Yum China 3Q 2021 Earnings Conference Call Transcript

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EDITED TRANSCRIPT

Q3 2021 Yum China Holdings Inc Earnings Call

EVENT DATE/TIME: OCTOBER 28, 2021 / 12:00AM GMT

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OCTOBER 28, 2021 / 12:00AM GMT, Q3 2021 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

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

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

PRESENTATION

Operator

Good day, and thank you for standing by. Welcome to the Yum China Third Quarter 2021 Earnings Conference Call. (Operator Instructions) Please be advised that today's conference is being recorded. (Operator Instructions)

I would now like to hand the conference over to your speaker today, Michelle Shen. Thank you. Please go ahead.

Michelle Shen Yum China Holdings, Inc. - IR Director

Thank you, Lyndon. Hello, everyone, and thank you for joining Yum China's Third Quarter 2021 Earnings Conference Call. Joining us 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 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 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.

Today's call includes 3 sections. Joey will provide an update regarding recent developments and our third quarter 2021 results. Andy will then cover the financial performance 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 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. As we shared in mid-September, we navigate a very challenging situation in the third quarter. The Delta variant outbreak that started in late July spread to 16 provinces. It became the most widely spread regional outbreak since the first quarter of 2020. Strict public health measures were implemented across the country. Trading was significantly impacted during the peak summer season, which is traditionally a very strong quarter for our business. Same-store sales declined by 7% in the quarter as demand fell for in dine-in, although this was partially offset by growth in delivery.

I want to take a minute to thank our 440,000 employees who are working diligently and rapidly finding solutions in this fluid situation. In response to the sharp decline in dine-in traffic, we quickly adjusted marketing campaigns, operations and supply chain to drive demand for off-premise. Delivery sales grew 23% year-over-year or 62% on a 2-year basis and contribute approximately 34% of sales in the third quarter.

New retail business grew rapidly with sales in the third quarter almost equal to the first 2 quarters combined. Our ability to engage

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OCTOBER 28, 2021 / 12:00AM GMT, Q3 2021 Yum China Holdings Inc Earnings Call

customers digitally was essential during this difficult time. In the third quarter, over 60% of system sales came from members. We add about another 20 million members, ending the period with a total member count of over 350 million. We sold 19 million Privilege subscriptions, including the popular KFC chicken lovers card, [Wang Zha Ka], which is a summer exclusive.

Having taken important initiatives to drive sales, we saw a sequential recovery in September. For the quarter, system sales growth was positive compared to last year and to pre-COVID. New unit growth more than offset the same-store sales decline. We broke record by opening 524 new stores, ending the quarter with 11,415 stores. However, we do not compromise quality for quantity. We have prudent new store approval process and carefully track the performance of each new store. New store payback remains healthy at around 2 years at KFC and 3 years at Pizza Hut. Our smaller store formats enable us to increase store density in higher-tier cities and further penetrate into lower-tier cities with lower CapEx and rent.

Let me provide some color on our key brands. First, KFC. We stepped up value and promotional campaigns to drive traffic, and we introduced great food items. Juicy whole chicken was sold out within a week. Our meat sauce Wagyu or Angus beef burger also proved popular. Our premium beef burgers have been very successful since becoming permanent menu items. We are building a beef burger platform covering different price points.

We're taking menu innovation and localization to the next level. Following the success of hot dry noodles, Reganmian, in Wuhan, we rolled that out nationwide in September. In a week of launching, we sold over 1 million bowls. It's the best-performing limited time offer breakfast item in the past 3 years. We also introduced steamed dumplings, xiao long bao, to more stores in Eastern China. More recently, we launched hot pepper soup, the very famous Hulatang, in Henan. All of these are very well received by our customers. KFC has added nearly 1,000 stores and entered 150 new cities over the past 12 months. As we mentioned during the Investor Day, we are now tracking 1,200 potential cities that we could enter in the future with multiple store formats.

Next, let's talk about Pizza Hut. Years of transformation has proved -- has improved Pizza Hut's fundamentals and resiliency. In the third quarter, Pizza Hut opened 103 stores, the highest number of store openings in a quarter since 2016. Satellite stores and other smaller formats accounted for over 70% of the new stores and enabled us to capture the strong demand for delivery with higher store density.

We upgrade our buy one, get one pizza promotion. For the free second pizza, customers were given more flexibility to choose when, where and what pizza they would like to have. This mechanism was a breakthrough for us, enabled by our upgrade digital platform. The promotion was exciting for customers and create sales uplift for us. During this 10-day campaign, we sold approximately 1 million buy one, get one pizza [sets]. For a limited time, we also offered new pizza flavors modeled on popular Chinese dishes such as sea bass pizza with pickled vegetables, Suan Cai Hai Lu Yu, and spicy stir-fried hot pizza, Ma La Xiang Guo. These innovative products were Pizza Hut's take on localization and position us to attract young consumers who love to try new things.

Moving on to coffee, our third growth engine. We are very excited about our deepened partnership with Lavazza. This 126-years-old Italian brand offers a truly authentic Italian experience. Our Italian coffee exclusively uses high-quality Lavazza beans roasted in Torino, Italy. In addition to coffee, customers love their delicious food, popular item like Emiliano, which is toasted sandwich, and mini croissant with ham and cheese and made fresh in our fully equipped kitchen. The high proportion of food, which is 25%, contributes to higher ticket average.

At the end of September, we had 26 Lavazza stores in 4 top-tier cities. We expanded beyond Shanghai to Hangzhou, Beijing and Guangzhou, where our stores received great customer feedback. Our first Beijing store is already ranked the most popular café in Chaoyang District. Encouraged by the positive results, we expect to enter into more top-tier cities and more than double our current store base in the fourth quarter.

Despite recent challenges, our commitment to China's long-term growth remains unshaken. We are always planning for the future and have been executing on the strategies outlined during our September Investor Day. Despite the difficulties posed by the outbreak, we worked diligently to build our store pipeline. We now expect to open over 1,700 gross new stores in 2021, up from 1,300. I'm also excited about our investment in Hangzhou Catering Service Group. This will allow us to accelerate growth across our brands in Zhejiang province.

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OCTOBER 28, 2021 / 12:00AM GMT, Q3 2021 Yum China Holdings Inc Earnings Call

Lastly, we continue to enhance capabilities in supply chain and digital. These are stores -- these are our core enablers for sustainable growth in the long term. Last week, we opened our digital R&D center with 3 sites in Shanghai, Nanjing and Xi'an. The center is a key part of our strategy to build a dynamic digital ecosystem. The R&D center will consolidate and expand dedicated resources to develop solutions and services to optimize customer experience and operating efficiency. We plan to invest $100 million to $200 million and to employ up to 500 staff over the next 5 years for this particular initiative.

As for supply chain, in addition to the logistics center in Chengdu, we have another one under construction in Huai'an, which is in Jiangsu province. There are also several sites in the pipeline. As we mentioned during the Investor Day, we plan to operate about 45 to 50 logistics centers and consolidation centers over the next several years to support our expansion and to further increase efficiency.

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

Ka Wai Yeung Yum China Holdings, Inc. - CFO

Thank you, Joey, and hello, everyone. Let me first review our third quarter financial performance and then discuss this year's outlook. Unless noted otherwise, all percentage changes are before the effects of foreign exchange.

Let me first cover the third quarter performance. Actual results are in line with the business update that we released in mid-September. Third quarter performance was disrupted by the Delta variant outbreak, resulting in same-store sales declines of 7% year-over-year. However, we still delivered positive revenue growth and system sales growth, which is led by new unit contribution. Total revenues grew 2% year-over-year and reached $2.55 billion. System sales increased 1%.

Similar to prior quarters, we are providing pro forma measures here for convenient comparison with 2019. Same-store sales were approximately 87% of the third quarter 2019 level. KFC's same-store sales were approximately 92% of the last year level and 87% of the 2019 level with same-store traffic at approximately 82% of 2019 level. Average ticket grew roughly 6% versus 2019, mainly due to the increase in delivery mix. Pizza Hut's same-store sales were approximately 95% of last year and 89% of 2019 level. Same-store traffic is on par with the 2019 level, while average ticket decreased by about 10%, driven by the increased mix in off-premise occasions, which have a lower ticket than dine-in.

KFC was likely more affected than Pizza Hut again this quarter as KFC has a higher store mix in transportation and tourist locations. These locations experienced a sharp decline in sales and approximately 40% on a 2-year basis in the quarter.

Restaurant margin was 12.2%, down 640 basis points compared to last year. This was mainly caused by sales deleveraging, more value promotions, higher wages and increased delivery costs associated with more delivery orders as well as lower COVID-related relief this year. Cost of sales was 32.2%, 100 basis points higher than last year. Modest decline in commodity prices year-over-year partially offset the step-up value promotions to drive customer traffic and phasing out of plastic packaging and other packaging upgrades.

Cost of labor was 25.6%, 400 basis points higher than last year. This is due to a few factors. First, wage inflation was 6% in the quarter, notably higher than the previous quarters. Second, increased delivery volume contributed to higher labor cost percentages. Third, additional labor hours were scheduled going into the third quarter, which is typically a seasonally strong trading period for us. We also scheduled more labor hours for increased safety protocol during the outbreak. We were quick to adjust labor scheduling and mitigate the sales leverage and impact.

Occupancy and other was 30%, 140 basis points higher than last year, mainly attributable to the sales deleveraging impact. In addition, we received $10 million COVID-related onetime relief in the third quarter last year, while the amount was only $2 million this year.

G&A expenses increased 6% year-over-year, mainly due to higher compensation costs and increased head count. We remained profitable in the quarter with operating profit of USD 178 million. Excluding a noncash remeasurement gain of our existing equity interest in Lavazza joint venture of $10 million, adjusted operating profit was $168 million, a 52% decrease year-over-year or a 48% decrease compared to 2019.

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OCTOBER 28, 2021 / 12:00AM GMT, Q3 2021 Yum China Holdings Inc Earnings Call

Our effective tax rate is 28.3%. We maintained the full year effective tax rate outlook at 27% to 29%. Net income was $104 million, and adjusted net income was $96 million. Excluding $32 million net investment loss of Meituan, it was $128 million, down 50% year-over-year. Diluted EPS was $0.24. Mark-to-market loss in Meituan negatively impacted our diluted EPS by $0.07. In the quarter, we returned $85 million to shareholders in the form of cash dividends and share repurchases.

As we look ahead to the fourth quarter, we remain cautious. Strict public health measures are still in effect. Consumer are cautious about spending and are traveling less. According to government statistics, for the 7-day National Day holiday starting October 1, the number of traveler was down 2% compared to the same period last year and down 30% versus 2019. Related travel spending was down 40% compared to 2019. While we are seeing a slight sequential recovery in same-store sales, they still remain below prior year and pre-COVID 2019 level, as overall dine-in volume and traffic and transportation hub are still significantly impacted. We expect the recovery of same-store sales to take time with a nonlinear and uneven path.

Recently, we have seen a resurgence of cases across 12 provinces and municipalities, including Inner Mongolia, Jiangsu and Beijing. We will continue to monitor the development and stay agile. In addition, the fourth quarter is seasonally the smallest quarter for sales and profit margin.

Based on what we are seeing so far, we expect the margin and operating profits in the fourth quarter to be significantly impacted by: One, sales deleveraging as same-store sales remained below the prior year and pre-COVID levels.

Rising commodity prices. Since the fourth quarter of 2020, we have benefited from a deflationary environment, which will very likely end in the fourth quarter. Cost of sales will also be pressured by aggressive campaigns as we will continue to drive traffic through attractive promotions.

Three, wage inflation, which is expected to be in the mid-single-digit range. Rider costs are likely to continue to increase as delivery trends further upward.

Please note that the fourth quarter last year include several onetime items, including: One, COVID and other onetime relief from government and landlords, almost $13 million; two, lower staffing level due to shortage of part-time workers. These are unlikely to repeat this year.

Now despite the near-term challenges, we remain committed to driving long-term growth. In the short term, we will focus on keeping our operations agile and resilient in the face of considerable disruption and uncertainty caused by the pandemic. For the long run, we will focus on fortifying our competitive moat and growing our business and making continuous improvements in our business model and store operations. We have a strong track record of managing our cost structure and growing our business profitably over the years. We will continue to focus on product innovation and leveraging the strength in our supply chain to mitigate the impact of commodity price swings.

On the COL front, we will continue to invest in technology, automation and digital infrastructure to improve labor productivity. On the other hand, the near-term challenges, while tough for the restaurant industry as a whole, also create favorable conditions for us to expand our store network and capture growth opportunities. As Joey mentioned, we now expect to open 1,700 new units in 2021, almost 5 stores per day. We are maintaining our previous capital expenditure target of $700 million to $800 million, which benefited from our ongoing efforts to reduce CapEx spending per new store.

Looking ahead, we will continue to invest in accelerating growth and fortifying our resiliency as outlined at the Investor Day in September. We will provide you details on 2022 targets during our fourth quarter earnings release in early 2022.

With that, I will pass you back to Michelle to start the Q&A. Michelle?

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