TRICON Global Restaurants, Inc. and Subsidiaries (collectively referred to as "TRICON," the "Company," "we" or "our") 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"). See Notes 1, 2, 9, and 19 to the Consolidated Financial Statements. TRICON is comprised of the worldwide operations of KFC, Pizza Hut and Taco Bell (the "Core Business(es)"). The Spin-off marked our beginning as a company focused solely on the restaurant business and our three well-recognized brands, which together have more retail units worldwide than any other single quick service restaurant ("QSR") company. Separately, each brand ranks in the top ten among QSR chains in U.S. system sales and units. Our 9,000 plus international units make us the second largest QSR company outside the United States.

This Management's Discussion and Analysis ("MD&A") is structured in five major sections. The first section provides an overview and focuses on items that either significantly impact historical comparability or are anticipated to significantly impact our future operating results. The second analyzes our consolidated, U.S. and International results of operations. The next two sections address our consolidated cash flows and financial condition. Finally, there is a discussion of certain market risks and our cautionary statements.

For purposes of this MD&A, we include the worldwide operations of our Core Businesses and, through their respective dates of disposal in 1997, our U.S. non-core businesses. These non-core businesses consist of California Pizza Kitchen, Chevys Mexican Restaurant, D'Angelo's Sandwich Shops, East Side Mario's and Hot 'n Now (collectively the "Non-core Businesses"). Where significant to the discussion, we separately identify the impact of the Non-core Businesses.

In our discussion volume is the estimated dollar effect of the year-over-year change in customer transaction counts. Effective net pricing includes price increases/decreases and the effect of changes in product mix. Portfolio effect represents the impact on operating results related to our refranchising initiative and closure of underperforming stores. System sales represents our Core Businesses' combined sales of the Company, joint venture, franchised and licensed units. Where actual sales data is not reported, our franchised and licensed unit sales are estimated. NM in any table indicates that the percentage is not considered meaningful. B(W) in any table means % better(worse). In addition, throughout our discussion, we use the terms restaurants, units and stores interchangeably.

This MD&A should be read in conjunction with our Consolidated Financial Statements on pages 43-65 and the Cautionary Statements on page 42. Tabular amounts are displayed in millions except per share and unit count amounts, or as specifically identified.

 

INTERNATIONAL OPERATIONS

In 1998, our international business accounted for 32% of system sales, 24% of total revenues and 21% of operating profit before unallocated and corporate expenses, foreign exchange gains, facility actions and unusual charges. We anticipate that, despite the inherent risks and generally higher general and administrative expenses of operations, we will continue to invest in key international markets with substantial growth potential.

During 1998, recognizing that two-thirds of our international profits were coming from seven countries, we decided to substantially reduce our number of primary equity markets from 27 to our ultimate goal of about ten markets. By the end of 1999, we expect to have only about 16 primary equity markets outside the U.S.

Given the significance of our international operations, it is 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 which may change consumer behavior and may impact our operating results. 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. We identify material effects on comparability of sales and operating profit arising from translation of operating results in the MD&A. 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 our general, administrative and other expenses. We reported a net foreign exchange gain of $6 million in 1998, compared to losses of $16 million in 1997 and $5 million in 1996. These reported amounts include transaction and translation 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. Translation gains and losses arise from remeasurement of the monetary assets and liabilities of our businesses in highly inflationary countries into U.S. dollars.

ASIAN ECONOMICS EVENTS

 

 

The overall economic turmoil and weakening of local currencies against the U.S. dollar which began in late 1997 throughout much of Asia presented a challenging retail environment during 1998. The difficult economic conditions adversely affected the U.S. dollar value of our foreign currency, denominated sales and profits ("translation") and reduced consumer demand as seen in reduced transaction counts, both of which impacted our 1998 consolidated results of operations.

Asian operations in such countries as China, Japan, Korea, Singapore, Taiwan and Thailand, among others, comprised approximately 34% of our international U.S. dollar translated system sales in 1998, versus 36% for 1997. Asian system sales declined $254 million or 10% in 1998. Excluding the impact of foreign currency translation, Asian system sales increased 8% in 1998. System sales increases in China and Taiwan were partially offset by declines in Japan, Korea and South Asia.

Our Company revenues from Asia declined $18 million or 3% in 1998. Included in our revenues are franchise fees, which decreased $13 million, or 18%. Excluding the negative impact of foreign currency translation, our revenues from Asia increased approximately 16% in 1998. New unit development in China, Taiwan and Korea led the increase, partially offset by volume declines in Korea, China and Thailand.

 

Our operating profits from Asia declined $27 million or 30% in 1998. Excluding the impact of foreign currency translation, operating profits decreased 7% in 1998. Lower margins in Korea and volume declines in both Korea and China were partially offset by new unit growth as well as increased store margins in China and Taiwan.

The discussion above reflects a change in the methodology we have used in 1998 to calculate the foreign currency translation effect attributed to Asia’s system sales, revenues and operating profits in previous MD&As. We believe this revised methodology, which is consistent with the method we have historically used for total international, is preferable because it results in analytical relationships that are more consistent with our local currency operating results in Asia. Under the revised method, the decline in operating profits attributed to the effect of foreign currency translation is $7 million less than previously disclosed.

Selected highlights of our recent operating results in Asia are as follows:

In 1999, we will continue to work with our suppliers to reduce food costs and focus on increasing our everyday value offerings, and we expect to continue to cautiously seek out investment opportunities in Asia, drawing on lessons learned there, and from our experience in other countries which have faced similar problems in the past such as Mexico and Poland. The complexities of the international environment in which we operate make it difficult to accurately predict the ongoing effect of currency movements. Actual effects will be reported in our financial statements as they become known. However, we currently expect our sales and operating profits in Asia will improve in 1999 aided by the reduction of certain regional support costs and more stable sales trends.

 

YEAR 2000

We have established an enterprise-wide plan to prepare our information technology systems (IT) and non-information technology systems with embedded technology applications (ET) for the Year 2000 issue, to reasonably assure that our critical business partners are prepared and to plan for business continuity as we enter the coming millennium.

Our plan encompasses the use of both internal and external resources to identify, correct and test systems for Year 2000 readiness. External resources include nationally recognized consulting firms and other contract resources to supplement available internal resources.

The phases of our plan -- awareness, assessment, remediation, testing and implementation -- are currently expected to cost $62 to $65 million from 1997 through completion in 2000. The new estimate is higher than our original estimate of $40 to $45 million. Our original estimate did not include approximately $7 million in costs related to the accelerated implementation of replacement systems. Additionally, we have increased our estimates for the approximate costs of remediating subsequently identified applications and the greater than anticipated complexity of certain remediation and contingency planning activities. Our plan contemplates our own IT/ET as well as assessment and contingency planning relative to Year 2000 business risks inherent in our material third party relationships. The total cost represents less than 20% of our total estimated information technology related expenses over the plan period. We have incurred approximately $35 million from inception of planned actions through December 26, 1998 of which $31 million was incurred during 1998. We expect to incur approximately $25 million in 1999 with some additional problem resolution spending in 2000. All costs related to our Year 2000 plan are expected to be funded through cash flow from operations.

IT/ET STATE OF READINESS  We have now completed our inventory process of hardware (including desktops), software (third party and internally developed) and embedded technology applications. Completion of the inventory process significantly increased the previously reported tabulations of applications, as defined below, as more complete counts, primarily regarding desktop, hardware and ET were obtained. We have also implemented monitoring procedures designed to insure that new IT/ET investment is Year 2000 compliant.

Based on this inventory, we identified the critical IT/ET applications and are in the process of determining the Year 2000 compliance status of the IT/ET through third party vendor inquiry or internal processes. We expect to be substantially complete with the conversion (which includes replacement and remediation) and unit testing of the majority of critical U.S. systems in the second quarter of 1999. Although our original timeline has been extended for approximately ten critical applications, we now expect to be able to convert, consolidate, or replace all such applications by late summer. This timetable reflects certain delays attributable to identified incremental complexities of the remediation processes as well as slippage in the execution of our remediation plan. Further delays on these efforts or additional slippage could be detrimental to our overall state of readiness. Our international IT/ET efforts, as expected, have continued to lag behind our U.S. efforts. However, we believe our business risk is minimized by the predominant use of unmodified third party IT in our international business for which Year 2000 compliant versions already exist. Current plans call for timely conversion of critical international systems to these compliant versions. We will continue to closely monitor international progress. We expect to continue integration testing on remediated, replaced and consolidated U.S. and international systems throughout 1999.

The following table identifies by category and status the major identified IT/ET applications at December 26, 1998:

 


Note: We based the tabulations on the total inventory of identified ‘applications’ that was completed at the end of 1998. We have defined the term applications (as used in this Year 2000 discussion) to describe separately identifiable groups of programs, hardware or ET which can be both logically segregated by business purpose and separately unit tested as to performance of a single business function. We will either replace or retire ‘Not Compliant’ applications before Year 2000. Applications have been prioritized and are being remediated based on expected impact of non-remediation. Of the remaining 472 ‘In-Process’ applications in the Internally Developed category, which by definition require internal remediation, less than half have been identified as critical.

MATERIAL THIRD PARTY RELATIONSHIPS We believe that our critical third party relationships can be subdivided generally into suppliers, banks, franchisees and other service providers (primarily data exchange partners). We completed an inventory of U.S. and international restaurant suppliers and have mailed letters requesting information regarding their Year 2000 status. We are in the process of collecting the responses from the suppliers and assessing their Year 2000 risks. Of approximately 550 suppliers considered critical, approximately 10% are high risk based on their responses and approximately 42% have not yet responded to inquiries to date. We expect to continue follow-up, but by mid-1999 we expect to source through alternate compliant vendors where possible. We will develop contingency plans in the first half of 1999 for U.S. and international suppliers that we believe have substantial Year 2000 operational risks.

We have sent letters to or obtained other information regarding compliance information from our primary lending and cash management banks (‘Relationship Banks’). We will develop contingency plans by early 1999 for all banks that have not submitted written representation of Year 2000 readiness. We have limited the following table to Relationship Banks as we are currently preparing an inventory of U.S. depository banks and have just completed the inventory of international banks responsible for processing restaurant deposits and disbursements. We are following the process used for Relationship Banks to evaluate the Year 2000 risks for the U.S. depository and international banks.

 

We have approximately 1,200 U.S. and 950 international franchisees. We have sent information to all U.S. and international franchisees regarding the business risks associated with Year 2000. In addition, we provided sample IT/ET project plans and a report of the compliance status in Company-owned restaurants to the U.S. franchisees. In the early part of 1999, we plan to mail letters to all U.S. and international franchisees requesting information regarding their Year 2000 status. In the U.S., we intend to accumulate survey data and an inventory of point-of-sale hardware and software in use by our franchisees. We then intend to contact POS vendors to assist the franchise community in determining Year 2000 compliance. Outside the U.S., our regional franchise offices will be conducting the franchise survey.

We have identified third party companies that provide critical data exchange services and mailed letters to these companies requesting Year 2000 status. We will develop contingency plans for companies that we believe have significant Year 2000 operational risks. Additionally, we are in the process of identifying all other third party companies that provide business critical services. We are planning to follow the same process used for the data exchange service providers.

The following table indicates by type of third party risk the status of the readiness process:

 

The forward-looking nature and lack of historical precedent for Year 2000 issues present a difficult disclosure challenge. Only one thing is certain about the impact of Year 2000 -- it is difficult to predict with certainty what truly will happen after December 31, 1999. We have based our Year 2000 costs and timetables on our best current estimates, which we derived using numerous assumptions of future events including the continued availability of certain resources and other factors. However, we cannot guarantee that these estimates will be achieved and actual results could differ materially from our plans. Given our best efforts and execution of remediation, replacement and testing, it is still possible that there will be disruptions and unexpected business problems during the early months of 2000. We anticipate making diligent, reasonable efforts to assess Year 2000 readiness of our critical business partners and will ultimately develop contingency plans for business critical systems prior to the end of 1999. However, we are heavily dependent on the continued normal operations of not only our key suppliers of chicken, cheese, beef, tortillas and other raw materials and our major food and supplies distributor, but also on other entities such as lending, depository and disbursement banks and third party administrators of our benefit plans. Despite our diligent preparation, unanticipated third party failures, general public infrastructure failures, or our failure to successfully conclude our remediation efforts as planned could have a material adverse impact on our results of operations, financial condition or cash flows in 1999 and beyond. Inability of our franchisees to remit franchise fees on a timely basis or lack of publicly available hard currency or credit card processing capability supporting our retail sales stream could also have material adverse impact on our results of operations, financial condition or cash flows.

1997 FOURTH QUARTER CHARGE

In the fourth quarter of 1997, we recorded a $530 million unusual charge ($425 million after-tax). The charge included estimates for        (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 certain restaurants we intended to refranchise in 1998; (3) impairment of certain restaurants intended to be used in the business; (4) impairment of certain joint venture investments to be retained; and (5) costs of related personnel reductions. Of the $530 million charge, approximately $401 million related to asset writedowns and approximately $129 million related to liabilities, primarily occupancy-related costs and, to a much lesser extent, severance. The liabilities were expected to be settled from cash flows provided by operations. Through December 26, 1998, the amounts utilized apply only to the actions covered by the charge.

 

The charge included provisions related to 1,392 units expected to be refranchised or closed. Our prior disclosure of 1,407 has been revised to eliminate a duplication in the unit count only of 15 units to be refranchised. Following is a reconciliation of the 1,392 units included in the charge to the remaining units at December 26, 1998:

Although we originally expected to refranchise or close all 1,392 units by year-end 1998, the disposal of 531 units was delayed. This was primarily due to longer than expected periods to locate qualified buyers, particularly for international units, extended negotiations with some lessors and execution delays in consolidating the operations of certain units to be closed with other units that will continue to operate. We expect to dispose of the remaining units during 1999.

As we indicated in our third quarter 1998 Form 10-Q, we re-evaluated during the fourth quarter of 1998 our prior estimates of the fair market values of units to be refranchised or closed and re-evaluated whether to sell or close certain other units originally expected to be disposed of. We made these re-evaluations based primarily on the improved performance of Pizza Hut in the U.S. Largely as a result of decisions to retain certain stores originally expected to be disposed of, better-than-expected proceeds from refranchisings and favorable lease settlements on certain closed store leases, we have reversed $65 million of the charge ($40 million after-tax) in 1998. These reversals have increased 1998 facility actions net gain by $54 million ($33 million after-tax) and decreased 1998 unusual charges by $11 million ($7 million after-tax).