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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-K

OR

For the transition period from                  to                 

Commission file number 1-13163

YUM! BRANDS, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (502) 874-8300

Securities registered pursuant to Section 12(b) of the Act:

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.   [__]

     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 14, 2003 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 $8,295,455,296.

     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 26, 2004 was 291,083,737 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 20, 2004 are incorporated by reference into Part III.

PART I

Item 1.     Business.

YUM! Brands, Inc. (referred to herein as “YUM” or the “Company”), formerly known as TRICON Global Restaurants, Inc., 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 its 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 page 40.

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.

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 27, 2003, December 28, 2002 and December 29, 2001 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 17 through 40 and in the related Consolidated Financial Statements and footnotes in Part II, Item 8, pages 41 through 81.

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.

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

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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. In addition, the Company is testing multibranding options involving one of its Concepts and a restaurant concept not owned by or affiliated with YUM. 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. and internationally. Through the consolidation of market planning initiatives across all of its Concepts, the Company has established, or is in the process of establishing in the case of LJS and A&W, 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 2003, there were 2,345 multibranded units in the worldwide system. These units were comprised of 2,282 units offering food products from two of the Concepts (a “2n1”), 51 units offering food products from three of the Concepts (a “3n1”) and 12 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.

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

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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 to 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 2003, KFC was the leader in the U.S. chicken QSR segment among companies featuring chicken as their primary product offering, with a 47 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 2003, KFC had 5,524 units in the U.S., and 7,354 units outside the U.S. Approximately 23 percent of both the U.S. and non-U.S. units are operated by the Company.
  
• While product offerings vary throughout the worldwide system, traditional KFC restaurants 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 also offer a variety of side items, such as biscuits, mashed potatoes and gravy, coleslaw, corn, potato wedges (in the U.S.) and french fries (outside of the U.S.), as well as desserts. Restaurant decor is characterized by the image of the Colonel, and KFC’s distinctive packaging includes the “Bucket” of chicken.

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 2003, Pizza Hut was the leader in the U.S. pizza QSR segment, with a 15 percent market share in that segment.
  
• Pizza Hut operates in 87 countries and territories throughout the world. As of year-end 2003, Pizza Hut had 7,523 units in the U.S., and 4,560 units outside of the U.S. Approximately 24 percent of the U.S. units and 22 percent of the non-U.S. units are operated by the Company.
  
  
  
  

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• 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. The distinctive Pizza Hut image typically features a bright red roof.

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 2003, Taco Bell was the leader in the U.S. Mexican QSR segment, with a 65 percent market share in that segment.
  
• Taco Bell operates in 13 countries and territories throughout the world. As of year-end 2003, there were 5,989 Taco Bell units in the U.S., and 249 units outside of the U.S. Approximately 21 percent of the U.S. units and 22 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 2003, 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 2003, there were 1,204 LJS units in the U.S., and 31 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.

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 14 countries and territories throughout the world. As of year-end 2003, there were 576 A&W units in the U.S., and 183 units outside the U.S. Approximately 14 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.

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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 2003, YRI had 12,377 units. Approximately 22 percent of these units are operated by the Company. In 2003, YRI accounted for 33 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 2003, approximately 24 percent of YUM’s worldwide units were operated by the Company, approximately 65 percent by franchisees, approximately 7 percent by licensees and approximately 4 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 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.

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

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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 57.

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. A&W units are not currently serviced by 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 trademarks and service marks, including certain of the 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 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 17 through 40 and the Consolidated Statements of Cash Flows in Part II, Item 8, page 43.

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.

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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 2003 the restaurant business in the United States consisted of about 870,000 restaurants representing approximately $420 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. The Company expensed $26 million in 2003 and $23 million in both 2002 and 2001 for R&D activities. From time to time, independent suppliers also conduct research and development activities for the benefit of the YUM system. No amounts were spent on customer-sponsored research activities during 2003, 2002 or 2001.

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 2003, 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.

A small portion of Pizza Hut’s and LJS’s net 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.

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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 2003, the Company employed approximately 265,000 persons, approximately 73 percent of whom were part-time employees. Approximately 52 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.

Financial information about International and U.S. markets is incorporated herein by reference from Selected Financial Data in Part II, Item 6, page 16; Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) in Part II, Item 7, pages 17 through 40; and in the related Consolidated Financial Statements and footnotes in Part II, Item 8, pages 41 through 81.

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.

Item 2.     Properties.

As of year-end 2003, YUM Concepts owned over 1,600 units and leased over 3,400 units in the U.S.; and YRI owned over 300 units and leased over 2,400 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

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information about the Company’s properties is included in the Consolidated Financial Statements and footnotes in Part II, Item 8, pages 41 through 81.

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.

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 29, 1997, a class action lawsuit against Taco Bell Corp., entitled Bravo, et al. v. Taco Bell Corp. (“Bravo”), was filed in the Circuit Court of the State of Oregon of the County of Multnomah. The lawsuit was filed by two former Taco Bell shift managers purporting to represent approximately 17,000 current and former hourly employees statewide. The lawsuit alleged violations of state wage and hour laws, principally involving unpaid wages including overtime, and rest and meal period violations, and sought an unspecified amount in damages. Under Oregon class action procedures, Taco Bell was allowed an opportunity to “cure” the unpaid wage and hour allegations by opening a claims process to all putative class members prior to certification of the class. In this cure process, Taco Bell paid out less than $1 million. On January 26, 1999, the Court certified a class of all current and former shift managers and crew members who claim one or more of the alleged violations. A Court-approved notice and claim form was mailed to approximately 14,500 class members on January 31, 2000. Trial began on January 4, 2001. On March 9, 2001, the jury reached verdicts on the substantive issues in this matter. A number of these verdicts were in favor of the Taco Bell position; however, certain issues were decided in favor of the plaintiffs. In April 2002, a jury trial to determine the damages of 93 of those claimants found that Taco Bell failed to pay for certain meal breaks and/or off-the-clock work for 86 of the 93 claimants.

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However, the total amount of hours awarded by the jury was substantially less than that sought by the claimants. In July and September 2002, the court ruled on several post-trial motions, including fixing the total number of potential claimants at 1,031 (including the 93 claimants for which damages had already been determined) and holding that claimants who prevail are entitled to prejudgment interest and penalty wages. The second damages trial for the remaining 938 claimants began on July 7, 2003. Before the trial concluded, the parties reached an agreement to settle this matter in full. The court granted final approval of the settlement on December 23, 2003 and final judgment of dismissal was entered on December 26, 2003. Payments to class counsel and eligible claimants were made in the first quarter of 2004. We have previously provided for the costs of this settlement as AmeriServe and other charges (credits).

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.

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. 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 (the “Court of Appeals”), and oral arguments were held on September 20, 2000. On July 6, 2001, the 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 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 continue to believe that the Wrench plaintiffs’ claims are without merit and have appealed the verdict to the Sixth Circuit Court of Appeals. Post-judgment interest will continue to accrue during the appeal process.

On July 9, 2003 we filed suit against Taco Bell’s former advertising agency in the United States District Court for the Central District of California seeking reimbursement for any final award that may be ultimately affirmed by the appeals courts and costs that we have incurred in defending this matter. We are also seeking reimbursement from our insurance carriers.

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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 26, 2004, and their ages and current positions as of that date are as follows:

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 Bank One Corporation.

David J. Deno is Chief Financial Officer of YUM. He has served in this position since November 1999. 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.

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Aylwin B. Lewis is President, Chief Multibranding and Operating Officer for YUM. He was appointed to this title in January 2003. From December 1999 to January 2003, Mr. Lewis served as YUM’s Chief Operating Officer. From July 1997 to December 1999, he served as Chief Operating Officer of Pizza Hut. Mr. Lewis previously served as Senior Vice President, Operations for Pizza Hut, a position he assumed in 1996. He served in various positions at KFC, including Senior Director of Franchising and Vice President of Restaurant Support Services, becoming Division Vice President, Operations for KFC in 1993, and Senior Vice President, New Concepts for KFC in 1995. Mr. Lewis joined KFC in 1991 as a Regional General Manager. Mr. Lewis is also a director of the Halliburton Company and the Walt Disney Company.

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.

Peter A. Bassi is President of YRI. He has served in this position since July 1997. Mr. Bassi served as Executive Vice President, Asia, of PepsiCo Restaurants International from February 1996 to July 1997. From 1995 to 1996, he served as Senior Vice President and Chief Financial Officer at PepsiCo Restaurants International. He served as Senior Vice President, Finance and Chief Financial Officer at Taco Bell from 1987 to 1994. He joined the Pepsi-Cola Company in 1972 and served in various management positions at Frito-Lay, Pizza Hut and PepsiCo Food Service International.

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.

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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 Region 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.

Emil J. Brolick is President and Chief Concept Officer of Taco Bell. He has served in this position since July of 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 of 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.

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

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PART II

Item 5.     Market for the Registrant’s Common Stock and Related Stockholder Matters.

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. All prices shown have been adjusted to reflect the two-for-one stock split distributed on June 17, 2002.

As of February 26, 2004, there were approximately 101,000 registered holders of record of the Company’s common stock.

The Company has not paid dividends on its common stock in the past.

The Company had no sales of unregistered securities during 2003, 2002 or 2001.

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Item 6.     Selected Financial Data.
Selected Financial Data
YUM! Brands, Inc. and Subsidiaries
(in millions, except per share and unit amounts)

Fiscal years 2003, 2002, 2001 and 1999 include 52 weeks and fiscal year 2000 includes 53 weeks. From May 7, 2002, fiscal year 2002 included 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“). See Note 12 to the Consolidated Financial Statements for further discussion. The selected financial data should be read in conjunction with the Consolidated Financial Statements and the Notes thereto.

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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 12,377 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 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

• 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

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• 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”).

All references to per share and share amounts in the following MD&A have been adjusted to reflect the two-for-one stock split distributed on June 17, 2002.

This MD&A should be read in conjunction with our Consolidated Financial Statements on pages 42 through 45 and the Cautionary Statements on page 40. All Note references herein refer to the Notes to the Consolidated Financial Statements on pages 46 through 81. Tabular amounts are displayed in millions except per share and unit count amounts, or as otherwise specifically identified.

Factors Affecting Comparability of 2003 Results to 2002 Results and 2002 Results to 2001 Results

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 and 2002 was not significant relative to the comparable prior year period.

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. There was no gain or loss recorded as a result of this transaction; however, restaurant margins decreased by approximately $3 million for the year ended December 27, 2003 as a result of the two amended agreements being accounted for as operating leases subsequent to the amendment. The decrease in restaurant margin was largely offset by a similar decrease in interest expense.

Wrench Litigation

We recorded 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 $26 million in 2003, $27 million in 2002 and $3 million in 2001. 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 Company sales and restaurant profits while increasing our franchise fees. Proceeds from refranchising increase the level of cash available to fund discretionary spending.

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The following table summarizes our refranchising activities:

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:

The impact on operating profit arising from our refranchising and Company store closures is the net of (a) the estimated reduction 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 open 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:

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

Impact of Recently Adopted Accounting Pronouncement

Effective December 30, 2001, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), in its entirety. In accordance with the requirements of SFAS 142, we ceased amortization of goodwill and indefinite-lived intangibles as of December 30, 2001. The following table summarizes the favorable effect of SFAS 142 on restaurant profit, restaurant margin and operating profit had SFAS 142 been effective in 2001.

Additionally, if SFAS 142 had been effective in 2001, reported net income would have increased approximately $26 million and diluted earnings per common share (“EPS”) would have increased $0.09.

SFAS 142 requires that goodwill and indefinite-lived intangibles be evaluated for impairment on an annual basis or as impairment indicators exist. In accordance with this requirement, we recognized impairment of approximately $5 million in both 2003 and 2002.

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Worldwide Results of Operations

Worldwide Restaurant Unit Activity

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The franchise unit counts include both franchisee and unconsolidated affiliate multibrand units. 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.

For 2003 and 2002, Company multibrand unit gross additions were 235 and 216, respectively. For 2003 and 2002, franchise multibrand unit gross additions were 194 and 166, respectively.

Worldwide System Sales Growth

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 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.

System sales increased 7% for 2003, after a 2% favorable impact from foreign currency translation. Excluding the favorable impact of both foreign currency translation and the YGR acquisition, system sales increased 3%. The increase was driven by new unit development, partially offset by store closures.

System sales increased 8% in 2002. The impact from foreign currency translation was not significant. Excluding the favorable impact of the YGR acquisition, system sales increased 5%. The increase resulted from new unit development and same store sales growth, partially offset by store closures.

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Worldwide Revenues

Company sales increased $550 million or 8% in 2003, after a 1% favorable impact from foreign currency translation. Excluding the favorable impact of both foreign currency translation and the YGR acquisition, Company sales increased 4%. The increase was driven by new unit development, partially offset by store closures and refranchising.

Franchise and license fees increased $73 million or 9% in 2003, after a 3% favorable impact from foreign currency translation. Excluding the impact of foreign currency translation and the favorable impact of the YGR acquisition, franchise and license fees increased 5%. The increase was driven by new unit development, royalty rate increases and same store sales growth, partially offset by store closures.

Company sales increased $753 million or 12% in 2002. The impact from foreign currency translation was not significant. Excluding the favorable impact of the YGR acquisition, Company sales increased 6%. The increase was driven by new unit development and same store sales growth. The increase was partially offset by refranchising and store closures.

Franchise and license fees increased $51 million or 6% in 2002. The impact from foreign currency translation was not significant. Excluding the favorable impact of the YGR acquisition, franchise and license fees increased 4%. The increase was driven by new unit development and same store sales growth, partially offset by store closures.

Worldwide Company Restaurant Margin

Restaurant margin as a percentage of sales decreased approximately 120 basis points in 2003. U.S. restaurant margin decreased approximately 140 basis points and International restaurant margin decreased approximately 50 basis points.

Restaurant margin as a percentage of sales increased approximately 120 basis points in 2002. The increase included the favorable impact of approximately 50 basis points from the adoption of SFAS 142, partially offset by the unfavorable impact of approximately 15 basis points from the YGR acquisition. U.S. restaurant margin increased approximately 80 basis points and International restaurant margin increased approximately 210 basis points.

The changes in U.S. and International restaurant margin for 2003 and 2002 are discussed in the respective sections.

Worldwide General and Administrative Expenses

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 year to date. Lower management incentive compensation costs were offset by increases in expenses associated with international restaurant expansion and pension expense.

General and administrative expenses increased $117 million or 15% in 2002. Excluding the unfavorable impact of the YGR acquisition, general and administrative expenses increased 10%. The increase was driven by higher compensation-related costs and higher corporate and project spending.

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Worldwide Franchise and License Expenses

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, primarily at Taco Bell.

Franchise and license expenses decreased $10 million or 18% in 2002. The decrease was primarily attributable to lower allowances for doubtful franchise and license fee receivables and the favorable impact of lapping support costs related to the financial restructuring of certain Taco Bell franchisees in 2001. The decrease was partially offset by higher marketing support costs in certain international markets.

Worldwide Other (Income) Expense

The increase in other (income) expense in 2003 was primarily driven by the improved operating performance of our unconsolidated affiliates, particularly in China.

Worldwide Facility Actions

We recorded a net loss from facility actions of $36 million, $32 million and $1 million in 2003, 2002 and 2001, 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.

Worldwide Operating Profit

The changes in U.S. and International operating profit for 2003 and 2002 are discussed in the respective sections.

Unallocated and corporate expenses increased $1 million in 2003 and $30 million or 20% in 2002. The 2002 increase was primarily driven by higher compensation-related costs and higher corporate and project spending.

Unallocated facility actions comprises refranchising gains (losses) which are not allocated to the U.S. or International segments for performance reporting purposes. See Note 7 for further discussion.

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Worldwide Interest Expense, Net

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.

Interest expense increased $8 million or 5% in 2002. Excluding the impact of the YGR acquisition, interest expense decreased 12%. The decrease was driven by a reduction in our average debt balance partially offset by an increase in our average interest rate. Our average interest rate increased due to a reduction in our variable-rate borrowings using proceeds from the issuance of longer term, fixed-rate notes.

Worldwide Income Taxes

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

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 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 2003 and 2002. However, the amended return benefit recognized in 2003 is 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. The valuation allowances recognized primarily related to deferred tax assets in Mexico and Thailand. See Note 22 for a discussion of valuation allowances.

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The 2002 effective tax rate decreased 0.7 percentage points to 32.1%. The decrease in the effective tax rate was primarily due to our claiming credit against our current and future U.S. income tax liability for foreign taxes paid in 2002, as opposed to deducting such taxes on our U.S. income tax returns as was done in 2001. This decrease was partially offset by the impact of lapping valuation allowance reversals recorded in 2001.

In 2003 and 2002, the effective tax rate attributable to foreign operations was lower than the U.S. federal statutory rate primarily due to the benefit of claiming credit against our current and future U.S. income tax liability for foreign taxes paid.

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 that we believe may impact our exposure.

U.S. Results of Operations

U.S. Restaurant Unit Activity

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For 2003 and 2002, Company multibrand unit gross additions were 222 and 212, respectively. For 2003 and 2002, franchise multibrand unit gross additions were 160 and 153, respectively.

U.S. System Sales Growth

System sales increased 3% for 2003. Excluding the favorable impact of the YGR acquisition, system sales increased 1%. The increase was driven by new unit development, partially offset by store closures.

System sales increased 9% in 2002. Excluding the favorable impact of the YGR acquisition, system sales increased 4%. The increase resulted from same store sales growth and new unit development, partially offset by store closures.

U.S. Revenues

Company sales increased $303 million or 6% in 2003. Excluding the favorable impact of the YGR acquisition, company sales increased 2%. The increase was driven by new unit development, partially offset by store closures and refranchising.

Franchise and license fees increased $5 million or 1% in 2003. Excluding the favorable impact of the YGR acquisition, franchise and license fees remained essentially flat as a decrease primarily driven by store closures was largely offset by new unit development.

Company sales increased $491 million or 11% in 2002. Excluding the favorable impact of the YGR acquisition, company sales increased 3%. The increase was driven by new unit development and same store sales growth. The increase was partially offset by store closures and refranchising.

Franchise and license fees increased $29 million or 5% in 2002. Excluding the favorable impact of the YGR acquisition, franchise and license fees increased 3%. The increase was driven by same store sales growth and new unit development, partially offset by store closures.

U.S. Same Store Sales

U.S. same store sales includes only company restaurants that have been open one year or more. U.S. blended same store sales include 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:

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For 2003, blended Company same store sales were flat due to a decrease in transactions offset by an increase in average guest check. For 2002, blended Company same store sales were up 2% due to increases in both transactions and average guest check.

U.S. Company Restaurant Margin

Restaurant margin as a percentage of sales decreased approximately 140 basis points in 2003. The decrease was primarily driven by 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.

Restaurant margin as a percentage of sales increased approximately 80 basis points in 2002. The increase includes the favorable impact of approximately 50 basis points from the adoption of SFAS 142, which was partially offset by the unfavorable impact of approximately 20 basis points from the YGR acquisition. The increase was primarily driven by the favorable impact of same store sales growth on margin and lower food and paper costs, partially offset by an increase in labor costs. The decrease in food and paper costs was primarily driven by cheese costs. The increase in labor costs was primarily driven by wage rates.

U.S. Operating Profit

Operating profit increased $10 million or 1% in 2003. Excluding the favorable impact of the YGR acquisition, operating profit was flat compared to 2002. Decreases driven by lower margins 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.

Operating profit increased $107 million or 15% in 2002, including a 3% favorable impact from the adoption of SFAS 142. Excluding the favorable impact of both SFAS 142 and the YGR acquisition, operating profit increased 9%. The increase was driven by same store sales growth and the favorable impact of lapping franchise support costs related to the restructuring of certain Taco Bell franchisees in 2001. The increase was partially offset by higher restaurant operating costs, primarily due to higher labor costs, and the unfavorable impact of refranchising and store closures. The higher labor costs were driven by wage rates.

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International Results of Operations

International Restaurant Unit Activity

For 2003 and 2002, Company multibrand unit gross additions were 13 and 4, respectively. Company multibrand restaurants at December 27, 2003 also include 9 units acquired during the year from an unconsolidated affiliate. For 2003 and 2002, franchise multibrand unit gross additions were 34 and 13, respectively.

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International System Sales Growth

System sales increased 14% in 2003, after a 7% favorable impact from foreign currency translation. The increase was driven by new unit development, partially offset by store closures.

System sales increased 8% in 2002, after a 1% unfavorable impact from foreign currency translation. Excluding the impact of foreign currency translation and the favorable impact of the YGR acquisition, system sales increased 8%. The increase was driven by new unit development and same store sales growth, partially offset by store closures.

International Revenues

Company sales increased $247 million or 12% in 2003, after a 4% favorable impact from foreign currency translation. The increase was driven by new unit development, partially offset by refranchising, same store sales declines and store closures.

Franchise and license fees increased $68 million or 23% in 2003, after a 9% favorable impact from foreign currency translation. The increase was driven by new unit development, royalty rate increases and same store sales growth, partially offset by store closures.

Company sales increased $262 million or 14% in 2002, after a 1% favorable impact from foreign currency translation. The increase was driven by new unit development, partially offset by refranchising and store closures. The unfavorable impact of refranchising primarily resulted from the sale of the Singapore business in the third quarter of 2002.

Franchise and license fees increased $22 million or 8% in 2002, after a 1% unfavorable impact from foreign currency translation. Excluding the impact of foreign currency translation and the favorable impact of the YGR acquisition, franchise and license fees increased 8%. The increase was driven by new unit development and same store sales growth, partially offset by store closures.

International Company Restaurant Margin

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Restaurant margin as a percentage of sales decreased approximately 50 basis points in 2003, including a 20 basis points unfavorable impact from foreign currency translation. The remaining decrease was driven by the impact on margin of same store sales declines. These decreases were partially offset by the impact of supply chain savings initiatives 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 which is held for sale.

Restaurant margin as a percentage of sales increased approximately 210 basis points in 2002, including the favorable impact of approximately 60 basis points from the adoption of SFAS 142. The increase was primarily driven by the favorable impact of lower restaurant operating costs and the elimination of lower average margin units through store closures. Lower restaurant operating costs primarily resulted from lower food and paper costs, partially offset by higher labor costs.

International Operating Profit

Operating profit increased $80 million or 22% in 2003, including a 7% favorable impact from foreign currency translation. The remaining 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 margins and higher general and administrative expenses.

Operating profit increased $56 million or 19% in 2002. Excluding the impact of foreign currency translation and the favorable impact from the adoption of SFAS 142, operating profit increased 13%. The increase was driven by new unit development and the favorable impact of lower restaurant operating costs, primarily lower cost of food and paper. The increase was partially offset by higher general and administrative expenses, primarily compensation-related costs.

Consolidated Cash Flows

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.

In 2002, net cash provided by operating activities was $1,088 million compared to $832 million in 2001. Excluding the impact of the AmeriServe bankruptcy reorganization process, cash provided by operating activities was $1,043 million versus $704 million in 2001. The increase was driven by higher net income and timing of tax receipts and payments.

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

In 2002, net cash used in investing activities was $885 million versus $503 million in 2001. The increase in cash used was primarily due to the acquisition of YGR and higher capital spending in 2002, partially offset by the acquisition of fewer restaurants from franchisees in 2002.

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

In 2002, net cash used in financing activities was $187 million versus $352 million in 2001. The decrease is primarily due to lower debt repayments and higher proceeds from stock option exercises versus 2001, partially offset by higher shares repurchased in 2002.

Consolidated Financial Condition

Assets increased $220 million or 4% to $5.6 billion primarily due to a net increase in property, plant and equipment, driven by capital expenditures in excess of depreciation and asset dispositions. The decrease in the allowance for

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doubtful accounts from $42 million to $28 million was primarily the result of the write-off of receivables previously fully reserved.

Liabilities decreased $306 million or 6% to $4.5 billion primarily due to the repayment of amounts under our Credit Facility, decreased short-term borrowings and the reduction in long-term debt as a result of the amendment of certain sale-leaseback agreements (see Note 14). These decreases were partially offset by an increase in accounts payable and other current liabilities primarily due to the accrual of $42 million related to the Wrench litigation.

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 two 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 and repurchases of shares of our common stock. 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 2004 and beyond.

Our primary bank credit agreement comprises a senior unsecured Revolving Credit Facility (the “Credit Facility”) which matures on June 25, 2005. On December 26, 2003, we voluntarily reduced our maximum borrowings under the Credit Facility from $1.2 billion to $1.0 billion. At December 27, 2003, our unused Credit Facility totaled $737 million, net of outstanding letters of credit of $263 million. There were no borrowings outstanding under the Credit Facility at December 27, 2003. Our Credit Facility 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. We were in compliance with all covenants at December 27, 2003, 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 $1.85 billion at December 27, 2003. The first of these notes, in the amount of $350 million, matures in 2005. We currently anticipate that our net cash provided by operating activities will permit us to make a significant portion of this $350 million payment without borrowing additional amounts.

We estimate that capital spending will be approximately $770 million and refranchising proceeds will be approximately $100 million in 2004. In November 2003, our Board of Directors authorized a new $300 million share repurchase program. At December 27, 2003, we had remaining capacity to repurchase, through May 21, 2005, up to $294 million of our outstanding Common Stock (excluding applicable transaction fees) under this program.

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In addition to any discretionary spending we may choose to make, significant contractual obligations and payments as of December 27, 2003 included:

We have not included obligations under our pension and postretirement 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 2004, but we may make discretionary contributions during the year based on our estimate of the plan’s expected September 30, 2004 funded status. During 2003, we made voluntary pension contributions of $130 million 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 2003.

Also excluded from the contractual obligations table are payments we may make for employee health and property and casualty losses 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

At December 27, 2003, we had provided approximately $32 million of partial guarantees of two franchisee loan pools, both of which were implemented prior to spin-off, related primarily to the Company’s historical refranchising programs and, to a lesser extent, franchisee development of new restaurants. The total loans outstanding under these loan pools were approximately $123 million at December 27, 2003. In support of these guarantees, we have posted $32 million of letters of credit. We also provide a standby letter of credit of $23 million under which we could potentially be required to fund a portion of one of the franchisee loan pools. 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 facility actions. New loans are not currently being added to either loan pool.

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We have guaranteed certain lines of credit and loans of Unconsolidated Affiliates totaling $28 million at December 27, 2003. Our Unconsolidated Affiliates had total revenues of over $1.5 billion for the year ended December 27, 2003 and assets and debt of approximately $858 million and $41 million, respectively, at December 27, 2003.

Other Significant Known Events, Trends or Uncertainties Expected to Impact 2004 Operating Profit Comparisons with 2003

New Accounting Pronouncements Not Yet Adopted

See Note 2.

Canada Unconsolidated Affiliate Dissolution

On November 10, 2003 our Unconsolidated Affiliate that previously operated 479 KFC, 236 Pizza Hut and 18 Taco Bell restaurants in Canada was dissolved. We owned 50% of this Unconsolidated Affiliate prior to its dissolution and accounted for our interest under the equity method. Upon dissolution, the Company assumed operation and acquired all associated assets of the Pizza Huts, as well as 17 Taco Bells and 5 KFCs. The Company also acquired the real estate associated with 140 KFCs for which the Company will not be the operator. Our former partner in the Unconsolidated Affiliate acquired full ownership of all other assets, as well as the franchise rights to operate 474 KFCs and one Taco Bell. Our former partner retained 10 KFCs and sold the remainder of these assets and franchise rights acquired to a newly-formed, publicly-held Income Trust in Canada, of which our former partner now holds a minority interest. The Company leases land and buildings for KFCs it does not operate to the Income Trust under operating and capital lease agreements through 2018. The Company will continue to receive a franchise royalty from the KFCs operated by our former partner and the Income Trust.

The Company realized an immaterial gain upon 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 of the Unconsolidated Affiliate.

The impact of the restructuring on our 2003 results of operations was not significant. As a result of the restructuring, 2004 Company sales are expected to increase by approximately $165 million and franchise fees are expected to decrease by approximately $10 million. The impact on net income is not expected to be material.

Amendment of Sale-Leaseback Agreements

As discussed in Note 14 and on page 18 of this MD&A, in 2003 we amended two sale-leaseback agreements assumed in our 2002 acquisition of YGR. We estimate the impact of these amendments in 2004 to be a decrease in restaurant profit of $8 million and a decrease in interest expense of $10 million.

Puerto Rico Business Held for Sale

Our Puerto Rican business has been held for sale since the fourth quarter of 2002. While a sale of the Puerto Rican business has not yet occurred, we continue to believe that it is probable that a sale will occur during 2004. Sales and restaurant profits of the Puerto Rican business were $187 million and $34 million in 2003.

Contingent Lease Guarantees

Under terms of our separation agreements at the time of the Spin-off, we indemnified PepsiCo for any losses incurred related to their guarantees of lease agreements of certain non-core businesses which were sold prior to the Spin-off. Two of these businesses, Chevys Mexican Restaurant (Chevys) and Hot 'n Now (HNN) filed for bankruptcy protection in October 2003 and January 2004, respectively. While we cannot presently determine our liability under these indemnities,

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if any, we do not expect the amount to have a material impact on our Consolidated Financial Statements. Any costs incurred will be charged to AmeriServe and other charges (credits). See Note 24 for further discussion.

Pension Plan Funded Status

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 no longer eligible to participate. As of our September 30, 2003 measurement date, these plans had a projected benefit obligation (“PBO”) of $629 million, an accumulated benefit obligation (“ABO”) of $563 million and a fair value of plan assets of $438 million. As a result of the $125 million underfunded status of the plans relative to the ABO at September 30, 2003, we have recorded a $101 million charge to shareholders’ equity (net of tax of $61 million) as of December 27, 2003.

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 6.25% at September 30, 2003. A 50 basis point increase in this discount rate would have decreased our PBO by approximately $58 million at September 30, 2003. Conversely, a 50 basis point decrease in this discount rate would have increased our PBO by approximately $60 million at September 30, 2003.

Our expected long-term rate of return on plan assets is 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, 2003, a one percentage point increase or decrease in our expected rate of return on plan assets assumption would decrease or increase, respectively, our 2004 pension plan expense by approximately $4 million.

The losses our plan assets have experienced, along with the decrease in discount rates, have largely contributed to the unrecognized actuarial loss of $230 million in our plans as of September 30, 2003. For purposes of determining 2003 expense our funded status was such that we recognized $6 million of unrecognized actuarial loss in 2003. We will recognize approximately $19 million of unrecognized actuarial loss in 2004. Given no change to the assumptions at our September 30, 2003 measurement date, actuarial loss recognition will remain at an amount near that to be recognized in 2004 over the next few years before it begins to gradually decline.

In total, we expect pension expense to increase approximately $14 million to $54 million in 2004. We have incorporated this incremental expense into our operating plans and outlook. The increase is driven by the recognition of actuarial losses as discussed in the preceding paragraph and 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 6.25% at September 30, 2003 would impact our 2004 pension expense by approximately $11 million.

We do not believe that the underfunded status of the pension plans will materially affect our financial position or cash flows in 2004 or future years. Given current funding levels and discount rates we would anticipate making contributions to fully fund the pension plans over the course of the next five years. We believe our cash flows from operating activities of approximately $1 billion per year are sufficient to allow us to make necessary contributions to the plans, and anticipated fundings have been incorporated into our cash flow projections. We have included known and expected increases in our pension expense as well as future expected plan contributions in our operating plans and outlook.

Avian Flu

In several Asian markets, including Thailand, Taiwan, South Korea, Japan, Indonesia, Malaysia, Singapore and certain sections of China, avian flu has impacted retail sales trends and sales trends at KFC through the date of this Form 10-K. Based on information as of the date of this Form 10-K, the Company believes that the most likely effect of avian flu

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outbreaks in these markets, some of which are completely franchised markets, will be short term. Additionally, the Company currently does not expect that the avian flu outbreak will materially affect its chicken supply in Asia or other markets.

Our most significant market that has been affected by the avian flu is China. As we have previously stated, if the avian flu outbreak were to affect the entire country of China for up to two months (through the end of March, 2004) with sales declines in the range of 20% at KFC, 2004 diluted EPS results for the Company would be unfavorably impacted by up to $0.02. We have incorporated this potential unfavorable impact in our operating plans and outlook.

AmeriServe and Other Charges (Credits)

During 2004, we expect to recover approximately $10 million related to recoveries from the AmeriServe bankruptcy reorganization process. We expect that this will substantially complete our recoveries related to the AmeriServe bankruptcy reorganization process. See Note 7 for a detailed discussion of AmeriServe and other charges (credits).

Critical Accounting Policies

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 judgements 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. 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). 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, we write down the restaurant to its fair value. We often refranchise restaurants in groups and therefore perform 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.

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

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before interest and taxes as used for our restaurants. The fair value of our investments in unconsolidated affiliates is 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 units 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 2003, there was no impairment of goodwill identified during our annual impairment testing. For our reporting units with goodwill, the fair value is generally significantly in excess of the recorded carrying value. Thus, we do not believe that we have material goodwill that is at risk to be impaired given current business performance. For 2002, we impaired $5 million of goodwill related to the Pizza Hut France reporting unit.

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 trademarks/brands of which we have acquired ownership (or the right to a perpetual royalty-free license in the case of A&W). 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 or royalty-free license 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 recorded trademark/brand assets resulted when we acquired YGR in 2002. Upon this acquisition, $140 million and $72 million were allocated to the LJS and A&W trademarks/brands, respectively. The results generated to date from the YGR acquisition on an overall basis have met our expectations. We also now believe opportunities exist beyond those assumed in justification of our acquisition price with regard to increased penetration of LJS, for both stand-alone units and as a multibrand partner. Accordingly, we now believe our system’s development capital, at least through the term of our current projections, will be primarily directed towards LJS.

The decision to focus short-term development on increased penetration of LJS and discretionary capital spending limits have resulted in less than originally planned development of A&W in the near term. Additionally, while we continue to view A&W as a viable multibrand partner, subsequent to acquisition we decided to close or refranchise 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. We incorporated these plans into our fair value estimates of the LJS and A&W trademarks/brands in 2003. As sales projections for LJS were in excess of those originally assumed when valuing the LJS trademark/brand, the trademark/brand’s current fair value is in excess of its carrying value. Both the decision to close the 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 charge of $5 million in 2003 to write the value of A&W trademark/brand down to its fair value.

While we believe the sales assumptions used in our determination of the fair value of the A&W trademark/brand are reasonable and 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 our determination of the fair value of the A&W trademark/brand would have been one percentage point higher, the trademark/brand would not have been impaired. Alternatively, if the long-term rate of sales growth would have been one percentage point lower, additional impairment of approximately $4 million would have been recognized.

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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 27, 2003. See Note 2 for a further discussion of our policies regarding franchise and license operations.

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 27, 2003, 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 $326 million representing the present value of the minimum payments of the assigned leases at December 27, 2003, discounted at our pre-tax cost of debt. 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.

Income Tax Valuation Allowances and Tax Reserves

At December 27, 2003, we have a valuation allowance of $183 million primarily to reduce our net operating loss and tax credit carryforwards of $231 million to an amount that will more likely than not be realized. These 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 that may impact our ultimate payment for such exposures.

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

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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 27, 2003 and December 28, 2002, a hypothetical 100 basis point increase in short-term interest rates would result in a reduction of approximately $3 million and $6 million, respectively, in annual 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 27, 2003 and December 28, 2002 would decrease approximately $5 million and $8 million, respectively. The fair value of our Senior Unsecured Notes at December 27, 2003 and December 28, 2002 would decrease approximately $87 million and $93 million, respectively. Fair value was determined by discounting the projected cash flows.

Foreign Currency Exchange Rate Risk

International operating profit constitutes approximately 36% of our operating profit in 2003, excluding unallocated and corporate expenses. In addition, the Company’s net asset exposure (defined as foreign currency assets less foreign currency liabilities) totaled approximately $1.3 billion as of December 27, 2003. 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 27, 2003, operating profit would have decreased $49 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 foreign currency denominated financial instruments. 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

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future and option contracts. Commodity future and option contracts entered into for the fiscal years ended December 27, 2003, and December 28, 2002, 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.

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, spending patterns and demographic trends; political or economic instability in local markets and changes in currency exchange and interest rates; 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.

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Item 8.     Financial Statements and Supplementary Data.

INDEX TO FINANCIAL INFORMATION

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.

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Consolidated Statements of Income
YUM! Brands, Inc. and Subsidiaries
Fiscal years ended December 27, 2003, December 28, 2002 and December 29, 2001
(in millions, except per share data)

See accompanying Notes to Consolidated Financial Statements.

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Consolidated Statements of Cash Flows
YUM! Brands, Inc. and Subsidiaries
Fiscal years ended December 27, 2003, December 28, 2002 and December 29, 2001
(in millions)

See accompanying Notes to Consolidated Financial Statements.

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Consolidated Balance Sheets
YUM! Brands, Inc. and Subsidiaries
December 27, 2003 and December 28, 2002
(in millions)

See accompanying Notes to Consolidated Financial Statements.

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Consolidated Statements of Shareholders’ Equity (Deficit) and Comprehensive Income
YUM! Brands, Inc. and Subsidiaries
Fiscal years ended December 27, 2003, December 28, 2002 and December 29, 2001
(in millions)

See accompanying Notes to Consolidated Financial Statements.

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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 in more than 100 countries and territories of which approximately 37% are located outside the U.S. 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 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 the 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. As the contributions to the cooperatives are designated for advertising expenditures, any cash held by these cooperatives is considered restricted and is included in prepaid expenses and other current assets. Such restricted cash was approximately $34 million and $44 million at December 27, 2003 and December 28, 2002, respectively. 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 franchisee and licensee contributions to these cooperatives in our Consolidated Statements of Income.

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 17 weeks in fiscal years with 53

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weeks and 16 weeks in fiscal years with 52 weeks. Our subsidiaries operate on similar fiscal calendars with period 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 27, 2003. These reclassifications had no effect on previously reported net income.

Franchise and License Operations. We execute franchise or license agreements for each unit which sets 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 payment of a renewal fee, a franchisee may generally renew the franchise agreement upon its expiration.

We recognize initial fees 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 as earned. We recognize renewal fees in income when a renewal agreement becomes effective. We include initial fees collected upon the sale of a restaurant to a franchisee in refranchising gains (losses). Fees for development rights are capitalized and amortized over the life of the development agreement.

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 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 includes rental income from subleasing restaurants to franchisees net of the related occupancy costs.

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. Included in franchise and license expense in 2003 is a net benefit for uncollectible franchise and license receivables of $3 million as we were able to recover previously reserved receivables in excess of provisions made. Net provisions for uncollectible franchise and license receivables of $15 million and $24 million were included in franchise and license expense in 2002 and 2001, respectively.

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. To the extent we participate in advertising cooperatives, we expense our contributions as incurred. At the end of 2003 and 2002, we had deferred marketing costs of $3 million and $8 million, respectively. Our advertising expenses were $419 million, $384 million and $328 million in 2003, 2002 and 2001, respectively.

Research and Development Expenses. Research and development expenses, which we expense as incurred, are reported in general and administrative expenses. Research and development expenses were $26 million in 2003 and $23 million in both 2002 and 2001.

Impairment or Disposal of Long-Lived Assets. Effective December 30, 2001, the Company adopted SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). SFAS 144 retained many of the

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fundamental provisions of SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of” (“SFAS 121”), but resolved certain implementation issues associated with that Statement. The adoption of SFAS 144 did not have a material impact on the Consolidated Financial Statements.

In accordance with 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. The impairment evaluation is based on the estimated cash flows from continuing use through the expected disposal date and 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 year ended 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.

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 and direct administrative costs of refranchising. 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 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 charge (or credit) 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.

SFAS 144 also requires the results of operations of a component entity that is classified as held for sale or has been disposed of be reported as discontinued operations in the Consolidated Statements of Income if certain conditions are met. These conditions include elimination of the operations and cash flows of the component entity from the ongoing operations of the Company and no significant continuing involvement by the Company in the operations of the component entity after the disposal transaction. The results of operations of stores meeting both these conditions that

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were disposed of in 2003 or 2002 or classified as held for sale at December 27, 2003 or December 28, 2002 were not material for any of the three years ended December 27, 2003.

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, 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 year ended December 27, 2003. If SFAS 143 had been adopted as of the beginning of 2002 or 2001, the cumulative effect adjustment would not have been materially different from that recorded on December 29, 2002.

Financial Instruments with Characteristics of both Liabilities and Equity. The Company has adopted SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 establishes standards for how an issuer classifies and measures three classes of freestanding financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS 150 was effective for financial instruments entered into or modified after May 31, 2003, and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003. The Company has not entered into or modified any financial instruments within the scope of SFAS 150 since May 31, 2003, nor does it currently hold any significant financial instruments within its scope.

Guarantees. The Company has adopted Financial Accounting Standards Board (“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 year ended December 27, 2003.

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).

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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.

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 general and administrative expenses.

Goodwill and Intangible Assets. The Company has adopted SFAS No. 141, “Business Combinations” (“SFAS 141”). SFAS 141 requires the use of the purchase method of accounting for all business combinations and modifies the application of the purchase accounting method. Goodwill 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 has also adopted SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). SFAS 142 eliminates the requirement to amortize goodwill and indefinite-lived intangible assets, addresses the amortization of intangible assets with a defined life, and addresses impairment testing and recognition for goodwill and indefinite-lived intangible assets. As a result of adopting SFAS 142, we ceased amortization of goodwill and indefinite-lived intangible assets beginning December 30, 2001. Prior to the adoption of SFAS 142, we amortized goodwill on a straight-line basis up to 20 years and indefinite-lived intangible assets on a straight-line basis over 3 to 40 years. 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 continue to be 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 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 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.

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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 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.

See Note 12 for further discussion of SFAS 142.

Stock-Based Employee Compensation. At December 27, 2003, 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,” and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans 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,” to stock-based employee compensation.

Derivative Financial Instruments. Our policy prohibits the use of 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 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

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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 related to debt and interest rate swaps.

New Accounting Pronouncements Not Yet Adopted. In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (“FIN 46”). FIN 46 was subsequently revised in December 2003. FIN 46 addresses the consolidation of entities whose equity holders have either (a) 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 46 requires the consolidation of these entities, known as variable interest entities (“VIEs”), by the primary beneficiary of the entity. The primary beneficiary is the entity, if any, that is subject to a majority of the risk of loss from the VIE's activities, entitled to receive a majority of the VIEs residual returns, or both. FIN 46 is effective for all entities at the end of the first reporting period ending after March 15, 2004 (the quarter ending March 20, 2004 for the Company). FIN 46 was effective for special-purpose entities (as defined by FIN 46) at the end of the first reporting period ending after December 15, 2003, which did not impact the Consolidated Financial Statements. FIN 46 requires certain disclosures in financial statements issued after December 31, 2003, if it is reasonably possible that the Company will consolidate or disclose information about VIEs when FIN 46 becomes effective.

FIN 46 excludes from its scope businesses (as defined by FIN 46) unless certain conditions exist. We believe the franchise entities which operate our restaurants, including our Unconsolidated Affiliates, meet the definition of a business. Thus, we are currently evaluating whether any of the aforementioned conditions exist that would subject any of our franchisees, including our Unconsolidated Affiliates, to the provisions of FIN 46, requiring us to determine if they are VIEs, and, if so, whether we are the primary beneficiary. We do not possess any ownership interests in our franchisees except for our investments in various Unconsolidated Affiliates accounted for under the equity method (see Note 24 for further description). Additionally, we generally do not provide financial support to our franchisees in a typical franchise relationship. While we continue to evaluate the applicability of FIN 46 to our franchise relationships, at this time we do not believe that the required consolidation of franchise entities, if any, would materially impact our Financial Statements.

The Company, along with representatives of the franchisee groups of each of its Concepts, has formed purchasing cooperatives 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 are continuing to evaluate whether any of these cooperatives are VIEs under the provisions of FIN 46 and, if so, whether we are the primary beneficiary. We do not currently believe that consolidation will be required for these cooperatives as a result of our adoption of FIN 46.

As discussed further in Note 24, we have posted a $12 million of letter of credit supporting our guarantee of a franchisee loan pool. Additionally, we have provided a standby letter of credit of $23 million under which we could potentially be required to fund a portion of this loan pool. The letters of credit were issued under our existing bank credit agreement. This loan pool, which is not held or funded by an affiliate of the Company, primarily funded purchases of restaurants from the Company and, to a lesser extent, franchisee development of new restaurants. The total loans outstanding under this loan pool were approximately $87 million at December 27, 2003. Our maximum exposure to loss as a result of our involvement with this loan pool was $28 million at December 27, 2003. During the year ended December 27, 2003 the entity which holds this loan pool sold these loans to a qualifying special-purpose entity (“QSPE”) as described in SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” and settled its existing obligations with the proceeds. As QSPEs are not within the scope of FIN 46, the Company will not be required to consolidate the entity that now holds this loan pool.

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

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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.

Note 4 - YGR Acquisition

On May 7, 2002, YUM completed its acquisition of YGR. At the date of 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. This acquisition was made to facilitate our strategic objective of achieving growth through multibranding, where two or more of our Concepts are operated in a single restaurant unit. We paid approximately $275 million in cash and assumed approximately $48 million of bank indebtedness in connection with the acquisition of YGR. The purchase price was allocated to the assets acquired and liabilities assumed based on estimates of their fair values at the date of acquisition. We determined these fair values with the assistance of a third party valuation expert. The following table summarizes the fair values of YGR's assets acquired and liabilities assumed at the date of acquisition.

Of the $250 million in acquired intangible assets, $212 million was assigned to trademarks/brands. The remaining acquired intangible assets primarily consist of franchise contract rights which will be amortized over thirty years, the typical term of a YGR franchise agreement including renewals. Of the $212 million in trademarks/brands approximately $191 million and $21 million were assigned to the U.S. and International operating segments, respectively. Of the remaining $38 million in intangible assets, approximately $31 million and $7 million were assigned to the U.S. and International operating segments, respectively.

The $209 million in goodwill was assigned to the U.S. operating segment. As we acquired the stock of YGR, none of the goodwill is expected to be deductible for income tax purposes.

Liabilities assumed included approximately $48 million of bank indebtedness that was paid off prior to the end of the second quarter of 2002 and approximately $11 million in capital lease obligations. We also 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. As discussed further in Note 14, two of these sale-leaseback agreements were amended during 2003 and are now being accounted for as operating leases.

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, as presented in

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the table below. The consolidation of certain support functions included the termination of approximately 100 employees. Our remaining exit liabilities, as well as amounts utilized through cash payments during 2003 and 2002, are presented below.

We expensed integration costs of approximately $4 million in 2003 and $6 million in 2002 related to the acquisition. These costs were recorded as AmeriServe and other charges (credits). See Note 7 for further discussion regarding AmeriServe and other charges (credits).

The results of operations for YGR have been included in our Consolidated Financial Statements since the date of acquisition. If the acquisition had been completed as of the beginning of the years ended December 28, 2002 and December 29, 2001, pro forma Company sales and franchise and license fees would have been as follows:

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 and 2001. The pro forma information is not necessarily indicative of the results of operations had the acquisition actually occurred at the beginning of each of these periods nor is it necessarily indicative of future results.

Note 5 - Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) includes:

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

Unexercised employee stock options to purchase approximately 4 million, 1.4 million and 5.1 million shares of our Common Stock for the years ended December 27, 2003, December 28, 2002 and December 29, 2001, 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.

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 subsequent to the adoption of SFAS 142.

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The following table summarizes the 2003 and 2002 activity related to reserves for remaining lease obligations for stores closed or stores we intend to close.

The following table summarizes the carrying values of the major classes of assets held for sale at December 27, 2003 and December 28, 2002. U.S. amounts primarily represent land on which we previously operated restaurants and are net of impairment charges of $2 million and $4 million at December 27, 2003 and December 28, 2002, respectively. The carrying values in International relate primarily to our Puerto Rican business, which we wrote down $16 million during 2003 to reflect then current estimates of its fair value. These write-downs were recorded as a refranchising loss. The carrying values of liabilities of the Puerto Rican business that we anticipate will be assumed by a buyer were not significant at December 27, 2003 or at December 28, 2002.

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