Yum China Holdings, Inc. Q4 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to Yum China Fourth Quarter and Fiscal Year 2020 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Ms. Debbie Ding. Thank you. Please go ahead.

Thank you, Operator. Hello, everyone, and thank you for joining Yum China's Fourth Quarter 2020 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 contains 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 the non-GAAP and GAAP measures is included in our earnings release. Today's call includes 3 sections. First, Joey will highlight our accomplishments over this past year and review our strategy and key priorities. Andy will review our financial performance and outlook in greater detail. Finally, we'll 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, our CEO.

Thank you, Debbie. Hello, everyone, and thank you for joining us today. I hope you and your families are safe and healthy no matter where you are. First, I want to acknowledge the great work of our 400,000-plus employees and express my heartfelt appreciation. With their dedication, productivity, and tireless effort, we have been navigating the difficult times and effectively managing our business. Looking back at the past year, we put the health and safety of our employees and customers as our #1 priority. Our team kept most of the stores open, even at the peak of the outbreak. Our execution capabilities and agility helped us overcome many challenges. We captured off-premises consumption opportunities and drove recovery in dining volume. Sales and traffic recovered sequentially since the first quarter. Our operating profit remained solid and grew double-digit year-over-year in the second half. This is the result of strong execution and efficiency improvement. KFC remained resilient. We accelerated store expansion with attractive returns and maintained solid profitability. We made remarkable progress in strengthening the fundamentals of Pizza Hut across all aspects that is reflected in the sales and margin improvement. Going forward, we will continue to fortify the resilience of Pizza Hut's business model. At the core of all these is our ability to innovate. KFC's premium Wagyu Beef Burger resonates well with consumers and was sold out within days, and their sweet pumpkin congee is the perfect item for the winter. Portuguese Chicken Curry at Pizza Hut became an instant hit on the delivery menu. We demonstrate our commitment to be a responsible corporate citizen. The pandemic reinforced our determination to look after our employees. We extended our Family Care coverage designed for our restaurant managers to 13,000 restaurant management team and supervisors and their families. Our efforts are recognized in the industry. For the third consecutive year, we were certified as a Top Employer in China and included in the Bloomberg Gender Equality Index. We were also recognized for our commitment to sustainability and we were named an industry leader in the 2020 Dow Jones Sustainability Index. Let's move on to growth strategy. Despite the challenges, we are optimistic about the future opportunities in China. We have been staying close with our long-term strategy, centering around three key growth initiatives. Let me give you some updates on our latest thinking. First, store growth. We opened 1,165 new stores in 2020, marking the highest number of new store openings in the 33-year history of operating in China. This is equivalent to opening one new store every 8 hours. Our new stores' payback remains healthy at approximately 2 years for KFC and 3 to 4 years for Pizza Hut. We intend to sustain this store-building momentum into 2021 and beyond and reach the next 10,000 stores much faster than the first. There's still plenty of white space in which we can expand. We are tracking over 700 cities in which we have no presence in China. To penetrate new markets, KFC is piloting a small-town model designed for the needs of Tier 6 cities or below. This model has localized manuals, store layouts, and operating models that require less CapEx. We are encouraged by the initial results of these pilot stores, and we will open more small-town model stores in 2021 in KFC. In more established cities, we will increase store density with our multiple store formats as the mix of off-premise occasions continues to increase. We have further reduced the average store size and CapEx per new store. One example is Pizza Hut's hub-and-spoke model, which we introduced in 2019 Investor Day. I'm excited to report that with nearly 50 hub-and-spoke stores at the end of 2020, the results are very promising. We will roll out more of these stores and other small store formats and assess our store models to evolving consumer needs. To create an even stronger foundation to accelerate expansion, we are stepping up investment in our infrastructure. More details will be provided by Andy later on. Second, portfolio growth. While KFC and Pizza Hut remain our key growth drivers, we are also leveraging Yum China's resources, execution capabilities, and learnings to develop our emerging brands. Regarding our brewing in coffee, we now have 3 distinct brands with clear segmentation and strategies. We are committed to accelerating the expansion of our coffee business and make a meaningful impact in China. K-Coffee fulfills that daily ritual with good quality coffee at affordable prices at over 7,000 KFC restaurants in China. 140 million cups of K-Coffee were sold in 2020, making us one of the top 3 players in terms of cups sold. COFFii & JOY has evolved to offer specialty coffee lovers while utilizing an asset-light model. We are working on improving the profitability of C&J and exploring other potential avenues of growth. Meanwhile, Lavazza offers premium coffee in an indulgent atmosphere. We now have 5 beautiful stores in Shanghai, and we are pleased with the initial results. We plan to accelerate openings in 2021 to test different store models, ranging from mini to flagship stores. On the Chinese cuisine market, post-acquisition integration of Huang Ji Huang has progressed well. We have driven synergies in product innovation, franchisee development, and supply chain. Huang Ji Huang sales recovered sequentially and delivered solid profits since acquisition. We will further work on the menu and operations for our Chinese cuisine brand to drive store expansion and growth in the seasoning and packaged food business. The third growth initiative is digital and delivery. The COVID pandemic highlighted the power of digital from member engagement, delivery to operations. Our membership has grown to over 300 million. Member sales now account for 60% of our sales. The privilege subscription program is effective in boosting frequency. We sold 38 million subscriptions in 2020. The average spending of privileged members doubled during their subscriptions. More targeted promotions help us keep marketing expenses down. Delivery has been growing rapidly and even faster during the pandemic and now accounts for 30% of our sales. In 2020, we upgraded our rider platform with AI-enabled zoning, rider routing optimization, and real-time monitoring. In the test market, on-time rate, customer satisfaction, and efficiency have improved. We also test rider sharing between KFC and Pizza Hut in Eastern China. We will expand this initiative into more brands and markets. In 2021 and beyond, we are allocating more CapEx to further strengthen our digital and delivery capabilities. To make our organization more efficient in the long run, we will deploy AI and automation in more of our operations and continue to advance end-to-end digitization from farm to fork. We are committed to driving long-term growth with these 3 growth initiatives. Investments across all 3 are necessary to build our leadership and agility. Let's move on to 2020 Q4. And I would like to make a few comments. First, sales improved sequentially from the third quarter, although the pace of recovery was impacted by the regional outbreak of COVID. October sales benefited from the National Day holiday. The sales in November and December were pressured by increased regional outbreaks. Traffic at transportation hubs remains significantly below the prior year due to reduced travel. Dine-in remained pressured but recovered a bit sequentially. Delivery and takeaway remained popular options and accounted for over 50% of sales. Digital orders increased to 83%. Pizza Hut's tableside mobile ordering has increased in popularity as we enhanced the user interface and now accounts for over 35% of sales, up from just 7% in the prior year period. Operating profit grew to $180 million. Andy will cover the financials in detail in his session. As we look into the first quarter of 2021, we see the resurgence of COVID-19 adversely impacting our business. Nationwide, authorities have tightened preventive measures and advised against travel, large gatherings, and dining out, especially during the Chinese New Year holiday period. Given the current situation, we see significant headwinds for the first quarter. Our teams are closely monitoring the situation and leveraging learnings from the past year. Our marketing programs encompass a wide array of compelling offers, targeting both dining and off-premise occasions and different party sizes. We will stay agile to adjust our marketing programs and operations to the evolving situation. Most importantly, we remain confident in the long-term potential of China and stay focused on generating sustainable shareholder returns. With that, I will turn the call over to Andy.

Thank you, Joey, and hello, everyone. I will first address key financials and developments in the fourth quarter, then provide some color on our 2021 outlook. Unless noted otherwise, all percentage changes are done before the effects of foreign exchange. Let me first cover our Q4 financial results. Revenue grew 5% and same-store sales recovered to 96% of the prior year period. The sequential improvement was supported by continuous strength in delivery and takeaway, while dine-in volume gradually recovered. KFC's same-store sales recovered to 96% of the prior year period compared to 94% in Q3. Our transportation and tourist hub sales improved but remained challenging. System sales grew 3% year-over-year, reflecting the contribution of new build acceleration. Pizza Hut same-store sales recovered to 95% of the prior year compared to 93% in Q3. Same-store transaction volume recovered to 98% of the prior year period. Huang Ji Huang and the consolidation of Suzhou KFC contributed to 4% of total sales revenues. We opened 505 stores in Q4, which helped us achieve the record level of new store opening for the year. Restaurant margin was 15.1%, up 2.7% compared to last year. I want to thank our team for their excellent work in driving operational efficiencies and managing costs. Cost of sales was 31%, 1.2% better than last year. This was mainly helped by lower poultry prices and more targeted value promotion at Pizza Hut. Cost of labor was 24.2%, almost flat year-over-year. Wage inflation and increase in rider costs associated with delivery volume increases were largely offset by labor productivity improvement and shortage in part-time workers. Occupancies and others was 29.7%, 1.7% better than last year, mainly attributable to reductions in advertising and savings in other operating costs. We also received around $7 million in rental and government relief, which is expected to phase out in 2021. G&A expenses decreased 9%, mainly due to lower performance-related compensation, timing shift of government incentives, and cost control. Operating profit was $180 million, up 78%, mainly due to restaurant margin improvement. Please keep in mind that some of the factors driving Q4 profit are not expected to recur such as lower advertising costs, performance-related compensation, and one-time relief. Some of the productivity improvements due to labor shortage are also temporary as we intend to increase staffing levels. Our effective tax rate was 28%, net income was $151 million, and adjusted net income was $153 million. Excluding $23 million of net investment gains in Meituan, it was $130 million, up 65% year-over-year. Diluted EPS increased 43% to $0.35. Now let's turn to our outlook for 2021. Heading into the first quarter, a cluster of outbreaks surged, impacting a large swath of the countries, especially in Northern and Northeastern China, Beijing, and Shanghai. Government implemented stricter public health measures across China such as advisory against travel, large gathering, and dining out. Several cities have also been put on citywide quarantine, including Xinjiang, a city of 11 million people. We anticipate significant headwinds for the first quarter. Our transportation and tourist locations, representing high single-digit of sales, will likely be more significantly impacted. Government statistics show that the number of travelers was down over 70% in the first few days of the Chinese New Year travel this year, which started in late January. Overall, dining traffic has been affected. We expect trading during the important Chinese New Year holiday period to be subdued, with sales impacted by substantially less travel, smaller gatherings, and generally reduced social activities. Sales in lower-tier cities, which represent over half of our sales, will also be impacted as fewer people will return to their hometowns for Chinese New Year. As KFC has a higher percentage mix of stores in lower-tier cities and transportation hubs, it will be disproportionately impacted. So Q1 will be all hands on deck. In response to the headwinds, we have stepped up our value campaigns and tailored our marketing candidates according to city tiers and trade zones. We have also adjusted our operations and delivery resources to capture shifting dine-in and off-premise demand. We will endeavor to do everything we can to mitigate the headwinds. Please also keep in mind that January and the first quarter will be a tough comparison. Last year, COVID-related lockdowns started only in late January. On a year-over-year basis, last year's sales benefited from strong first 3 weeks leading into Chinese New Year. We anticipate the recovery will remain nonlinear and uneven, influenced by regional outbreaks, reduced travel, and lingering effects on consumer behavior. In 2021, margins will remain subdued compared to pre-COVID levels as we face several headwinds. We expect full recovery of sales to pre-COVID levels to take some time. Compelling value campaigns to drive traffic will continue to be our focus. We expect 2-year wage increases since 2019 to be high single-digit, including 3% in 2020 and mid-single-digit in 2021. We are stepping up our efforts in sustainability. In light of the latest regulations in China, we are replacing plastic packaging with more eco-friendly materials. It's expected to increase our cost of sales by over $30 million in 2021. On a year-over-year basis, we are lapping over $100 million of COVID-related government and rental relief in 2020, which is mostly phased out now. On the pricing side, our commodity prices are expected to decline by low to mid-single digits, mainly driven by lower poultry prices. Since we usually lock our poultry contracts one quarter in advance, prices may still fluctuate throughout the year. We will build on our momentum in 2020 and target to open approximately 1,000 new stores in 2021. We will step up investment in digital, logistics, and other operational infrastructures to support accelerated growth. Total CapEx in 2021 will increase to approximately $600 million. This investment will impact profitability in the near term but will yield benefits in the long term. With that, let me cover our capital allocation framework. With over $4.3 billion in cash and short-term investments and strong cash flows, perhaps as much as $8 billion of capital will be deployed over the next 5 years. As we think about our long-term capital allocation, our key goals are to deploy capital efficiently, to accelerate growth, and to create long-term value for our shareholders. Now before I outline the use of cash, I want to emphasize that we will continue to run a prudent financial strategy, ensuring sufficient cash on hand for working capital and sufficient reserves to deal with potential contingencies. Organic growth remains the most important driver for our long-term strategy. As Joey mentioned, we aim to achieve the 20,000-store milestone much faster than the first 10,000-store milestone. We will prioritize our capital to support organic growth. Hence, we will more than double our CapEx over the next few years. A majority of our CapEx will be used for accelerating store network expansion and store remodeling for our core brands, KFC and Pizza Hut, growing them while keeping them fresh. We also plan to invest several hundred million dollars in our emerging brands, especially the coffee business, building them into meaningful scale and a mature part of our business mix. While expanding the network of physical stores is an important growth driver, enhancing our digital and delivery capabilities and logistics infrastructure is equally important to our future success. We efficiently and adequately support a network of 20,000 stores, which would require a bigger, more robust, and more agile digital and physical capabilities and infrastructure. In addition, we would also like to see greater digitization, automation, and intelligence across our operations. So we have earmarked over $1 billion investment to advance our end-to-end digitization program, including digitizing our stores, marketing, supply chain, and back-office operations. Roughly another $1 billion has also been earmarked to expand our logistic infrastructure to enhance automation capabilities to drive efficiencies. The rest of the capital will be allocated for shareholder returns and M&A. We resumed cash dividends in the fourth quarter and have returned $1.2 billion to shareholders since the spin-off. In the future, we expect steady returns to shareholders in line with our profit growth. We will also maintain a disciplined approach to M&A and investments while exploring opportunities to invest in brands with excellent growth potential, to acquire new capabilities and technologies, and to build and support our ecosystem. We believe this approach to capital planning will drive long-term shareholder returns. All in all, we are encouraged by the solid financial results we delivered in 2020. We will continue to invest for the long term. I'm confident that we are on the right path to emerge from the COVID pandemic, stronger and better prepared for future growth. With that, I will pass you back to Debbie to start the Q&A.

Thanks, Andy. We will now open the call for questions. Operator, please start the Q&A.

Our first question comes from the line of Xiaopo Wei.

Joey, Andy, my question will be regarding the Chinese New Year. As Joey, you mentioned that there are a very challenging environment in the first quarter, but we know that Yum China and yourself are so good at handling the challenges as we can see last year. So after learning a lot of experience in coping with the COVID situation in 2020, how could you do differently and make your business more flexible to capture any emerging demand while protecting yourself on the downside in terms of the business in the upcoming Chinese New Year? Any color would be highly appreciated.

Thank you, Xiaopo. The first quarter is expected to be challenging, primarily due to the Chinese New Year. We foresee significant obstacles, and recovery may take some time as the situation is dynamic. There are three key trends to note. First, there has been a rise in cluster outbreaks, leading to stricter preventive health measures and recommendations against travel, large gatherings, and dining out. Second, both travel and social activities have sharply declined, with travel volume already showing a significant drop. Third, sales in lower-tier cities, which account for over 50% of our KFC sales, particularly for larger orders, are expected to decrease. Additionally, we anticipate more competitors will remain open during the Chinese New Year compared to 2020. KFC is somewhat more affected than Pizza Hut due to a higher proportion of sales from lower-tier cities and transportation locations. The critical question then is how we will address these challenges. We will leverage our experiences from 2020, with the primary focus being the safety of our employees and customers. On that basis, we aim to remain nimble and agile. We are closely monitoring the situation, with two main strategies to maintain our flexibility. First, we will enhance our value campaign and align all our digital and delivery resources, including our membership program, in preparation for the Chinese New Year. Second, we will adjust our marketing efforts based on city tier, trade zone, party size, and location. Compared to our 2020 approach, we have developed multiple scenario plans to help us be more agile this year. Last year, we had to react quickly to changing circumstances, and our team performed exceptionally well. This year, with improved scenario planning, we believe our team will be able to respond promptly to the evolving COVID situation. Thank you, Xiaopo.

Yes, a quick follow-up on the new store. You did a great job in 4Q opening many stores, but if you look at the result, actually, we didn't see that a new store really dragged down the restaurant margin. So looking forward, shall we say that a new store will be the key driver for the growth without compromising our margin on a sustainable basis?

Thank you, Xiaopo. Quick answer as well. When we open stores, as you guys know us already, we have a rough idea how many stores we want to open, but the most important decision is whether this is a good store or not. So if we see an opportunity to open a store, we'll open more or less depending on the quality. So we always keep our quality, and as you can see, we still are opening more stores in lower-tier cities. Our quality control continues there. So it's always the disciplined approach that we have been following and will continue to pursue. Thank you.

Our next question comes from the line of Lina Yan from HSBC.

Thank you to the management team for the presentation and congratulations on the excellent results. My question pertains to the store openings. We've witnessed high-quality store openings in the fourth quarter, but I also want to point out that typically, there will be increased remodeling in that period. As Xiaopo mentioned, new stores may not significantly impact profitability. Therefore, I'm curious about the sustainability of what we've observed in the fourth quarter. Additionally, when we consider the potential for store openings to exceed expectations, will this also translate into a greater contribution to total revenue and enhanced profit growth?

Thank you for your question, Lina. I would like to discuss the store opening pace first. We are pleased to report that we opened 505 stores in the fourth quarter. However, I want to remind everyone that while this number is higher than we anticipated, we previously indicated that store openings would be more concentrated towards the back end due to the impact of COVID. With some easing in conditions last fall and winter, our development team accelerated the pace to capitalize on that opportunity and opened as many stores as they could. We also aimed to schedule some store openings earlier in the fourth quarter in anticipation of the Chinese New Year holiday. We expect to open 1,000 stores this year, which represents a significant pace, considering we currently have just over 10,000 stores. This would mean almost 10% new stores added. For perspective, last year we opened about one store every eight hours, a notably fast rate. While we plan to maintain a rapid pace, it's unlikely we can sustain opening more than 500 stores every quarter in the near term. We have strategies in place for expanding our store network and will allocate resources accordingly. Regarding new stores, as Joey mentioned, we maintain a disciplined approach to store openings. KFC has a strong payback period of 2 to 3 years, which has remained consistent. Pizza Hut has a payback period of around 3 to 5 years, also with solid returns. We have strong incentives to open as many stores as possible while adhering to our disciplined strategy to ensure appropriate financial returns. Furthermore, this accelerated pace of openings reflects our confidence in the Chinese market and the potential opportunities available. We encourage investors to consider overall system sales rather than solely focusing on same-store sales growth, as China remains a growth market.

Our next question comes from the line of Michelle Cheng from Goldman Sachs.

Joey, Andy, congratulations on the good results. My question is about Pizza Hut. It's clear that last year, even with the significant lab expression, we saw strong margin improvement. Additionally, in the fourth quarter, we opened a new Pizza Hut store. Could you share with us, after two years of our revitalization plan, what our new focus will be in 2021 and whether we can expect to see an improving trend in same-store sales as well as further market growth?

Thank you, Michelle. For Pizza Hut, we have followed through on our commitment to prioritize sales first and profits later in our turnaround process. Our operating profit in the second half more than doubled compared to last year. Recently, our focus has been on strengthening the core aspects of the business, which we believe will yield long-term benefits. Moving forward, we will continue to enhance these key areas to solidify the changes implemented over the past few years and to establish Pizza Hut as a robust business model. This is essential since we have already developed a strong KFC business, and after our dedicated efforts, we expect Pizza Hut to become resilient as well. To highlight our focus, I want to mention three key initiatives we have pursued over the past three years and will maintain in the future. First, we launched a new menu in late Q2, with 75% of the items being new or improved from two years ago. Food quality is incredibly important, and one example is our Portuguese Chicken Curry, which is both innovative and delicious, and we aim to keep driving such innovations. Second, we experienced double-digit growth in off-premise dining options, including delivery and takeaway, addressing concerns about our dine-in business. The current sales mix is much healthier, with over 40% coming from these channels, enhancing the resilience of our overall business. Third, our digital ordering capabilities are crucial in the restaurant industry today. Connecting our online and offline operations boosts efficiency and improves customer service. For instance, the proportion of tableside orders placed digitally rose to 37% in Q4, up from just 5% in 2019, after we began focusing on this in 2018. This transition has certainly enhanced customer service and reduced labor costs. Additionally, we introduced ready-to-cook steak and pasta to capitalize on the demand for home dining, a trend that emerged during the pandemic. This growth opportunity has become increasingly apparent, and we are eager to seize it. As a result of all these initiatives, we have seen a positive shift in our customers’ perception of value for money and overall satisfaction with the food, service, and dining environment. Therefore, the fundamentals are encouraging. As I mentioned earlier, we are concentrating on sales first and profits later. Now that our sales are in a healthy position, we are beginning to see profit improvements, and we aim for continued progress in both areas moving forward.

Our next question comes from the line of Anne Ling from Jefferies.

I have a question regarding CapEx and also in our investment. In the past, now we have around $400 million to $500 million CapEx, and depreciation roughly similar as well. So with the step-up in terms of more store opening and also a step-up in the CapEx of $600 million, does it mean that we will have a disproportionate increase in terms of the depreciation from year 2021 onwards, i.e., EBITDA growth will be higher than that of EBIT growth? And then our $2 billion, $1 billion each investment in digitization and also on the logistics, does that include this $600 million CapEx plan? And how does it roll out? Like for each year, how much will we spend on this part? And how will it impact our P&L?

Thank you, Anne. Regarding our capital expenditures, I would say that historically, our CapEx has been efficient, albeit stretched. Over the last three to five years, we've spent about $450 million on CapEx. We've been expanding our store openings, increasing from around 500 to 600 stores annually to over 1,100 in 2020. This growth shows that we can achieve more with less, thanks to our team's frugal approach to spending and focusing on savings in store development and infrastructure. Our capital allocation plan aims to shift our focus towards growth and long-term efficiency. We'll maintain a disciplined investment strategy for new store openings, while also seeking ways to enhance our market presence, particularly in smaller cities where we currently have no KFC or Pizza Hut locations. We're aware of several hundred potential new locations for KFC and around 1,000 for Pizza Hut, presenting significant opportunities ahead. In cities where we already operate, we plan to increase store density and invest in locations well-suited for delivery and takeaway, with most of our CapEx directed towards accelerating store expansion for KFC and Pizza Hut. Looking ahead, we're also keen on growing our emerging brands, particularly coffee, which we want to scale up and make a substantial part of our business, requiring further investment. As we grow these new branches, you may notice some initial impacts on costs and expenses due to the investment needed to establish new brands. Additionally, our digital initiatives will represent a significant $1 billion investment over the coming years, which is crucial for transforming our operations. We've been adapting to this transformation for several years and will now accelerate the deployment of new technologies across our operations. This includes increasing automation in our restaurants and supply chain, as well as utilizing more intelligent data analysis for marketing and operational efficiency. If we reflect on the past, capital expenditures were mostly focused on store openings, but now we must invest substantially in digital capabilities and infrastructure to support our extensive network of stores. This means reallocating capital towards technology rather than solely labor. Despite having a relatively stable workforce of 400,000 to 500,000 employees, our infrastructure investments have enabled us to manage more stores effectively. Both store expansion and digital investment are critical for our future success. In the near term, as we ramp up our initiatives, we plan to double our CapEx spending, which will affect depreciation. However, I believe that in the long run, we will see benefits in productivity and sales, leading to a great return on our investment. I hope this answers your question, Anne.

I just had one little point to add for Anne. Over the last few years, we look at these savings in terms of efficiency from automation and technology investment. Just think about it. In 2015, we had roughly about 7,000-plus stores. In 2020, we have 10,000 stores. Our number of employees actually still stayed at a number of 400,000 plus. So that gives you a sense of the achievement in the last 5 years. And hopefully, that gives you a sense of what kind of potential achievement we would like to achieve with the further investment in digital delivery and supply chain infrastructure. Because before opening the stores, we need to get the infrastructure in place in order to enable the acceleration of store expansion. Otherwise, if the infrastructure is just catching up to the store expansion, then we are dragging our feet totally, well, if I could describe it that way, if that makes sense.

Right. And also I want to give you one more anecdotal evidence of how digital and infrastructure investment is and how that helps us to actually be more productive and keep costs down. You think about our membership program. We developed that and invested in that over the past couple of years. Our whole digital CRM program will help us to keep our A&P lower compared to our revenue growth. And that's all possible because we have the ability to reach our customers and effectively utilize that technology. So you may see costs increasing as part of the P&L, but hopefully, in the long run, you see also improvement on the other side. And again, as we mentioned, if you think about China today, over the long term, you'll see more labor shortages as the population ages. So it's very important for us to stay one head of – one step ahead of the game and anticipate that and invest in productivities, in technology, and infrastructure.

Our next question comes from the line of Chen Luo from Bank of America.

Joey and Andy, so I would apologize if my question has been addressed by previous speakers as my line was disconnected in the middle of the call. So I'm more interested in the food and paper cost side. We understand that the chicken cost is coming down pretty dramatically these days. Meanwhile, we are also stepping up our value initiatives. During our recent checks, we also noticed that we possibly have actually raised price a little bit for KFC at the beginning of the year. So we guess this should be more than enough to offset the costs associated with our eco-friendly initiatives. So given all these kind of moving pieces, is it fair to say that food and paper cost is now going to be a major concern for 2021?

Thank you, Chen Luo. The cost of poultry has decreased over the past few months, and we secured a contract a month in advance, which should provide a short-term benefit for our sales costs. However, as you've pointed out, we are facing several challenges in the first quarter. We're experiencing significantly lower traffic at transportation hubs, particularly in the CMI sectors, along with reduced social gatherings and fewer activities. These factors will affect our sales in the first quarter. At this stage of recovery, it's crucial for us to focus on delivering value to consumers, and you can expect us to enhance our value campaigns, especially during the earlier part of the first quarter. Traditionally, we don't emphasize value campaigns during the Chinese New Year, but this year, we plan to increase our efforts. Additionally, our sustainable initiative this year is expected to cost around $30 million for the full year, as we transition from plastic to eco-friendly packaging materials. This is part of our ongoing commitment to ESG, and we anticipate introducing more initiatives in the future. Overall, despite these challenges, we remain focused on managing commodity prices.

I would like to just add the philosophical comment on food costs. Our Yum China employees all know that we believe in saving all the costs we could save, particularly the G&A, hotel, mail, whatever. So we don't save on the food cost for customers. It's our sincerity and our belief that we shall serve the best food we could to the customers. If we do get some savings from the commodity costs, we will actually reinvest that saving, a big part of the saving, to treat our customers better as well. And we believe that is the right thing to do in the short term and in the long term.

Thank you, Joey and Andy. I have a quick follow-up question. I understand we are facing several challenges heading into Q1. However, we should remember that last February and March were particularly weak due to a nationwide lockdown that lasted nearly two months. The government is currently implementing some measures. Looking ahead to February and March, I believe the situation will improve significantly. Therefore, it seems reasonable to expect a year-on-year recovery in Q1, although it might be challenging to reach the levels we experienced in Q1 of 2019. Would you agree with that assessment?

Chen Luo, I appreciate the challenge of projecting the first quarter. Internally, we also recognize that many factors are in flux. I want to stress that this year, the number of infected cases will remain just above 1,000. However, this does not imply any relaxation of preemptive measures; rather, the opposite is true. Lessons learned from last year have made government authorities and consumers more cautious, leading to increased preventive actions. For instance, during the Chinese New Year, the government has advised against new travel and encouraged people to stay in their cities to celebrate. We are seeing fluctuating traffic, with air travel down by more than 70% in the initial days of this significant period. Traditionally, the Chinese New Year has been crucial to our business, particularly for KFC, which typically sees a significant portion of its sales during this time, especially from transportation hubs and tourist spots, which will be heavily affected. Furthermore, the trading environment is becoming more complicated. Typically, when people return home for the celebrations, we see a sales increase, particularly in lower-tier cities. However, given that many are remaining in urban areas, this situation will be different this year. This change is likely to have a more pronounced effect on KFC due to our presence in these lower-tier cities and transportation hubs. Additionally, looking back to last year, we started January with strong momentum, but that changed later in the month. This year, we won’t benefit from that uplift. While KFC rebounded strongly in March and later in 2020, it was largely due to our ability to keep stores open and ensure the safety of both employees and customers, along with a significant increase in our delivery business, even in closed store locations like hospitals. Currently, most of our stores are open and only a few are closed due to impacts today, which will pose challenges in terms of capacity. In summary, we want to communicate both in our prepared statements and earnings release, to give a clearer understanding to those outside China, in Hong Kong, the U.S., and Europe. Even as reported cases may be lower, the strict COVID measures and their effects on consumer behavior have not diminished. The complexities surrounding the Chinese New Year further complicate modeling, but we aim to provide insights into what to expect in the first quarter.

Luo summarized the key details from last year's Q1 as Andy described. Despite same-store sales being down 11% in Q1 last year, which was quite reasonable considering the pandemic, total customer count decreased by 30%. However, our initiatives, particularly as people returned to work while many of our stores remained open, helped us tremendously. We concentrated on high-ticket deliverable items, leading to a 27% increase in transaction average. As a result, while total customer count dropped by 30%, the transaction average rose by 27%, which supported the same-store sales for last year's Q1. It will be challenging to replicate this benefit from increased transaction averages this year.

And actually, I took a train from Shanghai to Guangzhou last week. So I can understand how empty rail stations are at the moment and all the challenges that you are facing. And we really appreciate all the high efforts that you are making to sustain the business. Good luck. Thank you.

Thank you.

Thank you, Chen Luo. We try to be straightforward and present the forward picture here in the following quarter.

Our next question comes from the line of Lillian Lou from Morgan Stanley.

And most of my questions have been answered. I have a simple follow-up question because, Joey, at the beginning you mentioned this year and then going forward in the next couple of years, multi-format stores are going to be a focus. Just trying to understand the economics of the small format, i.e., the small town product. The unit sales space, how much lower per unit sales versus our previous average? Because I understand if we look at the unit store sales, pre-COVID-19 level is about USD 1.1 million per year per store. And just trying to get some picture of how lower it could be when we get more new stores in the smaller format.

Thank you, Lillian. I have two quick comments. First, as Yum China experiences significant growth, we consistently face the challenge of balancing system sales with same-store sales growth. It’s crucial for us to drive system sales, especially as we open new stores, but this can create pressure on same-store sales growth as well. We must aim to achieve both system sales and same-store sales growth effectively. Smaller stores generate less revenue, but we can open more of them, while their profitability is similar to that of larger stores. This is an important aspect. Overall, our system sales improve as we open more smaller stores. Historically, we’ve utilized various store formats, both large and small, based on location. Currently, as we expand into Tier 6 cities and below, we are opening even smaller stores with lower capital expenditure, yet the returns remain comparable.

I wanted to add to what Joey said. With the smaller store format, we expect the sales throughput to be less. However, our disciplined approach gives us confidence that profitability and return on investment will remain on par. We appreciate the small store concept to expand into lower-tier cities, and we are also working on smaller stores focused on delivery and takeaway, especially in urban areas. It's crucial to understand that delivery and takeaway benefit from a network effect. The closer and denser your network, the better your customer service and delivery speed. This also leads to increased sales because people are more likely to opt for takeaway if it’s within a short distance. We've been developing this strategy over the past couple of years, and the change in consumer behavior due to the COVID-19 pandemic has further accelerated this trend. We plan to continue developing this approach, and I hope that answers your question.

Our next question comes from the line of Sijie Lin from CICC.

Thank you, management, for taking my questions. And congratulations on the strong results for Q4.

Sorry, Sijie. We have very hard time to hear you. Would you mind to speak up a little bit, please?

Sure. And I have one question on margin. KFC's margin still recorded a year-over-year decline in Q3, but recorded a significant year-over-year increase in Q4. So I wonder what's the reason behind it? And will this continue into next few quarters?

Thank you, Sijie. In our margins, there were factors in the fourth quarter that we did not expect to occur again, such as some government and rental relief. Additionally, we're seeing some timing shifts in capital incentives that probably won't happen next year, especially related to COVID. On a positive note, our labor improvements have been strong, although part of that is due to labor shortages and part-time workers, which is likely a temporary situation. As we increase staffing levels, this may ease somewhat. Overall, our team has done a great job controlling costs, and some of these cost controls will carry into next year. Regarding commodity prices, they eased a bit in the fourth quarter, helping our costs of sales even as we ramped up promotional activities. In summary, while some cost savings and margin improvements due to productivity enhancements may carry forward next year, others will likely be more temporary. The focus for 2021 will be on driving sales and traffic recovery, which means we should anticipate higher costs related to sales promotions and an increase in advertising spending. Given that this two-year period has been affected by COVID-19, our same-store growth hasn't been as strong as in previous years. The increase in wage costs will be realized over two years. Therefore, we caution that in 2021, margins will still be subdued compared to pre-COVID levels, and we have a way to go before sales fully recover to pre-COVID levels. This is why we remain cautious about margins despite productivity improvements and the easing of commodity prices.

Our next question comes from the line of Terrance Liu from CLSA.

Okay. So I'm just curious about your statement on your coffee business. Because based on our understanding previously, I think you have been talking about refining the business model and I think store format for your coffee business, especially as to COFFii & JOY. So I think Andy just mentioned a couple of times that you will accelerate the expansion of your coffee business in the next couple of years to scale up to a meaningful scale. So I'm wondering, does this mean that you are redefining the current business model or the store format? Or you have redefined from the replicable model for your COFFii & JOY business going forward? So could you just elaborate more about your strategy as to your coffee business for the next 3 to 5 years, especially in terms of the store openings and its sales contribution? So anything you can share with us is highly appreciated.

Thank you, Terrance. Let's discuss C&J briefly before moving on to Lavazza. Currently, we have around 50 stores and are refining our business model. Our main focus is on solidifying the fundamentals. For instance, we are developing a daypart strategy, enhancing delivery, and improving store economics. In the fourth quarter of 2020, the delivery segment accounted for 30% of C&J's sales, significantly up from the previous year. The improvement is tied to system availability and food offerings. Additionally, we're expanding our B2B business through a three-year partnership to supply coffee to offices. This collaboration presents opportunities at 100 locations, and we will continue to explore it. Our growth potential lies in both store expansion and enhancing store economics. With 50 stores, we have a certain scale that allows us to focus on economics, which is challenging with only a few locations. Now, moving on to Lavazza. We currently have five stores in Shanghai, but we're seeing rapid improvements in economics. The brand is well-received by customers. Thanks to the technology and fundamentals we established at C&J, Lavazza's delivery segment has also benefited. Despite having only five stores, delivery accounts for a quarter of Lavazza's sales. We're enhancing our CRM and have already started refining the economics. For 2021, we plan to accelerate store openings for Lavazza and expand beyond Shanghai this year. I will pause here for now.

I'll add a couple of things. I think as Joey mentioned, we see the fundamentals at C&J is improving. So if you look at the stores over more than a year, I think they have returned to positive same-store sales growth in late 2020. And then with better sales and better mix of products, we also see more stores going to breakeven. So that's, I think, overall, a positive trend there. For Lavazza, it's obviously a very new initiative, but I think what we can say is that the reaction from consumers and their initial sales numbers were better than what we have initially forecast. So it's still early in the game for coffee for us, but we're very confident. And more importantly, I think we internally have decided coffee is a very important category for us in the longer term, and we'll invest what's needed to make it successful and material and an important part of our business going forward.

I would now like to hand back the conference to today's speakers. Please continue.

Thank you for joining the call today. We look forward to speaking with you on the next earnings call. That concludes today's call. And have a great day.

Thank you.

Thank you, everyone.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.