Yum China Holdings, Inc. Q1 FY2023 Earnings Call

Thank you, Ashley. Hello, everyone. Thank you for joining Yum China's First Quarter 2023 Earnings Conference Call. On today's call are our CEO, Ms. Joey Wat; and our CFO, Mr. Andy Yeung. Before we get started, I'd like to remind you that our earnings call and investor materials contain forward-looking statements, which are subject to future events and uncertainties. Our actual results may differ materially from these forward-looking statements. All forward-looking statements should be considered in conjunction with the cautionary statement in our earnings release and the risk factors included in our filings with the SEC. This call also includes certain non-GAAP financial measures. You should carefully consider the comparable GAAP measures. Reconciliation of non-GAAP and GAAP measures is included in our earnings release. You can find the webcast of this call and a PowerPoint presentation on our IR website. Now I would like to turn the call over to Joey Wat, CEO of Yum China. Joey?

Thank you, Michelle. Hello, everyone, and thank you for joining us today. We are pleased to have set new records for first quarter revenue and operating profit. It's a wonderful start to 2023, like the Chinese saying, 'Good fortune has arrived.' I want to thank all of our 400,000-plus employees. Without their hard work and dedication, our performance would not be possible. System sales grew 17% year-over-year. Back in early January, we had low visibility into how conditions would unfold after the relaxation of strict COVID measures. Chinese New Year is a critical trading period for us. This year, an earlier Chinese New Year was particularly challenging due to a shorter ramp-up period. We planned for multiple scenarios incorporating regional differences and focused on driving sales based on the more optimistic scenarios. Therefore, we were able to effectively deploy resources as opportunities emerged. Operating profit more than doubled to $416 million. Our efforts in enhancing operational efficiency and restructuring our cost structure in the past few years contributed to strong profitability in the quarter. System sales growth compared to 2019 is plus 20%, and operating profit compared to 2019 is plus 37%. These results exemplify our ability to remain resilient in challenging times and seize opportunities when conditions improve. During the quarter, we were encouraged by early signs of recovery, notably, dine-in, takeaway, and delivery all grew year-over-year on a same-store sales basis. Delivery accounts for around 36% of sales, the same as a year ago. Customers continue to appreciate the convenience that delivery provides. Off-premise sales were over 60% of total sales. Same-store sales grew year-over-year across different regions and trade zones. We benefited from increasing mobility and saw a growth of over 40% at transportation and tourist locations. However, same-store sales at these locations in the first quarter were still 20% to 30% below 2019 levels. Weekend sales growth slightly outpaced weekday sales. Apart from increased social gatherings, value programs since 2022 have also contributed to sales growth. We focused on our core pillars: good food at great value and excellent customer experience to capture demand. Good food at great value is our hallmark. We refreshed several signature products and achieved great results. After doing this for more than a decade, people expect our Chinese New Year bucket at KFC. To capture at-home consumption around family reunions, we added the option to trade up for a juicy whole chicken. We sold 11 million whole chickens in the first quarter, more than doubling year-over-year. We gave our classic Beef Wrap a localized spicy twist. This innovation generated considerable buzz, leading to a sellout in many markets in just 6 days. At Pizza Hut, the Supreme series is our most popular pizza lineup, accounting for nearly 30% of all the pizzas sold in the first quarter. We introduced Wagyu Beef and Seafood Supreme for the Chinese New Year. By including premium ingredients like abalone, sea cucumber, and wagyu beef, these pizzas became the perfect and fastest choice. We also created Double Durian Supreme, combining two types of durian with grapefruit and pineapple to create an explosive tropical flavor. Durian lovers appreciate it. We continue to provide good food at great value. At KFC, Crazy Thursday and Sunday’s Buy More, Save More promotions continued to drive sales momentum in their segments. This year, we offered these great values even during Chinese New Year. We also revamped our weekday value combos with more choices and lowered prices on select burger combos to just RMB 19.9. These three-item combos attracted new customers and increased frequency. We expanded our popular buy one, get one free campaign at Pizza Hut to include pizza and steak options. Customers can redeem the free item immediately or in their next visit within 30 days. This campaign significantly increased sales by encouraging repeat purchases during the promotion period. Now let's discuss operating efficiency. Late last year, a significant portion of our employees and riders were infected with COVID. At the peak, over 4,000 of our stores were temporarily closed or offered only limited services. By early January, as people gradually recovered from COVID, we made every effort to keep our stores open and resume normal operations. We prepared for the Chinese New Year period by planning crews and inventory based on optimistic scenarios. We also accounted for regional differences and continuously fine-tuned our plans based on regional learnings. We improved our hiring and incentive programs to manage staffing and minimize labor shortages. To enhance productivity, we expanded our initiative to share store management teams across multiple stores, which also offers career development opportunities for our young talents. Now let me share information about our digitization efforts. We have built a powerful digital ecosystem that is instrumental to our innovations while also enhancing operational efficiency. We utilized AI to optimize demand forecasting, inventory management, crew scheduling, and production. Our smart order system streamlined food preparation for dine-in and off-premise orders. These capabilities are particularly important during peak seasons like Chinese New Year. Additionally, migrating our key infrastructure to private YUMC's cloud enhanced the reliability of our operations, especially during significant traffic spikes during campaigns like Crazy Thursday. Our smart delivery system continues to improve delivery coverage and flexibility. Last year, we upgraded the system to dynamically adjust delivery coverage for each store by daypart. These capabilities, along with our dedicated delivery riders, allow us to capture more sales and fulfill orders even during the peak Chinese New Year season. We continued to improve digital touch points for better engagement with members. Digital orders accounted for approximately 89% of sales in the first quarter. Our loyalty programs now exceed 430 million members. Members steadily contribute to about 60% of sales. We actively engage members and drive frequency with exclusive subscription plans. K-Brand is an invitation-only program for our top 1 million loyal customers. K-Brand members receive exclusive coupons and a royal crown on the core screen when ordering in stores. This helps us gain valuable insights to improve service for our most loyal members and all customers. To sum up, we are extremely pleased to deliver a strong first quarter performance. Multiple scenario planning, innovative products, and value campaigns, along with our agile supply chain and digital capabilities, enable us to capture market opportunities. As we progress through 2023, we plan to remain nimble in adapting to evolving market conditions. Looking ahead, we will focus on building sales momentum, expanding our store network, and fortifying our competitive advantage. With that, I will turn the call over to Andy.

Thank you, Joey, and hello, everyone. Let me now share with you our first quarter performance. First quarter sales rebounded significantly from the fourth quarter. We made tremendous efforts to drive sales since the reopening by offering innovative food and compelling value campaigns. Restaurant margin reached 20.3%, the highest since 2017. Our margin expansion was driven by sales leveraging, efforts to rebase our cost structure in recent years, investments in improving operating efficiency, and temporary COVID-related relief from government assistance. Let's go through the financials. Foreign exchange had a negative impact of approximately 8% in the quarter. First quarter total revenues were $2.9 billion in reported currency, a 9% year-over-year increase. In constant currency, total revenue grew 18%. System sales increased 17% year-over-year in constant currency. The robust growth was fueled by same-store sales growth of 8%. The contribution from new units and significantly fewer COVID-related temporary store closures were also factors. Both KFC and Pizza Hut achieved 17% system sales growth. By brand, KFC same-store sales grew 8% year-over-year. Same-store traffic grew 6%, and ticket average grew 2%. Pizza Hut same-store sales grew 7% year-over-year, with same-store traffic growing 13%, while ticket average decreased 5%. These results were largely due to the successful promotional activities that drove strong traffic but resulted in a lower ticket average. Restaurant margin was 20.3%, 650 basis points higher than the prior year. Sales leveraging contributed to approximately half of the margin expansion. Labor productivity gains and lower occupancy costs were key factors. We also enjoyed an $18 million benefit from additional VAT deductions, thanks to the government policy intended to help businesses deal with the challenges posed by COVID-19. These benefits were partially offset by cost inflation and increased promotional expenses. Let me go through key items. Cost of sales was 30.1%, 100 basis points lower than the prior year. We kept commodity prices low through tremendous efforts locking in prices and innovating the menu. We also reduced wastage and benefited from higher VAT deductions. Gains were offset by increased promotional activity to drive traffic. Cost of labor was 24.6%, 160 basis points lower than the prior year. Sales leveraging and better labor productivity more than offset headwinds from low single-digit wage inflation. We further improved labor productivity through store management team and crew-sharing initiatives. Occupancy and others were at 25.0%, 390 basis points lower than the prior year, driven mainly by sales leveraging, lower rental expenses, and other cost-saving initiatives. Rental expenses improved due to more favorable rental terms for new stores and store portfolio optimization. We also reported an $8 million rental relief related to the COVID surge last year. G&A expenses increased 16% year-over-year in constant currency, mainly driven by performance-based bonuses, merit increases, and additional costs associated with resuming business activities. Operating profit reached $416 million, increasing 118% in reported currency. Our effective tax rate was 28.5%. We expect the full-year effective tax rate to be around 30%. Net income was $289 million, increasing 189% year-over-year in reported currency. Diluted EPS was $0.68, reflecting an increase of 196% year-over-year. In the first quarter, we generated $507 million in operating cash flow and $328 million in free cash flow. We returned $116 million to shareholders in cash dividends and share repurchases. At the end of the first quarter, we had around $3 billion in cash and short-term investments, plus another $1 billion in long-term deposits, which will benefit from better interest rates. We expanded our store network and remained committed to capturing future growth opportunities. In the first quarter, we opened 233 net new stores. Despite facing certain challenges this quarter, including an earlier Chinese New Year and labor shortages, we maintain a strong pipeline and are confident in our goal of opening 1,100 to 1,300 net new stores this year. Our new stores continue to perform well, with an average payback period of 2 years for KFC and 3 years for Pizza Hut. We will continue to focus on expanding our store network in a systematic and disciplined manner. Let's turn to our outlook. We're encouraged by our first quarter performance. Sales during the Chinese New Year trading period were buoyed by pent-up travel demand. However, same-store sales post-Chinese New Year have remained at levels below 2019. We are still in the early stages of recovery, and the pace and trajectory of that recovery are likely to be gradual and uncertain. Overall, global macroeconomic conditions remain challenging, and the pandemic lingers. Hence, our top priority this year is still driving sales. Consumers are value-conscious, so our investment in promotions to attract more traffic and sales is crucial. In the coming quarters, we expect gradual inflationary pressure, but we anticipate continued benefits from additional VAT deductions and rental releases. We have demonstrated our ability to capture opportunities in good times and manage downsides in bad times. We will continue to utilize extensive scenario planning, maintain a flexible cost structure, and adapt operational agility to navigate this uncertain environment. We remain committed to pursuing long-term growth opportunities in China, investing in strengthening our strategic advantage, and creating value for our shareholders. With that, I will pass you back to Michelle.

Thank you, Andy. Before we begin the Q&A, I want to inform you that our 2023 Investor Day is planned for September 14 to 15. It will be held in Xi'an, China, and we will provide a webcast for those unable to attend in person. More details will be shared soon. Now, let's move on to the questions. Ashley, please start the Q&A.

Your first question comes from Michelle Cheng with Goldman Sachs.

Congrats on the very strong results. My question concerns the value content you mentioned on the call just now. Since we have been going through this reopening for the past few months and given we see the trend is still quite challenging, can you share your thoughts on consumers' spending power and strategies on the product mix? Related to this question, what about food costs? We see decent improvements in food paper cost savings, but if we look into KFC versus Pizza Hut, it seems KFC benefited more from these cost savings, while Pizza Hut did not see as much benefit. Can you elaborate on how these value campaigns and product mix adjustments impact the two brands concerning costs?

Thank you, Michelle. Let me comment on the value campaigns, and then Andy can follow up with the cost comment. There are economic challenges right now. Therefore, consumers are quite value-conscious. The key question here is what are our strategies? They are three-pronged: The first pillar is the menu. We focus on food testing and innovative food alongside value campaigns because the pure value campaign is not enough; it must come with good food to gain the desired benefits. You'll see our new products, which are right after the Chinese New Year value campaign, performing very well. The second pillar is pricing. When we raise prices, we always do it very prudently. We also carefully design trade-up options to protect ticket averages and margins. While we go heavy with the value campaign, we manage to protect the margins for our shareholders. The third pillar of our strategy is to keep costs competitive amidst an inflationary environment. Our supply chain has successfully secured supply and enabled product innovation at scale. These value campaigns, while impressive, are not possible without a strong pricing strategy. Besides that, we drive operational efficiencies, including staff sharing and reducing food waste, while saving costs from rent to pass those savings on to customers. I’ll pause here and let Andy address the cost comments.

Yes, when you look at Pizza Hut, we’re very encouraged and happy with the results. For Pizza Hut, we saw 7% same-store growth in the quarter, along with 70% growth in EBITDA overseas. There has also been a strong acceleration in store openings. We also note very strong margin expansion, achieving almost 350 basis points on restaurant margin improvement. When we analyze the cost structure, each business operates slightly differently concerning their products and promotional activities. KFC benefits significantly from lower costs due to its more impactful product components, while Pizza Hut has experienced substantial store traffic growth driven by its value campaigns. While the strategies are slightly different for the two brands, both have worked well.

Congratulations again, Joey and Andy, for the strong results. My question is on the cost side, as both of you mentioned that there were benefits from cost rebasings in the first quarter, leading to significant margin improvements aside from the sales leveraging. Notably, I understand there have been significant savings on depreciation and amortization compared to last year. So, going forward, what's your margin outlook on a year-over-year basis? Can we expect a similar pattern of cost savings from operations aside from the phasing out of vacancies? Also, what is your guidance on depreciation costs for the full year, given the significant decrease in the first quarter?

It seems this question is for me, so let me take this. For internal margins, I think when we evaluate the first quarter’s margin improvement, we’re pleased. As expected, increasing sales will result in sales leveraging. Approximately half of the improvement comes from this sales leveraging. In terms of overall cost structure, we note that labor productivity and some of the efforts related to rebasing our cost structure are benefiting operations. Responding to your question regarding the backlog, we’re observing that temporary relief benefits will likely diminish towards the end of the year. As sales improve year-over-year, we anticipate leveraging these sales will support our margin improvement. However, I would caution that seasonality plays a role as January is traditionally strong for sales and therefore impacts margins. We also expect a gradual recovery for the cost of goods sold, but looking at the spot market, pricing pressures seem to be minimal at the moment. Therefore, we need to remain vigilant regarding wage inflation and manage through mid- to high single digits. Ultimately, margin improvements will largely depend on sales leveraging and the ongoing benefits in cost structure initiatives.

Thank you, Lillian. I want to add a few comments on the question. The current cost structure is certainly more resilient than it was three years ago. The challenges of the past years, particularly 2022, compelled us to rebase the costs. This effort is reflected in our results. For rent, it has improved significantly; we secured the best rental terms in the last decade for two main reasons: our store portfolio is better structured as we've pruned low-performing stores while building new stores under much better rent structures. Over 40% of our stores were built in the last three years. Concerning depreciation, we reduced our CapEx volume for new stores by 25% to 35% just last year. If we consider the improvements over the last three years, we see higher resilience. Therefore, we maintain profitability with a lower CapEx. Regarding labor costs, we see ongoing challenges; however, as Andy noted, we launched crew-sharing initiatives that started with delivery riders and are now extending to store staff. We believe this approach will continue to yield significant benefits.

I want to compare the recovery pattern on a same-store sales basis between the first quarter of 2023 and the first quarter of 2021. You've mentioned the situation concerning offline traffic recovery and the observed growth in delivery. Is this indicative of a structural shift in consumer spending patterns? Are we suggesting that dine-in will not return to 2019 levels, or is there still room to grow off-line traffic and dine-in services based on the growth of delivery in the post-pandemic era?

Lina, I understand your question. Andy, please go ahead.

Thank you, Joey. Clearly, 2021 and today are different macro environments and overall COVID recovery situations. Therefore, comparisons between 2023 and 2021 may not be appropriate. However, when evaluating delivery, we observe that off-premise sales have maintained growth before the pandemic and continue to grow throughout. As we mentioned in our last quarter, with the reopening, we anticipate dining traffic will rebound alongside delivery. Additionally, we note that delivery remains incredibly robust. As of the end of last year, delivery sales made up approximately 39% of our total; now, it's around 36%, which is within our expectations. Our store network restructuring has allowed us to capture this growth better. Furthermore, our delivery model stands out, as we use dedicated riders to deliver food to consumers, which ensures quality service. As we improve our trade zones through investments in technology, we can manage delivery more effectively. Overall, we are confident that our off-premise dining will be a crucial growth driver for us in the years to come.

Congratulations again on the full year results. My question is related to same-store sales growth as I want to gather more detailed insights into Q1 same-store sales. Your results suggest that during CNY, your same-store sales were below 2019 levels significantly. However, it seems that on a year-over-year basis, we are no longer comparing sales to 2022 during March due to the prior year's lockdown. Can you break down the performance by city tier and region? Are we seeing better growth in Tier 1, Tier 2 cities, or lower-tier cities? Which regions are growing? And regarding dine-in traffic, aside from challenges faced at transportation and tourist locations, are there any other hurdles constructing growth? For instance, have you seen cannibalization due to too many new stores in mature markets? What strategies will you implement to improve dine-in traffic?

Thank you, Chen. While focusing on same-store sales, I want to emphasize that examining system sales compared to 2019 is equally important. Our system sales grew by 20% compared to 2019, with operating profit at an increase of 37%. Our first quarter customer numbers also reflect good performance. The improvement we saw in the last two months was largely attributed to pent-up demand for travel during Chinese New Year. We had a solid sales trajectory that continued post-CNY, even if we recognize our same-store sales levels still lag behind those of 2019. We're encouraged by the performance indicators indicating we are on an upward trend and believe our same-store sales results year-on-year will build momentum as we move into Q2. Notably, growth was led by transactions for both KFC and Pizza Hut, a key performance indicator in our business. The system sales growth of KFC visibly outperformed Pizza Hut, specifically showing a growth rate of about 19% while the same-store sales lagged. To break it down, Tier 2 cities performed well this quarter thanks to increased domestic tourism, especially in areas where COVID restrictions were severe last year. In terms of location, the east coast performed steadily due to its robust economic environment, and northern regions enjoyed substantial growth due to reduced competitive pressure. Overall, dine-in is improving alongside other channels, which post-phased is important for our long-term strategy focusing on a blend of off-premise and dine-in sales.

Joey, I want to add a couple of comments. We noted that while our same-store growth is below 2019 levels after CNY, it initially rebounded sharply after reopening. Our same-store sales growth calculation excludes temporary store closures, while system sales growth includes closures and new unit growth. When making comparisons, consider that our same-store sales growth number may not fully capture total performance due to these factors.

Excellent results. I have some questions about the cost structure. Regarding the VAT benefit of $18 million, can you elaborate further on the specifics of this VAT advantage? What drives this benefit, and how will it impact upcoming quarters? Also, regarding the same-store sales forecast, should we expect longer timeframes for recovery back to 2019 levels, especially given the increase in store density within Tier 1 cities, meaning we should prioritize new store growth over same-store sales focus? My final query pertains to CapEx decline. You indicated a reduction of around 20% per store; however, depreciation expenses decreased by 41%. Can you clarify for us regarding any differences in back-end versus front-end CapEx costs contributing to this difference?

I'll address the CapEx briefly before passing it to Andy. Although CapEx for new stores declined by 20%, we also achieved savings from pruning our original store portfolio, which remains critical to achieve profitability.

Let me expound on the VAT deduction. This came from Chinese government policy that originally introduced in 2019, and it covers some reductions linked to certain input costs. Due to the pandemic, it has been expanded and adjusted in recent years. Currently, the policy remains valid for the first half of this year. The specifics can vary based on how well different businesses operate, which means that you could continue to see benefits from the VAT deductions throughout the year. To dive deeper into depreciation and amortization, you must recognize two components: depreciation, which aligns with asset lifecycle, and amortization, which stemmed from prior acquisitions, specifically our franchise rights for Hangzhou, which see sizeable reductions in its impact. Both factors led to significant changes in overall depreciation. Our overall strategy emphasizes careful management of our store portfolio, ensuring we’re optimizing expenses while managing through fluctuations in the market. Lastly, when evaluating our business model’s recovery, anticipate a gradual process towards total recovery, as the industry's overall performance will depend on multiple variables, including long-term consumer behavior, margin management, and economic conditions.

Many of the prior questions have already covered what I wanted to discuss, but I would like to follow up on depreciation. There have been significant reductions in depreciation expenses compared to prior periods. Andy, could you clarify the reduced figure of about $50 million? You mentioned an impact of $25 million per quarter from Hangzhou franchise rights; could you elaborate on other factors at play or should investors consider an annual depreciation figure around $110 million going forward?

Yes, Christine. As noted, we anticipate a recurring depreciation cost associated with the loss of franchise rights. Amortization of $25 million per quarter came from that asset, equating to nearly $100 million this year. The currency's exchange rate also affected our reports and overall valuation. With some optimizations made this quarter, it's reasonable to adjust expectations based on prior experience; thus we have continued to observe volatility in the RMB exchange rate significantly impacting our financials. We will provide additional details in our 10-Q filing.

Thank you for joining the call today. If you have further questions, please reach out through the contact information in our earnings release and on our website. Thank you.

That does conclude our conference for today. Thank you for participating. You may now disconnect.