Yum China : 4Q 2021 Earnings Conference Call Transcript

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EDITED TRANSCRIPT

Q4 2021 Yum China Holdings Inc Earnings Call

EVENT DATE/TIME: FEBRUARY 09, 2022 / 12:00AM GMT

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FEBRUARY 09, 2022 / 12:00AM GMT, Q4 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

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

Wing Hong Woo CMB International Securities Limited, Research Division - Research Analyst Xiaopo Wei Citigroup Inc., Research Division - Director & Head of Asia-Pacific Consumer Research

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

PRESENTATION

Operator

Good day, everyone. Thank you for standing by. Welcome to Yum China Fourth Quarter and Fiscal Year 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 first speaker today, Ms. Michelle Shen, IR Director. Thank you. Please go ahead.

Michelle Shen Yum China Holdings, Inc - IR Director

Thank you, Desmond. Hello, everyone, and thank you for joining Yum China's Fourth 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 presentation 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 over this past year and then review key actions. 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. In the fourth quarter, multiple waves of outbreaks across the nation significantly impacted our business. I would like to express my heartfelt gratitude to all of our employees for taking the right actions to ensure customer safety and minimize business disruptions.

For example, during the lockdown in Xi'an, our excellent supply chain team shield us from major disruptions. Our operation teams took immediate actions to quickly resume delivery and takeaway. They provide vital services to the community in this time of need. We also provided free meals to frontline medical and social workers as a token of our appreciation.

We consider people to be a critical pillar of our sustainability strategy. We aim to have a workplace where employees can thrive while

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FEBRUARY 09, 2022 / 12:00AM GMT, Q4 2021 Yum China Holdings Inc Earnings Call

protecting them and supporting their careers in times of uncertainty. Therefore, this year, we enhanced the medical insurance coverage for our RGMs, restaurant management teams and supervisors. These greater benefits cover around 100,000 frontline employees.

Despite the challenging environment, for the full year, we grew revenue by 19%. We delivered operating profit of $1.4 billion or $766 million, excluding special items. We opened over 1,800 stores. That is equivalent to 5 new stores per day compared to 3 new stores per day just a year ago.

On a net basis, we added over 1,200 stores. KFC continued to demonstrate remarkable growth and resiliency. System sales grew 8% in 2021. The brand opened more than 1,200 stores. Entering 160 new cities in 2021. More than half of new stores were in lower tier cities, but we're also adding store density in higher-tier cities. The business contributed to the majority of Yum China's product.

Pizza Hut came back stronger, achieving same-store sales growth of 7% for the full year. We are happy to see that growth was driven by transaction volume increase of over 10%. Pizza Hut opened over 300 stores, a record opening since 2016. The brand also strengthened its bottom line with full year segment operating profit up 77%. These results reflect remarkable improvement over the past few years.

Now let me provide some color on the fourth quarter. During the National Day holiday in early October, we saw a sequential recovery from the third quarter. As regional outbreak surged, November same-store sales were down by mid-teensyear-over-year or approximately 20% compared to November 2019. Same-store sales improved slightly in December but were still more than 10% below both prior year and 2019 levels.

Authorities implement mass testing, regional lockdowns and stringent travel measures nationwide. These significantly impact the overall restaurant industry and our business. At the height of the outlook, nearly 300 of our stores were temporarily closed or only provided delivery and takeaway services. But more importantly, reduced social activities, less traveling and softened consumption impact foot traffic across our brands.

Let me share with you the key actions we took to stabilize our business. First, we drive traffic and sales with great product and value. The ability to innovate is one of our core competitive advantages. We again launched over 500 new or upgraded product last year. At KFC, new categories, such as Beef Burgers and whole chicken, have received great customer feedback. Beef Burger sales in the fourth quarter exceed RMB 300 million and accounted for 3% menu mix. Juicy Whole Chicken had another successful limited time offer promotion, and therefore, we are putting it on permanent menu this year. We also partnered with popular Chinese brands, Zhou Hei Ya from Hubei and Wen He You from Hunan to design innovative new menu items. Customers love the Chicken & Duck Sandwich and spicy Crayfish Wrap we launched in the quarter.

Beyond national launches, in 2021, KFC launched 12 local dishes in regional markets. We expand our range from breakfast to late-night snack. Beef and lamb kebab from Northwestern China, Xi Bei Kao Rou Chuan and cold noodles with sesame sauce Wu Han Liang Mian are among customer favorites. We have a mechanism to roll out successful regional offerings to more places or even nationwide. Wuhan hot dry noodle, Wuhan Re Gan Mian last year was a big hit.

At Pizza Hut, we launched special winter-themed pizzas for the holiday season, featuring greek cheese, tiger prawns and filet mignon. We also offered more flexibility to our customers, allowing them the option to trade up pizza toppings, which translated into higher average ticket. In response to weakened consumption, we increased value promotions across our brands.

For example, at KFC and Pizza Hut, we built on a well-established promotion mechanism Crazy Thursday and Scream Wednesday to offer effective value promotions while minimizing margin impact. Second, we captured home consumption demand with off-premise services for both KFC and Pizza Hut.

In the fourth quarter, delivery continued to be a key growth driver, mitigating the drop in dining traffic. Delivery grew 60% in 2021 compared to 2019 and contributed to approximately 32% of sales. Combined with takeaway, off-premise services represent more than half of our sales.

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FEBRUARY 09, 2022 / 12:00AM GMT, Q4 2021 Yum China Holdings Inc Earnings Call

Driving profitable growth in off-premise occasion is core to our strategy. Our new retail products are designed to capture home consumption demand by leveraging our online and off-line channels. We added more food choices and tripled sales to over RMB 500 million within 2021.

Lastly, we unleashed the power of digital in customer service and operations. The KFC and Pizza Hut loyalty program exceeds 360 million members as of the end of 2021. It is 60 million or 20% more than the year before. Member sales account for approximately 60%. We continuously enhance our Super App to address the needs of customers and improve their digital experience. For example, KFC's personalized menu display and Pizza Hut order together feature.

With enhanced digital capabilities, Digital sales exceed USD 7 billion or over 85% in 2021. We empower our RGMs with in-store digitalization using AI, automation and IoT. At KFC, our system assesses real-time store level inventory and automatically dispatches coupons to digital ordering users to reduce food waste.

We also introduced a quality control system to automatically evaluate the quality of food products based on the color, shape, et cetera, et cetera. These technologies improve both the customer experience and our operating efficiency.

Now I would like to briefly update you on our emerging brands. Our coffee business is gaining momentum. We expand the Lavazza portfolio from 4 to 58 last year, covering all Tier 1 cities and leading Tier 2 cities such as Hangzhou, Wuhan, Changsha. We continue to enrich our food offerings and tap into lifestyle merchandisers to drive further growth. In 2022, we will open more stores to increase our coverage.

COFFii & JOY total revenue increased both year-over-year and compared to pre-COVID levels as same-store sales grew by over 30% last year. We ended the year with 36 new -- 36 stores with improved store economics, reflecting improved fundamentals.

K Coffee sold 170 million cups in 2021, representing a 22% growth compared to 2020. Taco Bell store count tripled last year from 12 to

37. We took actions to fine-tune the business and make the brand more approachable for Chinese consumers. Pilot tests on smaller formats has shown improved unit economics. This year, we will continue to refine the formula for long-term success just as we have done with KFC and Pizza Hut over the years.

Our Chinese cuisine brands, Little Sheep and Huang Ji Huang, faced a particularly adverse situation during COVID-19. A large number of their stores are located in Northern and Western China, where cases were concentrated. East Dawning was also hit hard due to the transportation location focus. After a careful review, we decided to wind down the operation in 2022 and focus resources on our hot pot brand.

Before I pass the call to Andy, I want to emphasize that we face enormous uncertainties and headwinds from the external environment, but we have the ability to embrace change and to innovate and adapt accordingly. We continue to focus on the key levers I just mentioned to drive sales and protect our profit in the short term. We are also building our core capabilities to strengthen our market leadership for long-term sustainable growth. I'm confident that we can emerge from this challenging period even stronger.

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

Ka Wai Yeung Yum China Holdings, Inc. - CFO

Thank you, Joey, and hello, everyone. The COVID situation has caused a great deal of volatility to our operations in 2021. We delivered strong performance in the first half of the year when COVID conditions was relatively stable. In the second half of the year, our business was significantly affected by regional outbreaks and tighter public health measures.

Despite the challenges, on a full year basis, revenue reached $9.9 billion. System sales grew 10% in constant currency. We reported operating profit of $1.4 billion and adjusted operating profit of $766 million. In 2021, we received roughly $90 million less in onetime relief from the government and landlord comparing to 2020. If we remove the onetime relief from the equation, our adjusted operating profit will be up 20% year-over-year. This result reflects the volatilities arising from COVID but also reflect the resiliency of our business

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FEBRUARY 09, 2022 / 12:00AM GMT, Q4 2021 Yum China Holdings Inc Earnings Call

and tremendous effort our teams put in.

We have accelerated store openings in the past few years. We maintained a healthy store payback period of 2 years for KFC and 3 years for Pizza Hut despite the impact from the pandemic. Even newer stores opened in the first half of 2021 have performed well. A majority of them achieved monthly breakeven within the first 3 months. There are still a lot of white space opportunities in China, especially in lower-tier cities. Small store formats enable us to expand more flexibly. The reduced store size, combined with other cost reduction initiatives, enable us to decrease CapEx per store by around high single digit year-over-year. We will continue to apply a disciplined and systematic approach in our store opening process to ensure we open promising and high-quality stores.

Now let me review our fourth quarter financial results. Even with the repeated outbreaks since mid-October, fourth quarter revenue grew 1% in reported currency to $2.3 billion and remain profitable. System sales were down 3% year-over-year, mainly due to the same-store sales decline, partially offset by new unit growth. Like prior quarters, we are providing pro forma measures here for convenient comparison with 2019.

KFC's same-store sales were approximately 88% of the prior year's level and 85% of the 2019 level with same-store traffic at approximately 80% of 2019 level. Average ticket grew roughly 6% versus 2019, mainly due to the increased in mix, partially offset by increased discounts.

Pizza Hut same-store sales were approximately 92% of the prior year and 88% of the 2019 level. Same-store traffic at approximately 96%, close to 2019 levels. While the average ticket was down by about 8%. This was driven by the increased mix in delivery, which has a lower average ticket than dine in.

KFC was more affected than Pizza Hut in the fourth quarter due to KFC having a higher store mix in transportation and tourist locations. This location experienced a sharp decline in sales, down approximately 40% on a 2-year basis.

The fourth quarter is seasonally the smallest quarter for our sales and margins. So the sales deleveraging impact on margins is more prominent. Restaurant margin was 7.5%, down 760 basis points compared to last year. This was mainly caused by significant sales deleveraging, cost inflation, more value promotions as well as higher delivery costs due to increasing sales in delivery volume.

Let me go through each expense line item. Cost of sales was 32.5%, 150 basis points higher than last year. This was mainly due to increased value promotions to drive customer traffic and upgraded packaging to phase out plastic. Cost of labor was 27.9%, 370 basis points higher than last year. This is due to sales deleveraging, wage inflation of 6%, delivery volume increase resulting in higher delivery rider costs and higher staffing levels as more staff were scheduled to implement increased safety protocols. Occupancy and other was 32.1%, 240 basis points higher than last year. This is mainly attributable to the sales deleveraging impact. In addition, utility prices went up by double digits starting in December.

G&A expenses increased 7% year-over-year in constant currency, mainly due to increased compensation and benefit expenses as well as the impact of consolidating Hangzhou KFC. Compared to last year, we received $10 million less relief from the government and landlords. Proactive cost management and productivity enhancements enabled us to partially mitigate the headwinds and achieve a profitable quarter.

Operating profit was $633 million. Adjusted operating profit was $16 million. The difference is mainly due to the noncash gain of $618 million from the fair value revaluation of Hangzhou KFC. In December, we completed the investment in Hangzhou Catering and now own approximately [60%] of Hangzhou KFC directly and indirectly. Other than these noncash gains, the impact from consolidating Hangzhou KFC was small as the transaction was completed only on December 10.

Effective tax rate was 25.1%. Net income was $475 million, and adjusted net income was $11 million. This includes a mark-to-market investment loss of $9 million in Meituan, in contrast to a gain of $23 million in the fourth quarter of 2020.

Let's now turn to our outlook for 2022. First, we expect stringent health measures to remain in effect in the near future. The development

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