Yum China : 4Q 2022 Earnings Conference Call Transcript

REFINITIV STREETEVENTS

EDITED TRANSCRIPT

Q4 2022 Yum China Holdings Inc Earnings Call

EVENT DATE/TIME: FEBRUARY 08, 2023 / 12:00AM GMT

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FEBRUARY 08, 2023 / 12:00AM GMT, Q4 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. - Director of IR

CONFERENCE CALL PARTICIPANTS

Brian John Bittner Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst

Chen Luo BofA Securities, Research Division - MD

Kin Shun Ling Jefferies LLC, Research Division - Equity Analyst

Lillian Lou Morgan Stanley, Research Division - Executive Director

Michelle Cheng Goldman Sachs Group, Inc., Research Division - Executive Director

Sijie Lin China International Capital Corporation Limited, Research Division - Analyst

Rap Tse CIMB

Xiaopo Wei Citigroup Inc., Research Division - Director & Head of Asia-Pacific Consumer Research

Yushen Wang CLSA Limited, Research Division - Research Analyst

PRESENTATION

Operator

Thank you for standing by, and welcome to the Yum China Fourth Quarter and Fiscal Year 2022 Earnings Conference Call. (Operator Instructions) I would now like to hand the conference over to Ms. Michelle Shen, IR Director. Please go ahead.

Michelle Shen Yum China Holdings, Inc. - Director of IR

Thank you, Zari. Hello, everyone. Thank you for joining Yum China's Fourth Quarter 2022 Earnings Conference Call. On today's call are our CEO, Ms. Joey Wat; and our CFO, Mr. Andy Yeung.

Before we get started, I'd like to remind you that our earnings call and investor materials 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 statements in our earnings release and 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 talk about our journey in the past 3 years and discuss fourth quarter performance. 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 the PowerPoint presentation which contains operational and financial highlights on our IR website.

Finally, we plan to host our 2023 Investor Day in Shanghai this September. We look forward to sharing more details about this event with you in due course. 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. I want to wish everyone joining us today a happy and healthy Chinese New Year.

Before looking at the fourth quarter and full year, I would like to reflect upon our journey these past 3 years with COVID, some of our key learnings and how we have grown. First, I'm incredibly grateful to the entire Yum China team for their agility, creativity and tenacity during this difficult time. Together, we became a more resilient, nimble business, better positioned for long-term growth.

During the past 3 years, we quickly pivoted when dine in traffic came under pressure. Delivery doubled from just 20% sales mix in 2019 to 39% in 2022. Our hybrid delivery model and dedicated riders enabled us to capture the increase in demand. Combined with takeaway, off-premise sales reached almost 2/3 in the fourth quarter of 2022. Digital ordering also rocketed from 55% of sales in 2019 to now 89%. That's over USD 20 billion in digital sales in 3 years.

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FEBRUARY 08, 2023 / 12:00AM GMT, Q4 2022 Yum China Holdings Inc Earnings Call

We maintained our rapid growth. Our store portfolio expanded by nearly 40%, a total of 3,800 net new stores. KFC and Pizza Hut stores maintained a healthy payback of 2 to 3 years, respectively. The first year profitability of new stores also improved. Strong new store performance was driven by our flexible store models. We optimized store size and secured more favorable lease terms. For new stores opened in 2022, more than half were in smaller formats. Such flexibility allow us to continue to increase density in higher-tier cities which is particularly useful and helpful for delivery and capture white space in lower-tier cities.

We enhanced the coverage and agility of our world-class supply chain to support business growth. We expanded from 29 to 33 logistics centers for better self-sufficiency in each province. During extended lockdowns, we added rail and sea freight to move our inventory apart from our traditional trucks.

Our store inventory visibility system allows real-time sales forecasting and smart inventory replenishment. These capabilities helped mitigate severe disruption even during lockdown and minimize wastage. Our agile supply chain also supported product innovation by securing supply at scale. Apart from our classic offerings, we launched over 500 new or upgraded menu items last year from regional offers to national launches.

We invested in digital and automation to improve operating transparency and efficiency. For example, we are rolling out smart order system, (Ding Dan Zhi Neng Jiao Fu) at KFC. The AI-powered system more accurately predicts demand and recommends food preparation plan to minimize stock outs and wastage and also reduce waiting time for customers. It also enhances customer experience by reducing wait time and providing real-time order update.

And recently, we added robotic servers at 1/3 of our Pizza Hut restaurants, (Chuan Cai Ji Qi Ren) freeing up crews to serve customers. We remain profitable each and every quarter since the beginning of the pandemic in 2020. By rebasing cost structures and implementing austerity measures, we cushioned shocks created by the volatile market situation. In the past 3 years, we were able to generate USD 1.9 billion in free cash flow and returned over USD 1 billion to shareholders.

Notably, I'm proud to say we did this while also protecting the jobs of our employees. We have had no staff layoff since the pandemic began.

Looking back over this period, we seized opportunities and proved our ability to operate in good times and bad times. Looking forward, our anti-fragile operations will enable us to shine and drive long-term growth in China.

Now let me provide some highlights for the fourth quarter and full year. 2022 was filled with unprecedented challenges. In just 12 months, we managed sporadic COVID outbreaks, entire city lockdowns, nationwide infections and the sudden lifting of COVID-related restrictions. In October and November, COVID infection quickly evolved into major regional outbreaks, leading to tightened COVID-related restrictions.

In December, as China entered a new phase of COVID response, we faced brand new challenges. With surging infection rates, a significant portion of our employees and riders became infected, resulting in labor shortage. Thousands of our stores were temporarily closed or only provide limited services. Many residents also opted to stay at home to avoid infection or recover from symptoms. Dine-in traffic fell sharply.

During this time, as always, the health and safety of our employees and customers remained our top priority. We moved quickly and support our employees with relief medicines and antigen test kits. Mandated daily testing for all crews and riders to minimize infections, and organized informative health talk and a consultation hotline for our employees.

At the same time, we took immediate steps to address the labor shortage. We simplified the menus, shortened operating hours and optimized labor shifts. We reallocated crew resources among stores, prioritizing stores with stronger demand, and we adjusted delivery operations, encouraged customers to pick up orders and promoted packaged food products.

I'm thankful for our team's nimble actions and amazing execution. Even in this challenging quarter, we delivered substantial

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FEBRUARY 08, 2023 / 12:00AM GMT, Q4 2022 Yum China Holdings Inc Earnings Call

year-over-year restaurant margin expansion despite lower sales. This was achieved by our extensive scenario planning, operational efficiency improvement, cost rebasing initiatives and temporary relief. We were also able to open a record 538 net new stores in the fourth quarter, or 1,159 net new stores in the full year.

Let's move on to the brands. By brand, KFC and Pizza Hut continue to introduce delicious food and exciting campaigns to delight our customers. At KFC, new categories grew with solid momentum. Juicy whole chicken, (Mi Zhi Quan Ji), and Beef Burger, (Niu rou han bao), doubled in sales in 2022. Combined, they generated around 5% of KFC sales mix in the fourth quarter, nearly equal to our Original Recipe chicken. We continued to introduce more flavors in these categories, such as the Spicy Whole Chicken, (La Lu Feng Wei Quan Ji) launched during Chinese New Year. Following the success of Pokemon Psyduck in quarter 2, (Ke Da Ya) our toys in the fourth quarter also generated huge social buzz. These include Bouncy Chicken, (Beng Beng Ji) and Fluffy Chicken popcorn, (Ji Mi Hua), both were originally designed as pet toys or toys for your cat, but quickly became very popular with all customers and drove traffic.

At Pizza Hut, pizza sales grew nicely for the year, reaching almost 40% of sales. We sold over 100 million pizzas in 2022, that's nearly 7 pizzas per second. Apart from our signature pan, hand-tossed and crispy pizzas, we have added stuffed-crust pizzas. Customer can choose fillings like double cheese, sausage and meat floss(Rou Song). These new launches encouraged the trade ups and lifted effective price.

We continue to offer stunning value for money. Our signature value campaign at KFC, Crazy Thursday, (Feng Kuang Xing Qi Si) attract excellent traffic, generating over 50% more sales on Thursdays compared with other weekdays. Sunday Buy More Save More (Zhou Ri Feng Kuang Pin) continues to spur weekend sales. Customers love the option to mix and match and the sizable discount. At Pizza Hut, we brought back the wildly popular 2 pizza for CNY 59 promotion in November. The amazing value drove great traffic and sales uplift.

New retail packaged foods provided us flexibility during lockdown and when we were short of staff. In 2022, packaged food sales grew 50% (corrected by company after the call) and reached nearly CNY 900 million. We continue to broaden our offerings, adding some of the classics such as Egg tart and popcorn chicken(Ji Mi Hua)

Now moving on to our emerging brands. We have solid management teams and strategies in place. While it will take time to fine-tune and test the business models, we are making solid progress-- Lavazza continues to execute its 4-pillar strategy, which includes brand building, menu innovation, digital and delivery, and store development. Throughout the year, we introduced new coffers flavors such as orange bufala latte with buffalo milk, (Chen Guang Si Rong Na Tie). We also introduced sweet and savory food with -- that pair well with coffee, such as Cube Cornetto, which is a fluffy lave croissant(Gao Bai Qian Ceng Ke Song).

Loyalty members more than double to 1 million in 2022, continue -- contributing to over 40% of sales. We enhanced operational efficiency and optimized new store designs, lowering upfront investment. Although COVID disruptions have delayed store openings, Lavazza reached 85 stores by the end of quarter 4.

Taco Bell doubled its store count in 2022 to 91stores. We continue to localize the menu for Chinese customers. For example, Crispy Wonton taco, (Ya Xiao Su),uses duck and a wonton wrapper in place of a tortilla. Why not? We also continue to improve the value proposition, customer experience and unit economics.

Little Sheep and Huang Ji Huang were acutely impacted by COVID due to their dine-in focus. We used 2022 to refine their business models and strengthen fundamentals from menu, marketing, store models, supply chain to digital initiatives. Huang Ji Huang also continued to generate operating profit.

To wrap up, with a new chapter opening in 2023, we are excited to see positive momentum in the Chinese New Year season. We took decisive action to ensure operational efficiency and capture sales. At KFC, we brought back our signature golden bucket, (Jin Tong) which is a holiday favorite. At Pizza Hut, we introduced a holiday-themed pizza with Wagyu Beef and seafood. It's called (Xian Tiao Qiang He Niu) Pizza, which is inspired by a popular game. It's gratifying to see how our delicious food play an important part in our customers' celebration during the holiday.

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FEBRUARY 08, 2023 / 12:00AM GMT, Q4 2022 Yum China Holdings Inc Earnings Call

Yet COVID remains a reality, and many challenges still lay ahead, including cautious consumer spending post the holiday. While we anticipate the road to recovery will be gradual and uneven, I'm optimistic that brighter days are ahead. We will continue to execute our proven RGM strategy which stand for resiliency, growth and strategic moat to capture the growth opportunity and deliver shareholder value.

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

Ka Wai Yeung Yum China Holdings, Inc. - CFO

Thank you, Joey. And belated Happy Chinese New Year to everyone. Let me share with you our fourth quarter performance.

As Joey mentioned, we faced an extremely fluid and challenging fourth quarter as there were substantial changes in COVID conditions and related policies. In late November, due to rising infections and strict COVID-related health measures, the number of stores that were either temporarily closed or offered only takeaway and delivery services, reached a peak of over 4,300 stores.

In December, we faced a different situation when most of the COVID measures were lifted. Due to labor shortage, we had to temporarily close or provide limited services at over 1,300 stores on average. In such a volatile environment, we took quickly action to capture the off-premise demand. Furthermore, we controlled costs, limited wastage and enhanced productivity despite lower sales. Our team did a wonderful job improving restaurant margins by almost 3 percentage points despite very difficult circumstances.

Let us now go through the financials. Unless noted otherwise, all percentage changes are before the effect of foreign exchange. Foreign exchange had a negative impact of approximately 11% in the quarter.

Fourth quarter total revenue declined 9% year-over-year in reported currency to $2.1 billion. In constant currency, total revenues grew 2%. The contribution of new units and the consolidation of Hangzhou KFC were partially offset by same-store sales decline and temporary store closures. System sales and same-store sales both declined 4% year-over-year. By brand, KFC same-store sales were 97% of the prior year's level, with same-store traffic at 84%. Ticket average grew 16% due to the rise in delivery mix, which has a higher ticket average than dine-in.

Pizza Hut same-store sales were 92% of prior year level. Same-store traffic was at 98%. Ticket average was at 95%, driven by lower ticket average of delivery orders and smaller party size due to the pandemic.

Restaurant margin was 10.4%, 290 basis points higher than the prior year. The year-over-year increase was mainly driven by labor productivity, operational efficiency and temporary relief. These were partially offset by the sales deleveraging impact, which includes temporary store closures as well as higher rider costs due to higher delivery volume.

We also faced inflationary headwinds in commodity and labor costs. Our team worked hard to protect margins during the fourth quarter, which is seasonally low quarter in terms of sales and profits.

Let me go through the key items and highlight the actions we took. Cost of sales was 31.9%, 60 basis points lower than prior year. We kept commodity inflation relatively modest by strategically locking in prices and innovating the menu. We also carefully planned promotional activities and reduced wastage. Cost of labor was 28.8%, 90 basis points higher than prior year. This was mainly due to increased rider cost from higher delivery sales mix, low single-digit wage inflation and sales deleveraging. This was partially offset by better labor productivities and temporary relief of $14 million. Occupancy and other was 28.9%, 320 basis points lower than prior year despite sales deleveraging. This was mainly due to lower rental expense and other cost-saving initiatives. Rental expense as a percentage of sales benefited from rental relief of $12 million, store portfolio optimization and more favorable lease terms.

G&A expenses increased 2% year-over-year, mainly due to increased compensation and benefit expenses as well as the consolidation of Hangzhou KFC. The increase was partially offset by cost control initiatives. Operating profit was $41 million compared to $633 million in the prior year period. In the fourth quarter of 2021, we recorded a noncash gain of $618 million from the remeasurement of our previously held equity interest in Hangzhou KFC. By excluding the remeasurement gain, adjusted operating profit increased 189% year-over-year

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