Standard & Poor's raises Yum Brands' corporate credit rating to BBB from BBB-, saying company's credit metrics have been improving because of successful restaurant growth initiatives

Nevin Barich

NEW YORK , February 28, 2012 (Standard & Poor's) – Overview

-- U.S. restaurant franchisor and operator Yum! Brands Inc.'s credit metrics have been improving because of successful restaurant growth initiatives.

-- We also take a favorable view of the company's financial policies to fund shareholder and growth initiatives with internal cash flows.

-- We are raising our ratings on Yum! Brands, including the corporate credit rating, to 'BBB' from 'BBB-' and are assigning our 'BBB' rating to the company's proposed $1.3 billion revolving credit facility.

-- The stable rating outlook reflects our view that the company should be able to sustain healthy EBITDA margins and cash flows, and maintain a moderate financial policy.

Rating Action

On Feb. 28, 2012, Standard & Poor's Ratings Services raised its corporate credit rating on Yum! Brands Inc. to 'BBB' from 'BBB-'. The rating outlook is stable.

At the same time, we assigned our 'BBB' issue-level rating to the company's proposed revolving credit facility. We also raised our issue-level rating on the company's senior unsecured debt to 'BBB' from 'BBB-'.

Rationale

The ratings on Yum! Brands reflect its fairly good earnings and cash flow predictability due to its highly franchised restaurant business, successful international growth, and our expectation that the company will sustain credit measures despite cost pressures we see occurring in the near term. We anticipate that the company will maintain its moderate financial policies of using internally generated cash flows to fund shareholder initiatives such as stock repurchases and international store openings.

We assess Yum! Brands' business risk profile as "satisfactory" (as defined in our criteria) based on its good market position, consistent operating performance despite tough market conditions, and steady growth in international markets, particularly China. We view its financial risk profile as "intermediate" (as defined in our criteria), reflecting its meaningful cash flow generation and strengthening credit measures, which its history of returning significant cash to shareholders partly offsets.

Yum! Brands derives strength from its diverse operations. Earnings of one restaurant concept or geographic location can temper the weaker performance of another. Although we expect its U.S. business to be flat--we believe Taco Bell's same-store comparisons will improve due to product initiatives and KFC will continue to struggle--growth in its international business, particularly China, should help mitigate weaker earnings in the U.S. It faces commodity cost increases that we think will be difficult to pass on because of intense competition. As such, we expect modest profit margin contraction in 2012 due to cost inflation, with EBITDA margin of about 23% compared with 23.7% for the previous year.

In our forecast assumptions, we expect the company to maintain credit measures that are consistent with our 'BBB' rating medians. We expect leverage to decline to about 2.4x by year-end 2012, and funds from operations (FFO) to debt to increase to about 34%, on debt repayment and EBITDA gains.

Key aspects of our performance expectations are:

-- Our economists expect GDP growth of about 2% in the U.S. and 8% in China in each of the next two years. Yum! Brands generates about 80% of its restaurant profits in these two countries.

-- We believe Yum! Brands' sizable growth in China will continue, reflecting new store openings as well as its recent acquisition of a majority interest in Little Sheep Group.

-- Modest EBITDA margin contraction due to cost inflation.

-- Yum! Brands will fund shareholder initiatives with generated cash flows.

-- We believe the company will use existing cash to repay its $263 million debt maturity in July 2012.

-- We currently expect the revolving credit facility to be undrawn, given our cash flow expectations.

-- We assume any tax adjustments proposed by the IRS would not significantly damage credit ratios.

Liquidity

We view Yum! Brands' liquidity as "strong" (as defined in our criteria), based on our expectation for sources to exceed uses for the next one to two years. Sources of liquidity include its proposed $1.3 billion revolving credit facility; cash of about $1.2 billion as of Dec. 31, 2011; and expected cash flows. Our analysis of the company's liquidity includes the following
assessments:

-- Sources will remain above uses by 1.5x or more.

-- Sources would continue to exceed uses even if EBITDA were to drop 30%.

-- Compliance with financial covenants, including maximum total leverage and minimum fixed-charge coverage ratios, would survive a 30% decline in EBITDA.

-- Yum! Brands will fund shareholder initiatives without harming liquidity or financial flexibility.

We expect cash flow generation to remain robust in the next year, given the company's franchised business model and likely benefits from overseas growth. Yum! Brands has historically generated significant free operating cash flows, which averaged about $1 billion in each of the past three years. For the 12 months through Dec. 31, 2011, it generated approximately $1.2 billon in free cash flow after capital spending of about $940 million. Our forecast analysis shows the company generating free cash flows of about $1.6 billion in 2012, about half of which we think Yum! Brands will use for share-buybacks.

Outlook

The stable outlook reflects our opinion that Yum! Brands will maintain its solid operating momentum along with modest improvement in leverage ratios from EBITDA gains and debt repayment. We forecast EBITDA growing about 9% in 2012, which--combined with the use of cash to repay its upcoming debt maturity--would likely lead to leverage of about 2.4x, a level consistent with the rating.

We could lower the ratings if performance weakens and results in leverage 2.7x or higher and FFO to debt of about 25% on a sustained basis, which could result from a 7% drop in EBITDA due to intensified competitive pressures or greater-than-anticipated cost inflation. Higher leverage could also result from an aggressive financial policy if Yum! Brands uses debt to finance share repurchases. In addition, although we think it is unlikely, leverage could increase if a tax adjustment payment results in credit deterioration. We do not expect an upgrade to occur in the near term, given our business risk assessment and cash flow expectation.

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