Yum China Holdings, Inc. Q1 FY2022 Earnings Call

Thank you, Tara. Hello, everyone. Thank you for joining Yum China's First Quarter 2020 Earnings Conference Call. Joining us on today's call are our CEO, Ms. Joey Wat; and our CFO, Mr. Andy Yeung. Due to the current COVID restrictions in Shanghai, we are dialing in from different locations today. If we experience a technical difficulty during the call, please remain on the line as we reconnect. 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 in the first quarter. 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 Joey Wat, CEO of Yum China. Joey?

Thank you, Florence. Hello, everyone, and thank you for joining us today. We are battling the most severe outbreak of COVID-19 since it first emerged 2 years ago. The challenges we face are unprecedented. The case count, duration, geographical coverage, and restrictive measures are far more extensive than previous outbreaks. Shanghai, Tianjin, Jilin, and Guangzhou were among the places to experience extended periods of lockdown. Shanghai, one of the most impacted cities, has been locked down for more than a month now. Our operational headquarters in Shanghai are all working remotely. Hundreds of millions of people across China are currently under some level of restrictions. Even regions with new cases have tightened containment measures, in line with the dynamic zero-COVID policy. Compared to 2020, it's far more complex to keep our stores open, get our employees to work, and obtain necessary approvals. Our store operations, delivery, and supply chain have been heavily impacted due to ever-changing restrictions. I want to thank our frontline employees at restaurants and logistics centers, our delivery riders, and our staff at the back office for working tirelessly during this difficult time. I'm extremely proud to see how quickly we adapt to each new challenge and how teams from across the company support one another. From procurement, logistics, IT, HR to public affairs, we work as one team. Our mission is to serve the community and customers in need to the best of our ability. Hundreds of our back-office staff have risen to the occasion. They volunteered to serve at the frontline, supporting our restaurants. They performed health checks at restaurants, delivered food using their own cars, and served as customer service representatives. Soon after the lockdown in Shanghai started, where most business activities have come to a halt, we became one of the few and first authorized food suppliers to serve the communities. While we can only offer limited services, we are prioritizing food and drinks to frontline workers, volunteers, and mixed shift hospitals. We also provide ready-to-eat products to the elderly living alone and KFC to children in quarantine centers. During the lockdown, the demand for KFC and Pizza Hut products surged. Many of our customers went on social media like WeChat and Bing, equivalent of TikTok in China, expressing their longing for our signature products. Many of them also shared their happy moments on social media when they enjoy the KFC fried chicken or Pizza Hut pizza. I'm glad we could bring some comfort and joy to our customers in trying times like this. It also gives us energy and a renewed sense of purpose. Program wellness of our employees is always our top priority. We delivered over 10,000 food packages to closed-off employees. We also provide packages with essential supplies and upgrade medical plans for those who are infected. Our ability to accept the dynamic operating environment is at the core of our resiliency. With valuable learnings from prior outbreaks, we have developed extensive scenario planning and toolkits to deal with different situations. Nationwide, we quickly adjusted marketing campaigns and simplified menus to streamline operations. Our hybrid delivery model with dedicated riders allowed us to maintain adequate rider capacity and continue operations in most places. Delivery grew at double digits, reaching 36% of company sales. Seizing the demand for home consumption, we promoted new retail packaged products, such as steak, pasta, and fried rice. New retail sales in the first quarter more than doubled compared to the prior year period. The surge of Omicron cases and ensuing lockdown have turned everything upside down for us in Shanghai. Despite the citywide lockdown, we were able to keep about 10% to 15% of our stores open for delivery or takeaway in April. To serve as many communities as possible when mobility is heavily restricted, we introduced community purchasing across all brands as early as mid-March. This is a new way to group orders among residents to maximize efficiency, focusing on key menu categories by offering only a few preset combos. We also promoted new retail packaged foods, which are perfect items, ready-to-eat and easy to store under these circumstances. The retail sales mix in April surged to over 15% in Shanghai. By swiftly implementing these initiatives, we were able to generate 40% to 50% of pre-lockdown levels of sales in Shanghai despite having very limited stores offering off-premises services only. In other words, 10% to 15% of our stores generated 40% to 50% of our pre-lockdown sales in Shanghai. Community purchasing creates new business opportunities for our brand. KFC optimized its community purchasing menu to just one item, the fried chicken combo, as it is one of the most desired food items during lockdown. Our customers share their appreciation on social media, quoting that having KFC fried chicken is the happiest moment in the last month, and our fried chicken is a comfort food and nourishment for the soul. People are craving KFC, and we are working our best to fulfill their needs. We also look forward to serving customers at our restaurant when they come to satisfy their craving after the lockdown. Pizza Hut was one of the few players to offer hot pizza during this time. To meet the demand, we simplified the menu to combos with 2 pieces: fried rice and ready-to-cook steak and pasta. Our customers were so excited to receive high-quality, well-packaged, and safe products during the lockdown. Community purchasing presented fantastic cross-selling opportunities and increased brand awareness for our emerging brands. These brands captured a significant portion of sales compared to the level before lockdown with signature products and packaged food offerings, even when only a few stores were opened in Shanghai. For example, Lavazza served packaged cheese and ham in addition to its famous coffee and pastries. Taco Bell served Hawker, Fried Chicken, and Burritos DIY packages. Little Sheep offered takeaway Hoppa with meats and fresh vegetables, highly sought after items during lockdown. Let's move on to supply chain and digital. Our industry-leading supply chain and digital capability are critical business enablers to fulfill ever-changing demand. Our in-house supply chain team works wonders in difficult situations like this. We quickly introduced strategic redundancy in our supply chain with backups in different logistics centers to lessen the impact of supply chain disruptions and to allow us to continue operations. We immediately designed a 200-kilometer detour route to ensure supply to logistics centers in Eastern China. Instead of just using trucks, we moved inventories by rail and sea freight as well. In just a few days, we set up a temporary drop-off and pickup site not far from Shanghai to support the region under lockdown. We also repurposed ingredients from one product to another and reallocated inventory across restaurants and even brands to fully utilize our resources and minimize wastage. Digital enables us to put innovative ideas into action. Since March, we cut back on advertising. We leveraged our membership program and our own channels to digitally engage our customers. We rapidly launched a digital mini program to make community purchasing easier. Our digital infrastructure provides real-time visibility to store inventory, allowing us to precisely forecast material demand, manage supply chain routes and minimize wastage.

Ladies and gentlemen, it appears that Joey has dropped from the call. Please stand by while she reconnects the line.

Hello. The line just dropped, and I just called back. Can you hear me?

Yes, Joey. Please go ahead.

Yes. I hope by now, you have a better picture of the challenges that we face and even in situations like this how we find ways to serve our customers and communities. This is the third year of the COVID pandemic, so it is understandable that pandemic fatigue may be settling in. I'm very proud of our team members. They have been courageous and continue to maintain a positive attitude in the face of adversity. The pandemic will surely pass, and our business will recover. As we look ahead, I'm confident that as long as we focus on new opportunities, remain agile in our actions, and control our cost structure, we can get through this challenging time and become even stronger. We remain confident in the long-term prospects in China. We will continue to invest and focus on our RGM strategy so we can fortify our market leadership and capture the significant growth opportunities across our brands. Before I pass to Andy, let me say a few words about changes in our leadership team. I'm pleased that Jonathan Huang, previously the General Manager of KFC, is now our first Chief Customer Officer. This strategic move will better integrate customer centricity into a brand-driven culture. Jonathan will focus on building capabilities to better understand and serve customers. He will be the head across functional initiatives, including cross-brand customer loyalty programs and delivery initiatives. He will also oversee COFFii, JOY, Lavazza, and Taco Bell. With Jonathan's strong technology background and deep understanding of the organization, I'm confident that he's the best leader for this role. Warton Wang, our Chief Development Officer, sees Jonathan as the new KFC GM. Warton joined KFC as an operations management trainee 24 years ago and worked his way up. He led various initiatives to improve KFC's business operations and innovate performance and business models. I believe that Warton's strong leadership and deep operations experience will bring KFC to new heights. Warton's achievement as a homegrown leader will also inspire our entire frontline employees. With that, I will turn the call over to Andy. Andy?

Thank you, Joey. And hello, everyone. Now let me share some color on our first quarter performance. Compared to a relatively stable January and February, the COVID situation in March rapidly deteriorated. Large same-store sales declined by more than 20%. As Joey mentioned, our team put in tremendous efforts to sustain operations, mobilize and fully utilize available resources to drive sales and proactively manage costs. We achieved a profitable quarter, demonstrating the resiliency of the business. We continued to grow by opening 329 net new stores and ending the quarter with over 12,000 units. First quarter total revenue grew 4% in reported currency to $2.7 billion. The contribution of new units and the consolidation of Hangzhou KFC was partially offset by the same-store sales decline and temporary store closures. System sales were down 4% in constant currency. Same-store sales were 92% of prior year's level. By brand, KFC same-store sales were 91% of prior year's level with same-store traffic at 86%. Average ticket grew 6%, mainly due to the increase in the delivery mix, which has a higher average ticket than dine-in. Pizza Hut same-store sales were 95% of prior year's level, same-store traffic was at 97%, while average ticket was down by 2%. This was driven by the increased mix of delivery, which has a lower average ticket than dine-in. Restaurant margin was 13.8%, down 490 basis points compared to last year. This was mainly due to managing higher commodity prices and wage inflation as well as higher delivery costs due to increasing delivery volume. Now let me go through each expense line item. Cost of sales was 31.1%, 90 basis points higher than last year. This was mainly due to commodity inflation. We also incurred higher logistics costs and wastage due to the regional outbreaks. Cost of labor was 26.2%, 90 basis points higher than last year. This is due to sales leveraging, rate inflation of 5%, and higher delivery rider costs from the higher delivery mix. Occupancy and others was 28.9%, 110 basis points higher than last year, mainly attributable to the sales leveraging impact and a 10% increase in utility prices. The impact was partially mitigated by proactive savings in advertising expenses. G&A expenses increased 14% year-over-year in constant currency, mainly due to the consolidation of Hangzhou KFC and Lavazza as well as increased compensation and benefit expenses. Operating profit was $191 million. Solid performance in January and February enabled us to achieve a profitable quarter. The net contribution from Hangzhou KFC's consolidation was 5% of operating profit in the quarter. It also includes the amortization of intangible assets acquired, roughly $60 million per quarter that went through the end of this year. Below the operating profit line, we incurred a $30 million mark-to-market net loss on our equity investment this quarter. It was $4 million more than the same period last year. Our effective tax rate was 33.1%. The high tax rate is mainly due to lower pretax income and the Hangzhou KFC consolidation. Prior to consolidation, the aggregate income from JVs was not subject to tax, resulting in a lower tax rate. These factors will likely continue to impact the effective tax rate for the rest of the year. Therefore, we expect the full year effective tax rate to be low to mid-30s. Net income was $100 million. Diluted EPS was $0.23. The mark-to-market loss in Meituan negatively impacted diluted EPS by $0.07. Let's now turn our attention to the outlook for the second quarter of 2022. As the COVID situation deteriorates, we faced even stronger headwinds in the second quarter. Eastern China, the most economically vibrant region in China, is severely impacted this time. Eastern China is also our most important market, accounting for around 30% to 40% of our store mix and sales mix. Apart from Shanghai, many large cities, such as Guangzhou, Suzhou, Tianjin, Shenzhen, and Jilin were also partially locked down in April. Strict proactive measures are in place nationwide, significantly limiting social activities and mobility. For example, during the Labor Day holiday in Beijing, restaurants provided only primary services. Residents are required to provide proof of a negative PCR test to eat at public venues. Consumer spending has also been weak. Non-manufacturing PMI dropped from 48 in March to 42 in April, according to government statistics. This was the lowest and steepest reduction since February 2020. In April, our same-store sales declined more than 20%. In addition, around 3,000 stores were temporarily closed or provided only delivery or takeaway services, significantly more than March. Around half of temporary closures were indeed temporary. As a reminder, stores providing only delivery and takeaway services are included in our same-store sales calculation. Temporary closures are excluded from the same-store sales calculation during the closure period but would negatively impact system sales and revenue. Margins are expected to be pressured further in the second quarter. Significant sales decline is expected due to the worsening COVID outbreak. Sales leveraging impact will be more pronounced, too, as sales and margins are seasonally lower in the second quarter. Furthermore, we continue to face several cost headwinds, including the surge in commodity prices, rates, and utility prices. The increase in delivery sales mix will also increase rider costs. The current situation is very challenging. We incurred a loss in March. Barring a significant improvement in external conditions in May and June, we expect to operate at a loss in the second quarter. We are taking actions to lessen the short-term impact. In addition to what Joey mentioned, we are adjusting our marketing events and promotional activities, temporarily postponing store remodels, negotiating rent relief, optimizing raw material cost structure, and implementing G&A austerity. We quickly deployed various initiatives across the country while staying flexible depending on local conditions. Now looking past the very tough business environment in the near term, our efforts will have a long-term positive impact. We have strengthened our brand equities and bonded with our customers. We have also gained valuable experience and developed toolkits to help us navigate different situations. Our business model is even more agile and resilient than before. We have made important breakthroughs in community purchasing and new retail. We will continue to make constructive and strategic changes to seize market opportunities as they arrive. We're here in China for the long run. Powered by healthy store economics, we are confident to further expand our store network. KFC and Pizza Hut new store linking has healthy store payback at 2 years and 3 years, respectively. The majority of stores opened in 2021 also achieved a monthly breakeven within the first 3 months. While we expect a slower pace of store openings in the second quarter due to COVID, we still intend to achieve our full-year target of 1,000 to 1,200 new units. We will continue with our systematic and disciplined approach and prudently evaluate the situation. Also, I'm pleased to share that we have entered into an agreement with Yum! Brands to join a step-up investment in accelerating Taco Bell's store growth in China. We are committed to expanding the Taco Bell store network to at least 100 stores by the end of this year and at least 225 stores by the end of 2025. In turn, Yum China will have the exclusive right to upgrade the brand in China for 50 years. I'm confident in Taco Bell's long-term potential in China. Now turning to capital allocation. The Board of Directors expanded the authorization of share repurchases by $1 billion in March to an aggregate of $2.4 billion. At the end of the first quarter, our remaining authorization was approximately $1.4 billion. We returned over $280 million to shareholders in cash dividends and share buybacks in the first quarter. We continue to employ a disciplined and balanced capital allocation strategy. As I mentioned before, our priority is to have sufficient cash for daily operations and to deal with contingencies. We will continue to make significant CapEx investments in digital supply chain infrastructure and our store network expansions. We are confident that this investment will widen our strategic moat, drive sustainable growth and capture attractive long-term opportunities in China.

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

Our first question comes from Sijie Lin at CICC.

So I have two questions. The first is about the multiple waves of COVID outbreak, especially the Omicron this year. It's a very difficult situation for market players in the whole restaurant industry. Regarding the impact on industry supply, what's your observation? If there were many closures of mom and pop businesses during the last 2 years, are we seeing more small- and medium-sized chains facing difficulties this year? And my second question is, could you please give us more insight into the promotion strategy at the current stage? What's the difference compared to the last 2 years considering the situation?

Thank you, Sijie. Let me share some thoughts here. First of all, we are very grateful for our own business model. This is Yum China, particularly KFC and Pizza Hut—fantastic business models that we can do well. The timing is good, but it's also proven again and again during challenging times that this is a very resilient business model. So we are very grateful, and we still can capture 40% to 50% of sales in Shanghai with 10% to 15% of stores. In terms of the competitive landscape, it's still a bit difficult to tell, particularly in Shanghai or locked down cities because we are still going through it, but I think this is definitely the time that differentiates companies with solid operating capability and also prudent financial arrangements versus others. Fortunately, I think for Yum China, both our operation and digital capabilities and our prudent financial philosophy helped us through this difficult time. In terms of promotion strategies, we have multiple scenarios. So while the formation-wise, the sales are under pressure, for the cities and provinces that are still operating normally, the business is as usual. We still pursue good products with fantastic values, with promotions. Recently, we just launched the entry-level beef burger priced at CNY 19. For Pizza Hut, we just launched the new menu for the year, which again has a 40% improvement on the menu items. This is still going on, and we still have our famous Crazy Thursday for KFC and Screaming Wednesday for Pizza Hut as value programs. But for cities that are in lockdown such as Shanghai or Guangzhou or Shenzhen, we scale back the promotions because the focus is on maximizing our limited resources to meet customers' unmet needs. Here, we really have unmet needs as only a small percentage of our stores can open, and we also scaled back our menu. As I mentioned earlier, in KFC’s case, we only offer one combo, which is for our chicken. We don't have burgers or fries, just fried chicken with some Pepsi cola. For Pizza Hut, there are just two pieces included, the very famous...

Sorry, ladies and gentlemen, it looks like Joey's line has dropped once again. Please stand by. Thank you, Joey. You're now back on the call. Please continue.

Okay. We can take the next question.

And given all the challenges the operation is facing, could you give us a bit of an update about the trends in Eastern and Southern areas close to the end of April or May, i.e., the latest trend? Especially, I think in Southern China, it seems like the situation is better than the Eastern region. If we talk about the economic importance, both regions are very important. So just give a little bit of color on what the lockdown's impact could be.

Thank you. Andy has mentioned earlier about his thoughts and our thoughts about Q2 and early May trading, so I'm going to comment on the trading patterns. Let me take KFC as an example to help understand the overall big picture. The dine-in sales have dropped significantly, and delivery has come up, and we can understand that. Nationwide, we drove growth through our hybrid delivery model with our own riders. As I mentioned earlier, in Shanghai's case, when we don't have enough riders or our riders are being quarantined, our own back-office staff volunteered to deliver whenever we could if we got the license or approval to go out and deliver. So that’s the dine-in versus delivery. The transportation hubs, as you can imagine, really suffered. The transportation hubs, like the train station, etc. The train right now is about 50% below the pre-COVID level. Non-transportation locations also declined because the decline is nationwide. In terms of weekend versus weekday, weekdays are doing slightly better than weekends since weekends are typically busier. Lower-tier cities are doing slightly better because they are less impacted by the transportation hubs. Higher-tier cities face more impact from the regional outbreaks. Interestingly, despite the outbreak in the southern and eastern parts of China, Eastern China is still doing better in terms of same-store growth. It's a very resilient part of the country, and we are very focused on Eastern China, so this is not bad news. Similar patterns apply to Pizza Hut as well. Regarding logistics and procurement, our team has just been amazing. This is our in-house logistics supply chain, and they stay in logistic modes. Our team has come up with alternative arrangements very quickly. We traditionally used trucks to move goods around, but it has become a bit challenging to move goods across provinces, so we utilized rail to send goods west. We also used sea freight to send goods to different regions. Our logistics center in Shanghai and Kunshan are working in a closed-loop arrangement to keep our logistics running without major disruptions. Because this is our in-house team, we can move supply between stores and brands to minimize wastage. Again, it has proven our investment in supply chain and our digital capability is a very important strategic moat because we have digital visibility of real-time store stocks. With the visibility, we can be a lot more efficient to keep our supplies as much as we could and minimize food wastage, particularly when food is a challenge for Shanghai. So that's where we are. It's not easy. There are a lot of challenges, but we seem to be able to adapt quickly and be as agile as ever. Some of these innovations will help us in the long term as well. Not to mention, beyond logistics and procurement, our innovations in new retail have been remarkable. We have been incubating the new retail business for 2 years now. It's a brand called Soul Fun. By the second week of March, we recognized potential opportunities in new retail with Shanghai having a sort of soft lockdown. Literally within days, we initiated community purchasing across all brands, not only KFC but also Pizza Hut, Lavazza, and Taco Bell, and we do it together. Originally, community purchasing was only a hotline; later on, we implemented a mini app. We also provided ready-to-eat, ready-to-heat, and ready-to-cook products. The packaging allowed us to be more efficient with logistics processes because the new retail packaged food is already better suited for storage and movement in bulk. So I will pause here where we are. With challenges come opportunities because Yum China is very well-positioned to capitalize on extensive store networks, our membership, our online channel, and already established channels via third parties such as Jingdong or Tmall for the new retail as well. Thank you.

Our next question comes from Anne Ling at Jefferies.

Just a follow-up regarding the same-store sales comment that Joey just mentioned that the same-store sales were better in the Eastern part of China despite all these challenges. Does it mean that for the rest of the nation, we are seeing much weaker same-store sales trends? I just want to check with management, what is the take on this? Does this indicate more fundamental issues regarding consumer sentiment or some underlying structural issues which we should continue to worry about even when the COVID situations start to subside? We're also seeing membership sales as a percentage of sales lower on a quarter-on-quarter basis. Does this mean that during this period, we have more new customers? If that is the case, how are we able to capture these and turn them into our members? If it is not the case, how are we going to remedy that?

Thanks, Anne. This is Andy. I will take your question. The first question is about the regional differences between Eastern China and the rest of the country. I think there's a couple of things. One is, obviously, we're referring to the overall Eastern part of China that is not significantly impacted by COVID. For example, Shanghai, obviously because of the lockdown is significantly below the national average. Overall, the situation in Eastern China, outside of Shanghai, is probably still performing quite well. I believe it has to do with the overall economic vibrancy in Eastern China. As you know, Eastern China is the most vibrant economically speaking region in the country, which accounts for a large part of GDP and has strong growth rates. The wealth distribution is also quite evenly spread. That’s why we continue to see Eastern China as a very important and good growth market for us. There are regional differences. For instance, the northeastern part of China has faced challenges with repeated COVID outbreaks, and overall, it has been hit harder compared to the eastern part. Regarding the sales decline, it’s essential to note that the recent months' sales decline is driven by the COVID surge and Omicron surge that has resulted in strict proactive measures and health measures that have impacted the restaurant industry, but also non-manufacturing service sectors in China. It's important to recognize the temporary or short-term nature of this decline. We’re confident in the long run. We did great things to handle short-term challenges—providing service to our customers, managing costs, and meeting demand in impacted regions. We're confident about long-term opportunities in China. Looking at the rebound that occurred between the second half of 2020 and the first half of 2021 when conditions stabilized, we were able to capitalize on that recovery in both sales and margins. So we believe this is a short-term situation, and we maintain our long-term confidence in the market opportunity. As for membership sales, it’s important to know that a higher percentage of membership sales isn't always better. Our membership is growing, and in this period, we focused on attracting new customers. If we had 100% membership sales, that would be problematic for us in the long term since it would indicate we’re not bringing in new customers. Therefore, maintaining a healthy mix of member sales and new customers is crucial.

Our next question comes from Veronica Song at Credit Suisse.

This is Veronica from Credit Suisse. I have a quick question on the store expansion. So the expansion today is on track, and I understand the management maintains the annual expansion target for now. But may we ask what market conditions or at what point will the management consider lifting or cutting the annual expansion target?

Okay. Joey, let me address this question for Veronica. In terms of our store network expansions, it's worth keeping in mind that we employ a very disciplined strategy for store network expansion, and we continue to see good opportunities. That's why we continue to expand our network, and our store economics, our payback period reflect that disciplined approach. If you look at KFC, for example, the payback period for those new stores is 2 years, and for Pizza Hut, it's about 3 years. Those are strong economics. We’ve innovated our store model over the past few years to lower CapEx, making us more flexible. Of course, COVID impacts store openings, but if the situation prolongs, we will reflect this in our payback period calculations. Temporary slowdowns in new store openings are practical decisions. The quality of stores is more important to us than simply running a growth number. We remain focused on returning investments from our store openings, success rates, and overall market tendencies as these factors will inform our model inputs going forward. So to sum up, the long-term strategy remains unchanged. Store economics are still very healthy.

I think there are a lot of uncertainties in the short term, so I want to ask a question about the longer term. If I look at KFC's store sales per year, like in 2019, it was close to RMB 8 million per store. That number is lower in 2020 and even more reduced in 2021, likely because we opened more stores in lower-tier cities. Considering the long term, and the mix of new stores opening, does the management have an estimate of where KFC's per store sales can settle in, in the absence of COVID situations? Regarding the opportunity from retail, Joey just shared that the retail has grown very fast. Theoretically, what kind of retail revenue can we expect in 2022? What is the medium-term target?

Thank you. Let me share some thoughts with you in this area. For store average sales, I’d like to take a step back and note that KFC and Pizza Hut both have a range of store models. There are larger stores with more seating and smaller ones that are more off-premise-driven. This distinction is important because if we continually chase average store size, we may miss significant opportunities concerning convenience. Our off-premise business continues to grow, driven by the store network. As Andy mentioned earlier, our new store openings' strategy emphasizes store density within key top-tier cities while also opening stores in lower-tier cities. In mathematics, the more stores within the same 5-kilometer radius, the quicker and more efficiently we can deliver. For Pizza Hut, 70 to 80 of the new stores opened this year are smaller stores, typically 100 square meters or smaller. In terms of retail, it’s still early days. Our sales for 2021 were approximately USD 80 million, which was a doubling from the previous year because we've been incubating this business. In Q1 of this year, we further doubled compared to the earlier year, achieving close to USD 40 million in new retail sales. When looking at the entire business, it accounts for about 1% to 2%. But in locked-down cities such as Shanghai, that could be 10%, 20%, or even 50% for the emerging brands. It's difficult to predict how large it will become, but we are well positioned because we possess the product, store network, online channel, and established logistics. The new retail business, though still relatively small, is profitable—achieving profit is quite rare in this space. It has been particularly crucial in challenging times like this, showcasing the flexibility and agility of the new retail offerings that we brought during the pandemic.

Thank you so much for sharing on store sales and different formats, Joey. I also observed that your per store number of employees declined by around 30% from 2021 to 2019. So I assume that when things return to normal, there is hope for labor cost productivity gains to be reflected in your financial results. I'm not sure if that aligns with your expectations.

Yes. Labor profitability is an ongoing challenge. Back in 2015, 2016, with over 7,000 stores, we had about 420,000 or 440,000 staff. Right now, we have 12,000 stores, and we still have around 420,000 staff. During the Shanghai lockdown, some stores operated with only 5 to 10 people, which is not sustainable; our staff truly pushed themselves. However, there will be innovations coming out of this experience as we explore sharing management headcount across different stores, which is something we learned from our delivery rider operations. Some innovations are likely to last, but we are still in the process of assessing these strategies.

Our next question comes from Xiaopo Wei at Citi.

My question is about the new business. I appreciate the effort during this time. We know that our sophisticated supply chain and agile digital capabilities will shine during tough periods. You mentioned about the group purchase, which is a new model in Shanghai. Do you think this will be a valid model to expand into other parts of China even when the COVID situation improves? Secondly, regarding the market consolidation, we see the post-COVID market conditions always presenting good opportunities to consolidate. Remembering the second quarter of 2020, you quickly seized market opportunities following the initial COVID wave. Do you think this means that your Pizza Hut business could benefit from even more advantages of market consolidation compared to previous periods?

Thank you. Regarding community purchasing, we will, of course, share the best practices within the company. We have scenario plans for whatever cities or provinces are going to be locked down. After lockdown, we keep options open. Right now, community purchasing is less utilized in Shanghai as shopping becomes slightly easier. We can see demand coming down a bit, which is a good sign. At its peak, we had 10 to 15 stores open in Shanghai, but now we have about 40% of our stores open. Thus we can serve customers better with more stores open than solely relying on community purchasing. However, this showcases our agility and the strength of our business model and team. Thank you.

Our next question comes from Jack Chen at CLSA. It seems Jack dropped from the call. Our next question will come from Christine Peng at UBS.

Thanks for answering the questions. I have a quick question regarding the cost-cutting measures. Given this prolonged and fluid situation with COVID restrictions and lockdowns in China, I'm wondering what kinds of cost-cutting measures management has put in place or is considering. Also, if I recall correctly, there were some government grants given to Yum China during the COVID period back in 2020. Are there any similar grants that could be provided for Yum China for the remainder of the year?

Christine, let me address your questions regarding cost control and reductions. We are currently dealing with strong inflationary pressures globally. Hence, we will continue working with our long-term supply chain partners to manage that, potentially through longer-term contracts. Our supplies are generally locked in a quarter or two ahead of time, but we are dealing with the inflationary pressure. For example, we have secured supply contracts for coffee beans lasting until 2023, which will help mitigate cost increases. Energy prices, both internationally and domestically in China, have also risen. Additionally, utility prices have risen by about 10%. This emphasizes the necessity to invest in technology for improved energy efficiency in the long haul. We're deploying technology across our supply chain to ensure flexibility and efficiency in operations. This includes logistics network refining and employing rail and sea freight to manage the situation. We believe technology will enhance labor productivity in the long run. Ultimately, margins and costs are driven by sales. Thus, focusing on initiatives that drive sales while maintaining a sustainable cost structure remains crucial. We are also seeking rental relief with landlords, and government relief introduced in early 2022 mainly assists small to medium enterprises. We will pursue alignment with government programs as possible, but we anticipate those measures mostly favor smaller players. Meanwhile, for rental relief, we will negotiate with landlords to maintain competitive rental structures long-term.

I just want to confirm that the previous guidance regarding commodity costs and labor cost increases for 2022 will not change despite all the global volatility we've seen over the past 3 months.

Some changes may occur. As I mentioned, sales leverage will greatly influence margins, but inflationary pressures are other factors. Commodity prices have remained stable, but some have increased, leading to adjustments. For example, poultry and pork prices align with our expectations, but prices for beans and cooking oil have surged. Thus, while short-term volatility exists, sales leveraging will remain the most significant factor.

Our final question comes from Brian Wong at China Merchants Securities.

I want to understand your opinion on how much of your cost of goods sold and restaurant expenses remain variable. In the P&L, I don’t see costs running at 30%. How much is largely based on store sales?

Brian, I think your line was coming in and out, but if your question pertains to fixed versus variable costs—our key cost structure largely consists of variable costs, including all inputs, packaging, and marketing expenditures. We employ a hybrid model with a large part-time workforce based on flexible schedules. A significant percentage of rent, around 80%, has variable components depending on sales. Overall, I’d say that a majority of our costs are variable, but there are fixed costs associated with G&A expenses and salaries at headquarters. Sales leverage is essential; thus, we are proactively managing costs in both the short and long term, including G&A responsibilities.

Our final question comes from Jack Chen at CLSA.

My question concerns Taco Bell's brand strategy. This brand has entered the China market for years, but it's still small-sized. We plan on having over 100 Taco Bell stores by this year. Could you please share us more about how we plan to develop this brand to benchmark KFC and Pizza Hut? Given the COVID impact on major cities in China, how might this trend affect our store openings, especially in lower-tier cities and less-impacted regions?

Thank you, Jack. Looking at the Taco Bell opportunity, we have carefully considered it for a long time. Pizza Hut operates in 700 cities, and KFC serves in 1,700 cities. In the next 3 years, we aim to open at least 225 stores. Honestly, this target isn’t overstretched. If we evaluate our success with Taco Bell, we can effectively expand through the smaller format stores with lower capital expenditure and ongoing product testing leading to promising results, especially within urban settings. The top-tier urban centers, with younger generations more open to new goods, provide a significant opportunity. We'd anticipate Taco Bell doing well with delivery coverage. We’re enthusiastic about the prospects of expanding this brand and expect to see more growth over the next several years.

Joey has dropped off the line. I will conclude by reiterating that we've explored Taco Bell for multiple years and are confident about the growth strategies we are implementing with the brand and its anticipated alignment with our other brands in the Yum China portfolio. Thank you for your questions.

Thank you for joining the call today. We look forward to speaking with you on the next earnings call, and I apologize for the connection issues. Have a great day.

Thank you so much. This does conclude the call today. Thank you all for joining. You may now disconnect.