Yum China Holdings (NYSE:YUMC) Q2 2020 Earnings Call

0:00 Ladies and gentlemen, thank you for standing by and welcome to the Yum China 2020 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Following the presentation, there will be a question and answer session. To ask a question today, you will just need to press star 1 on your telephone. But I will now hand the conference over to your first speaker today. Thank you and please go ahead, Debbie. Thank you, Operator. Hello, everyone, and thank you for joining Young China's second quarter 2020 earnings conference call. Joining us on today's call are our CEO, Ms. Joey Wat, and our CFO, Mr. Andy Yang. Before we get started, I'd like to remind you that our earnings call and investor presentation contains forward-looking statements, which are subject to future events and uncertainties.

0:49 Our results 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. Consideration of the non-GAAP and GAAP measure is included in our earnings release. Today's call includes three sections. First, Joey will provide an update regarding recent developments. Then she will offer some highlights around the quarterly results. Andy will then cover the financial results and provide an update on our four-year outlook.

1:34 Finally, we will open the call to questions. You can find the webcast of this call and a platform presentation which contains operational and financial information for the quarter on our IR website. Now I would like to turn the call over to Ms. Joey Wat, CEO of Young China. Joey? Thank you, Debbie. Hello, everyone. and thank you for joining us today. I will first update you on COVID developments and then we'll move on to cover performance in more detail. Throughout the COVID pandemic, we have been committed to safely providing good food, great value and convenience for our customers wherever they are. Safety is the key word here. At our stores, temperature checks, face masks, and frequent disinfection and cleaning protocols remain in place.

2:29 A safe and healthy environment creates confidence for customers and employees, which helps drive recovery in our business. We approach this challenge with an open mind, with flexibility, speed and the courage to try new things. Our nimble marketing, enabled by our digital infrastructure, helped drive improvements at both of our core brands compared to the first quarter. KFC launched Buy One Get One Weekend in June for the first time for our members. Pizza Hut drove traffic with its first ever all-you-can-eat promotion, featuring steak and baked crayfish.

3:16 We focused our resources on engaging with our members, targeting specific specific offers and promotions. Our privileged programs drive frequency, span, and cross sales. However, we are still experiencing significant headwinds. The recovery path is nonlinear and uneven. April and May sales improved sequentially, while June was impacted by delayed school holidays and more stringent social distancing due to resurging regional infections. Our transportation and tourist locations continue to experience significant year-on-year volume declines, which impacts KFC more than Pizza Hut.

4:05 Around 60 of our stores in Wuhan and northern China remain closed for the time being. Even with short-term uncertainty, we are enthusiastic about our long-term prospects In an incredibly challenging environment, we celebrate three important achievements. First, we opened our 10,000th store in July. This is truly an incredible achievement that would not have been possible without our exceptional employees. We are seizing this opportunity to expand our footprint. Second, Pizza Hut has now been serving our Chinese consumers for 30 years. Beginning in June, we kicked off our 30th anniversary celebration with an all-new menu and all-you-can-eat promotion.

4:59 We saw long queues and new customers. We are now a proud food service sponsor of the 2022 Olympic and Paralympic Winter Games in Beijing. We are honored to work with the Olympic Committee to promote Olympic values of excellence respect and friendship here in China to our millions of members and customers. These achievements show how Yum! China has become deeply ingrained in the lives and memories of millions of Chinese people. From the first taste of KFC in 1987 in Beijing to trying something new at Pizza Hut, we are proud to be the largest and still growing restaurant company in China.

5:45 With the combined effort of our team, we continue our sales recovery and, importantly, remain profitable in this quarter. This profitability is a reflection of our resilience, our adaptability, and the strong, dedicated execution of our team. As we enter the third quarter, I look forward to continuing our innovation journey. We are cautiously optimistic. The recent regional outbreaks highlight that the recovery is nonlinear and uneven. While the summer season will be challenging, I'm grateful to be leading a dedicated team to ensure that we are building a strong and stronger Yang China.

6:35 So let's talk about digital strategy. Benefits of our digital strategy were particularly evident over the past few months. I would like to take some time to talk about how our member program and digital ecosystem have built our resilience, both for the short and long term. Our over 265 million members provide a strong base for engagement. We interact with members within a digital ecosystem supported by our super app, strategic partnerships with online platform and in-store digitization, Whether letting our customers know about our contactless delivery model or promoting weekend-specific offers, we reach our members faster, with greater flexibility, and at lower cost.

7:29 Member sales account for over 60% in the second quarter. While overall sales declined during the outbreak, our year-on-year member sales grew by double-digits. We acquire new members in innovative ways. Using popular social media apps and websites, we convert online traffic into in-store sales. We also engage at the corporate level. Over 10,000 corporations have signed up to our corporate delivery program, bringing entirely new groups of customers to Yum! China. Once members are acquired, we are able to design more targeted promotions, We improved the stickiness of our members as they use our super app or mini program, eventually upselling members into our privileged program.

8:21 We have sold close to 10 million privileged subscriptions this year. Frequency and spending of these loyal users is more than double pre-subscription levels. Overall, we doubled the average revenue per active member over the past few years. Our members are increasingly loyal to our brand. Engagement is crucial for our member retention. Over years of consumer insight, we have developed award-winning games, marathon clubs, and even one of the largest online children's bookstores on our KFC app. Whether through short-term promotions or long-term member engagements, Our digital strategy extends across brands and channels, from dine-in delivery to takeaway. With this solid digital foundation, we are well positioned to capture future growth opportunities.

9:24 Off-premise dining remains a key pillar of growth. Delivery sales accounted for 29% of sales in a quarter, a 36% year-on-year growth. Our delivery business is top of mind with our consumers. Its consistency rates highly in taste, convenience, and value. Our dedicated delivery riders once more support growth during this time. At Pizza Hut, digital engagement drove incremental takeaway growth. With redesigned menu and packaging suitable for takeaway, we used our digital channels to communicate the value and convenience of our one-person set meals. Over half of all takeaway orders were done through mobile.

10:16 I'm proud of our achievements thus far, but there's much more we are targeting. From ready-to-cook, corporate, and late-night deliveries, we have the scale, the resources, and the vision to capture those future opportunities. Now let's move on to menu innovation and value promotion. Our digital initiatives rely on an enticing innovative menu to get customers excited. Pizza Hut launched its new platinum menu in conjunction with its 30th anniversary celebration kickoff. Learning from successful limited time offers, this menu is substantially fresher, extending our appeal to young and family-oriented customers.

11:06 We showcase our pizza innovation with our Pizza Air series, Bo Cui Bing Di Xie Lie, thin crust pizzas that appeal to smaller appetites. We extend our leadership in the steak category with Thicker Anger Steak, and importantly, make steak available for delivery. Our Monet Afternoon Tea Set, with virtual reality effects of Monet paintings in select stores that appealed to our young social media savvy customers. Many menu items also got an upgrade. Our baked crayfish with cheese got high marks on value and our lasagna was appreciated by young and old alike. I'm really excited about all the innovation in our 30th anniversary menu.

11:57 The look and feel show our pizza and our Pizza Hut positioning, which is always something new. So I hope you will try it soon. Cassie brought back favorites, Beef Wraps and Taco Jr. during the quarter, with crayfish in the taco to showcase abundance and premium. We extended drinks, desserts, and late-night delivery lines. Our breakfast tofu pudding, which is Xin Dian Feng Wei Dou Hua, quickly became a crowd favorite, and we showcased festival innovations with exciting products such as scallops, salty egg yolk, rice dumplings. In Chinese, that's 干贝咸蛋黄八宝粽子.

12:45 To drive traffic, KFC also launched value campaigns throughout the quarter. A plant-based protein pilot was successful, introduced across KFC, Pizza Hut, and Taco Bell. They sold out quickly. Once the domestic production may be scaled, this has great potential to bring our brand to new and discerning consumers. Now, let me wrap up with a few brand-specific observations. First, KFC. KFC continued to demonstrate its resilience and operational excellence. Second quarter transactions substantially improved compared to the first quarter. Compared to the rest of our portfolio, KFC has a higher concentration of stores located in transportation and tourist hubs.

13:41 And they are impacted by the downturn in business and holiday travel. Delayed and shortened school holidays, together with lingering effects of the outbreak on consumer behavior, will continue to pressure sales. We will work on providing value and occasion to draw customers in, but recovery is likely to take an extended period of time. Next, Pizza Hut. Our 30th anniversary All-You-Can-Eat campaign went viral with over 80 million views and comments on social media, driving long queues and obstacles. We have seen encouraging signs of transaction recovery, However, the delayed and shortened summer holidays will impact our business as well.

14:31 We will strengthen our offerings for individuals and for delivery and takeaway while family dining volumes recover. Third, Taco Bell has now expanded beyond Shanghai. We opened our first flagship store in Shenzhen and will be opening soon in Beijing. We are excited to bring this new cuisine to more of China. and we are working hard to create an appropriate business model just right for Chinese customers. Finally, integration of our Chinese dining unit is on track. Our Little Sheep and Huan Ji Huan store sales are recovering and we are leveraging the Yangtze network in areas of delivery, retail and logistics to further Huan Ji Huan's capabilities.

15:21 I will hand over the call to our servo, Andy Yang. Andy, please.

15:25 Thank you, Joey, and hello, everyone. I will first address financials and developments in the second quarter, then provide some color on our outlook. Unless noted otherwise, figures mentioned refer to the second quarter of 2020. All percentage changes are before the effect of foreign exchange. Now, let me start with the second quarter results. With over 99% of stores open, Total Q2 revenues recovered to 93% of the prior year. In the first quarter, revenues were 79% of the prior year level. Both of our core brands have quarter-over-quarter improvement in transaction volume. However, traffic is still below pre-COVID levels.

16:13 KFC's theme store sales recovered to 90% of prior year, compared to 89% in the first quarter. We saw sequential increases in average unit volumes in April and May, but a weaker June, while weaker weekday and dine-in recovery benefited from our promotional campaign, regional differences persist. Our transportation and tourist hub sales, which accounted for high single-digit sales mix, were still significantly and negatively impacted. The higher mix of younger school-age customers meant that the delayed and shortened school holidays had a bigger impact on KFC than Pizza Hut.

16:59 Lingering effects of the outbreak on consumer behavior remain a headwind. Pizza Hut seems to have sales recovered to 88% of prior years. This is a significant improvement from the first fiscal quarter when sales were 69% of prior years. Relative to KFC, Pizza Hut has a significantly lower exposure to transportation hub locations. Our store in lower tier cities continues to perform better than stores in the higher tier cities, partly driven by a higher concentration of transportation hubs and tourist locations in higher tier cities. Our strong brand equity also helps relative performance in the lower tier cities.

17:46 The sales recovery is nonlinear and Anivin. As Joey mentioned, growth momentum was slowed by the resurgence of regional infections, delayed and shortened summer holidays, and continued anemic sales at major transportation and tourist locations. We opened 169 stores, mostly at KFC. Construction activities have mostly normalized, and the pace of the new build is on track. The threshold margins were 13.7% compared to 14.7% last year, mainly due to sales leveraging, which was partially offset by our efforts to control costs and runoff benefits. Cost of sales was 32.9%, a 1.4% year-over-year increase.

18:37 While protein supply eased in the second quarter, our contracts are generally signed three to six months in advance. Commodity inflation for the quarter was 3%. Value promotions are key to drive traffic into our stores, which will also impact our margins. Cost of labor was 22.7%, a 0.7% year-over-year decrease. Productivity improvement and temporary relief more than offset the impact of sales leveraging and wage inflation. Within this figure, Wage inflation was 3%. This was used in many of our markets as government-mandated increases in minimum wage were deferred.

19:26 And increased proportions of delivery sales contributed to higher labor cost percentages. These factors were mitigated by digital scheduling tools and pocket manager real-time monitoring, which drive improvements in productivity. Lastly, Reductions in social insurance payments were roughly $30 million. We negotiated approximately $10 million in rental relief in this quarter. We implemented cost realignment measures and benefited from reduced social insurance payments. However, due to timing of government incentive receipts, G&A costs increased by 8% year-over-year, excluding the impact of timing shifts of government and other one-time expenses G&A would have decreased slightly year-over-year.

20:20 We recorded impairment charges of $24 million. We achieved offering profits of $128 million, bolstered by cost realignment and one-time relief. Looking below the line, our gain from equity investment in May 2020 was $45 million, which is before $14 million in U.S. income tax, relative to gains recognized during the second quarter and prior period. Our effective tax rate was 25.2%. Net income was $132 million. Diluted EPS was $0.34, and adjusted diluted EPS was $0.35. Now, I will turn to our outlook for 2020. The situation is still evolving.

21:08 However, resilience, adaptability, and innovation are key strengths as we Navigate an Unprecedented Environment. Our outlook is based on certain key realities. One, transportation and tourist volumes continue to be unlimited. Two, the delay and shortened school holidays will impact sales momentum. Three, the COVID situation is unpredictable with its lingering effects and regional outbreaks. We expect the recovery to remain nonlinear and uneven. Four, will continue to pressure margins, especially as one-time government and rental leave are face-up. In response to this reality, we need to be patient and vigilant in rebuilding ourselves' momentum, focusing on our strength in manual and digital innovation.

22:03 Successfully leveraging our member base and digital ecosystem to drive frequency and spend will be key. Our promotions are adaptable, and we have seen some successes in building weekend recovery through greater value offering. Lastly, we are taking decisive actions to realign our core structure. As we look ahead, we continue to target 800 to 850 new stores for this year. Investment in digital technology and supply chain continues. Our 2020 CapEx plan is unchanged in the range of 500 to 550 million dollars. We expect wage inflation to stay at mid-single digits this year, as minimum wage increases have been delayed in many provinces.

22:53 Finally, while protein supply in China appears to be loosening, our best estimate of 2020 commodity inflation is for low single digits. Risks to your global supply chain remain, which may have potential implications to our domestically sourced products. As previously announced, we will increase our stake in the Suzhou KFC Joy Venture. The transaction is expected to close in August, subject to satisfaction of closing conditions. We see the new normal of reduced travel, social activities with bouts of disruption as secondary regional outbreaks occur and are contained. The lingering effect of COVID will impact consumer behavior.

23:41 That being said, With our digital infrastructure, solid execution, and strong balance sheets, we are prepared to capture opportunities for recovery and growth. With that, I will pass you back to Debbie to start the Q&A. Debbie? Thanks, Andy. We will now open the call for questions. In order to give as many people as possible the chance to ask questions, please limit your questions to one at a time. Operator, please start the Q&A. Thank you. Ladies and gentlemen, again, we will begin that Q&A session. If you did wish to ask a question, again, you can just press star 1 on your telephone keypad and just wait for your name to be announced. But your first question comes from Chen Lu from Bank of America. Please ask your question, Chen.

24:30 So I noticed that we highlight a few risks and challenges throughout the conference call and also in the earnings announcement. We also mentioned that these challenges may continue to impact operations in July. Can you actually help to give us a little bit more color on how we compare the July performance with June? Are we seeing any sequential improvement? And just now, Joe, you also mentioned that the summer season is likely to be challenging. And do we have any rough idea as to the trends in Q3 versus Q2? Thank you.

25:11 Hi, Cheng Lu. Let me take this question first, and then maybe Joey can add a little bit more time later. In terms of, you know, the sequential improvements in, you know, July compared to June, and, you know, as we mentioned before, you know, on our prepared remarks, Right now, you know, there's a couple of headwinds that we see, right? So we have seen, you know, the transportation hubs as well as, you know, the tourist locations, you know, which account for high single-digit of our sales mix being impacted quite significantly, right, by the COVID effect, you know, down, you know, 50%, 50%, right? So I think, you know, unless, you know, there's significant changes in the situation, I think, you know, that would continue to be a headwind for us.

25:56 Now, we also mentioned that, you know, shortened and delayed school holidays, which have a large impact on KFC compared to, say, you know, Pizza Hut. You know, as you know, normally in China, you know, school holiday started, you know, in January, you know, it would be in June. This year, because of COVID situation, it has been delayed until mid to late July, depending on, you know, weather location in the provinces and whatnot. So I think we will still have some impact in July. For the full quarter, we also this year we have a holiday shift for the Mid-Autumn Festival, which last year was in September. This year is going to be in October 1st, I think.

26:42 So that's also a holiday shift impact. So that would probably impact Temple Pond, if you look at that kind of shift. So those are the main, you know, some of these. And then, of course, you know, in June we have this mini outbreak in Beijing that also impacted cells not just in Beijing but the surrounding provinces. So, you know, the situation has improved quite significantly in Beijing. However, we do see, you know, other regional outbreaks, for example, in Dalning, right, and also in Xinjiang. So we do expect that kind of, you know, potential, you know, regional outbreak to persist until, you know, either the COVID-19, you know, have a vaccine or effective treatment.

27:30 I think we will still continue to see potentially, you know, many outbreaks in regional areas. Obviously, you know, this summer, we got a lot of rain here in China's eastern part. Along the entire Yangtze River, I think, you know, a lot of provinces have flooding, and the flooding is quite severe compared to, you know, the past, you know, few years. So, we do expect that that would have some impact on, you know, our eastern part of operation, which is our strong base. So, you know, in Wadong District, right? So I think we still see pretty strong headwinds in some of these difficulties in the third quarter. Now, however, as we mentioned, we have a very strong digital platform, and we have very strong execution, including our logistic operation, which continues to work well even in the midst of the flooding situation in some of the regions. So we would...

28:33 make our efforts to, one, you know, obviously to drive sales recovery and then also continue to be vigilant on our cost fund as well. So we have made some, you know, cost alignment as we have mentioned on our preparing market and also our funding release. You know, that has shown up, you know, quite well. So if you look at, you know, our labor productivity for the quarter, it has improved significantly. If you look at, you know, our G&A, right, so excluding all those one-times and timing issues, we actually see, you know, G&A decline year-over-year, which is quite significant given the fact that, you know, we normally would have, you know, merit increase, wage increase, and, you know, higher.

29:19 So that's my comment. Hopefully, I addressed your question. Thank you, Andy. I guess, Lawton, in the last earnings release, we mentioned The challenge in transportation hub and tourist location and the summer holiday delayed and shortened. And the delay shortened two weeks in June, two weeks in July. And for this earning release, Andy just also mentioned the regional resurgence of the COVID-19 and the not so little flooding challenges in different parts of China. So I think we are ready for next question. Thank you. Thank you. Your next question comes from Lillian Lu from Morgan Stanley. Please ask your question.

30:01 Thank you. I have a follow-up question on the same-style sales growth. Obviously, I think Pizza Hut did very well, actually better than thought in second quarter. Well, I think Joey also mentioned in the opening remark that KFC was more affected. Just wanted to understand a little bit more in detail in terms of the impact to you These two major banners, recovery pace, why it's a little bit different right now under the headwinds. And related to that is more the outlook. How are we going to picture KFC and the Pizza Hut, Simstar Sales Growth recovery pace in second quarter or the fourth quarter? Thank you. Thank you, Lillian. For KFC and Pizza Hut, as I mentioned in my presentation earlier, I'm proud of both of the progress.

30:59 Q2 has been difficult, but both brands did well in their own different way. And let me, you know, make few comment one at a time. KFC reached to 89% same-store sell within quarter one, which is very, very quick. supported by a few weeks of strong sales before Chinese New Year and also very few trust restaurants opened during the pandemic time. So KFC rebounded very, very quickly. And Pizza Hut, because of the closure of dining business in many of our stores during Q1, so sales were more impacted. Once the dining business was allowed during Q2, the dining business for Pizza Hut bounced back quite quickly.

31:49 as I can share with you that the piece that had signing business recover from 40% to 55% during the Q2. So that helped. In terms of the recovery path and outlook, for both brands that really come down to the theme that we talk about, the resilience, adaptability, and innovation, and to be specific, I'm going to talk about short-term and long-term. For the short-term initiative, which is something that we have been doing from the very beginning of Q1 and then throughout Q2, is value. A lot of value promotions because we see that as a challenge and also opportunity.

32:40 As I mentioned in the last earnings release, the weekend, was challenged. And thus, in the Q2 time, we have shipped our promotion towards more weekend and holiday. And we are seeing the results. And then second short-term initiative, which is something that we have been doing quite well, is manual and innovations. I'm talking about the product innovations. So for KFC, we have We have the exciting Zhong Zhi, the Dragon Ball Festival Zhong Zhi. And we have the Douhua, which is a very, very popular item. And then for Pizza Hut, we have something exciting, the roast steak rice and crayfish pasta.

33:32 And for people in Wuhan, we even launched Le Gan Mian with crayfish, with pasta. It was sold out very well in Wuhan. So these are the short-term initiatives that we have been pushing. And then, on top of that, we are also taking this year as a challenge but also opportunity to work on our short-term and long-term business model transformations and innovations here. Let me give you some examples. So for KFC, we have been working very hard to expand our business to B2B2C. which is the corporation delivery members. We have been preparing for it and the COVID-19 gave us perfect opportunity to give a push.

34:23 So by now we have signed up more than 10,000 companies in our corporate delivery membership. And you can see the impact of our number in TA increasing both Q1 and Q2. In quarter one, KFC TA increase is 27%. For Q2, it's 12%. So it's not only driven by delivery, it's also driven by corporate delivery. Very big order. Not to mention, it gave us another source of traffic, on top of our own app. So that is short-term and long-term.

35:09 and then of course the contactless delivery that is very popular throughout the world right now. For Pizza Hut, our hard work in many fundamental capabilities comes through. So we've been working very hard on digital upgrades and guess what? We get our mobile ordering before Chinese New Year. We did not know that COVID-19 was coming. And then COVID-19 came. It became a very good platform for takeaway and mobile order. So our mobile order or digital order just increased significantly. And Pizza Hut alone, the digital order for Q2 is 61%. And that compared to last year's 29%, it almost doubled.

35:57 So again, the business model is transformed. And for Pizza Hut, when we add the takeaway business, which is very, very driven, it's very much incremental because it's for one person, together with delivery, the non-dying business become more than 40% of our business. So we become less reliant on dying business. So that is an example of both short-term and long-term transformations. and then I would like to mention the members. We have reached 268 million members and the members are our digital assets to allow us cross-sell between the brands and between the business within the brands to increase frequency and cross-sell. As I mentioned in my presentation earlier, we saw the doubling of average revenue Her active user, and that's very exciting in the past years and for the coming few years.

37:00 And last but not least, as Andy mentioned earlier, we are accelerating our digitization to help cause realignment as well. And all these are very long-term but also short-term. Last but not least is our new builds and storage fresh. So not only are we recovering cells, we are We are innovating our business model. We are building our long-term prosper in China because despite the short-term challenges here, we are committed to China and we are very excited about the future development opportunity here. Thank you, Lillian. Thanks a lot, Joey. Okay, we have our next question from Michelle Cheng from Goldman Sachs.

37:46 Please ask your question, Michelle. Hi, Joey and Andy. A question about Pizza Hut. The second quarter improvement is quite encouraging, as you mentioned. We are pushing this takeaway, one person, same menu, et cetera. So can you share with us what are we going to focus in second half? And given this kind of like a sales mix change, so like are we going to see like some downsizing of the store or some new store format going forward? Thank you. Thank you, Michelle. For the revitalization of Pizza Hut, I stay away from the turnaround because Pizza Hut was never so bad to meet the turnaround. It has always been a very profitable business.

38:32 But for the revitalization of Pizza Hut, we always have a very clear step-by-step progress. And good things do take time. In the last few years, it took us 18 months to turn the and many more. Let's look at the key things we have done in the last few years. One is about the value for money and the quality of the product. By last year, we managed to upgrade more than 70% of the manual. By this year, when we launched the 30-year platinum manual, we We further upgraded the menu.

39:17 So that is in really good progress, and the momentum will continue because Chinese customers does want and require good food with great value for money. And then one of the other things that we have done, we have taken our time to rebuild our delivery infrastructure. So that's the hardware for 2018. We took the delivery rider back to our system. We rebuilt it to improve the quality of delivery. Without the quality of delivery, without ensuring pizza will reach our customer nice and warm, it's very hard to grow the sales. So we did the hardware, and you can see the impact of the delivery business growth in 2019.

40:02 Now, in the last two or three years, we also take the chance to rebuild the digital infrastructure, anywhere from member cells to mobile to digital ordering, you name it. And right now, the digitization. So now, we have seen the increase of the pre-order, digital order, that all help save our labor costs. but also to build a business on takeaway. That comes through, but it does take time. With these infrastructure in place, not to mention we have also a great team. There are a lot of people movement here in the brand in the last few years, and I'm quite happy with the team right now.

40:54 I think we have a fantastic team who are focused, who are innovative, who work hard, who can execute well. And what else are we doing to build the business in the short and long term? As you mentioned, Michelle, the new build is so refreshed. We have focused on store refresh in the last two quarters without building new stores. Actually, if we look at the last three years, we have been very conservative with building the new store until we get to the right business model. However, we have not been slow to upgrade our stores. Since 2017, we have refreshed about half of an entire piece of our store portfolio. In the process, as you can imagine, we reduce the store size. We upgrade the store look and feel. We improve the efficiency.

41:42 And we'll continue that. We'll continue to take aggressive pace to refresh our store. At the same time, when we are rebuilding the new store, You will be able to see the total portfolio probably won't move that much, but the content, the component within the portfolio will change from sort of bigger store to sort of smaller store. Because even for the new store that we rebuilt in the last two quarters, the majority of them are much smaller store, which is the satellite store that I introduced to our investors back to last year, investor day. much smaller, much better return of investment, much more suitable to increase the density of the store to improve the quality of delivery.

42:29 So these are the few things that we are working on. And last but not least, the cost realignment. This is not short-term. I mean, anyone can do the short-term cost cut. But what we are looking for is the long-term cost Thank you Michelle. Thank you Joey. Your next question comes from the line of Kevin Yin from JP Morgan.

43:15 Please ask your question, Kevin.

43:18 Thank you, Jerry and Andy. I have two questions. The first one for a technical question for Andy. Can you help us to understand why the operating leverage impact on Pizza Hut is not that bad as a KFC? Because if you look at the first quote, second quote, Their restaurant margins are pretty stable versus KFC's continued declining. So this is a technical one. Second one, I'd like to know more on the impact from the flood. Can you give some vivid example or vivid case that, like in some region or province, how badly the store sales are? Thank you, Kevin. So let me take your first questions regarding the impact on KFC and Pizza Hut and how they differ. So I think there's a couple of questions about

44:31 you know, the performance of the two brands. You know, I think, you know, as we might have mentioned on the call, you know, the SSG, which is same-store growth, you know, was 10% decline in KFC and about 12% in pizza, which is, you know, a quite improvement, right? So, you know, in the, you know, for KFC cases, you know, improved by 1% and then, you know, more pronounced improvement at Pizza Hut, which in the last quarter was down about 31%. So that's quite a lot of improvement there. But that's still massive actual improvement. So if you look at both brands, because the SSG calculation actually exclude temporary store closure.

45:21 And so if you look at the store reopening in the second quarter, The system sales recovery actually improved quite a bit at both fronts. And on a year-over-year basis, it improved from negative 20% in Q1 to about 7% in Q2. So that's important. And obviously, we also see April and May improvement, sequential improvement, in both SSG and also overall system sales improvement. As we mentioned, we did get impacted by some and many more events in June and early part of July. One is that there's regional outbreak in northern China, and then there's a delayed summer holiday.

46:09 And then, of course, as you mentioned, there's flooding in June and July in a large, large part of China. So I think that's very question. And as you mentioned, obviously, carefully have a very strong recovery right after the peak of the outbreak. Pizza Hut, in the first quarter, more impacted and therefore see a relatively better recovery. But both brands actually have recovered quite well in their operations. In terms of the margins as well, so I think if you look at the margin at both brands, it has improved. And I think this is hopefully will continue to be the case at Saudi leveraging are beginning to ease as we move forward in the coming quarter.

47:01 But obviously, KFC have, you know, been very profitable before, right? You know, the use margin was about, you know, 17%, almost 18%. And then, you know, the sales revenue would impact a little bit more on that. Particularly, the reason is because if you look at Transportation Hub, which is, you know, not only account for the Thank you, Andy. Let me make a comment about the flooding. This year, we do have a lot of water. I mean, the water volume is comparable to 1998, but the impact is nothing like 1998. Let me give you a big picture, and then I'll go through why.

48:06 The big picture is lower-tier cities cells actually recover better than that of the top-tier cities. And that includes the regions that were... More impacted by flooding. That's mainly like Jiangxi and Huadong area, but mainly in the lower tier cities. So why the cells in lower tier cities still hold up slightly better despite the flooding? Because there are five reasons. One is a lot of these lower tier cities, that means we only have some pocket of stores being impacted, not huge scale.

48:53 So when some stores are impacted that is not at the scale of tier one cities, so we can handle that kind of challenge. But also due to the second reason is our store tend to recover much faster than our competitors. So one example is that one little time, The gas got turned off by the city government the entire time. But actually, that means more business to our store because our store uses electricity, not gas. So when our customers could not have hot food at home, they come to KFC, they could have hot food there. Not to mention, we always have free chargers for your phone and free clean water if needed.

49:43 Third reason is the lack of Transportation and tourist hubs in the small time city. In the small time, the transportation hub and the tourist hub, as Andy mentioned, is almost at a high single digit, almost double digit of ourselves. And when it's severely impacted, it does impact our overall number. But the small time, usually the stores are less impacted by that. And fourth reason is we are one of the few trust brands in the lower tier cities. So during the difficult time, we actually benefit from it. Last but not least, delivery growth actually is even higher in the lower tier cities than top tier cities. So I hope that gives you a better color of the dynamic of the low tier cities despite the flooding challenges.

50:38 Thank you, Kevin. Thank you. Your next question comes from Anne Ling from Jefferies. Please ask your question, Anne.

50:48 Hey, hello, management team. Thank you very much for taking my call, my questions. And so I have a question regarding some of this one-off benefit. Andy, you mentioned about, like, you know, the $30 million in second quarter on the social insurance payment and also, like, you know, $10 million rental relief. If we look at, like, yesterday's and Starbucks Resells. They also mentioned about some VAT extension, which we saw the announcement back in February that all the catering business and lodging business will have this tax reduction. That helped their same-sale sales as well as their profitability.

51:35 I just wonder whether for this quarter, are you enjoying any sort of this kind of VAT Extension Benefit. And since this benefit will last until December, may I know how soon we will be able to get this kind of benefit? What are the procedures on this part? And is there any additional one-time benefit in this quarter and in the foreseeable future? Thank you.

52:04 Hi, and I will answer your question about it. Hi, can you hear us?

52:09 Yes, yes.

52:11 Okay. So thank you for the questions. VAT and its impact is a little bit more complicated. Obviously, we are aware and have looked into the VAT reductions, temporary suspension of that by the government at the beginning of the year. And generally, VAT that we collect from our sales is generally less than our VAT credit for our company services for the input cost. So that's offsetting factors, right? So you have these sales to consumer, and we have also used product and services, and that's offsetting. So after very careful analysis that we have done, we don't see there's meaningful impact on our top line or bottom line from the VAT exemption that the government had launched this year.

53:07 Obviously, we'll continue to look into it because tax itself is a very complex issue. But in regard to VAT, we would have very limited impact on our sales or our profitability. In terms of other one-times, so we obviously received the social insurance payment reductions in both the first quarter and the second quarter. But as you know, that was because the government launched that in February and then have extended that to June. Unless some new update, that may go away in the first quarter. So unless the government extend the program again, we may see that one time relief to go away. The other one is that rental relief.

53:53 We received that in the first quarter after negotiating with the landlord. You know, the amount is less, you know, in the second quarter compared to the first quarter. We do expect that as, you know, the recovery continues, that would also be phased out, you know. So I think, you know, some of these one-time impacts may be lessened in the third quarter and then potentially also in the fourth quarter.

54:19 Andy, when will we know that the government might extend the social insurance payment exemption?

54:28 Yeah, when they announce it, then we'll know.

54:31 There's no timeline on that part?

54:35 No, I think it's government policy, so it's up to the government to announce the program.

54:41 Okay, got it. Thanks. Your next question comes from the line of Christine Peng from UBS. Please ask your question, Christine. Thank you, Andy. So I just have a question regarding the cost alignment that you mentioned earlier in your presentation. So can you elaborate as regards to, number one, what measures you have been taking to do this cost alignment? And secondly, what's going to be the margin implication, for example, in 2021's once the revenue normalizes to the pre-COVID-19 level, especially for Pizza Hut. Thank you.

55:26 Okay. Christine, thank you for your question. Yeah, so, you know, obviously, you know, as we, you know, look into the cost structure and we align that, there's two sort of, like, you know, drive and go for us. One, obviously, is to continue to make our cost structure more flexible to handle, you know, contingency, such as we have seen in COVID-19. The other part is that we'll continue to try to drive, you know, our overall cost structure more efficiently. So that, as Joey mentioned, taking advantage of the current situation where folks are more aware of the need for better cost control and better cost of reliance to push through some of the initiatives that would help us to make our cost strategy, cost structure a competitive advantage for us in the longer term.

56:24 So with that in mind, so we go through sort of like each major category of our cost components. Now, so if you look at our, for example, COS, it's obviously almost all wearable. But we're also focusing on using technologies, using product innovations to sort of improve and many more. So, this is a very good example of how we can improve wastage in a restaurant level to manage inventory time better. So, that can handle fluctuations in demand shift, for example. In labor, for example, as we mentioned before, over time we have shifted some of the labor components into more wearable portions. with more flexible, cool scheduling, et cetera. Again, give us some resiliency in terms of handling the flux in sales changes.

57:26 And then also, if you look at, obviously, we benefit from social benefit, but in the longer term, it's the labor-positive improvement that we use technology to drive that will really help us in the long run to maintain that and many other labor productivity improvements that we have seen over the past two quarters. So we will continue to focus on that, invest in technology, digital technologies, both in the store fund as well as in the back of the kitchens as well as our offices to make sure that labor productivity continues to improve. Now if we turn to, for example, occupancy and other expenses, have variable components as part of that, royalty fees, advertising, marketing.

58:12 That's somewhat tied to sales. But if you look at over the past few years, for example, we have reduced the F-bund investment cost for our store opening. That has a beneficial impact, which is per store basis, depreciation has decreased, even though it is fixed, per store basis. If you look at rent, for example, you know, we have, you know, 80% of our lease have wearable components to it. You know, if you look at, you know, the rental cost, only 60% of that is fixed. So we have been in some flexibility in our rental expenditure. Obviously, we're working very hard to negotiate, you know, better lease and better contract whenever possible, you know, given their current situations.

59:02 Now, if you look at G&A, as we mentioned, we have done a very large initiative looking into G&A, and that has been ongoing for the last couple of years now. We continue to see our effort there. For example, as we mentioned, excluding some one-time and timing shifts, you actually see G&A expenses declining year over year. So that will continue to be our focus, which is basically we align the overall cost structure. Make us more flexible, more competitive in the long run. Thank you, Andy.

59:38 Thank you, Andy. Can I just ask a question? Sure. Sorry, we have one last question from Xiaopo Wei from Citigroup. Please ask your question, Xiaopo.

59:51 Thank you for taking my question. I have a very quick question on Pizza Hut. If you look at the Pizza Hut recovery, actually, not only the top line, but also the profit improved a lot, queue on queue. You mentioned a lot of factors. I think it's going to be short-term, but let's recall what Julie had been talking about, the revitalization effort at Pizza Hut the past two years. Shall we say that the behavior changes of consumers post-COVID may actually put Pizza Hut in a better position of revitalization post-COVID? The COVID outbreak because we're seeing other kind of dining players actually recover much slower than Pizza Hut in my observation. Could you give us a call on that?

1:00:38 Hi, Xiaopu. Thank you. Well, we are certainly grateful to see the recovery in both top line and bottom line. As I mentioned, the dying recovery as well. And the bottom line recovery, of course, to a great extent is because of the sales leverage. Our sales is bad, so the bottom line definitely looks better. But with that said, there are certainly few things that happen here to help us recover better. I don't know whether I would say COVID-19 you know give us opportunity or we just have been prepared in the last few years and it just happened that the timing is not too bad for us you know the innovation capability the food improvement certainly helped a lot because our team right now is so innovative and it's something that I mentioned in the last earning release we are able to use whatever are all the ingredients in our store to come up with very cost-effective and efficient food for the takeaway business. One example is the jufan, the baked rice, which we use actually our pizza oven to cook.

1:02:03 Just go through like use the pizza oven, go through a very efficient and efficient in terms of cost structure as well. worked very well for the takeaway for the one-set meal and therefore it worked. And that is not because COVID gave us the opportunity, because we've been working on the innovation capability. And then secondly, the delivery. We have our own delivery rider when we really need it. As you can imagine, if we did not have our delivery rider, even if the business is there, Whether you have or you don't have the delivery rider, decide whether you have or don't have yourself. As simple as that. Because everyone will be fighting for the delivery rider at certain times, such as COVID-19 or big rain or snow, whatever, et cetera. And then the third is the digital effort.

1:03:06 The digital capability infrastructure of PISA has slided behind KFC. because the KFC revitalization happened much faster. It happened as early as 2015, and then PISA has started later, so the infrastructure follows. But once we get the infrastructure ready, the pre-order, the mobile ordering, the digital payment, et cetera, et cetera, it just works. Our takeaway business just happens and does. It was less than 5% of our business last year, and now it's double-digit of our business, and it's quite substantial. Not to mention, last but not least, our long-term, very strategic-focused membership.

1:03:53 Pizza Hut itself has over 80 million members now, and the sales for members is more than 50%, and that's a big number. Just imagine, 50% of ourselves, we can reach out to the customer directly at very low cost, efficiently, and that helps us drive the business. Last but not least, our store environment is much better because of the hardware in the last few years. So when the store environment looks much nicer, when the food is good and the price is good, it allows us to do some very effective promotion like zi zhu can or you can eat for steak and crayfish. and Stephen Kravish, we can put it in the all-you-can-eat menu because our supply chain is very efficient. So all the hard work comes together, particularly during this difficult time, to allow us to recover probably slightly better than the other casual dining restaurants.

1:04:55 Last but not least is Pizza Hut does not have a high proportion of sales from transportation and tourism. and that is quite a almost mixed single digit sales impact in things ourselves for KFC. Pizza Hut, we don't have the challenge in this particular time. So you can see why it helped Pizza Hut revitalization even during this difficult time and we certainly are hopeful and right now we have the right team, right asset, right product, right price. We are hopeful for the Thank you for joining the call today. We look forward to speaking with you on the next earnings call and that concludes today's call. Have a great day.

1:05:42 Thank you. Thank you. Thank you. Yes, ladies and gentlemen, that will conclude today's conference call. Again, thank you all for participating. You may now all disconnect.