Description

[this was written at the beginning of April, before the 1q17 results, so the data is a little stale given the move in the stock]

COMPANY DESCRIPTION:

YUMC is the leader in the Chinese restaurant industry. The KFC brand generated 70% of sales and 84% of EBITDA for YUMC in 2016. KFC is the largest QSR brand in China with 2x more units than MCD, its largest peer. Pizza Hut Casual Dining (“PH”) was 26% of sales and 23% of EBITDA. PH is the largest casual dining brand in China with 6x as many units as its largest peer. YUMC pays a 3% royalty to YUM for the exclusive use of the KFC, PH, and Taco Bell brands in China. 11% of total units are franchised. YUMC was spun off of YUM in October 2016.

INVESTMENT THESIS:

·         YUMC is executing well. In 12 months, YUMC launched CRM and has grown its loyalty program from zero to 80mm users. Delivery and mobile sales are growing 40% and 3x per year. With its renovation program, over 75% of KFC stores and 85% of PH stores are either new or have been renovated over the previous 5 years. The current COO, Joey Wat, led a rejuvenation at KFC. The brand has been repositioned and is resonating well with millennial consumers. Menu innovation has picked up, with 150-200 new items in 2016 vs. 75 in 2015. KFC has embraced digital with digital menus, digital signage, cashless payment, etc. These initiatives should help KFC regain lost market share (KFC 3yr sales CAGR of -11% vs. peers at 3-20%). The COO is now starting to focus on PH.

·         The stock is cheap and under-owned. YUMC trades at 8.4x 2017E EBITDA vs. china restaurant peers at 7.5-12.5x, global QSR peers at 8-17x, and global casual dining peers at 7-11x. YUMC’s current multiple seems cheap for the clear leader in a growing, fragmented market where scale offers meaningful competitive advantages. YUMC is also the most underweight Chinese consumer name and one of the most underweight stocks overall in MSCI China. This is because YUMC, which used to be the darling of the YUM franchise, has become the orphan after underperformance and investors' focus on capital-light franchisee models. 

·         Solid ROIC on new unit growth. According to the company, cash-on-cash returns on new KFC units are 40% and 26% for new PH units. Economics are so good because expansion is primarily in tier 3/4 cities where the brand is well regarded and competition isn’t as intense.

·         Recent evidence of o2o price competition abating –

o    YUMC’s CEO indicated in October 2016 that discounting has moderated a little.

o    The current CEO of a local QSR business indicated that his aggregator-funded subsidies have been reduced by Meituan and Baidu.

o    After CCTV showcased food safety issues on delivery platforms in 2016, the platforms have also been partnering more with larger brands and emphasizing food safety over discounts.

o    A current employee of one of the major delivery platforms also indicated that delivery fees have increased from zero a year ago to 6 rmb, a level at which survey data indicates would cause ~50% of consumers to be unwilling to pay for delivery.

o    A current employee of another delivery competitor indicated that merchants have been shifting more towards full-price selling on delivery platforms over the last 6mo because many restaurants have hit their delivery capacity limits during peak times. He indicated that subsidies are waning as well because user count growth is slowing. Consumer surveys indicate that ~60% of users would slow or stop their aggregator usage if subsidies or discounts waned.

·         Primavera made a big commitment to YUMC. Primavera invested $410mm in YUMC from its latest $1.9b PE fund, representing a substantial commitment as a % of Primavera’s AUM. Primavera’s Chairman is the Chairman of the YUMC board.

RISKS:

·         China Macro – YUMC faces macro risks with the Chinese economy. However, there are signs that China macro is strong right now. Also, KFC is less exposed to macro because consumers trade down from more expensive restaurants and the delivery aggregators may become more rational during a downturn. PH is a casual dining concept, so it would be exposed to macro to a greater extent.

·         Competitive threat – the Chinese restaurant space is over-stored. QSR demand has been growing 5% over the last 3 years, but supply has been growing ~10%. Exacerbating the problem, food delivery, powered by the o2o aggregators, has become a competitive threat to traditional restaurants. Delivery platforms have offered significant rebates to consumers to grow their user bases, meaningfully expanding and subsidizing consumer choice. But I’ve heard anecdotal commentary that store expansions are slowing and weaker competitors are exiting the market.

·         Signs of fatigue with Western QSR brands – there have been consumer surveys showing that Chinese consumers want to eat healthier and prefer local brands. Surveys also indicate that consumers prefer local brands when ordering online, so the growth in delivery could pressure YUMC’s market share over time. YUMC could also be impacted by any protectionism or US-China trade relations issues.

·         Food safety – any food safety issue that gains traction on social media or with the press could cause a significant decline in comps or margin compression. YUMC has had two food safety issues in the past 5 years, so the Company is particularly sensitive and responsive to the issue, but it’s impossible to be error-free across YUMC’s entire supply chain given its scale

Chicken cost inflation – two years ago, China banned imports of grandparent breeder chickens from the US. This is expected to cause an increase in chicken prices soon. Historically, YUMC has been able to pass inflation along through pricing, but if chicken prices increase in an outsized manner, this could be challenging. Most competitors and former employees I spoke with didn’t expect this to be an issue however.

Catalyst

Earnings releases.