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Yum China Holdings, Inc. (YUMC) Q3 2021 Earnings Call Transcript

YUMC Earnings Call - Final Transcript

Yum China Holdings, Inc. (NYSE: YUMC) Q3 2021 earnings call dated Oct. 27, 2021

Corporate Participants:

Michelle Shen — Director of Investor Relations

Joey Wat — Chief Executive Officer

Andy Yeung — Chief Financial Officer

Analysts:

Michelle Cheng — Goldman Sachs — Analyst

Lillian Lou — Morgan Stanley — Analyst

Xiao Po Wei — Citigroup — Analyst

Chen Luo — Bank of America — Analyst

Anne Ling — Jefferies — Analyst

Presentation:

Operator

Good day, and thank you for standing by. Welcome to the Yum China’s Third Quarter 2021 Earnings Conference Call. [Operator Instructions]

I would now like to hand the conference over to your speaker today, Michelle Shen. Thank you. Please go ahead.

Michelle Shen — Director of Investor Relations

Thank you, Lindon. Hello everyone, and thank you for joining Yum China’s third quarter 2021 earnings conference call. Joining us on today’s call are our CEO, Ms. Joey Wat; and our CFO, Mr. Andy Yeung.

Before we get started, I’d like to remind you that our earnings call and investor presentations contain forward-looking statements, which are subject to future events and uncertainties. Our actual results may differ materially from these forward-looking statements. All forward-looking statements should be considered in conjunction with the cautionary statement in our earnings release and the risk factors, included in our filings with the SEC. This call also includes certain non-GAAP financial measures, you should carefully consider the comparable GAAP measures. Reconciliation of non-GAAP and GAAP measures is included in our earnings release.

Today’s call includes three sections; Joey will provide an update regarding recent development and our third quarter 2021 results. Andy will then cover the financial performance in greater detail. Finally, we will open the call to questions. You can find the webcast of this call in the PowerPoint 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 Yum China. Joey?

Joey Wat — Chief Executive Officer

Thank you, Michelle. Hello everyone and thank you for joining us today. As we shared in mid-September, we navigate a very challenging situation in the third quarter. The Delta variant outbreak that started in late July spread to 16 provinces. It became the most widely spread regional outbreak since the first quarter of 2020. Strict public health measures were implemented across the country. Trading was significantly impacted during the peak summer season, which is traditionally a very strong quarter for our business. Same store sales declined by 7% in the quarter, as demand fell for dining, although this was partially offset by growth in delivery.

I want to take a minute to commend our 440,000 employees for working diligently and rapidly finding solutions in this [Indecipherable] situation. In response to the sharp decline in dining traffic, we quickly adjust marketing campaigns, operations and supply chains to drive demand for off-premise. Delivery sales grew 23% year-over-year or 62% on a two-year basis and contribute approximately 34% of sales in the third quarter.

New retail business grew rapidly with sales in the third quarter almost equal to the first two quarters combined. Our ability to engage customers digitally was essential during this difficult time. In the third quarter, over 60% of system sales came from members. We added about another 20 million members, ending the period with a total member count of over 350 million. We sold 19 million privilege subscriptions, including the popular KFC Chicken [Indecipherable], which is a summer exclusive. [Indecipherable] important initiatives to drive sales, we saw a sequential recovery in September. For the quarter, system sales growth was positive compared to last year and to pre-COVID. New unit growth more than offset the same-store sales decline.

We broke record by opening 524 new stores, ending the quarter with 11,415 stores. However, we do not compromise quality or quantity. We have prudent new store approval process, and carefully track the performance of each new store. New store payback remains healthy at around two years at KFC, and three years at Pizza Hut. Our smaller store format enable us to increase store density in higher tier cities, and further penetrate into lower-tier cities, with lower capex and rent.

Let me provide some color on our key brands. First KFC; we stepped up value and promotional campaigns to drive traffic and we introduced great food items. Juicy Whole Chicken was sold out within a week. Our Meat Sauce Wagyu or Angus Beef Burger also proved popular. Our premium beef burgers have been very successful, since becoming permanent menu item. We are building a beef burger platform covering different price points.

We’re taking menu innovation and localization to the next level, following the success of Hot Dry Noodles, Re Gan Mian in Wuhan. We rolled that out nationwide in September. In a week of launching, we sold over 1 million bowls. It’s the best performing, limited time offer breakfast item in the past three years.

We also introduced steamed dumplings, xiaolongbao, to more stores in Eastern China. More recently, we launched Hot Pepper Soup, the very famous Hulatang in Henan. All of these are very well received by our customers. KFC has added nearly 1,000 stores and entered 150 new cities over the past 12 months. As we mentioned during the Investor Day, we are now tracking 1,200 potential cities, that we could enter in the future with multiple store formats.

Next, let’s talk about Pizza Hut. Years of transformation has improved Pizza Hut’s fundamentals and resilience. In the third quarter, Pizza Hut opened 103 stores, the highest number of store openings in the quarter, since 2016. Satellite stores and other smaller formats accounted for over 70% of the new stores, and enable us to capture the strong demand for delivery with higher store density.

We upgrade our Buy One Get One pizza promotion. For the free second pizza, customers were given more flexibility to choose when, where and what pizza they would like to have. This mechanism was a breakthrough for us, enabled by our upgraded digital platform. The promotion was exciting for customers and created sales uplift for us. During this 10-day campaign, we sold approximately 1 million Buy One Get One pizza sets.

For a limited time, we also offered new pizza flavors, modelled on popular Chinese dishes such as Seabass Pizza with pickled vegetables, [Foreign Speech] and spicy stir-fried pot pizza, [Foreign Speech]. These innovative products were Pizza Hut’s pick on localization, and position us to attract young consumers, who love to try new things.

Moving onto coffee, our third growth engine. We are very excited about our deepened partnership with Lavazza. This 126 years old Italian brand offers a truly authentic Italian experience. Our Italian coffee exclusively uses high quality Lavazza beans, roasted in Perino, Italy. In addition to coffee, customers love the delicious food. Popular item like Emiliano, which is toasted sandwich, and mini croissants with ham and cheese, are made fresh in our fully equipped kitchen. The high proportion of food, which is 25%, contribute to a higher ticket average.

At the end of September, we had 26 Lavazza stores in four top-tier cities. We expand beyond Shanghai to Hangzhou, Beijing and Guangzhou, where our stores received great customer feedback. Our first Beijing store is already ranked the most popular cafe in Chaoyang district. Encouraged by the positive results, we expect to enter into more top-tier cities and more than double our current store base in the fourth quarter.

Despite recent challenges, our commitment to China’s long-term growth remains on chicken. We are always planning for the future and have been executing on the strategies outlined during our September Investor Day. Despite the difficulties posed by the outbreak, we work diligently to build our store pipeline. We now expect to open over 1,700 gross new stores in 2021, up from 1,300. I’m also excited about our investment in Hangzhou Catering Service Group. This will allow us to accelerate growth across our brands in Xinjiang province.

Lastly, we continue to enhance capabilities in enterprise and digital. These are our core enablers for sustainable growth in the long term. Thus, we opened our digital R&D center with three sites in Shanghai, Nanjing and Xi’an. The center is a key part of our strategy to build a dynamic digital ecosystem. The R&D center will consolidate and expand dedicated resources to develop solutions and services to optimize customer experience and operating efficiency. We plan to invest $100 million to $200 million and to employ up to 500 staff over the next five years for this particular initiative.

As for supply chain, in addition to the logistics center in Chengdu. We have another one under construction in Huai’an, which is in Jiangsu Province. There are also several sites in the pipeline. As we mentioned during the Investor Day, we plan to operate about 45 to 50 logistics centers and consolidation centers over the next several years to support our expansion and to further increase efficiency.

With that, I will turn the call over to Andy.

Andy Yeung — Chief Financial Officer

Thank you, Joey, and hello everyone. Let me first review our third quarter financial performance and then discuss this year’s outlook. Unless noted otherwise, all percentage changes are before the effect of foreign exchange.

Let me first cover the third quarter performance. Actual results are in line with the business update we released in mid-September. Third quarter performance was disrupted by the Delta variant outbreak, resulting in same-store sales decline of 7% year-over-year. However, we still delivered positive revenue growth and system sales growth, which is led by new unit contribution. Total revenues grew 2% year-over-year and reached $2.55 billion. System sales increased 1%.

Similar to prior quarters, we are providing pro forma measures here for convenience comparisons with 2019. Same-store sales were approximately 87% of the third quarter 2019 level. KFC’s same-store sales were approximately 92% of the last year level, and 87% of the 2019 level, with same-store traffic at approximately 82% of 2019 level. Average ticket grew roughly 6% versus 2019, mainly due to the increase in deliveries made [Phonetic].

Pizza Hut’s same-store sales were approximately 95% of last year and 89% of 2019 level. Same-store traffic is on par with the 2019 level, while average ticket decreased by about 10%, driven by the increased mix in off-premise occasions, which have a lower ticket than dining. KFC was slightly more affected than Pizza Hut again this quarter, as KFC has a higher store mix in transportations and tourist location. These locations experienced a sharp decline in sales and approximately 40% on a two year basis in the quarter.

Restaurant margin was 12.2%, down 640 basis points compared to last year. This was mainly caused by sales deleveraging, more value promotion, higher wages and increased delivery costs, associated with more delivery orders, as well as lower COVID related relief this year.

Cost of sales was 32.2%, 100 basis higher than last year. Modest decline in commodity prices year-over-year, partially offset the step-up value promotions to drive customer traffic, and phasing out of plastic packaging and other packaging upgrade.

Cost of labor was 25.6%, 400 basis points higher than last year. This is due to a few factors; first, wage inflation was 6% in the quarter, notably higher than the previous quarters. Second, increased delivery volume contributed to higher labor cost percentage. Third, additional labor hours were scheduled going into the third quarter, which is typically a seasonally strong trading period for us. We also scheduled more labor hours with increased safety protocols during the outbreak.

We were quick to adjust labor scheduling, to mitigate the sales leverage and impact. Occupancy and other was 30%, 140 basis points higher than last year, mainly attributable to the sales deleveraging impact. In addition, we received $10 million COVID related one-time relief in the third quarter last year, while the amount was only $2 million this year. G

&A expenses increased 6% year-over-year, mainly due to higher compensation costs and increased headcount. [Technical Issues] profitable in the quarter with operating profit of $178 million, excluding a non-cash remeasurement gain of our existing equity interest in Lavazza joint venture of $10 million, adjusted operating profit was $168 million, a 52% increase [Phonetic] year-over-year or a 48% increase compared to 2019. Our effective tax rate is 28.3%. We maintained a full-year effective tax rate outlook at 27% to 29%.

Net income was $104 million and adjusted net income was $96 million, excluding $32 million net investment loss of Meituan, it was $128 million, down 50% year-over-year. Diluted EPS was $0.24, mark-to-market loss in Meituan negatively impacted our EPS by $0.07. In the quarter, we returned $85 million to shareholders in the form of cash dividends and share repurchases.

As we look ahead to the fourth quarter, we remain cautious. Strict public health measures are still in effect. Consumers are cautious about spending, and are traveling less. According to government statistics, for the seven-day National Day holiday starting October 1st, the number of travelers was down 2% compared to the same period last year, and down 30% versus 2019. Related travel spending was down 40% compared to 2019.

While we are seeing a slight sequential recovery, our same-store sales will still remain below prior year and pre-COVID 2019 level. As overall dining volume and traffic and transportation hubs are still significantly impacted. We expect the recovery of same-store sales to decline, with a non-linear and uneven gap.

Recently, we have seen a resurgence of cases across 12 provinces and municipalities including Inner Mongolia, Gansu and Beijing. We will continue to monitor the development and stay agile. In addition, the fourth quarter is seasonally the smallest quarter for sales and profit margin. Based on what we are seeing so far, we expect the margin and operating profit in the fourth quarter to be significantly impacted by; one, sales deleveraging, as same-store sales remain below prior year and pre-COVID level. Rising commodity prices; since the fourth quarter of 2020, we have benefited from a deflationary environment, which will very likely end in the fourth quarter. Cost of sales will also be pressured, by aggressive campaign, as we continue to drive traffic through attractive promotion. Three, wage inflation which is expected to be in the mid-single digit rate. [Indecipherable] costs are likely to continue to increase, as delivery trends further upward.

Please note that the fourth quarter last year includes several one-time, items including one COVID and other one-time relief from government level, almost $30 million. Two, lower staffing levels due to shortage of part time workers. These are unlikely to repeat this year. Now, despite the near-term challenges, we remain committed to driving long-term growth. In the short term, we will focus on keeping our operation agile and resilient, in the face of considerable disruption and uncertainty caused by the pandemic. For the long run, we will focus on fortifying our competitive mode [Phonetic] and growing our business, and making continuous improvement in our business model and store operations.

We have a strong track record of managing our cost structure and growing our business profitably over the years. We’ll continue to focus on product innovation and leveraging the strength in our supply chain to mitigate the impact of commodity price swing.

On the [Indecipherable] front, we will continue to invest in technology automation and digital infrastructure with improved labor productivity. On the other hand, the near-term challenges, while tough for the restaurant industry as a whole, also create favorable condition for us to expand our store network and capture growth opportunity. As Joey mentioned, we now expect to open 1,700 new units in 2021, almost five stores per day.

We are maintaining our previous capital expenditure target of $700 million to $800 million. We should benefit from our ongoing efforts to reduce capex spending for our new stores. Looking ahead, we will continue to invest in accelerating growth and fortifying our resiliency as outlined at the Investor Day in September. We will provide you details on 2021 [Phonetic] target during our fourth quarter earnings release in early 2022.

With that, I will pass you back to Michelle to start the Q&A. Michelle.

Michelle Shen — Director of Investor Relations

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. Lindon, please start the Q&A.

Questions and Answers:

Operator

[Operator Instructions] Your first question comes from Michelle Cheng from Goldman Sachs. Your line is open.

Michelle Cheng — Goldman Sachs — Analyst

Hi, Joey and Andy, thank you for taking my questions. My question is about the commodity cost inflation. So we hear many companies starting to talk about price hike recently. So understanding the customer sentiment is still very challenging. So can you share with us your pricing strategy? And also compared with the previous chicken cost inflation cycle back in ’18-’19, when we managed the margin pretty well, so what could be the difference now versus the past experience? Thank you.

Andy Yeung — Chief Financial Officer

Good morning, Michelle. Thank you for your questions. Regarding pricing, s we have a long-term pricing strategy here at Yum China. We want to provide good food at good value for consumer. And so over the years, we always have been very cautious about price increase. We do — partial inflation to invest [Indecipherable] of consumer. But mostly, we will try to find efficiencies in our operation to offset those inflationary pressure.

Now, if you look back in the last few years, obviously there is commodity price fluctuation. Sometimes, it goes up, sometimes it comes down and then over the years in China, we always have seen labor inflation right, so labor inflation generally is in the mid-single digit to high-single digit range. And I think sometimes, when there is a sudden surge or disruption in the market, then you do see the impact on our margin. For our quarter, this quarter for example, the biggest impact obviously is our sales right, because of COVID outbreak, and so you have a deleveraging impact which is ultimately impacting the margin. And then — so if you think about commodity prices, and we generally have a very — over time, we will have new product innovation, how to make use — our material better. We would also have diversifying, the different protein, right? So we have chicken now, we have beef, we have duck and a variety of fish and other seafood. So that has also helped us to balance the commodity price increase over time.

And then obviously, we have a strong supply chain. We always work with our supplier closely to try to mitigate some of this pricing fluctuation. We generally have a — sort of like place our order or sign a contract, a quarter or two ahead of the quarter, so that we sort of know how to manage that cost increase over time. And then, we also work with our supplier obviously to — when good time, the price go up, they just have to earn a little bit less, and when time is bad, we also have to try to support them. So over time, we have a stable pricing situation for us as well.

So that’s generally how we deal with it, and in terms of labor inflation, over the year, you have seen that. We have invested quite a bit in digital automations and technology in our infrastructure. Overall, just trying to improve labor productivity. As we have outlined in the Investor Day, you have seen — labor have presented how technology help us, sort of like improve labor productivity. So a few years ago, we had 400,000 plus employees. Today, we have similar number of employees, but we have a high number of stores, so our labor will still [Indecipherable].

So if you look at our UC margin or look at our restaurant margin, they have remained relatively stable. Right. So I think 15% [Phonetic], or roughly 15% range and then in 2019, it was about 16%. And then last year, it was about [Technical Issues]. So all in all, we — over time, we are able to manage all these different cost components, the cost structure, while maintaining [Indecipherable]. Thank you.

Michelle Cheng — Goldman Sachs — Analyst

Thank you, Andy. That’s clear.

Operator

Your next question comes from Lillian Lou from Morgan Stanley, your line is open.

Lillian Lou — Morgan Stanley — Analyst

Thanks management. My question is more on the capex plan, because we definitely increased gross new opening quite a lot versus the previous guidance but maintained capex overall. So maybe a little more detail. I know that company talked a bit for some times in terms of the unique capex per store with this small format model, but can you share with us a little bit more about details of how they have been doing in the recent quarters, in terms of the unique capex and the unique sales mix versus before, that caused us maintaining the similar capex, with much more comp for stores? Thank you.

Andy Yeung — Chief Financial Officer

Thank you, Lillian. So obviously this quarter, we did set up our capex budget. For the whole year, we already probably higher than last year. I think our capex year-to-date is about $480 million and I think — let me check that number here. Yeah, so you know — obviously, as we have outlined in our capital expenditure plan in our Investor Day, investment for capex which will drive organic growth and also give you the competitive mode. So there’s multiple components to it. One is obviously the stores that we’re opening, and we are accelerating that and as we have mentioned before, we have — over the past few years, we have reduced the capex per store upfront investment. So if you think about few years back, our capex per store was about RMB2.5 million and then now is under RMB3 million, mostly RMB2.5 million. And as we continue to — there is two driver for that. One is obviously, the size of the store changed. The other one is overall per store footage cost reduction. And so our team worked very hard. Our [Indecipherable] team, our brand team worked very hard to do that and make it more efficient.

So I think with our new smaller store format for example, Pizza Hut, KFC, neutral [Phonetic] models and small store format Catering towards delivery and take away, I think we still have some opportunity to further do with use that capex per store going forward.

Also, the other component obviously is remodeling. I think that over time will continue to trend up, just because we have a bigger portfolio of stock. And then the third part is you know, investment in supply chain and infrastructure that we have outlined before and in Investor Day, is to drive efficiencies and resiliency in our supply chain, is to drive labor productivity improvement through investment in technology, digitalization etc. So, I don’t think there’s a material change to our plan. So hopefully, we can give you more update next quarter in terms of our full year capex spend. Thank you, Lillian.

Joey Wat — Chief Executive Officer

I will just add to your comment on this one, Lillian. For today we update the new store guidance for the year from last quarter, 1,300 stores to 1,700 stores for the year. But we did not increase the capex spend for the year, it will stay at $700 million to $800 million range. So what happened here? What happened here obviously, as you guys know us quite well, we don’t chase after a blind store number. We open good quality stores. If we can find a good quality store with additional profit and sales, then we will open it.

So in terms of store economics here, I would like to give you a comment. One is, the store — the smaller store are driven by increased off-premise mix, means that delivery and takeaway. So that small — that helped that business and the smaller store helped us increase the store density in the top tier city in particular. So these are the Pizza Hut store, the KFC smaller store and also, these stores with lower investment and incremental sales and profit, they help penetrate into the smaller cities, because we have variety of different business models for different locations.

So number two comments, it is normal that these smaller stores have smaller sales per unit. But as I mentioned earlier, they drive incremental sales and profit, and it demands less capex per store so as Andy mentioned earlier. Third, the payback is healthy. So you know that KFC payback is always about two years, and Pizza Hut right now, if you notice what I said earlier, is the Pizza Hut, the store payback is at three years now in total. That is an improvement, because in the past, we always concluded that the payback for Pizza is about three to four years. So now, it has improved to three years, because the small store, the Pizza Hut store right now, the payback is at two to three years. So in total, the improvement is at three years. So I hope that gives you a sense about why we are increasing the new store guidance for the year, because if we look at our system sales growth number, it also tells the story for the entire Yum China versus 2020, we are driving 15% year-to-date same-store sales growth, and that includes 12% year-to-date system sales growth for KFC and 20% system sales growth year-to-date for Pizza Hut. And then for KFC even compared to 2019 for year-to-date, we are also achieving 4% system sales growth. Despite all the challenges of the outbreak and also same-store sales.

So let me conclude the question here. Thank you, Lillian.

Lillian Lou — Morgan Stanley — Analyst

Thanks a lot Joey and Andy. That’s is very detailed and helpful.

Operator

Your next question comes from Xiao Po Wei from Citi. Your line is open.

Xiao Po Wei — Citigroup — Analyst

Hi, good morning, Joey and Andy, a very brief question on your acquisition. In the press release this morning, you mentioned that you acquired 28% stake in Hangzhou Catering Services, which operates a few great local Chinese brands. My question is, will you open in some store on standalone basis under those brands, pursuing to any arrangement with the Hangzhou Catering Company? Or you are more looking at those great local cuisine like [Foreign Speech] to your existing KFC stores or Pizza Hut to diversify your portfolio to bring more great local food into the Chinese consumers. So any color would be highly appreciated. Thank you.

Joey Wat — Chief Executive Officer

Thank you, Xiao Po. So we have been working with Hangzhou Catering, this company for a few decades now. This is our joint venture partner, of Hangzhou KFC stores and Hangzhou market is one of our best market, in terms of sales and profit. And we are very grateful that we have the opportunity to invest 28% into the Hangzhou Catering and that enables us to achieve consolidation of Hangzhou KFC business, which is about 700 stores, with future, very nice expansion opportunity ahead, so that’s point one.

Point two is, while Hangzhou Catering has other business, such as the [Indecipherable] etc, our focus is still on our KFC business. In terms of future cooperation, we do see cooperation in two areas. One is working with them on their central kitchen or factory, whatever you call it. They have very high quality facilities and actually with this already with our Xiao Long Bao launch in Hangzhou market, there we went alone, but guess what, they were produced by the central kitchen or the factory of Hangzhou Catering.

The second area we see we are going to further expand our cooperation, is store opening, because another key shareholder of Hangzhou Catering is a very successful and important player in the commercial properties in Zhejiang province. And we — already what we’ve done to open our first and the most important flagship store for Lavazza in Hangzhou. So these are the two areas that we certainly will see us accelerate our cooperation on top of KFC, for expansion in Zhejiang province and particularly, Hangzhou. Thank you.

Xiao Po Wei — Citigroup — Analyst

Thank you very much.

Operator

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

Chen Luo — Bank of America — Analyst

Thank you, Joey and Andy. My question is on the marketing side. Our Q3 record margin saw over 6% year-on-year decline. I understand that it has been negatively impacted by the COVID outbreak in the quarter. However, if we look at Q2 and Q3 last year, we had a similar or even higher same-store sales decline, but our margin trends were better back then. I’m just curious to get more color on the different dynamics behind, in particular, our labor costs reduced, but up 4% year-on-year, which was higher than the net [Indecipherable] of labor cost increase in Q1 last year, which was the worst time of the COVID outbreak.

Apart from the wage inflation and sales deleverage, it actually deleveraged a bit more on other regions for us to better understand the reason or the dynamics behind labor cost increase. In addition, our occupancy and other cost ratio have also increased normally — in normal times, it is always trending down and serves as a big driver to our [Indecipherable] margins. So do we still see further room of positivity line item in the future, barring extraordinary decreases, in like two or three years’ time? Thank you.

Andy Yeung — Chief Financial Officer

Thank you, Chen Luo, for your question. I think let me try to address the question here. First of all, I think before, we go into each line item, I want to really emphasize that, [Indecipherable]. We are running a restaurant business, so when sales come down, and it would have an impact on our labor cost and on our O&O. So I don’t want any misunderstanding. I know we have done very well over the last couple of years, and last year was also some special situation obviously.

So let me address that year for example, on the cost of labor, on the sales dynamic. If you look back in, for example, in 2020, right. As we have mentioned at that time, we have a very strong, strong sales trading going into the Chinese New Year period in 2020, and the period before Chinese New Year and during Chinese New Year, normally is a very important, very good trading season for us, for both sales and profitability. So we have a benefit at that time for that first month okay. Because if you recall, the outbreak was right around Chinese New Year period. But there is timing difference. In terms of — this quarter for example in the third quarter, the outbreak happened and impacted the full quarter at the beginning to the end. So we have this full quarter impact in the same trading situation. So that’s why when you have a very profitable quarter for example, especially for us which is July and August time period, before they could go back to school, that sales trading will have an impact on the sales leverage.

The other one is commodity prices obviously. This year, we have a couple of things that is going to impact us. One is, as we have mentioned before, we are phasing out plastic in our packaging. We have mentioned that last year, that’s really going to have an impact on us, and then when we look at the — gear up our sales revenue obviously, we have always been structured to deliver product to our restaurant. So when sales deleveraging happens, it is going to impact the [Indecipherable] per package for example that they deliver to a restaurant.

And then if you look at labor, for example, labor this year as we have mentioned in last quarter, we raised our best average in June and July. That’s out there, it felt like holding it back and control the cost for the — and first half of the year. So at that time, our labor inflation was about 2% to 3%. In the third quarter, it’s about a 6% to 7% increase, so it is higher. And then another thing that is very important to notice is that we, as Joey mentioned in her prepared remarks, this is a peak trading season. So we have planned some of this labor schedule ahead of time. The thought is that during the outbreak, we also have to step up staffing and make sure that we have even tightened up — followed up that tightening of health protocol. Right. So we measure temperature to check if you are cold [Phonetic], to do more sweeping, table cleaning, etc, etc. So there is still an impact there.

And then all in all, for — obviously we have some labor costs, but whenever you open a restaurant, you have the utility cost, you only have some of the land, some of it is fixed, and some of it is variable. So again, you’re going back to that — there will be less impact on the margin.

I think in the long run, I think we have been able to manage the cost structure quite well. We have seen, obviously as mentioned before, commodity price fluctuations, labor cost increase. Again, going back to what we do best, we’re working with our team, our innovation team, to introduce good products at great value for consumer. One example that we have recently done is, we have a fried chicken bone at the stack, the [Speech Overlap]. So that’s a good way to utilize obviously part of the chicken that we have not used previously. We also use that for example, soup right. So to a point, innovation is very important for us and we will continue to do that.

Working with supply chain is very important. I think a couple of years ago, when price again was surging or coming down, we have mentioned consistently that we work with our supplier for the long term. So we have each other in good time and bad times. And so in that case, we have to start to mitigate, not completely eliminate the impact, but will try to mitigate. So we’ll continue to do that working with our supply chain and still have. And still obviously, it is very important you notice that, delivery cost, volume go up in pandemic, it is going to have an impact on sales [Indecipherable], but we are able to manage that long term. But you know sometimes some of this short term change in the delivery and timing, could also have an impact. So again, we’re going to invest in technology, infrastructure, automation, including investment in our pizza delivery and make it more efficient right. So production, queuing for food production, the route optimization for our rider; tracing, [Indecipherable] in all that, so we are trying to continue to make that operation more efficient.

Chen Luo — Bank of America — Analyst

Thank you for the helpful color and also look forward to having a try on Penang pizza [Phonetic] next time. Is it just a nationwide launch or just offloaded in Northeastern China?

Joey Wat — Chief Executive Officer

And many other products, [Speech Overlap].

Andy Yeung — Chief Financial Officer

Right. Thank you, Chen Luo.

Chen Luo — Bank of America — Analyst

Okay. Thank you, Andy.

Joey Wat — Chief Executive Officer

Thank you.

Operator

Your next question comes from Anne Ling from Jefferies. Your line is open.

Anne Ling — Jefferies — Analyst

Okay. Thank you. Hi management team. Also questions regarding your acquisition, the Hangzhou Catering Group. Does that mean that you’re now owning 73% of the company? So meaning that moving forward, you will consolidate that 700 stores, in terms of sales and operating profit and then you take out your minority — at the minority line? So if this is the case, number one, is that will there be any exceptional gain on the revaluation of your KFC investment or subsidiaries in the 4Q? Second question is like, how should we be expressing in terms of the sales and/or the operating profit impact? Is it, I mean, be it in Hangzhou, their sales will still possibly will be higher, and what would be the profitability impact like?

And the minor question is regarding — if it is solely an associate, then I’m not sure my calculation is correct. It seems that third quarter, it was a loss of $6 million. So I’m not sure whether it is related to the Hangzhou business or it is something else? Thank you.

Andy Yeung — Chief Financial Officer

Sorry, Anne. Like the last part, I didn’t get it, like what was the $6 million [Indecipherable]?

Anne Ling — Jefferies — Analyst

Oh, the $6 million loss is associated to the equity contribution, below the operating profit line. So it’s the equity contribution from your investment — is in the cash flow in your…

Andy Yeung — Chief Financial Officer

Okay. So I didn’t quite understand the question, so we may have to take that question offline, but I will try to address the first question. I think first of all, like we did not acquire Hangzhou Catering. We invest 28% in Hangzhou Catering. So we have a 28% stake in that company, not acquisition of that company. The other part is that, because of that and also because of some of other [Indecipherable] arrangement, so now we actually have basically control of the Hangzhou JV and so. So now, we will consolidate that. And you’re correct, similar to prior consolidation of our JV at Wuxi and Suzhou, generally, we would have a match winning game [Phonetic], because obviously, it was a very successful JV, right. So, but it is kind of complicated accounting, if we have two business combination. right. So on the U.S. GAAP, even though you only acquire a portion of the stake, you’re generally treated as a combination of business, and then they’ll treat you as a whole, what the gain of your entire consolidation or a portion of that.

So it’s not just the proportion to the interest that you acquire, but the overall company. And so that’s why normally, you would see this proportionate measurement gain. And then eventually, it will flow into the balance sheet, because obviously, it is based on the acquisition or foundation allocation, and so generally, with the increase in goodwill as well as intangible. So — and that profit is similar to our treatment of that in Suzhou and Wuxi, okay. And so, if you want more detail, I will refer you to our filing, the 10-Q and 8-K statements, they will have more detailed explanation and technical information, of the kind of treatment of such a combination.

Joey Wat — Chief Executive Officer

And just to be very clear, we have originally, a minority control of our Hangzhou joint venture of KFC, with additional 28% investment into Hangzhou Catering, we will — Yum China will control and consolidate our Hangzhou KFC with approximately 60% equity interest, directly and indirectly.

Andy Yeung — Chief Financial Officer

That’s right. And yeah, so, and then in terms of the impact, you know, obviously, it will not impact sales. It would probably increase that result. But in terms of the profitability or will it increase that, we still are assessing it, because as we mentioned, there will be some, you know, amortization coming from this and then also the measurement of the franchise right is a lot complicated. So, we still are assessing it, you know — but similar to, as we mentioned to the impact of consolidation of, like accounting impact with similar to that of Suzhou and Wuxi, but the entire offer is not as straightforward as [Indecipherable] active deposit.

Anne Ling — Jefferies — Analyst

Okay, okay, got it. Got it. Thank you very much.

Operator

Presenters there are no further questions at this time.

Joey Wat — Chief Executive Officer

Thank you for joining the call today then. We look forward to speaking with you on the next earnings call. Have a great day.

Michelle Shen — Director of Investor Relations

Thank you, all.

Andy Yeung — Chief Financial Officer

Thank you, everyone.

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