Ladies and gentlemen, thank you for standing by, and welcome to Yum China 2019 Third Quarter Earnings Conference Call. [Operator Instructions]. I must advise you that this conference is being recorded. I would now like to hand the conference over to your speaker, Florence Lip. Thank you. Please go ahead.

Thank you, Raq. Hello, everyone, and thank you for joining Yum China's Third Quarter 2019 Earnings Conference Call. Joining us on today's call are Ms. Joey Wat, CEO of Yum China; and Mr. Andy Yeung, 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 call will include certain non-GAAP financial measures. You should carefully consider the comparable GAAP measures and reconciliation thereto. Today's call includes four sections: First, Joey will cover Yum China's third quarter 2019 highlights, and Andy will cover the financial results before Joey provides an update on our strategic priorities. We will then open the call to questions. The webcast of this call will be available on our IR website. A PowerPoint presentation, which contains operational and financial information for the quarter, is available for download as well. At this time, I would like to turn the call over to Ms. Joey Wat, CEO of Yum China.

Thank you, Florence. Hello, everyone, and thank you for joining us today. Let's start with the overview. We are pleased with our continued strong performance and robust operating profit growth in the third quarter. We continue to build on our market-leading position in China and further strengthen our competitive advantages in the area of innovation, digital and delivery across the whole of our business. Let me share some highlights from the quarter. First, we delivered our 12th consecutive quarter of system sales growth since spinoff with positive same-store sales growth at both KFC and Pizza Hut. Second, we are on track to hit the high end of our new store target of 800 to 850 for 2019. This is driven by the good performance of our brands, in particular KFC, and the many attractive opportunities to expand our portfolio across China. Third, we continue to innovate on multiple fronts. This includes launching exciting new products and leveraging technology to drive sales and operational efficiency. We continue to see strong growth in our digital KPIs, including total members, members' contribution sales, digital orders, Privilege subscriptions and delivery sales. I also want to formally welcome Andy Yeung, who has recently joined as our new CFO. Andy brings a wealth of finance experience, specifically given his tenure serving as CFO at other companies, including a New York Store Exchange-listed technology company. I would like to thank Jacky for his leadership over the last several years and wish him all the best as he relocates back to Hong Kong to be closer to family. With that, I would like to walk you through the third quarter performance. Let me start with the progress we have made on the digital and delivery front as they are a crucial driver of our success. Maintaining our market…

Thank you, Joey. Good day, everyone. Thank you for joining us today. I'm very excited to have joined Yum China recently. I look forward to meeting with everyone in the coming months. Now let us turn our attention to the third quarter financial results. Total revenues was $2.3 billion in the third quarter of 2019, up 8% year-over-year, excluding foreign exchange translation. Total system sales grew 8% year-over-year, excluding FX, driven by same-store sales growth of 2% and new store openings. We opened 231 new stores during the quarter, increasing our total portfolio to 8,917 restaurants as of the end of September. We have opened 646 restaurants year-to-date and are on track to hit the high end of our target, which is 800 to 850 new store openings for 2019. KFC same-store sales grew 3% driven by a 4% year-over-year increase in ticket average. This was due to increased share of delivery, lower promotional activity and increased pricing. Traffic decreased 1% year-over-year primarily due to few value promotion. Pizza Hut achieved its third consecutive quarter of same-store sales growth of 1%. Traffic increased 6% year-over-year, remaining positive for both dine-in and delivery. This was largely driven by increased promotional activity year-over-year, which also drove a 5% year-over-year decrease in ticket average. Overall, Yum China restaurant margin was 17.7%, slightly up compared to the same period last year. Wage inflation was 5%, while commodity inflation was 2% compared to the same period last year. We continue to expect overall commodity inflation to be low single digits for 2019. KFC restaurant margin increased 0.9% year-over-year to 20.1%. It was driven by sales leverage, lower intensity of promotions and excellent management of core sales and labor productivity during the critical summer peak season. Combined, this more than offset margin pressure from wage inflation…

Thank you. Thank you, Andy. I wanted to take a few minutes at the end of the call today to highlight our overall strategic priorities. In short, we are focusing on a number of key areas that will drive our long-term growth. First, we will focus on expanding our core brands, KFC and Pizza Hut. In the near term, as Andy mentioned, we have a very busy investment program in terms of both remodels and new builds in the fourth quarter. In 2020, we expect to open stores at a similar pace compared to 2019. Second, we will continue to invest in key growth opportunities, including our smaller brands. We expect to accelerate the store openings of our smaller brands. In particular, we'll be increasing our investment in expanding our presence in the coffee category. We believe coffee has a bright future in China, but it would take additional patience, hard work and investment to fully realize this segment opportunity within our diversified portfolio. Third, we will leverage and increase our investment in our industry-leading digital and technology capabilities. Fourth, we will be vigilant on controlling costs and driving efficiencies to protect margins. That being said, given the current pressures across the protein supply due to pork shortage, we anticipate 2020 will be another challenging year for commodity inflation. We will be prudent on the portion of these costs that's passed on to our customers, particularly for Pizza Hut. We will continue to build on recent gains made in our value-for-money perception. We will provide additional details on specific 2020 targets with our Q4 earnings release in early 2020. With that, I'll pass it back to Florence to start the Q&A. Florence?

Thanks, Joey. We will now open the call for questions. [Operator Instructions]. Operator, please start the Q&A.

[Operator Instructions]. And our first question comes from the line of Michelle Cheng from Goldman Sachs.

Congrats for the very good results, especially KFC. It's such a competitive and high-potent coffee inflation market, we'll still deliver strong margin improvement. But can you please give us some color about the chicken cost increase in the third quarter or year-to-date? And I believe you probably have some visibility on the first quarter's cost trend, can you also share with us? And given we have such a strong product innovation and cost efficiency, can we have some idea about how should we look at the margin trend into next year for KFC?

Okay. I will take this question. This is Andy. So regarding overall commodity price inflation, I think it was 2% in the third quarter for us and about 2% in the first half this year. For full year, again, we expect that to be at low single digits. I think all through this year, we've seen significant price increase in protein in China driven by the African swine flu, and that is likely going to continue. The commodity prices are volatile so it's hard to predict going forward. Chicken prices, as far as we know, up almost 20% to 30% year-over-year in China this year. For us, because we have very strong supply chain and procurement management, so we are able to manage that significantly below that. And in fact, we have probably managed that below 10% this year. In terms of commodity prices, again, it's very hard to predict because if you look at spot prices, for example, in September, I think it reached a new record, up almost 60%-plus year-over-year. So I think we'll continue to monitor the situation and give you guys an update. But again, I want to mention that our team have done an amazing job in mitigating the impact of elevated chicken price inflation through several initiatives, supply chain relationship, leveraging our scale and long-term partnership with our suppliers. And then our team also have tremendous product innovation creating products using our chickens and also non-chicken protein choices. So we have been able to manage that commodity price pretty well this year. And so if you think about this, with all the effort, the impact will be more significant. So chicken is about 4% of our cost of sales, and it have increased by 20% to 30% this year. So that would normally mean 8% to 12% commodity inflation just from chicken alone and about like 2.5% to 3.5% impact on our margin. Obviously, we haven't seen that kind of impact on our overall margins and our sales increase. So hopefully, our team will continue to be able to do a good job in managing that pressure as well. Joey?

Sure. I just want to add two comments, Michelle. One is we are excited and committed to our vision of becoming the most innovative restaurant company in the world. So in this -- in facing the challenge of chicken price hike, we certainly take this vision even more serious than otherwise it would be. So for Q3 alone, we have some really exciting new products like the portobello mushroom burger, which is we replaced the meat with the entire piece of portobello mushroom with cheese in the middle. We have the duck wrap instead of -- other than chicken wrap that we traditionally have, we have the duck. We also, in our combo, start to introduce chicken strips to replace chicken wings. So although still chicken, but the cost on chicken strip, which is essentially breast meat which is not very popular among the Chinese customer, the price of chicken strip is lower. So our product innovation will continue for the rest of the year and going forward for next year. And it's very exciting. We even get to the point of selling a lot of [Foreign Language], which is the last small tip of the chicken wing, which is not something you think that we can sell but we could because there are a group, not a huge group, but there's still a group of people who just love it. So that's point one. Point two is our commitment to good food. If we look at our cost structure, let's say with Pizza Hut, we can see improvement of the cost management in almost every line, but we leave the flexibility to cost of sales. Why? Because it's our commitment. We would push ourselves to drive efficiency and effectiveness in everything. However, we have the commitment to pass all these savings, better food, to serve our customers. Even though we are a big business, but we need to have that sincerity, and good food is sincerity to a customer. And we have the commitment. And thus, we always have the flexibility there in terms of investment, but we must have the good product of us to drive good traffic and increase sales. Thank you, Michelle.

Yes. I think I'll answer the -- sorry, I think I'll answer the same question, some part of the question, which is about the margin trend for KFC. I think a couple of things, right? One is that I think, in the fourth quarter, as we mentioned before, we're going to accelerate our store remodeling, so that will have an impact on our sales and margins. And also, if you look at KFC, it also benefit from some onetime items, including the tariff rebate, which impacted -- benefited our margin by 0.3%. And then also, we also benefited, as Joey mentioned, to a very successful rollout of some of our productivity, especially in the summer peak season. We gained a lot of productivity improvement, and that may not be as prominent in the fourth quarter, which is traditionally a smaller quarter and not a peak season for us. So overall, I think also for the sales, also if you look at KFC, we'll be lapping some very successful initiative, right? We have the first full quarter of Crazy Thursday that rolled out in 2018. So that will be a tough comparison lapping that. So all in all, I think the margin trend, we have done a great job and I think better than we have expected probably in the third quarter, and I think it will normalize more in the fourth quarter.

And our next question comes from the line of Chen Luo from Bank of America Merrill Lynch.

I've got a question on the sales. Just now, Andy mentioned that we expect a moderation of sales growth in fourth quarter. Are we talking about the slowdown of same-store sales growth compared with Q3? And we also highlight that in Q3, we have purposely scaled back the promotional intensity to achieve a balance between margins and same-store sales growth. But going forward, we are going to see very tough laps of same-store sales growth. Are we going to continue with this balanced strategy or, if necessary, we are going to actually step up promotion again to sustain same-store sales growth? Any color on that front will be helpful.

Thank you, Chen. So yes, you're right. Like so if you look at the third quarter, the margin improved at KFC partially due to the strategic management of promotional activities. So again, I think our team will continue to look at balancing between promotional activity versus protecting margins and respond to the market appropriately. And so -- but we do expect that some active in promotional activities is likely in the fourth quarter for KFC. So hope that answers your question.

Yes. Okay.

I think Andy just mentioned a bit earlier that we just have to remind ourselves that quarter four last year for KFC was very strong. That's the first full quarter of Crazy Thursday, which is one of our best promotions now. And with that strong result, naturally, we will have the challenge of lapping this year for the Q4. But at the same time, as we mentioned a few times already, given the cost pressure particularly in Q3 and looking at Q4, we also look for ways to protect our margin as well. The third point is same-store really is not the only criteria for Yum China. Despite the scale of our business, we are still growing very fast, and the market opportunity is still very exciting there. We will not be doing something good and fair for our shareholders if we do not have a good balance of same-store sales and system sales growth. So if we look at Q3, for KFC, the same-store sales is 3%, but the system sales is 10%, which is fantastic given the scale of our business already. So Q4, as Andy mentioned, we -- while we are driving the same-store sales, this is also a very big quarter for us to build new stores. And we must keep this pace going to maintain our dominant market leadership in our business. So therefore, you can see the balanced consideration from a management team's point of view towards Q4. Thank you, Chen.

And your next question comes from the line of Xiaopo Wei from Citigroup.

Andy, welcome to the company. I have one question regarding the new opening and, as you mentioned, on the release that you accelerate opening in the third quarter. Interestingly, we are seeing very impressive improvement in KFC restaurant margin. Shall we say that actually, the new store restaurant margin on a like-for-like basis actually is better than last year? Because we are seeing you are opening more stores looking forward, shall we say that the drag of a new store looking forward on a like-for-like basis actually will be much less than previous years? Because I'm seeing the trend that your top line is more driven by the new opening looking for rather than the same store. If your restaurant margin of the new store, it is better than previous years, shall we say that the margin pressure will not be as much as we feared by normal operation?

Thank you, Xiaopo. Let me take this question. For the Q3 restaurant margin, there are a few contributing factors. One, as Andy mentioned earlier, there are some one-offs, like the tariff rebate, like the government incentive that was happening in Q4 last year. This year, it moved to Q3. But more importantly, actually, we have some very impressive labor productivity gain during the Q3. I mean that number is big, and that number is from all stores. And there are reasons behind it. And the cost does not go down by itself. Usually, it's a result of a very aggressive management and hard work behind. So the hard work behind the all-store labor productivity and thus the restaurant margin is our new real-time automated labor scheduling system in place. So right now, for all my store managers in KFC, the data of the operational detail, particularly for labor scheduling, is real time, it's in their phone, we call it [Foreign Language], the manager in your pocket. So the transparency of the data and then the automation of the labor scheduling, gives our store managers a very good tool so that they can respond and react immediately. And this particular benefit is very, very important. And it was proven in our Q3, which is our peak trading season for the summer, right, it's very, very significant. And thus, Andy also mentioned earlier that such benefit is less likely to replicate in Q4 because Q4 is a very small quarter. So we spend a lot of money on labor cost, and the saving there is slightly more impressive. So the restaurant margin really is -- the improvement is the result of all store margin not only a new openings. But all our new opening stores, we do have a bottom-up approach. Each store, the decision to open one single store, any store in Yum China, we have a very robust process to approve it. However, when the new store mature, then we are expecting a bit more benefit from it as well. Thank you, Xiaopo.

And your next question comes from the line of Anne Li from Jefferies.

I have a question. Regarding Pizza Hut, Pizza Hut always have promotion. We noticed that not only is it Scream Wednesday but also Scream Monday, Tuesday and Wednesday for some of the weeks in the third quarter. So is that 1% same-store sales like up to management's expectation? And we also see like margin a little bit more volatile. I think we can understand that. But like what do you think that -- in terms of restructuring Pizza Hut, what is still missing? Is it more like -- in the four pillars, which one will be the one that you want to highlight a little bit more about? Are you happy with your current ASP for Pizza Hut? If not, what are the trends? And maybe just one follow-up question from -- a sales question. Regarding the one -- you mentioned about the one-off costs -- one-off gains regarding the labor efficiency. Is it fair to say that although it happens in the third quarter, it might not be that impressive in 4Q and this efficiency will come back again in first quarter and third quarter next year because it's a high season?

Thank you, Anne. There are quite a few questions here. Let me try to start with the big picture. For Pizza Hut, we are very happy with the third quarter of same-store sales growth and then also the consecutive fourth quarter of traffic growth, which is the first time we achieved since 2014. And then the year-to-date margin is actually 12.4% versus last year, 11.8%. So with all the good efforts going in despite the seasonal -- despite the quarterly fluctuation, we are very happy with the overall trend. So when it comes to the same-store sales growth, is it in line with our expectation? We always want a bit more if we could. But we are happy with the positive same-store sales. And in terms of ASP and all the four pillars that we are all familiar with, my thoughts are as follows. One is it's very good for the business in the long term when we are driving traffic, even when the ticket average or ASP is going down. What does that mean? It means that we are rebuilding value for money, which is absolutely critical for our business. So for our dine-in business, the trade-off is very obvious, and the result is impressive. We are increasing 10% TC and then TA go down 9%. That's what we wanted. That's good. In terms of four pillars, I guess the question is what else can we do. The answer is we continue to drive four pillars. But the focus will shift slightly along all four pillars as well. As we get something under the belt, we'll move on to the next thing that we can focus on. Let me give you an example, the fundamentals. We are talking about menu, the product, the value for money, the layout, et…

Well, I would add a little bit more to that. So like if you look at the labor book, you see improvement in the summer season, I think that's because during the summer peak season, normally, we have a larger temporary crew. And generally, the labor productivity because of that is lower. But with this near-time, almost automated, labor scheduling tool, we're able to see significant improvement in labor productivities. Now we continue to expect this tool to be helpful in improving labor productivities throughout the year. But obviously, the lowest-hanging fruit for that is in the summer peak season where labor, demand and supply are more different. So hopefully, that addressed your question.

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

I think a lot of questions were answered. I have a follow-up question. I think so far, Pizza Hut is on a very good trend. As Joey mentioned, positive traffic is a very important metric that we need to follow at this stage. So in terms of balancing Pizza Hut and KFC rolling over to 2020, I know it's still early to give exact guidance, but in terms of strategic focus, between those two, what's the most biggest challenge in 2020 for KFC and Pizza Hut?

Let me share my thoughts, Lillian, thank you. For 2020, a more specific target guidance we'll give in Q4. But I think as we can look at it right now for KFC, obviously, the same-store sales because Q1, Q2 this year was very, very strong, it was phenomenal, like 5% same-store sales plus the new store opening, that is very, very tough to lap. And then the chicken price, it will continue -- the chicken price pressure, it will continue. And then the third bit is the labor productivity. While we are very happy with the Q3 improvement, Q4 -- for next year, every year is a challenge because of the government minimum wage challenge to the fundamental nature for our business and how are we going to continue to learn to use our new automated scheduling tool. So these are the sort of the Top 3 challenges that we are paying a lot of attention to. And last but not least, the new store openings, obviously, while we are targeting and pushing ourselves for same-store sales -- for positive same-store sales, we are acutely aware that there's huge opportunity in China market because we're only in 1,100 cities, and there are still 700, 800 cities that we don't have a KFC, and we still want to keep the pace. So to balance the multiple sort of focus for the business is always a tough game. For Pizza Hut, the revitalization will continue, as I mentioned many times before, the focus is still on four fundamentals. And it does take two to three years' time after turning around the same-store sales to cement all the changes I mentioned along the four key pillars and others that I did not mention. Because for a turnaround -- for a revitalization process, because Pizza Hut is still very profitable, it just require tweaking the key dimension of the business, but also everything else. However, there's still a fundamental difference between the two businesses. What are the differences here? For our priority of making decisions, we are very clear, we want the traffic first. We want the sales, and then we want to profit. So Pizza Hut, because of where it is, we certainly focus on the traffic and sales, and we give a bit more flexibility to the profit because that's where the business is. However, for KFC, the return is higher. Not only we wanted traffic, we wanted sell but we also want the profit. So this is something someone clever described that sales is vanity, profit is vanity. And as a good business people, we want a bit of both. And we certainly want a bit of both for KFC, and we are probably okay for Pizza Hut. We have a bit more vanity than sanity for the time being. So thank you, Lillian. Andy, any...

Yes. So I'll add a little bit. So I think it's a little bit too early to provide specific guidance for outlook for 2020. But as Joey mentioned, I think there are a couple focus that we're going to have, right? One is that we're going to continue to drive sales through product innovation, so again because we're going to face some headwinds in the commodity prices. And then the second part is that we will also invest in a number of areas, right, store remodeling, we'll also invest in technology, that's very important for us next year as well. We'll also continue to invest in our own delivery platform. And so it will be likely an investment year for us in 2020 as well. So I think -- overall, I think we will see some tough comparisons, for example, because both Pizza Hut and KFC have very strong first half 2019 so it would be a tough comparison. If you remember, like we achieved same-store sales growth of almost 5% in the first half for KFC, so that would be a pretty tough comparison. So as Joey mentioned, we expect then to have both vanity and also sanity, so that will be a component for them to balance between continuing sales growth and also of maintaining, protecting margins going forward. So thank you, Lillian.

And your last question comes from the line of Dylan Chu from CLSA.

Actually, most of my questions have been cleared, so thanks for a lot of details. I guess, could I please maybe ask about your coffee strategy? Because I recall, Joey, you mentioned this is still a large potential area but you still need patience. So I'm just wondering if you could elaborate a bit on that. Sort of what kind of signs, which you need to see or what kind of metrics do you need to see before you want to invest in coffee a bit larger scale? And what kind of initiatives would drive to do that? Just slightly longer term, coffee is certainly a big potential category. But currently, it seems mostly food drives coffee. Coffee is sort of a supplement to our other food categories. In the future, do you think coffee has the potential to drive food, the other way around, at least in some of the dayparts? Just any color on that will be really helpful.

Thank you, Dylan. We believe in the great potential of the coffee business, and we are committed to grow our coffee category. And there are two areas that we are focusing on right now. One is K-Coffee. Because coffee is a very, very resilient business model already, and we are introducing or growing the coffee as a product inside the business. So as I mentioned, year-to-date, we sold 98 million cups already, and that's more than the total of 2018 full year, which is about 49%. Well, let's round it up, call it, 50% increase. So that's very, very impressive growth. And this number of coffee cups growth is comparable to some other pretty significant other coffee players in the market. However, given the base of business, our coffee business, even with almost 100 million cups sold, it's only 3% of our business. And we are very happy with the growth, in the 3%, but it just gives you the sense of the scale of the overall KFC business and Yum China business there and thus the challenge of growing. The other bit of the coffee strategy is the C&J, the COFFii & JOY, which we are building and rolling out. And this is a new brand. When it comes to building a new brand, it takes time, right? Whatever successful brand that we're testing up in China like KFC, Pizza Hut and others, it does take time because not only does it take a great product that customers know already, but we have to build the store prototype, build the brand, build the supply chain, build the member base, build the talent pool and the complementary offering, such as food, in order to build the brand. And right now, we are also testing the scale and network effect as we increase density of our store in a given trade zone. So where we are right now, we have opened 19 stores in Q3 -- by Q3, and we are targeting to get to 40, 45 stores by the end of the year. And next year, we'll commit -- we are committed to increase our investment. But the decision is always dynamic. It's a dynamic process, which is the same as Pizza Hut and KFC when it comes to new store openings. It's a dynamic process. It's a bottom-up process. But we are committed to grow the scale so that we can continue to learn all these building blocks of a new coffee brand, including the scale and the network effect. So that's where we are in terms of the coffee strategy, Dylan. Thank you very much.

All right. Thank you for joining the call today, and we look forward to speaking with you on the next earnings call. That concludes today's call, have a great day.

Thank you, Florence. Thank you.

Thank you.

And that does conclude your conference for today. Thank you for participating. You may all now disconnect. Speakers, please stand by.