Yum China : 2Q 2023 Earnings Conference Call Transcript

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EDITED TRANSCRIPT

Q2 2023 Yum China Holdings Inc Earnings Call

EVENT DATE/TIME: AUGUST 01, 2023 / 12:00AM GMT

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AUGUST 01, 2023 / 12:00AM GMT, Q2 2023 Yum China Holdings Inc Earnings Call

CORPORATE PARTICIPANTS

Joey Wat Yum China Holdings, Inc. - CEO & Executive 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 - Co-head of Asia Consumer Research Sijie Lin China International Capital Corporation Limited, Research Division - Analyst

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

PRESENTATION

Operator

Thank you for standing by. And welcome to the Yum China Second Quarter 2023 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, Ashley. Hello, everyone. Thank you for joining Yum China's second quarter 2023 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. 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 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. You can find a webcast of this call and a PowerPoint presentation on our IR website.

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

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

Hello, everyone, and thank you for joining us today. I'm delighted to report outstanding performance in the second quarter, both top line and bottom line. Our results are a testament to our resilient and anti-fragile business, which allows us to capture upside in good times and protect downside in bad times. From the back office to the front lines, our teams are doing a great job. During the quarter, we reached new heights on multiple fronts.

First, sales performance. Total revenue of $2.65 billion set a new record for second quarter, especially given the exchange rate. System sales grew 32% and same-store sales grew 15% year-over-year. We observed strong demand around holidays. Trading for the May 1 Labor Day holiday was vibrant. However, demand actually softened afterwards with a dip in customer traffic. We adjusted nimbly with attractive campaigns and regained sales momentum in June. On June 1, Children's Day, we hit a record 8.5 million transactions. That's equivalent to a transaction every minute in every location across our 13,000-plus store portfolio in a single day.

Thanks to our amazing operation team, robust end-to-end digitalization and agile supply chain, we flexibly handled the spike in demand during campaign without compromising quality and customer service. The results demonstrate our brand equity and ability to connect with customers with delicious, innovative food and compelling value for money.

Second, store expansion. In the first 6 months this year, we opened 655 net new stores, setting a new record. We continue to see vast opportunities across all regions and city tiers in China. KFC continued its aggressive expansion, hitting 9,500 stores in over 1,900 cities.

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AUGUST 01, 2023 / 12:00AM GMT, Q2 2023 Yum China Holdings Inc Earnings Call

Notably, Shanghai became our first city to reach 500 KFC stores. Our 500th store is in the Shanghai Library, (Shanghai Tu Shu Guan). As part of our Book Kingdom Program for kids, it features a dedicated leading area to promote the love of reading to children. It's also one of our 36 Angel restaurants of KFC China. The restaurant offers a warm inclusive space for employees and customers with special needs. This showcases our commitment to positive social impact in the communities we serve.

Pizza Hut opened a record 169 net new stores in the first half of the year, supported by strengthened fundamentals through the revitalization program. Healthy new store payback gives us confidence for accelerated growth. In addition, Pizza Hut reached 3,000 stores in China, a milestone that few casual dining restaurant chains can claim. Our 3,000th store is in Qinhuangdao, a popular holiday destination in Northern China. This resort themed store boasts a beautiful patio with stunning sea view. In addition, it was built with eco-friendly materials and an intelligent energy management system.

Third is profitability. Our operating profit for the first half of 2023 has already exceeded the entire year of 2022. This achievement reflects our ability to capture sales and rebase our cost structure. Our rent ratio in the first half was below 9%. That is the best ratio in the past decade.

Now, let's talk about KFC. Our value platforms generated amazing sales results. First, Crazy Thursdays, the famous Crazy Thursday, (Feng Kuang Xing Qi Si) continue to be a tremendous draw, driving 50% more sales than other weekdays. Second, Sunday Buy-More-Save-More(Zhou Ri Feng Kuang Pin) energized Sunday sales. We captured at home consumption with our juicy Whole Chicken (Mi Zhi Quan Ji). We sold 22 million of this product in the first half and more than doubled its sales year-over-year. Third, our Weekday Value Combos (OK San Jian Tao) are gaining popularity. We added the new Sizzling Roasted Chicken Thigh Burger (Zi Zi Kao Ji Tui Bao) to enrich our entry price point offering for just USD 3. Customers love the new Weekday Value Combos.

Delicious and innovative food continues to delight our customers at KFC. In the second quarter, we introduced K-zza, a creative twist on pizza that utilized our existing ingredients. We used the wrap from our Dragon Twister to make the thin crust and Popcorn Chicken as the topping. This fun, innovative, limited time offer generated strong sales. We see great potential for more K-zza variations in the future.

K-Coffee sales grew 50% with 47 million cups sold in the second quarter. Our Iced Sparkling Americano with Zesty Lemon (Bao Zhi San Ning Qi Pao Mei Shi) is the perfect drink to beat the summer heat. We use our soda fountain machines to make this sparkling drink without additional investment in the store. It has become K-Coffee'sbest-ever limited time offering.

Now, let's talk about our marketing campaigns. Connecting with families and children is an important part of strengthening our brand affinity. Around Children's Day, we partnered with Sanrio and sold nearly 3 million meal sets with adorable toys such as Hello Kitty. This campaign contributed to our overwhelming success on Children's Day. Of course, these popular toys also work very well with adults.

Let's move to Pizza Hut. We continuously innovate to offer better products at great value. Our new menu launched in May has been a big success and strong sales driver. Over half of the menu items are either new or upgraded from a year ago. Pizza is our biggest category, accounting for over 1/3 of sales. We continue to fortify our Pizza Expert image by upgrading existing products and introducing new toppings. Apart from our signature Super Supreme, (Chao Ji Zhi Zun) and Durian pizzas, we introduced new pizzas like Bolognese Pizza with Beef (Yi Shi Rou Jiang Niu Rou Pi Sa). It has the familiar taste of Spaghetti Bolognese. It has become a customer favorite, especially among children. We use quite a bit of existing ingredients to simplify store operations and to keep the ingredients fresh as well.

In addition, many customers are trading up to stuffed crust pizza, (Juan Bian Pi Sa), which accounts for nearly 40% of pizza sales. Most recently, we launched pineapple and cream stuffed crust, (Nai Xiang Bo Luo Juan Bian), to complement our other stuffed crust choices of cheese and sausage. Pizza Hut has been sharpening its value proposition and customer engagement. Our value platform, Scream Wednesdays successfully drove sales and traffic growth. Every Wednesday, we offer different meal choices from pizza, steak, rice and pasta to appetizers at attractive price of USD 3 to USD 5.

There are choices for 1 person meals and for social gathering. We continued our collaboration with Genshin Impact for the second year. This campaign significantly boosted sales and attracted many young customers. We sold more than 2 million meal sets with themed accessories, tripling last year's numbers. This wildly popular campaign helped us recruit over 1 million new members.

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AUGUST 01, 2023 / 12:00AM GMT, Q2 2023 Yum China Holdings Inc Earnings Call

Let's switch gears to Lavazza. Lavazza continues to make good strides forward. In July, we crossed the 100-store milestone. In addition to the coffee shop business, we sell Lavazza coffee beans and capsules to premium hotels, restaurants and other channels. Recently, Lavazza also started supplying coffee beans to Pizza Hut to upgrade the coffee at Pizza Hut. I'm happy with the progress we have made and excited about the growth opportunities.

Now on to digital. Our digital ecosystem plays a crucial role in recruiting and engaging members, driving the activities and unlocking sales performance and potential for us. Our loyalty programs now exceed 445 million members. Member sales increased to 66%, setting a new record. Our SuperApps had a major update earlier this year, offering our customers a better digital experience. We introduced interesting member exclusive perks to tickle our customers, such as App-exclusive new product pre-sales and lucky draws utilizing member points.

In addition, we have been working with third-party online platforms to expand our reach. For example, prepaid discount vouchers (Yu Fu Quan) have been gaining popularity on short video platforms. By offering geographically specific deals, we effectively attracted new members and increased spending of existing [members] (corrected by company after the call).

Our end-to-end digitization unleashed great potential of our Restaurant General Managers (RGM). Our store management team sharing initiative is progressing well at KFC and Pizza Hut. Selected RGMs for the first time in our history, can now manage multiple stores. Our AI-enabled systems have streamlined administrative work to help relieve our RGMs of repetitive tasks. By further integrating our store management systems, we enhanced the visibility of store operations and cross-store data analytics. These digital tools empower our RGMs to manage multiple stores more effectively, while upholding operating standards. This will be a driver for future store cost management and also address our bottleneck of new store openings. So, we are looking forward to more progress going forward.

As we speak, we have entered our summer peak trading season. We are ready to capture summer holiday traffic with eye-catching menu items backed up by rock solid operations. At KFC, we have brought back our crowd-pleasing fried chicken taco with a new ingredient - Bullfrog (Niu Wa Ta Ke). It does not translate well but trust us, it is a delicacy for our customers in China. At Pizza Hut, we have extended our popular Durian pizzas with a new product, Durian Coconut Lava Pizza, (Bao Jiang Liu Lan Sheng Ye Pi Sa). To handle increased demand in the summer peak season, we are ramping up crew resources, securing supplies and staying vigilant with multiple scenario planning.

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

Ka Wai Yeung Yum China Holdings, Inc. - CFO

Thank you, Joey, and hello, everyone. Let me now share with you our second quarter performance. I'm delighted to report a robust performance in the second quarter. We achieved record revenues of $2.65 billion, representing 25% year-over-year growth. Operating profit of $257 million also reached a record level, more than tripling that of the prior year. We accelerated new store openings. We opened 542 new stores, resulting in net new store growth of 422, setting a new second quarter record.

Even though same-store sales remained below 2019 levels, we saw 25% growth in revenues and 26% growth in operating profit in the second quarter compared to the pre-pandemic levels in 2019. We accomplished all this while operating in a challenging and volatile environment. An uptick of COVID infections started in late April. Consumers continued to be value conscious. Sales materially weakened after the May 1 holiday. But by leveraging our multiple scenario planning, we swiftly responded by launching attractive offers to drive sales. Our sales subsequently improved in June.

To provide more context, in the second quarter last year, multiple cities were under lockdown. We are lapping last year's austerity measures and temporary relief. Now with that, let's go through the financials. Foreign exchange had a negative impact of approximately 6% in the quarter. Second quarter total revenues were $2.65 billion in reported currency, a 25% year-over-year increase. In constant currency, total revenue grew 32%. System sales increased 32% year-over-year in constant currency. The strong growth was mainly from same-store sales growth of 15%. The remaining growth can be roughly split equally between new unit contribution and the lapping of last year's temporary closures.

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AUGUST 01, 2023 / 12:00AM GMT, Q2 2023 Yum China Holdings Inc Earnings Call

Dine in sales rebounded significantly year-over-year, while delivery continued to grow. By brand, KFC same-store sales grew 15% year-over-year.Same-store traffic grew 21% and ticket average decreased 5%. It was driven by successful traffic-driving promotions, the lapping of large community purchasing orders and the decrease in delivery mix. Delivery has a higher ticket average than dine in. Pizza Hut's same-store sales grew 13% year-over-year.Same-store traffic grew 27% and ticket average decreased 11%. It was driven by successful promotional activities and the lapping of community purchasing orders. Lower mix of delivery, which has a lower ticket average than dine in at Pizza Hut partially offset the ticket average decrease.

Restaurant margin was 16.1%, 400 basis points higher than the prior year. Occupancy and Other expenses improved significantly year-over-year. This was primarily due to operating leverage derived from higher sales and ongoing benefits of cost structure rebasing efforts. These were partially offset by lapping last year's austerity measures, increased promotional activities and wage inflation.

Let me now go through the key items. Cost of sales was 30.7%, 20 basis points lower than the prior year. We kept our cost of sales low despite increased promotional activities to drive traffic. Our supply chain team's hard work and innovative use of affordable ingredients contributed to the favorable commodity pricing. Cost of labor was 26.4%, 70 basis points lower than the prior year. This was driven by operating leverage from sales growth, lower rider costs due to lower delivery sales mix and benefits from store management sharing initiatives. This more than offset wage inflation, the lapping of austerity measures and temporary relief last year.

Occupancy and Other was 26.8%, 310 basis points lower than the prior year. Rental expense and depreciation improved year-over-year. Operating leverage from higher sales, store portfolio optimization and more favorable new store rental terms all contributed to the improvement. This was offset by lapping austerity measures and higher rental relief last year.

G&A expenses increased 15% year-over-year in constant currency, mainly from higher performance-based incentive accruals and merit increases. Operating profit was $257 million, more than tripled year-over-year. Our effective tax rate was 24.7%. We continue to expect our full year effective tax rate to be around 30%. Net income was $197 million, increasing 138% in reported currency. Diluted EPS was $0.47, increasing 135% in reported currency. We generated $417 million in operating cash flows and $264 million in free cash flows. We returned $116 million to shareholders in cash dividends and share repurchases. At the end of the second quarter, we had around $3 billion in cash and short-term investments and another $1.2 billion in long-term bank deposits and notes to benefit from better interest rates.

Now, let's turn to our outlook for the third quarter. Driving sales remains our top priority. As Joey mentioned earlier, we are stepping up promotional activities and have planned attractive offers with great food at compelling values. We are also lining up exciting marketing campaigns and resources to support those initiatives to capture peak summer holiday sales.

In terms of store openings, with healthy store economics and a robust store pipeline, we are confident to achieve 1,100 to 1,300 net new stores in the full year. Our team has put tremendous efforts into developing multiple store formats, lowering CapEx and securing more favorable lease terms. We opened 655 net new stores in the first half of 2023. Our new stores have maintained a healthy payback of 2 years for KFC and 3 years for Pizza Hut. This gives us confidence to expand across different city tiers and regions.

Regarding margins, our store network expansion and our cost structure rebasing efforts over the past few years have positioned us well to capture both sales and drive operational leverage since the reopening. With 40% of our current stores opened after 2019, we are opening an average of 1 new store every 5 hours. Our store portfolio is well-suited to operate efficiently in the evolving market conditions. We expect our effort on efficiency improvements and cost structure rebasing to continue to benefit profitability in the long term.

We note that last year's record third quarter restaurant margin set a relatively high benchmark due to austerity measures and $30 million of temporary relief in the prior year. We also expect summer hiring to normalize and wage inflation of low to mid-single digits in the second half.

Despite macro uncertainty and volatility in the near term, our multiple scenario planning capabilities and agility position us well to capture opportunities in good times and manage the downside in bad times. We continue to focus on driving sales, improving

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