Yum China : 2Q 2022 Earnings Conference Call Transcript

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EDITED TRANSCRIPT

Q2 2022 Yum China Holdings Inc Earnings Call

EVENT DATE/TIME: JULY 29, 2022 / 12:00AM GMT

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JULY 29, 2022 / 12:00AM GMT, Q2 2022 Yum China Holdings Inc Earnings Call

CORPORATE PARTICIPANTS

Joey Wat Yum China Holdings, Inc. - CEO & Director

Ka Wai Yeung Yum China Holdings, Inc. - CFO

Michelle Shen Yum China Holdings, Inc. - IR Director

CONFERENCE CALL PARTICIPANTS

Lillian Lou Morgan Stanley, Research Division - Executive Director

Michelle Cheng Goldman Sachs Group, Inc., Research Division - Executive Director Bryan Wang China Merchants Securities (HK) - Equity Research Associate

Xiaopo Wei Citigroup Inc., Research Division - Director & Head of Asia-Pacific Consumer Research Sijie Lin China International Capital Corporation Limited, Research Division - Analyst

Kin Shun Ling Jefferies LLC, Research Division - Equity Analyst

Yan Peng UBS Investment Bank, Research Division - Executive Director and China Consumer Staples Sector Analyst Lucy Yu BofA Securities, Research Division - Research Analyst

Wing Hong Woo CMB International Securities Limited, Research Division - Research Analyst

PRESENTATION

Operator

Thank you for standing by, and welcome to the Yum China Second Quarter 2022 Earnings Conference Call. (Operator Instructions)

I would now like to hand the conference over to Michelle Shen. Please go ahead.

Michelle Shen Yum China Holdings, Inc. - IR Director

Thank you, Melanie. Hello, everyone, and thank you for joining Yum China's Second Quarter 2022 Earnings Conference Call. Joining us on today's call are our CEO, Ms. Joey Wat; and our CFO, Mr. Andy Yeung. We are dialing in from different locations today. If we experience a technical difficulty during the call, please remain on the line as we reconnect.

Before we get started, I'd like to remind you that our earnings call and Investor Presentations contain forward-looking statements, which are subject to future events and uncertainties. Our actual results may differ materially from these forward-looking statements. All forward-looking statements should be considered in conjunction with the cautionary statement in our earnings release and the risk factors included in our filings with the SEC. This call also includes certain non-GAAP financial measures. You should carefully consider the comparable GAAP measures. Reconciliation of non-GAAP and GAAP measures is included in our earnings release.

Today's call includes 3 sections. Joey will provide an update regarding our performance in the second quarter. Andy will then cover the financial performance and outlook in greater detail. Finally, we will open the call to questions. You can find the webcast of this call and a PowerPoint presentation, which contains operational and financial information for the quarter on our IR website.

Now I would like to turn the call over to Ms. Joey Wat, CEO of Yum China. Joey?

Joey Wat Yum China Holdings, Inc. - CEO & Director

Thank you, Michelle. Hello, everyone, and thank you for joining us today. Second quarter was the most difficult quarter in the past 2.5 years. With our main focus always on keeping our employees and customers safe, we also want to bring joy to our customers. We kept our morale high and came together to deliver better-than-expected results. I'm both glad and honored to fight the battle alongside the wonderful Yum China teams.

We operated with our Shanghai headquarters under lockdown for over 2 months and still managed to execute with extraordinary agility, quickly forming cross-functional and across brand crisis management team [working from home], while we developed flexible tool kits to tackle each problem as it arose. Through it all, we have stood firm and built the business stronger in so many ways.

We have innovated new menu offerings, delivery and digital solutions as well as cost optimization initiatives. These solved not just the imminent problems but can serve as our learning base to make us more agile and resilient for the longer term.

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JULY 29, 2022 / 12:00AM GMT, Q2 2022 Yum China Holdings Inc Earnings Call

During this trying time, we continued to execute our RGM strategic framework. That is Resiliency, Growth and Moat. Let's start with resiliency. Our resilience shines brightest in tough situations. Let me share with you some of the measures we implemented to overcome considerable operational difficulties. During the city lockdown in Shanghai with very limited restaurant staff and riders, our goal was to sustain minimum level of restaurant operations and serve desired food to customers.

We simplified menus, we reduced complexity of operations and inventory management. At the extreme, we just had 1 bucket of fried chicken on the menu, one item on the menu and that's it. Fried chicken was perhaps one of the most desired food items in Shanghai during lockdown and brought our customers great happiness. We launched community purchasing (Tuangou), as early as in mid-March, including packaged food products not just for KFC and Pizza Hut, but also for our emerging brands, Lavazza, Taco Bell and Little Sheep.

In the Q1 earnings call, I shared that with 10% to 15% of the stores opened in April, Shanghai achieved 40% to 50% of pre-lockdown sales. In May, with less than half of our stores open, we reached pre-lockdown sales level. This was a remarkable achievement. We were able to continue serving our customers, thanks to our in-house and agile supply chain management system as well as dedicated last-mile delivery riders. We obtained the necessary permits and managed to serve the majority of Shanghai under severe mobility restrictions.

Digitization also played a very critical role. In just a day's time, our stellar IT team launched an AI-enabled delivery route planning tool for community purchasing in Shanghai. The tool optimize full day delivery routes covering a wide geography well beyond our usual store-based vicinity radius.

Across the country, where we faced a challenging operating environment, we dialed down advertising and promotions to save costs. Some of you may remember the Psyduck (Kedaya) and other Pokemon meal companion tours we launched around Children's Day on June 1. The Psyduck instantly went viral becoming a smash hit with children and adults alike. The sensational buzz from this campaign drove almost 20% of sales in the first 2 days of the promotion. Who would have thought that we chose Psyduck just to accommodate our reduced advertising budget.

The results were phenomenal. We were thrilled to bring joy to a customers' life during an exceptionally hard time and to see their social media posts. We also focused on driving off-premise sales, delivery grew 7% year-over-year and reached a record sales mix of 38% in the second quarter.

Combined with takeaway, off-premise dining contribute to almost 2/3 of sales. Also, excitingly, our new retail packaged food sales reached CNY 200 million in the second quarter. This more than doubled the sales compared to last year. These initiatives partially offset the reduced dine-in services.

Let's move on to growth. Even in conditions like this, we don't stop delighting our customers with innovative food and value campaigns. Our ability to innovate is an important pillar to capture growth opportunities.

KFC diversified into adjacent categories to drive additional growth. With Wagyu and Angus beef burgers as premium options, we launch entry price choices at only around half of the price, which is CNY 18 versus CNY 33. On the weekends, we are now offering juicy whole chicken at CNY 29.9 to drive sales. This juicy whole chicken is one of my personal favorites now, and it's absolutely delicious. These 2 new categories have proven popular, accounting for mid-single digits of menu mix combined in June.

Our food innovations team lets their creativity fly when designing new products. At KFC, we launched a super abundant chicken bucket (Duoduotong) in select cities. This bucket features chicken feet, chicken wing tips, necks and other parts traditionally favored by Chinese people. For some of the analysts who asked me before when would we start to sell chicken feet, we are officially selling chicken feet right now after 35 years.

This follows on the heels of KFC's launch last year of its super popular late-night snack Chicken bone nibblers (Jijia). In addition, the usage of all parts of chicken provides an intriguing variety to our customers at a very good cost.

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JULY 29, 2022 / 12:00AM GMT, Q2 2022 Yum China Holdings Inc Earnings Call

Pizza Hut's new menu received amazing customer feedback and generated a boost in sales. We launched the campaign on social media and sponsored TV shows instead of using celebrities. With just 1/3 of the advertising costs, the menu achieved the same customer awareness as last year's menu. The new menu included 35 brand new or upgraded items such as Stuffed crust pizza with sausage and meat floss (Rousong), while Wagyu Supreme pizza and Deep-fried cereal prawns. Yes, we put the cereal around the prawns and it tastes wonderful.

Taco Bell launched a Wrist burrito (Shouwanjuan) with a lighter sauce and more vegetables tailored for Chinese customers. It gained great popularity and appealed to our more health-conscious customers. Value for money resonates well with customers under the current circumstances. As part of the 35th anniversary celebration in China, KFC offered its signature product at amazing prices. Original recipe chicken at its CNY 19.87 price and the Family bucket at almost 60% off a la carte price. This campaign brought back fond memories and became a hit with customers. We rotate the offers weekly to have the flexibility to adjust according to the market conditions in different regions and customer response.

Our iconic Crazy Thursday value campaigns have won the hearts of our customers. Since we first launched it back to 2018, we have been constantly spoiling our customers with very attractive offers. The campaign now inspires scores of creative social media posts. Thursday's also generate significant sales uplift compared to regular weekdays and sometimes even weekend.

At Pizza Hut, we brought back its signature buffet. And sold all 400,000 buffet sets in a preorder promotion in just 15 days. We also launched a Buy More Save More combo offering more abundant options. The new combo successfully lifted ticket average and lowered our costs.

Let's move on to moat. Digital initiatives and supply chain infrastructure are the key enablers in our strategic moat. Leveraging our dynamic digital ecosystem, we generated around 4 billion in digital sales in the first half of 2022. This represents 88% of our sales.

Our loyalty program exceeds 385 million members as of the end of the second quarter. We shared the latest launches and engage with members through our Super App, mini programs and social media groups. We, also, constantly upgrade these tools to improve our customer service. KFC Super App now features a senior-friendly interface option with simpler graphics, less promotion information, bigger forms for mature eyes and streamlined ordering functions. We tailored it to the need of our older customers.

Pizza Hut also upgrade their mobile ordering menu for more flexible Buy More Save More combos and customized product displays. Our digital capabilities were crucial to streamline restaurant efficiency. Tools like our restaurant sales forecasting system and Pocket Manager gave us full visibility of the situation in each store. With these, we can rapidly adapt to changing scenarios.

Our real time inventory visibility from logistics centers to stores helped enable us to dispatch raw materials with greater precision. Restaurants could adjust orders daily based on their operating environment and share inventories across the stores when fulfilling community purchasing or other large orders.

As an ongoing effort of Delivery 3.0, which allows rider sharing across trade zones, we now offer the same flexibility to our restaurant staff. Staff now can schedule shifts across stores and even across cities. We continue to invest in building a world-class intelligent and digitized supply chain to improve operating resiliency and support business growth.

Our first 2 greenfield logistics centers in Chengdu and Huai'an, in Jiangsu are now complete and operational. And a week ago, we announced construction starting on our new Jiading Supply Chain Management Center in Shanghai. This project is our largest greenfield project yet and will serve as the headquarters for our 33 logistics centers across China. It will integrate the latest state-of-the-art digital technologies and support restaurants in Eastern China.

2022 has indeed been extremely challenging. We learned many lessons and now emerge as a stronger and more resilient organization. And I'm not saying this just for KFC and Pizza Hut. Some of our emerging brands have also demonstrated great agility and potential during lockdowns. I'm convinced that by executing on our RGM framework, we are well positioned for sustainable long-term growth.

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JULY 29, 2022 / 12:00AM GMT, Q2 2022 Yum China Holdings Inc Earnings Call

True to our hallmark DNA of resiliency, we are taking every action to quickly drive returning traffic to our stores by providing good food, great value and good customer experience. Going forward, we will continue to delight our customers and seize new opportunities to grow our business in China.

With that, I'll turn the call over to Andy. Andy?

Ka Wai Yeung Yum China Holdings, Inc. - CFO

Thank you, Joey, and hello, everyone. Let me share some color of our second quarter performance. The COVID situation has significantly impacted our second quarter results. In April and May, same-store sales declined by more than 20% year-over-year. On average, more than 2,500 stores were temporarily closed or provided only limited services.

The situation gradually improved in June. We were able to capitalize on that improvement with same-store sales decline narrowed to high single digits year-over-year and the number of temporary store closures also reduced. We achieved operating profit of $81 million and restaurant margin of 12% in the second quarter. We were able to generate meaningful profit in the quarter, which exceeded our expectations, not only by capturing sales when the COVID situation improved in June, but also, by taking swift and decisive actions.

We adjusted offers and promotions, spent tremendous efforts in driving productivity gains, secure onetime release and rebase our cost structure. Let me go through the financials and our cost control initiatives. Unless noted otherwise, all percentage changes are before the effects of foreign exchange. Foreign exchange have a negative impact of approximately 3% in the quarter.

Second quarter total revenue decreased 13% year-over-year in reported currency to $2.1 billion due to the same-store sales decline and temporary store closures. This was partially offset by the contribution of new units and the consolidation of Hangzhou KFC. System sales were down 16%. Same-store sales were 84% of prior year's level.

By brand, KFC's same-store sales were 84% of prior year's level with same-store traffic at 75%. Ticket average grew 12%, mainly due to the increase in delivery mix and higher ticket average of community purchasing orders.

Pizza Hut's same-store sales were 85% of prior year's level. Same-store traffic was at 80% while ticket average increased by 6%. This was driven by the higher ticket average of community purchasing.

Restaurant margin was 12.1% down 370 basis points compared to last year. This was mainly due to significant sales deleveraging impact, significant sales cost inflation and higher delivery costs. To take actions, we have taken actions to mitigate their impact. Let me next go through each expense line and the actions we have taken. Cost of sales was 30.9%, almost flat year-over-year. We took prompt actions to reduce promotional activities and discounts to keep commodity price increase to low single digits and to optimize the distribution frequency from warehouse to store to in order to reduce logistics costs.

Cost of labor was 27.1%, 290 basis points higher than last year, mainly due to sales deleveraging, wage inflation of 5% and more delivery-rider costs, resulting from higher delivery mix. This was partially offset by improved labor productivity as we simplified promotions and menu items, reduced operating hours as necessary, reduced hiring and prioritize scheduling of full-time employees.

Occupancy and other was 29.9%, 60 basis points higher than last year. The modest increase was mainly attributable to sales deleveraging and rise in utility prices, which was partially offset by our cost initiatives.

Over the past few years, we spent considerable efforts to reduce the fixed components of our rental expenses, shifting them more to variable components. These efforts continues to improve the flexibility of our operations. In addition, we negotiated meaningful rent relief from landlords. Apart from that, we pulled back on marketing and advertising and took on more energy-saving initiatives.

G&A expenses increased 6% year-over-year, mainly due to increased compensation and benefit expenses as well as the consolidation of Hangzhou KFC. This was partially offset by lower share-based compensation expenses.

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