Yum Brands Inc expects higher labor and commodity costs in the restaurant operator's key China market in the second half of 2010, company executives said on Wednesday.

We now expect very high labor inflation for the second half of the year, Chief Financial Officer Richard Carucci said on a conference call with analysts,

Yum, the parent of the KFC, Taco Bell and Pizza Hut brands, reaps 35 percent of its profit from its China division.

China labor costs were up $12 million in the first half of 2010, and Yum expects labor costs to increase $32 million in the second half, the executives said.

Labor costs rose 14.9 percent in the second quarter of 2010, up from 14.2 percent in the second quarter of last year, JPMorgan analyst John Ivankoe said in a client note.

Yum executives said wage inflation was a little less than typical in China last year, and 2010 has been a catch-up year with higher-than-normal inflation.

There has been considerable discussion of what a 20 percent labor rate inflation across China would do to Yum, Ivankoe said.

We argue the company can take 2.5 percent-plus of pricing to offset its own cost inflation in such an environment, and that the increased wage rates would increase spending confidence of its existing consumers and drive new consumers to the business, Ivankoe said.

Yum executives said it was difficult to quantify how the company could benefit if Chinese workers have more cash in their pockets but agreed that the country's growing middle class creates opportunities for higher restaurant sales and growth in its China division.

I think people are going to have more money to spend throughout the day, Chief Executive David Novak said.

Yum on Tuesday raised its 2010 earnings growth forecast to 12 percent from 10 percent, based on the company's strong growth in the first half of 2010.

But that was below the roughly 14 percent growth assumed, on average, by analysts. This prompted some on Wall Street to call the outlook conservative, and Yum shares fell about 3 percent on Tuesday.

Yum shares were down 54 cents, or 1.3 percent, at $40.96 in midday trading on Wednesday.

Yum's China division saw $30 million in commodity deflation in the first half of the year. Executives expect to see $15 million in commodity inflation in the second half, with most of the rise coming in the fourth quarter.

We also now expect that there will be some favorability from currency in the balance of 2010 as a result of the Chinese government's decision to loosen the peg of the yuan to the U.S. dollar, Carucci said.

For the balance of the year, Yum expects a foreign exchange benefit from China of around $10 million. That would be partly offset by a $5 million hit from other international operations, Carucci said.

At the close of regular trading on Tuesday, Yum shares were up around 19 percent year to date, a slightly higher gain than the roughly 14 percent increase in the Dow Jones U.S. Restaurant and Bars index <.DJUSRU>.

(Reporting by Lisa Baertlein; Editing by John Wallace and Steve Orlofsky)

Inflation China