unnecessary or redundant initiatives that don’t add customer or shareholder value.

PROSPECTS NEVER LOOKED BRIGHTER   Our Passion is to put a YUM on people’s faces around the world with crave and rave food, comeback value and with customer-focused teams. Our goal is to do that better than any other restaurant company in the world. It’s clear we’re aggressively executing against our goals, both on the operational and financial front, and we believe we’ve created an infrastructure to sustain our sales and profit momentum for the long-term.

As you read through the following pages, you’ll see a lot of beaming faces. The people of Tricon have good reason to be proud. Their achievements are a true testament to the success of our overarching strategy: invest in the people who will satisfy our customers better than anyone, and profitability follows. We’d like to thank the more than 600,000 employees across the Tricon system, our franchise partners and outstanding Board of Directors for their dedication and inspired ideas throughout this important first year.

We expect great things in 1999, and well into the millenni-YUM.

From all of us at Tricon, YUM to you,

David C. Novak 
Vice Chairman and President 
   Andrall E. Pearson   
   Chairman and CEO