Yum China Holdings, Inc. (NYSE:YUMC) Q4 2022 Earnings Call Transcript

Yum China Holdings, Inc. (NYSE:YUMC) Q4 2022 Earnings Call Transcript February 7, 2023

Operator: Thank you all for standing by and welcome to the Yum China Fourth Quarter and Fiscal Year 2022 Earnings Conference Call. All participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session. I’d now like to hand the conference over to your first speaker, Ms. Michelle Shen, IR, Director. Please go ahead.

Michelle Shen: Thank you, Zari. Hello everyone. Thank you for joining Yum China’s fourth quarter 2022 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 statements — 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 three sections. Joey will talk about our journey in the past three years and discuss fourth quarter performance. 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 highlights on our IR website. Finally, we plan to host our 2023 Investor Day in Shanghai through September. We look forward to sharing more details about this event with you in due course. Now, I would like to turn the call over to Ms. Joey Wat, CEO of Yum China. Joey?

Joey Wat: Thank you, Michelle. I want to wish everyone joining us today a happy and healthy Chinse New Year. Before looking at the fourth quarter and full year, I would like to reflect upon our journey these past three years with COVID, some of our key learnings and how we have grown. First, I’m incredibly grateful to the entire Yum China team for their agility, creativity, and tenacity during this difficult time. Together, we became a more resilient, nimble business, better positioned for long-term growth. During the past three years, we quickly pivoted when buying traffic came after pressure. Delivery doubled from just 20% sales mix in 2019 to 39% in 2022. Our hybrid delivery model and dedicated riders enable us to capture the increase in demand.

Combined with takeaway, off-premise sales reached almost two-thirds in the fourth quarter of 2022. Digital ordering also rocketed from 55% of sales in 2019 to now 89%. That’s over $20 billion in digital sales in three years. We maintained our rapid growth. Our store portfolio expanded by nearly 40%, a total of 3,800 net new stores. KFC and Pizza Hut stores maintained a healthy payback of two to three years, respectively. The first year profitability of new stores also improved. Strong new store performance was driven by our flexible store model. We optimized store size and secured more favorable lease terms. For new stores opened in 2022, more than half were in smaller formats. Such flexibility allow us to continue to increase density in higher-tier cities, which is particularly useful and helpful for delivery and capture white space in lower-tier cities.

We enhanced the coverage and agility of our world-class supply chain to support business growth. We expand from 29 to 33 logistics centers for better self-sufficiency in each province. During expanded lockdowns, we add rail and sea freight to move our inventory apart from our traditional trucks. Our store inventory visibility system allows real-time sales forecasting and smart inventory replenishment. These capabilities help mitigate severe disruption even during a lockdown and minimize wastage. also supported product innovation by securing supply at scale. Apart from our classic offerings, we launched over 500 new or upgraded menu items last year from regional offers to national launches. We invest in digital and automation to improve operating transparency and efficiency.

For example, we are rolling out smart order system, at KFC. The AI-powered system more accurately predict demand and recommend food preparation plan to minimize stock outs and wastage, and also reduce waiting time for customers. It also enhances customer experience by reducing wait time and providing real-time order update. And recently, we added a robotic service at one-third of our Pizza Hut restaurants, freeing our crews to serve customers. We remain profitable each and every quarter since the beginning of the pandemic in 2020. By rebasing cost structure and implementing austerity measures, we cushion shocks created by the volatile market situation. In the past three years, we were able to generate US$1.9 billion in free cash flow and returned over US$1 billion to shareholders.

Notably, I’m proud to say we did this while also protecting the jobs of our employees. We have had no staff layoff since the pandemic began. Looking back over this period, we see opportunities to improve our ability to operate in good times and bad times. Looking forward, our anti-fragile operations will enable us to shine and drive long-term growth in China. Now let me provide some highlights for the fourth quarter and full year. 2022 was built with unprecedented challenges. In just 12 months, we managed sporadic COVID outbreaks, entire city lockdowns, nationwide infection and the certain lifting of COVID-related restrictions. In October and November, COVID infection quickly evolved into major regional outbreaks, leading to tightened COVID-related measures.

In December, as China entered a new phase of COVID response, we face brand new challenges. With surging infection rates, a significant portion of our employees and riders became infected, resulting in a labor shortage. Thousands of our stores were temporarily closed or only provided limited services. Many residents also opt to stay home to avoid infection or recover from symptoms. Buying traffic fell sharply. During this time, as always, the health and safety of our employees and customers remain our top priority. We moved quickly and support our employees with the relief medicines and antigen test kits. We mandate daily testing for all crews and riders to minimize infections, and we organize informative health talk and a consultation hotline for our employees.

At the same time, we took immediate steps to address the labor shortage. We simplified the menu, shortened operating hours and optimized labor shifts. We reallocated crew resources among stores, prioritizing stores with stronger demand, and we adjusted delivery operations, encourage customers to pick up orders and promote packaged food products. I’m thankful for our team’s nimble actions and amazing execution. Even in this challenging quarter, we delivered substantial year-over-year restaurant margin expansion despite lower sales. This was achieved by our extensive scenario planning, operational efficiency improvement, cost rebasing initiatives and temporary relief. We were also able to open a record 538 net new stores in the fourth quarter or 1,159 net new stores in the full year.

Let’s move on to the brand. By brand, KFC and Pizza Hut continue to introduce delicious food and exciting campaigns to delight our customers. At KFC, new categories grew with solid momentum. Juicy whole chicken, and beef burger, , doubled in sales in 2022. Combined, we generate around 5% of KFC sales mix in the fourth quarter, nearly equal to our Original Recipe chicken. We continued to introduce more flavors in these categories, such as the Spicy Whole Chicken, , launched during Chinese New Year. Following the success of Pokemon Psyduck in quarter two, , our toys in the fourth quarter also generated huge social buzz. These include Fancy Chicken, , and Fluffy Chicken Popcorn, both were originally designed as pet toys or toys for your pet, but quickly became very popular with all customers and drove traffic.

At Pizza Hut, pizza sales grew nicely for the year, reaching almost 40% of sales. We sold over 100 million pizzas in 2022, that’s nearly seven pizzas per second. Apart from our signature pan-tossed and crispy pizzas, we have added stuffed-crust pizzas. Customers can choose fillings like double cheese, sausage and meat floss, Rousong. These new launches encourage the trade up and lift effective price. We continue to offer stunning value for money. Our signature value campaign at KFC, Crazy Thursday, , attract excellent traffic, generating over 50% more sales on Thursdays compared with other weekdays. Sunday, Buy More Save More continues to spur weekend sales. Customers love the option to make the math and the sizable discount. At Pizza Hut, we brought back the wildly popular two pizza for CNY 59 promotion in November.

The amazing value drove great traffic and sales uplift. New retail packaged foods provide us flexibility during lockdown and when we were short of staff. In 2022, packaged food sales grew 90% and reached nearly CNY 900 million. We continue to broaden our offerings, adding some of the classics such as our egg tart and Popcorn Chicken Now moving on to our emerging brands. We have solid management teams and strategies in place. While it will take time to fine-tune and test the business model, we are making solid — Lavazza continues to execute its four-pillar strategy, which includes brand building, menu innovation, digital and delivery, and store development. Throughout the year, we introduced new coffers flavors such as orange buffalo latte with buffalo milk.

We also introduced sweet and savory food that would pair well with coffee, such as Cube Cornetto, which is a fluffy, . Loyalty members more than double to 1 million in 2022, continue — contributing to over 40% of sales. We enhanced operational efficiency and optimize new store designs, lowering upfront investment. Although COVID disruptions have delayed store openings, Lavazza reached 85 stores by the end of quarter four. Taco Bell doubled its store count in 2022 to 91 stores. We continue to localize the menu for Chinese customers. For example, a crispy one-time taco, , use duck and a one-time wrapper in place of a tortilla. Why not? We also continue to improve the value proposition, customer experience and unit economics. Little Sheep and Huang Ji Huang were expectedly impact by COVID due to their dine-in focus.

We used 2022 to refine their business models and strengthen fundamentals from menu, marketing, store models, supply chain to digital initiatives. Huang Ji Huang also continued to generate operating profit. To wrap up, with a new chapter opening in 2023, we are excited to see positive momentum in the Chinese New Year season. We took decisive action to ensure operational efficiency and capture sales. At KFC, we broadband our signature Golden Bucket, , which is a holiday favorite. At Pizza Hut, we introduced a holiday-themed pizza with wagyu beef and seafood. It’s called , which is inspired by a popular game. It’s gratifying to see how our delicious food play an important part in our customers’ celebration during the holiday. Yet COVID remains a reality, and many challenges still lay ahead, including cautious consumer spending through the holiday.

While we anticipate the road to recovery will be gradual and uneven, I’m optimistic that brighter days are ahead. We will continue to execute our proven RGM strategy, which stand for resiliency, growth, and strategic mode, to capture the growth opportunity and deliver shareholder value. With that, I will turn the call over to Andy. Andy?

Andy Yeung: Thank you, Joey and belated Happy Chinese New Year to everyone. Let me share with you our fourth quarter performance. As Joey mentioned, we faced an extremely fluid and challenging fourth quarter as there were substantial changes in COVID conditions and related policies. In late November, due to rising infections and strict COVID-related health measures, the number of stores that were either temporarily closed or offer only takeaway and delivery services, reached a peak of over 4,300 stores. In December, we faced a different situation where most of the COVID measures were lifted. Due to labor shortage, we had to temporarily close or provide limited services at over 1,300 stores on average. In such a vital environment, we took quickly action to capture off-premise demand.

Furthermore, we controlled costs, limited wastage, and enhanced product despite lower sales. Our team did a wonderful job improving restaurant margins by almost three percentage points despite very difficult circumstances. Let us now go through the financials. Unless noted otherwise, all percentage changes are before the effect of foreign exchange. Foreign exchange had a negative impact of approximately 11% in the quarter. Fourth quarter total revenue declined 9% year-over-year in reported currency to $2.1 billion. In constant currency, total revenues grew 2%. The contribution of new units and the consolidation of Hangzhou KFC were partially offset by same-store sales decline and temporary store closures. System sales and same-store sales both declined 4% year-over-year.

By brand, KFC same-store sales were 97% of the prior year’s level, with same-store traffic at 84%. Ticket average grew 16% due to the rise in delivery mix, which has a higher ticket average than dine-in. Pizza Hut same-store sales were 92% of prior year level. Same-store traffic was at 98%. Ticket average was at 95%, driven by lower ticket average of delivery orders and smaller party sites due to the pandemic. Restaurant margin was 10.4%, 290 basis points higher than the prior year. The year-over-year increase was mainly driven by labor productivity, operational efficiency and temporary relief. These were partially offset by the sales leveraging impact, which includes temporary store closures, as well as higher rider costs due to high delivery volume.

We also faced inflationary headwinds in commodity and labor costs. Our team worked hard to protect margins during the fourth quarter, which is seasonally slow in terms of sales and profits. Let me go through the key items and highlight the actions we took. Cost of sales was 31.9%, 60 basis points lower than prior year. We kept commodity inflation relatively modest by strategically locking in prices and innovating the menu. We also carefully planned promotional activities and reduced wastage. Cost of labor was 28.8%, 90 basis points higher than prior year. This was mainly due to increased rider cost from higher delivery sales mix, low single-digit wage inflation and sales leveraging. This was partially offset by better labor productivities and temporary relief of $14 million.

Occupancy and other was 28.9%, 220 basis points lower than prior year despite sales deleveraging. This was mainly due to lower rental expense and other cost-saving initiatives. Rental expense, as a percentage of sales, benefited from rental relief of $12 million, strong portfolio optimization and more favorable lease terms. G&A expenses increased 2% year-over-year, mainly due to increased compensations and benefit expenses, as well as the consolidation of Hangzhou KFC. The increase was partially offset by cost control initiatives. Operating profit was $41 million compared to $633 million in year period. In the fourth quarter of 2021, we recorded a non-cash gain of $618 million from the remeasurement of our previously held equity interest in Hangzhou KFC.

By excluding the remeasurement gain, adjusted operating profit increased 189% year-over-year from $60 million to $40 million. The net contribution from Hangzhou KFC’s consolidation was 12% of operating profits in the quarter. We included the last quarter of amortization of intangible assets acquired, which was roughly $15 million. Effective tax rate was 29.9%, 480 basis points higher than prior year, due to lower pre-tax income and Hangzhou KFC consolidation. Prior to consolidations, the equity income from JVs was not subject to tax, resulting in a lower tax rate. Net income was $53 million. Adjusted net income was $52 million. Excluding the $4 million mark-to-market net gain on our equity investment in Meituan in the quarter and the $9 million net loss in the prior year period, adjusted net income grew 154%.

Due to the diluted EPS and adjusted EPS were at $0.13, the mark-to-market gain in Meituan increased value EPS by $0.01. In December, we acquired an additional 20% stake in Suzhou KFC JV for approximately $115 million. This increased our total ownership in the JV from 72% to 92%. For the full year 2022, we generated free cash flow of $734 million. We returned roughly $668 million to shareholders in cash dividends and share repurchases. Cash, cash and short-term investments was $3.2 billion, down from $4 billion in the third quarter. The reduction in cash and short-term investments was mainly due to the reclassification of around $600 million from short-term investments to long-term time deposits. We invested in long-term bank deposits to benefit from better interest rates.

Let’s now turn to our outlook for 2023. In January, most of the temporary closed stores resumed normal services. Our same-store sales from the comparable Chinese New Year holiday season were up mid single-digits year-over-year, but remained below the compared level. Same-store sales benefited from pent-up demand as the relaxation of COVID policy coincided with the Chinese New Year holiday. However, the real test will be the sales trajectory after the holiday, as we face more cautious customer spending and macroeconomic uncertainties. Looking ahead, we are encouraged by the new COVID policy. The future indeed looks bright. But we must keep a level head and recognize that uncertainties and challenges still lie ahead. Our country has shown that further outbreaks in the emergence of new COVID variants will pass after COVID restrictions are lifted.

We also face macroeconomic headwinds such as elevated commodity and wage inflation as well as softening global economic conditions. These factors may impact our operations and consumer spending in China. Now at the risk of sounding like a broken record, we continue to expect recovery to take time and be non-linear and uneven. For 2023, our top priority is to drive steps. At the same time, we will remain agile. One of the lessons we learned in the recent years is the importance of planning and preparing for a wide range of scenario, both to capitalize on growth opportunities and to mitigate risks when needed. On store development, we are targeting to open 1,100 to 1,300 new stores. We expect capital expenditure of $700 million to $900 million to support organic growth remodeling, digital, supply chain and other infrastructure development.

As always, the quality of growth is what matters to us the most, not just the quantity. So we will continue our systematic and disciplined approach to investment and growth. Finally, we remain committed to returning capital to shareholders. The Board has approved to raise the cash dividend from $0.12 per share to $0.13 per share. This is supported by our healthy balance sheet and strong cash flow. With that, I will pass you back to Michelle to start the Q&A. Michelle?

Michelle Shen: Thanks, Andy. We’ll now open the call for questions. In order to give more people to chance to ask questions, please limit your questions to one at a time. Sari, please start the Q&A.

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Q&A Session

Operator: Thank you. Your first question comes from Brian Bittner from Oppenheimer & Company. Please go ahead.

Brian Bittner: Thank you. Good morning to you. My question is on the new stores that you’ve built since COVID began. You’ve built a significant amount of new stores over the last three years, over 3,700 of these new stores. And I know the payback on these stores are still very strong despite operating in a pandemic, which is incredibly impressive. But Andy, can you talk about where the sales productivity and the margins on this class of stores that have been built since COVID where it currently stands relative to the rest of the asset base, so we can kind of understand how to think about the model moving forward?

Andy Yeung: Thank you, Brian. If we look at our store opening for the past three years, as Joey has mentioned, we have been opening almost €“ increased our store count by almost 40%, right? And €“ but nevertheless, I think if you look at the new store performance, the payback period were very consistent, very good. For KFC, it’s about three years for €“ sorry, for KFC, it’s about two years and for Pizza Hut, it’s about two to three years. And Pizza Hut is €“ the reason why it’s two to three years, because if you go a satellite or model, which is the new model that we have, the performance on par with KFC, which is about two years. And then obviously, there’s more standard models, their payback period is a little bit longer.

And if you look at overall for this year and last year, the new store that we opened, their unit economics continue to perform very well. If we look at the store that opened recently, they’re €“ the breakeven €“ most of them are breakeven within three months of time even with this very challenging environment. So if you look at our new store portfolio, the difference with the existing store is that over the past couple of years, we did increase penetration in lower KFCs, where is the white space. And then we also increase density in the urban area, especially with smaller model, satellite model or KFC smaller model. We need to cater to consumers’ demand for convenience and delivery and takeaway services. The new store January are smaller.

So the throughput, the sales throughput, generally, are less than their existing portfolio, roughly about two-third of the sales competitive portfolio average. Now the probability of those new stores are better. As we mentioned, we have lower step-up investment for the small store. If you look at it properly, we probably spent about $2.5 million for our new store opening. And then now like we are spending on average about RMB 2 million and then for the small model, it’s close to RMB 1.5 million. And so €“ and then also, we have obviously improved the efficiencies throughout this pandemic. As you look at the restaurant margin, for example, last year €“ in 2022, despite the fair market environment throughout the year and sales leveraging, we managed to improve restaurant margins, especially at KFC.

So — so I think we’re pretty confident that we have the right format and resources to grow our store network at a healthy pace and also maintain a very robust payback for our investment.