Description

The last and only write-up of YUMC on VIC was from May 2017 at $34 per share which was an $11.8B EV.  Today the stock is at $30 per share and an $8.7B EV.  The business likely hasn’t performed as expected by the author but I think this can mostly be explained by Covid and macro weakness in China.  Since 2017, sales are +40%, EPS is +100%, and company-wide units are +80%.  KFC (the majority of units and profits) unit economics have remained strong with mid/high teens restaurant level margins and ~2 year paybacks.  An investor in 2017 could have done very well as the stock peaked at $70 in 2021, but the stock has suffered since then due to weak business performance from 2020-2022 (Covid hit QSRs harder in China than the U.S.) and a general negative sentiment towards China.  We believe the stock is far too cheap at 10x PE ex-cash when it should compound earnings and free-cash-flow per share in the mid-teens.  We expect the company to return more than 100% of its earnings to shareholders in dividends and buybacks (mostly buybacks) over the next three years.

Overview

Yum China became an independent publicly traded company in November 2016 on the NYSE following a spin-off from Yum Brands. They did a secondary listing on the HKEX in September 2020. The stock has CAGR’d at just 3.1% since inception and is currently in a >55% drawdown since its peak almost exactly three years ago. We largely attribute this poor stock performance to broader market concerns within China. Since the beginning of 2021, YUMC has had a total return of -45% while the iShares China Large-Cap ETF (FXI) has lost 40%. We believe these geopolitical concerns are warranted in some areas of the market (tech, financials) but believe that the leading QSR business that operates strictly within China is particularly insulated from these risks.

Yum China is a collection of seven restaurant brands: KFC, Pizza Hut, Lavazza, Taco Bell, Little Sheep, Shaofaner, and Huang Ji Huang. As of the most recent quarter, they have 10,603 KFC restaurants, 3,425 Pizza Huts, and over 1,000 between their other brands. I will focus on KFC, Pizza Hut, and Lavazza in this writeup given that they account for 95% of company-wide locations.

KFC

KFC accounts for 70% of total company-wide locations with 10,603 restaurants across China.  KFC is by far the most dominant QSR brand in China.  It has a 5% market share while the next top 10 brands are less than 10%. KFC has entered roughly 2,000 cities in China, and they still plan to expand into more than 1,000 untapped cities. In 2023, they did >1.4bn transactions. Annual KFC net new stores have grown at a >20% CAGR since 2018 while average new store cash investment has declined at a 9% CAGR in the same span.

This targeted growth will come from three major initiatives: Mini Stores, Franchisees, and their Membership Program.

Standard restaurants in higher tier cities average 180 square meters. Mini stores are designed to cover a more modest area and are roughly 120 square meters. The investment required for smaller restaurants is about one third lower than the standard size. The stated goal of these mini stores is to increase their restaurant density in higher tier cities and to improve the customer experience given that digital sales have nearly doubled since pre-covid and represent nearly 90% of total sales.

Franchisees currently make up 10% of total KFC locations but they plan to make that 20% of future growth. They use two primary franchise models to accelerate growth: Channel Franchising and Targeting Lower-Tier Cities with Franchise Partners.

They gave examples of each method in their 2023 Investor Day:

“Channel franchising is used primarily to achieve rapid store opening and expansion in major business districts. For example, as Joey (CEO) just addressed, to open stores in highway service centers, due to limited resources and low availability of dedicated locations, it would be hard for us to engage in each store and open each store individually, not to mention the prolonged store opening process. So, we reached out to Zhejiang Communications Investment Group and they became our channel franchisee for highway service centers. In just a few years, we opened 32 restaurants in highway service centers across Zhejiang province. We have partnered with resourceful channel franchisees at highway service stations in 12 provinces. Our channel franchisees also include universities, hospitals, tourist locations, gas stations, etc.”

"The other franchise model we utilize targets lower-tier cities and remote areas. Our goal here is to accelerate store openings in these markets and improve management efficiency. For example, our Tibet partner has opened 16 KFC restaurants in Tibet. As you can see from the picture, in Nagqu, Tibet, we have the world's highest KFC restaurant at 4,510 meters. It is located 1,500 meters higher than Lhasa. You cannot imagine how hard it would be for us to open and manage restaurants directly in such areas. In such examples, franchising is how we enter low-tier cities in remote locations where we see huge potential for small restaurant openings. Rather than attempt to open and manage these stores directly and face low store efficiency, we will continue to work within our franchise model for these types of locations."

A major reason for KFC’s resurgence post-covid has been their focus on their loyalty program. They now have 450mm members which account for 65% of total sales at KFC. Members have more than doubled since the end of 2019. They are better able to track various KPIs within their locations using these apps and drive transaction size and frequency. Currently, the annual purchase frequency for new members is three times per year, six times per year for existing customers, twenty-six times per year for privilege customers, and over one hundred times per year for their highest-level members called K Friends.

Below is the historical performance for KFC since the spin-off:

We believe that through the various growth initiatives mentioned above, KFC can see improving unit economics in the coming years.

Pizza Hut

Pizza Hut is the number one casual dining restaurant brand in China with over 3,300 restaurants across nearly 700 cities. Their market share in the Chinese casual dining sector is bigger than the next nine brands combined. Annually, they sell 20mm steaks, 100mm pizzas, and 50mm pasta bowls. They are the leader by a big margin in all three categories. They plan to add 400-500 new locations per year over the coming four years while maintaining their new store payback period of 2-3 years. While this brand hasn’t performed as well as they planned since the spin, they believe they have a long runway for growth. Current plans are to penetrate 1,200 new cities in which they already have a KFC location. Like KFC's expansion plan, they will achieve this growth due to flexible store models across, utilizing their franchise model, and furthering their lower tier city penetration. Two thirds of the new locations added in the last year are “delivery-focused” which have a slightly lower payback period than traditional locations.

This growth at Pizza Hut is focused on higher tier cities and high-quality store development. They are leveraging their satellite stores in tier 1 cities to increase the density of delivery trade zone. These satellite stores have a payback period of close to 2 years. Densification in high tier cities improves delivery speeds and customer experience allowing them to gain market share in the delivery market. They also plan to introduce a new compact store model which has a selective menu, requires less investment, and has a faster payback period than the standard dine-in-store model.

Currently, Pizza Hut is only 5% franchised but they plan to increase this to roughly 20% following the same Franchise playbook discussed above for KFC.

Menu improvements have been a major key in this performance. They spent the last few years making improvements on their pizza offerings and as a result, pizza sales were 50% higher in 2023 than in 2019. They have also added burgers and their exclusive brand of coffee, Lavazza, which they believe could create a massive opportunity.

They aim to expand restaurant margins over the next few years by way of reducing the amount of workload done in the store, leveraging automation, and increasing the mix of costs to a variable structure. Below is the historical performance for Pizza Hut.

Lavazza

While I attribute zero value to this brand, I believe it is a free option for YUMC shareholders today. Lavazza is their coffee brand that has a little over 100 stores today. Sales doubled in 2023 vs 2022 and they aim to reach 1,000 stores in the next 3-5 years. They spend very little time discussing this brand and do not provide specific financials for it, but I believe this brand is worth keeping an eye on as an investor.

Competition in China

The QSR market in China is very competitive. YUMC faces competition from McDonald’s, Dominoes, and Restaurant Brands International as well as local brands such as Dicos (KFC competitor), Wallace, and Laoxiangji. We believe that YUMC’s market leadership will be maintained in the coming years due to the quality of their brands, their operational expertise, and their expansion potential across lower tier cities and with the younger demographic in China.

Capital Returns

At the end of 2023, the company became very shareholder friendly and announced a large buyback along with a dividend increase. They are planning to spend $1.25bn on buybacks and $250mm on dividends in 2024. They are likely close to reaching this target within the first half of this year after repurchasing $681mm of stock in the first quarter.  We believe they will increase this amount for 2024 if the stock remains in this context.  This will be well in excess of the FCF for the year so we are happy to see the aggressiveness in deploying their net cash sitting on the balance sheet.  They have guided to spend more than $1.5bn in 2025-26 on a combination of repurchases and dividends in the following two years. At the end of 1Q24, YUMC had $3.1bn in net cash on the balance sheet representing nearly one third of their current market cap. Through May 3rd of this year, they have reduced their share count by 6%.

Valuation

YUMC stock has experienced significant multiple compression over the last three years which we believe to be severely overdone.  As mentioned in the introduction, it is currently trading at 10x 2024E earnings and 9x 2025E earnings, excluding cash.  Including cash, it is trading at 14x and 12x, respectively.  Since the spin, historically this business has traded for 20-30x PE as illustrated below:

Just a reversion to the low end of its historical range of 20x earnings would represent a 75% appreciation in the stock.  With unit growth and modest margin improvement compounding earnings in the mid-teens, the stock price performance in the medium-term could be explosive. Given the very large cash balance, PE is a little misleading but even on an EV/EBITDA valuation, the stock is trading at an extremely depressed multiple from and absolute sense and relative to its own historical multiple:

Risks

• Unit expansion into lower tier cities could dilute system-wide margins, offsetting any operational efficiencies deployed in existing units in tier one cities
• Competition from other QSRs, especially domestic competitors if US-China tensions pressure consumers to support local brands
• Consumer weakness in China

Catalyst

• Aggressive buybacks and shrinkage of excess balance sheet cash
• Operational improvements increasing restaurant-level margins
• Earnings growth
• Multiple expansion
• Bonus: Lavazza growth and success