Ladies and gentlemen, thank you for standing by, and welcome to Yum China 2018 Second Quarter Earnings Conference Call. [Operator Instructions]. I must advise you that this conference is being recorded today, 2nd of August 2018. I would now like to hand the conference over to your speaker today, Ms. Millicent Tu. Thank you. Please go ahead.

Thank you, Operator. Hello, everyone, and thank you for joining Yum China's Second Quarter 2018 Earnings Conference Call. Please note that a PowerPoint presentation and the live webcast of this call are available on our IR website under the Events & Presentations section. Joining us on today's call are Ms. Joey Wat, CEO of Yum China; and Jacky Lo, CFO of the company. 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 presentation also includes certain non-GAAP financial measures. You should carefully consider the comparable GAAP measures and reconciliation thereto. Today's call includes three sections, first, Joey will discuss Yum China's second quarter 2018 highlights; and Jacky will discuss the financial results. We will then open the call to questions. At this time, I would like to turn the call over to Ms. Joey Wat, CEO of Yum China.

Thank you, Millicent. Hello, everyone, and thank you for joining us today. I would like to begin with Slide 4, providing a few high-level comments before going to details. Overall, we are leveraging our strong fundamentals to invest proactively for long-term growth. We are building capabilities in delivery, digital and data across all brands for a sustainable platform. We observed some softness in consumer spending and competitors increasing promotional activities, focusing on value. Despite the challenges, we achieved profitable growth in the second quarter of 2018. We continue to return value to shareholders, distributing over $110 million in form of dividends and share repurchases during the past quarter. KFC achieved robust system sales growth lapping two strong quarters in 2017 and 2016. Supported by healthy brand fundamentals, we accelerated KFC new builds and will continue to explore new ways to grow different dayparts and categories. We aim to serve our customers faster and better. Pizza Hut remained challenging, but we are executing the key aspects of the revitalization plan. With smart investment and cost control, margin is better managed in the second quarter compared to the first quarter of 2018. Next, I would like to discuss the performance by our key brands. We'll start with KFC on Slide 5. Our knowledge of the local culture, capability in connecting with customers and product innovation, first-class execution and over 5,600 stores nationwide now continue to give us confidence in strengthening our leadership in the QSR sector. Second quarter system sales grew by 5% year-over-year and 7% year-over-year in the first half of 2018, thanks to KFC's very strong fundamental and excellent execution. Encouraged by the long-term potential in China, we accelerated new store builds by adding 272 stores in the first half of 2018. That means 63% year-over-year growth rate of new…

Thank you, Joey. Good morning to those calling from Asia, and good evening to those calling from the U.S. Let's take a look at our second quarter 2018 performance on Slide 17. We accelerated our new build openings by adding 164 in the second quarter and 367 in the first half, mainly under KFC. That is equivalent to 2 stores per day covering all city tiers in China. Our portfolio reached almost 8,200 restaurants as of the quarter-end, representing 6% year-over-year growth. Supported by new build, system sales grew 3% year-over-year in the second quarter and 5% in the first half before foreign exchange translation. Total revenues reached $2.1 billion in the quarter, up 5% year-over-year ex FX. Operating profit increased by 5% year-over-year ex FX, primarily due to moderate top line growth and G&A optimization. We are committed to returning excess cash to shareholders. In the second quarter, we returned over $110 million to our shareholders, including a cash dividend of $38 million and common stock repurchases of $73 million. Slide 18 analyzes the key moving parts behind our operating profit in the second quarter. Overall, our operating profit increased by 5% year-over-year, ex FX in the quarter. The key positive operational factors include net new unit growth and G&A improvement. To be specific, 86 net new stores were added in the second quarter, led by KFC. G&A expenses were reduced by 22% year-over-year in the second quarter. We revisit our cost structures and policies to make the organization more efficient. We'll continue to actively manage G&A expenses effectively to achieve our long-term goal of a G&A growth rate lower than the revenue growth rate. Same-store sales had a deleverage impact on the operating profit in the quarter mainly due to Pizza Hut. Wage inflation was up 6%, and…

Thank you, Jacky. Our long history of doing business in China, decades of know-how and people-oriented culture have built a solid foundation for Yum China. That foundation enable us to invest and capture more growth in the future. Both KFC and Pizza Hut are household names in China. While we work to strengthen these core brands, we will continue to nurture smaller and emerging ones such as Taco Bell, Little Sheep and our latest coffee store, Coffee Enjoy; leverage our capabilities in delivery, digital and data. And we invest for long-term future growth. Turning to the last page of our presentation. I would like to conclude the call - the presentation by emphasizing Yum China's vision to become the world's most innovative pioneer in restaurant industry. We are confident in our business model and its long-term prospects. Each of our 460,00 employees is making an effort, working hard towards this goal. With that, I will turn you to Millicent to commence the Q&A. Millicent?

Thank you, Joey and Jacky. We will now open the call for Q&A. [Operator Instructions]. I also want to quickly touch on recent media stories and market rumors around our business. As you may know, as a matter of policy, like any public company, we don't comment on rumors or speculation. Our board and senior management team remain focused on creating value for our shareholders. We are here today to discuss our performance and outlook and ask that you keep your questions focused on these topics. Operator, please provide the instruction for Q&A.

[Operator Instructions]. Your first question comes from the line of Lillian Lou from Morgan Stanley.

I have two questions. First is on KFC. I think the second quarter is a little bit surprising that margin is also under pressure. So can Joey explain a little bit more in detail in terms of the strategy, how much we invest for growth? Understand that in terms of same-store sales, we're on a very high comp, but going to next quarter, it's a quarter we are probably even on a higher comp. I would say could you provide us what's the same-store sales growth for KFC in third quarter 2016? Because we understand third quarter 2017 was 10%. Second question is on Pizza Hut. The delivery growth was at 18% in second quarter, so it was a little bit more slowed down in terms of the pace versus first Q. So understand that we are in the process of integrating dining in and delivery service. So what are we looking for in terms of rejuvenating the delivery growth for Pizza Hut?

Thank you, Lillian. For the KFC Q3 number, you - I'm sorry, are you asking for the 2018 or 2016?

So there's two parts of the question, first for trying to understand our KFC strategy because the second quarter margin was declining on a year-on-year basis, so we're trying to see what's the strategy going forward and what the impact on the margin. And the second part is on the same-store sales growth. So third quarter last year was 10%. What was the number in third quarter 2016 on the restated basis?

Let's try one by one. So let's focus on the sales, and then Jacky can answer the margin question. So the KFC, we are lapping two very strong quarters in 2016 and 2017, and the number was 4% and 7% for the two years' Q2 number. And that represent 4% of CAGR on full year basis, which we believe was very healthy growth rate. For our business, the ultimate test of our belief in our fundamental is how many new store we'll open as well. So based on our - strength in our fundamental, we accelerated new store opening last year and we continued the new store openings this year, so in a short term, actually put pressure on our same-store sales but we believe it's absolutely right thing to do given our leadership in the market and our ambition to maintain the leadership and also market share in the long run. So for the Q2, certainly, it impact our same-store sales, particularly in the lower tier city, where we open store very, very aggressively in the - in China. So for margin, I'll pass it to Jacky. Then, I'll come back to the Pizza Hut.

I think, Lillian, you're asking for 2016 Q3 same-store sales growth rate on a restated basis.

Yes.

That's negative 5%. That was negative 5%.

Negative 5%, okay.

Your next question comes from...

Sorry. Sorry, Davina. We do have the Pizza Hut question. Okay. Lillian, for the Pizza Hut question, for the delivery, so let's take a step back. The delivery for 2017 for Pizza Hut was also very, very good growth because we had the record rollout of the delivery service to all the stores in Pizza Hut store back to 2017. And also, we benefit from the aggressive promotional activities partly sponsored by third-party aggregators. So right now basically for 500 cities in China for Pizza Hut delivery service, we are having the delivery service already. That compares to KFC. KFC by now, our delivery service coverage was in 1,000 cities. That was about 68% coverage. So Pizza Hut, within 2017, we just covered 100% very, very quickly because we can deliver, right? But that gives you sort of the background, the opportunity and the challenge for 2018 is now we are everywhere, so we need to grow the same-store sales of the delivery business. And on top of that, we are integrating the Pizza Hut Home Service and Pizza Hut Dine-In as well. So the growth rate slightly - slowed down slightly compared to 2017 from the coverage. And also, you will understand, the industry - the delivery industry is going through consolidation in China. They are also rationalizing their business models, so you can imagine the subsidies or the promotional support from the third-party aggregator has subdued a little bit. And that's another reason why, for 2018, we are aggressively building our own channel as well because we can see the future benefit of strengthening our own channel sales or our ability to drive traffic from own channel while also building the delivery capabilities, the rider team with Pizza Hut. And the long-term duration is not too different from what we have been doing with KFC in the last few years. So in terms of strategy, Lillian, in Pizza Hut delivery, we are moving towards more the - building the own channel with stronger percentage of traffic from own channel, building our own delivery team, delivery rider team while we, of course, in pair are working with the aggregators. So I hope that answer your question, Lillian.

Your next question comes from the line of Xiaopo Wei from Citigroup.

I have two questions. First for Joey. Before I look at operation of KFC in second quarter, I'm seeing that accelerated openings and the decelerated same-store sales. But if I look at restaurant margin, the restaurant margin is quite resilient relative to our expectation because, yearly, when I'm seeing decelerated same-store sales, there will be deleveraging. We understand - we would like to understand the reason. Is that because a strong delivery, preorders or better economics of the new openings? And is that the right way to look at system sales looking forward at the KFC business rather than same-store sales? Any color from you are very appreciated. The second question is for Jacky. We are seeing significant drop in the headquarter G&As. Could you elaborate whether this trend will continue in the second half of the year.

Thank you, Xiaopo. It's good questions. For KFC, given our size of operation, how many store we have, driving same-store sales is really not easy, but we are committed to it. But at the same time, the China market is still a growing market, still has a lot of opportunity. We still have the long-term growth potential to reach 20,000 store. Therefore, we - as a management team, we need to maximize the opportunity and the growth opportunity here for our shareholder by capitalizing on both same-store sales and new store opening. And Q2 is a good example that the new store opening actually will put pressure of things ourselves, but it's absolutely the right thing to do. So internally, we, of course, look at the system sales growth. And actually, historically, back to the high-growth time of Yum China, management really focused a lot on the system sales growth because the new store opening contributes such a high percentage of the sales and profit to the business. But right now - even right now with our 5,600 store, we still see new store opening as a significant source of contribution. So internally and I hope externally, we have more balanced focus on the system sales growth other than just same-store sales growth. In terms of the margin, I think KFC team, over many years, have become very, very good at managing the margin. While on the one hand, whenever we achieve some cost saving, either from cost of sales, cost of labor or G&A, anywhere, our first priority is to reinvest back to customer, let customer have the benefit. And we believe that's the absolute right thing, right way to build a brand in the longer term. But specifically, if you look at the cost of labor from 2014…

Thank you, Joey. Xiaopo, on your second questions on G&A expense, obviously, it is very encouraging to see that our G&A expenses decreased year-over-year in this quarter. I mean, this is the first time we achieved a G&A cost reduction since spinoff. So the quarter and year-to-date decrease in G&A expenses, excluding the impact of foreign exchange, was primarily driven by a mix of one-off benefit and ongoing cost control. I mentioned this on the last call. We set up a special task force in late 2017 just to proactively analyze and manage G&A cost. So we review our overall cost structure, our policies and processes around G&A cost to identify savings opportunities. So in the second quarter, we already started to see some positive effect. And we intend to reinvest some of these G&A savings into new businesses initiatives for the long-term growth of the company. So in the long run, our goal is just for G&A cost to grow at a slower pace than our revenue growth.

Your next question comes from the line of Brian Bittner from Oppenheimer.

This is Mike Tamas on for Brian. Just a quick follow-up on KFC. I'm still not sure that I totally understand what happened kind of sequentially from the first quarter. I understand the comparisons were tough and whatnot. But it sounds like the softening consumer and the stepped-up competitive environment and the effects of cannibalization are not things that are going to turn overnight. So I just want to see, how do you think about same-store sales over the next several quarters, especially with the tougher comparison for the next two quarters.

Thank you, Mike. Given our strong seasonality in our business, it's actually very difficult to compare performance on a sequential basis and forecast on a quarterly basis. Q1 KFC, the same-store sales was very, very good. We have three very strong Chinese New Year that was historically high one year after another year, another year. The team has done a brilliant job to capture that. For Q2, it's on par with our management trend on this very, very low positive side. It's like 0.3%, something like that. The competition certainly has impact, but we have very, very strong program. The new product, which is one of the most important driver of our same-store sales, performed very, very well. And we have very solid program for the Q3 and Q4 as well, and we remain confident with our KFC plan. But in terms of the economy softness, we do see - I mean, it's nothing sort of solid number, et cetera, but you kind of just have to feel that it has certain psychological expectation because we can see our competitors are putting up very, very aggressive promotional activities to either meet the expectation, the customer want more value right now or in the anticipation that there's certain softness in economy that we need to respond to or prepare for. But we remain confident with our program because there are many factors we cannot control. What we can control is our new product, our capability marketing and our ability in the 460,000 staff and in KFC's case, 360,000 staff's ability to execute the program very, very well. Thank you, Mike.

Your next question comes from the line of Anne Ling from Deutsche Bank.

A question on the - also on the KFC. We talk about like accelerated store opening trend. But in fact, right now I would have thought that the rental cost will move up a bit because we have some like new store. But it was actually controlled, but however, it seems that there is a like cost of goods sold. The food cost actually increased. So how should we look at like, moving forward? Is it because we are - the reason is we are doing a little bit more promotion that actually hindered the second quarter like the margin rather than store opening time we're investing in the new store? And in third quarter, we noticed that we are seeing some promotion regarding return - some of the promotion returning to the price back in like 30 years ago. So does it mean that we will see a weaker GC margin in the third quarter? And second one is on the delivery side. We also see that delivery side, I'm seeing some slowdown for KFC. From - in the past, like 40%, 50%; so these days, about 40%. So do we think that, moving forward, this will be the new sort of norm? Or we will see some pickup in the future? And do we have any breakdown in terms of how much of the sales these days in the online delivery come out from our own apps both for Pizza Hut and also KFC?

Maybe Jacky can handle the cost side, and then I'll talk about the promotion price back to 1987. Okay?

Yes. Anne, in the short term, our strategy for KFC is just to proactively invest in food upgrade and value for money to drive top line growth. I mean, the competitive environment's increasing. It's getting more intense. And also, KFC, we are focusing on accelerating new builds to capture market share and build a brand. So this helps to drive system sales growth and operating profit growth, but albeit it creates some short-term pressure on same-store sales and margins. But same-store sales and margins, obviously very important for us for KFC, but the brand is in a market growth phase. China is still expanding rapidly, so store - new store expansion is the key strategy for KFC. So in the long run, it's our market share gains and also our scale expense. And with the investment in digital, data and all the other technologies, efficiencies will improve, so it will create some opportunities for margin expansion and also same-store sales growth.

For the food cost, I just want to comment on our thinking to build a brand. Like, you will see we have some quite exciting ingredients sometimes like the crayfish and - et cetera, et cetera. What KFC has been doing quite well is whenever we could, whenever we could, we will have some - we will invest in some very nice ingredients to say thank you to our customer. Usually, when we do such - when we put together such ingredient, product, the margin's slightly higher. But from our point of view, it's okay because it usually drives the ticket average a little bit more at the cost of slightly tighter margin. So in the short term, we benefit from ticket average. In the long term, we build a brand because you want your customer to think that you have - we have fantastic food and fantastic product. And actually, our approach is sort of saying becoming a case study in our industry, if not, in other - in the retail industry in China. Let me focus on the delivery sales. Delivery right now I mean, the percentage seems to - so on the service slowed down because it grew 26% year-on-year and right now contributed 16% of our sales in Q2 but partly because the pie, the base gets bigger now. The base is much bigger now. For Pizza Hut, it's already 24% of our sales. So when the base gets bigger, the growth rate would naturally slow down. And also, we can see - as I mentioned earlier, we can see the third-party aggregators. They are going through consolidation in their industry to rationalize the business model. So we have seen sort of the subsidies or the promotional activities have slowed down from the aggregator. So in a way - in a short term, sort of we put some pressure on ourselves, but I think, in the long term, this will come. We expect it. And it's the right thing to do because the market bit by bit is back to normal instead of being bundled or pushed up by some excessive subsidies in the market. So Anne, I hope that answer your question.

Yes. And how fast are we...

Sorry, Anne, I think - sorry, Anne, we have a lot of people in the queue. Can we just move on? And you can jump back on to the queue later on.

And your next question comes from the line of Sara Senatore from Bernstein.

So I am just trying to understand what exactly the cannibalization impact might be from new units on same-store sales because you've mentioned it a couple of times. And I was hoping you could quantify what you think that is. And then is there any offset from the fact that stores tend to have better same-store sales in the first couple of years after they're open as they sort of ramp to mature volumes? So if that's the case, if you could just give me a sense of the maturity curve because there have been periods where KFC has grown faster in terms of units, but historically, it's had positive same-store sales at the same time.

Sara, I think there are a few parts of the question here. For the cannibalization, well, when we open a new store, let's say you - let's take an example, if we - in a small city, we have two KFC stores. We opened a third one. well, you would - you can see the sales - we'll have certain sales transfer from the old store to the new store. So the old store would have some impact on the same-store sales, but net-net, it's the right thing to do because, in a market, we have higher system sales growth if that makes sense. Historically, you get - we get both because the base is different. If the base is smaller, then the impact on the existing store is slightly less. Now we have stores everywhere, especially in top tier cities. So the base is different. And thus, when we have the new store opening, it will have slightly stronger impact on the existing store. Maybe Jacky can add to that.

I'll just add on to what Joey said. Well, yes, cannibalization is really difficult to quantify because, I mean, you also have competitors adding new stores as well. So overall, it's just a mix of competition and also our own rapid expansion. And on your questions on maturity curve, maybe I can just share with you. Approximately, it takes 3 to 5 years to reach sales maturity. It depends on location. So it's location by location. But historically, China has been growing so fast, so you see both same-store sales and also store expansion at the same time.

Maybe I'll just add one comment. Like in particularly in lower tier city, why do we still insist on opening new store even the situation we see the impact on the existing store? Because, historically, we also learn that if we open up stores quicker and faster, we will have the first-mover advantage to grow the taste of customer, and that is invaluable to us because once customer like our taste, they are KFC customer in the long, long time. So that is more from the marketing point of view, but we have learned that lesson over 30 years.

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

I've got just one question on KFC same-store sales growth in Q2. Just try to get a better sense on what is going on because we have started various regions at different part of this conference call. I'd like to know, if you look at the traffic decline pressure in Q2, are we seeing more pressure in the lower tier cities or in the bigger cities? And also, the - in terms of the same-store sales growth, is it more because of the cannibalization from the new store opening? Or it is more because of the more promotional environment, high competition, softening consumption environment in China because a lot of other restaurant names have also reported pretty good numbers in for Q2?

Maybe let me just make few comment, and then Jacky can comment on the specifics. For our numbers in Q2, we certainly see the pressure a bit more than historically in the lower tier cities. We have talked about how many store we opened in Q2, for the first half, 65% more. And you can imagine our competitors, big and small, are opening store in lower tier city aggressively as well. So historically, in Yum China, we have higher same-store sales probably generated by the lower tier cities in many occasion, but we certainly see the impact of new store opening in lower tier cities. But at the same time, for the same-store sales, I think you have pointed out very well that we also feel the pressure from the significant increase of the promotional activities from our competitors as well. So that put some pressure on us for sure. I realized I forgot to answer Anne's question earlier, but that's along the seams. So I might just bring it in, is the return the price to 1987 promotion. That is a very interesting promotion because it's very, very big discount, but we were out the number. It worked for us. It worked for us in many ways. It drive traffic, but most importantly, it built a brand. We first ran that promotion - it's not new by the way. We ran the promotion back to last year when we celebrate our 30 years anniversary, and we realized one key asset of KFC is the emotional connection between us - between customer and KFC brand. People from our generation have such strong emotional feeling of 1987 KFC. So we want to capitalize on that, and we want to build a brand in the long term. So in the short term, we've got extra traffic. The numbers were up. In the longer term, it built a brand. So for us, therefore, we continue to run that, and we probably will continue to run that in the future. But usually, such deep discount program is very short, few days, and that will really work. And our customer likes it, and we like it too. Jacky, any other comments?

Yes, in terms of traffic, I'll just add on what Joey just said. I mean, the - we have seen the industry stepping up promotional activities, and obviously, there's more competition in the lower tier cities. But I think, overall, KFC, we have a very clear strategy set up for long-term growth in market share and profitability. So we are very confident in the sustainability of KFC's leading position in the quick service restaurant industry in China.

I guess, one last thing I want to add is KFC has gone through some very interesting time over 30 years, many ups and downs. Back to 2014, we have double-digit negative comp growth for the business, but from there onward, we have gone through very strong turnaround and revitalization. And what has it done to the team is we have amazing team right now that are ready to take on the market challenges and to compete effectively in China and to maintain our leadership here. I sense there is concern of the softness of the economy, and I also acknowledge the increased competition. Actually, Luo Chen [ph], the competition in China's dining sector, the increase of competition is more significant in casual dining than in QSR. We certainly saw that. So in the QSR competition, the number of new store that came into the market last year, it was sort of just on par with what we expected. And KFC is in very good position to maintain our leadership. However, on the casual dining sector, the increase of the number of stores, both from existing and from the new competitor, is very significant. The increase is very, very significant. However, we also - that was 2017 by the way. 2017, we saw significant increase of new store coming in. But in 2018, China, ups and down, we already see the exit or the closing down of many stores as well. But I guess, the beauty for KFC and Pizza Hut as well, we've been here for 30 years, and we have successfully compete and survived and established the leadership in our position - in our market position, and we have confidence that we can continue to do that as well.

Our last question comes from the line of Matt McGinley from Evercore ISI.

Jacky, I have a quick follow-up and then G&A. And I understand that you have that special task force that you said would manage that given the high growth rates from the prior year. But I'm just not sure I understand how much of that step-down either sequentially or year-over-year with the structural reduction in your G&A base versus onetime events like not take stock-based comps. So can you, I guess, help me understand what the underlying base is of the G&A compared to what we saw, I guess, in first quarter or even year-over-year?

Okay. Well, Matt, so as I mentioned, the G&A decline, it was a mix of one-off benefits and ongoing cost control. So just for Q2, we were actually helped by some government subsidies, which is one-off, and then we have also performance-based compensation as the decrease. But overall, it's offset by the salary increase or annual merit increase. So that's the high level breakdown of the G&A decline. Yes - but again, our long term - in the long run, our goal is just to keep G&A growth less than our revenue growth.

Okay. Thank you, Jacky. And thank, everyone, for your time in joining the call. With that, we conclude this earnings call. Have a good day. Thank you.

Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may all disconnect.