Yum China : 1Q 2023 Earnings Conference Call Transcript

REFINITIV STREETEVENTS

EDITED TRANSCRIPT

Q1 2023 Yum China Holdings Inc Earnings Call

EVENT DATE/TIME: MAY 03, 2023 / 12:00AM GMT

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MAY 03, 2023 / 12:00AM GMT, Q1 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

Chen Luo BofA Securities, Research Division - MD

Hau-YeeYan HSBC, Research Division - Hong Kong and China Consumer Analyst 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

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 First 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 First 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. 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 the GAAP measures is included in our earnings release.

You can find the 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

Thank you, Michelle. Hello, everyone, and thank you for joining us today. We are pleased to have set new records for first quarter revenue and operating profit. It's a wonderful start to 2023, like the Chinese saying, (Kai Men Hong). I want to thank all of our 400,000-plus employees. Without their hard work and dedication, our performance will not be possible.

System sales grew 17% year-over-year. Back in early January, we had low visibility into how conditions will unfold after the relaxation of strict COVID measures. Chinese New Year is a critical trading period for us. This year, an earlier Chinese New Year was particularly challenging due to shorter ramp-up period. We planned for multiple scenarios incorporating regional differences and focused on driving sales based on the more optimistic scenarios. Therefore, we were able to effectively deploy resources as opportunities emerged.

Operating profit more than doubled to $416 million. Our efforts in enhancing operational efficiency and rebasing our cost structure in the past few years contributed to strong profitability in the quarter. And our system sales growth compared to 2019 is plus 20%, and operating profit also compared to 2019 is plus 37%. These results exemplify our ability to stay resilient in challenging times and seize opportunities when better times emerge. Our initiatives and investments, along with our Resiliency, Growth, Moat, strategy have made us more agile and responsive.

During the quarter, we were encouraged by early signs of recovery, notably, dine-in, takeaway, delivery all grew year-over-year on a same-store sales basis. Delivery accounts for around 36% of sales, same as a year ago. Customers continue to love the convenience that

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MAY 03, 2023 / 12:00AM GMT, Q1 2023 Yum China Holdings Inc Earnings Call

delivery provides. Off-premise was over 60% of sales. Same-store sales grew year-over-year across different regions and trade zones. We benefited from increasing mobility and saw a 40% plus growth at transportation and tourist locations. However, same-store sales at these locations in the first quarter were still 20% to 30% below 2019 level.

Weekend sales growth slightly outpaced weekday sales. Apart from increased social gatherings, value programs since mid-2022 also contributed to growth. Let me share about how we drove sales. We focused on our core pillars, good food at great value and good customer experience to capture demand.

Good food at great value is our hallmark. We refreshed several signature products and achieved great results.

After doing it for more than a decade, people come to expect our Chinese New Year bucket at KFC. To capture at-home consumption around family reunions, we add the option to trade up for a juicy whole chicken, (Quan Ji). We sold 11 million whole chickens in the first quarter, more than doubled year-over-year.

We gave our classic Beef Wrap a localized spicy twist, (Mao Xue Wang Neng Niu Wu Fang). The innovation sparked social buzz leading to a sellout in many markets in just 6 days.

At Pizza Hut, the Supreme series is our most popular pizza lineup, accounting for nearly 30% of all the pizzas we've sold in the first quarter. We introduced Wagyu Beef and Seafood Supreme, (Xian Tiao Qiang He Niu Chao Ji Zhi Zun) in Chinese New Year. By including premium ingredients like abalone, sea cucumber and wagyu beef, these pizzas became the perfect, festive choice. We also created Double Durian Supreme, (Shuang Chong Liu Lian Chao Ji Zhi Zun). For durian supreme, two types of durian, (Su Dan Wang/Jin Zheng) were combined with grapefruit and pineapple to create an explosive tropical flavor. Durian lovers love it.

We continue to make our good food available at great value. At KFC, Crazy Thursday and Sunday's Buy More, Save More promotions, (Feng Kuang Xing Qi Si, Zhou Ri Feng Kuang Ping), continued to drive sales momentum and excitement. This year, we offered these great values even during Chinese New Year. We also revamped our weekday's value combos, (OK San Jian Tao), with more choices and lowered prices of select burger combos to just RMB 19.9. These 3-items combos attracted new customers and drove frequency. We also expanded our popular buy one, get one free campaign at Pizza Hut to include pizza and steak options. Customers can redeem the free item immediately or in their next visit within 30 days. The campaign significantly increased sales by encouraging repeat purchases during the promotion period.

Now let's talk about operating efficiency. Late last year, a significant portion of our employees and riders were infected with COVID. At the peak, over 4,000 of our stores were temporarily closed or offered only limited services. By early January, as people gradually recovered from COVID, we made every effort to keep our stores open and resume normal operations.

We got ready for the Chinese New Year period. We planned for crews and inventory based on the more optimistic scenarios. We also accounted for regional differences and continuously fine-tuned our plans based on regional learnings. We further improved hiring and incentive program to manage staffing and minimize labor shortages. To enhance productivity, we expanded our initiative to share store management teams across multiple stores. It also provides career development opportunities for our young talents.

Now let me share with you about our digitization. We have built a powerful digital ecosystem that's instrumental to our innovations while also enhancing operational efficiency. We leveraged AI to optimize demand forecasting, inventory management, crew scheduling and production. Smart order system, (Zhi Neng Ding Dan Jiao Fu), streamlined the food preparation for dine-in and off-premise orders. These capabilities are particularly important during the peak season like Chinese New Year. Also, migrating our key infrastructure to private YUMC's cloud enhanced the reliability of our operations. It's especially important when we face significant traffic spikes during campaigns like Crazy Thursday.

Smart delivery, (Zhi Neng Shang Quan), continued to improve delivery coverage and flexibility. Last year, we upgraded the system to dynamically adjust delivery coverage for each store by daypart. These capabilities, along with our dedicated delivery riders, allow us to capture more sales and fulfill orders even during the Chinese New Year peak season.

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MAY 03, 2023 / 12:00AM GMT, Q1 2023 Yum China Holdings Inc Earnings Call

We continued to improve digital touch points for better engagement with members. Digital orders accounted for around 89% of sales in the first quarter. Our loyalty programs exceeded 430 million members. Members steadily contribute to about 60% sales. We actively engage members and drive frequency with privileged subscription plans. K-Friends, (Zhi You Ka), is an invitation-only program for top 1 million loyal customers. K-Friends received exclusive coupons and perks and a royal crown on the call screen when ordering in stores. This help us gain valuable insights to improve service for our most loyal members and all customers.

To sum up, we are extremely pleased to deliver strong first quarter performance. Multiple scenario planning, innovative products and value campaigns, along with our agile supply chain and digital capabilities, enable us to capture market opportunities. As we progress through 2023, we plan to stay nimble to the evolving market conditions. Looking ahead, we will focus on building sales momentum, expanding our store network and fortifying our competitive moat.

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. Let me now share with you our first quarter performance. First quarter sales rebounded significantly from the fourth quarter. We made tremendous efforts to drive sales since the reopening by offering innovative food and compelling value campaigns.

Restaurant margin reached 20.3%, the highest since 2017. Our margin expansion was driven by sales leveraging, efforts to rebase our cost structure in recent years, investments in improving operating efficiency and temporary COVID-related relief from government and landlords.

Let's go through the financials. Foreign exchange had a negative impact of approximately 8% in the quarter. First quarter total revenues were $2.9 billion in reported currency, a 9% year-over-year increase. In constant currency, total revenue grew 18%. System sales increased 17% year-over-year in constant currency. The robust growth was fueled by same-store sales growth of 8%. The contribution from new units and significantly fewer COVID-related temporary store closures. Both KFC and Pizza Hut achieved 17% system sales growth.

By brand, KFC same-store sales grew 8% year-over-year.Same-store traffic grew 6%, and ticket average grew 2%. Pizza Hut same-store sales grew 7% year-over-year.Same-store traffic grew 13%, and ticket average decreased 5%. These results were largely due to the successful promotional activities, which drove strong traffic and lowered ticket average.

Restaurant margin was 20.3%, 650 basis points higher than the prior year. Sales leveraging contributed to approximately half of the margin expansion. Labor productivity gains and lower occupancy costs were key factors. We also enjoyed $18 million benefit from additional VAT deduction, thanks to the government policy to help businesses deal with the challenges posed by COVID-19. These are partially offset by cost inflation and increased promotion expense.

Let me go through the key items. Cost of sales was 30.1%, 100 basis points lower than prior year. We kept commodity prices low through tremendous efforts locking in prices and innovating the menu. We also reduced wastage and benefited from higher VAT deductions. Gains were offset by increased promotional activity to drive traffic.

Cost of labor was 24.6%, 160 basis points lower than the prior year. Sales leveraging and better labor productivity more than offset headwinds from low single-digit wage inflation. We further improved labor productivity through store management team and crew-sharing initiatives.

Occupancy and others was 25.0%, 390 basis points lower than the prior year. This was mainly driven by sales leveraging, lower rental expense as well as other cost saving initiatives. Rental expense improved due to relatively more favorable rental terms for new store and store portfolio optimization.

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MAY 03, 2023 / 12:00AM GMT, Q1 2023 Yum China Holdings Inc Earnings Call

We also recorded $8 million rental relief related to COVID surge last year. G&A expense increased 16% year-over-year in constant currency, mainly from performance-based bonus and merit increase as well as additional travel expenses from the resumption of business activities. Operating profit was $416 million, increasing 118% in constant currency -- sorry, in reported currency. Our effective tax rate was 28.5%. We expect full year effective tax rate to be around 30%. Net income was $289 million, increasing 189% year-over-year in reported currency. Diluted EPS was $0.68, an increase of 196% year-over-year. In the first quarter, we generated $507 million in operating cash flows and $328 million in free cash flows. We returned $116 million to shareholders in cash dividends and share repurchases. At the end of the first quarter, we had around $3 billion in cash in short-term investments and another $1 billion in long-term deposit, which would benefit from better interest rates. We expanded our store network and remained committed to capturing future growth opportunities.

In the first quarter, we opened 233 net new stores. In the first quarter, we faced an earlier Chinese New Year and labor shortage as well as delayed contract signing and building permit process due to the widespread infection in the fourth quarter. However, we have a strong pipeline and are confident in reaching our goal of opening 1,100 to 1,300 net new stores this year.

Our new stores continue to perform well with payback periods of 2 years at KFC and 3 years at Pizza Hut. We will continue to focus on expanding our store network in a systematic and disciplined manner.

Let's turn to our outlook. We're encouraged by first quarter performance. Sales during the Chinese New Year trading period were buoyed by pent-up demand to travel. But same-store sales post Chinese New Year has remained at teens level below 2019. Now we are still in the early stages of the recovery. The pace and the trajectory of the recovery are likely to be gradual and uncertain. Overall, global macroeconomic conditions remain challenging, and the pandemic is still lingering.

So the fact that -- so the top priority for us this year is still driving sales. Consumers are value conscious, so our investment in promotions to attract more traffic and sales are crucial. In the coming quarters, we expect gradual inflationary pressure, and we anticipate the benefits from additional VAT deductions and rental relief to phase out. We have demonstrated our ability to capture opportunities in good times and manage the downside in bad times. We will continue to utilize extensive scenario planning, flexible cost structure and operational agility to navigate the uncertain environment. We remain committed to seizing the long-term growth opportunities in China, investing in strengthening our strategic moat and creating value for our shareholders.

With that, I will pass you back to Michelle. Michelle?

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

Thanks, Andy. Before starting the Q&A, we'd like to share a head up that we have scheduled our 2023 Investor Day on September 14 to

15. The event will take place in Xi'an, China, and it will also be webcast for those who can't join us in person. We will provide more details soon.

Now we will open the call for questions. (Operator Instructions) Ashley, please start the Q&A.

QUESTIONS AND ANSWERS

Operator

(Operator Instructions) Your first question comes from Michelle Cheng with Goldman Sachs.

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

Congrats for the very strong results. My question is about the value campaigns you mentioned on the call just now. So since we have been going through this reopening for the past few months and given we see the trend is still quite challenging, so can you share with us what is your thinking about the consumers' spending power and strategies on the product mix?

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