A yummy dish for investors!

Key Points

• Play on China with high probability of success due to multiple ways to grow.
• Established market leader with somewhat of a moat that I believe can be a compounder
• Trades at a significant discount to comparables with capable management that is focused on growing the firm at high single digits while increasing operating profit at double digits.
• Management plan is realistic if not conservative.  A purchase at current levels would produce low double-digit annual returns over the next few years assuming multiple remains steady and doesn’t close the gap.

Company Description

YUM China (YUMC) is listed on the NYSE, reports in USD but essentially operates in China.  With over 8000 restaurants, the company is among the world’s top 10 by market cap.  Brands include:

• KFC (1987) which is the most important brand with 6,100+ stores in 1,200+ cities.
• Pizza Hut (1990) with 2,300+ stores in 500+ cities
• East Dawning (2005) – a quick service restaurant brand specializing in Chinese cuisine with around 10 stores.  
• Little Sheep – a hot pot restaurant with over 300+ stores in China and internationally (280+ stores are franchised).  
• Taco Bell (2016)
• K-PRO – a healthy food alternative
• Coffii & Joy – coffee chain.

The company is a lot more popular and different than the typical YUM brands restaurants in other countries.  

• In 2001, it was Chinese consumers favorite brand ahead of McDonalds, Pepsi and Nike, 
• KFC sells items such as egg tarts, congee, soymilk, etc.,  
• In 2017 was ranked the “Most Preferred Casual Dining Restaurant” in China (including Chinese and western brands) by the Nielsen corporation, 
• Is the biggest fast food chain in China (around twice the size of its nearest competitor) and 
• It was the first American Chain in China, established in 1987.  

When I presented this idea at a small private event recent, I started with “Guess who” slides and only one person (a shareholder) guessed correctly.  Each of these historical facts actually tell us a lot about the company that was spun off from Yum Brands (YUM) in 2016.  

Kentucky Fried Chicken (KFC) is the flagship brand and when it opened at the entrance of Beijing’s Imperial Palace it was the largest KFC in the world at 1,100 square meters.  Thousands waited for hours and the police had to be called to maintain order.  Back then KFC was considered a luxury with people eating it on special occasions as the combo meal was 7-yuan (vs 100-yuan average monthly salary).  This included 2 pieces of fried chicken, mashed potato, coleslaw and a dinner roll.  Parents used the chain as an incentive to get their kids to get good grades and locals even got married on the 3^rd floor which was reserved for special occasions every Sunday.  KFC earned people “face”.

KFC China grew from 1 to 1,000 restaurants in 16 years.  Over the next 4 years, they doubled to 2,000 (2007) and in the following 12 years grow to 6,100+.  According to Warren Liu “No other restaurant company, Chinese or foreign has achieved such remarkable growth in China”.

The company did face competition early on from state owned Ronghua Chicken – a copycat founded in 1991.  It gained popularity as it was slightly cheaper than KFC and found support as the local brand, but by 2000 it was gone!  According to the head of Ronghua, “[it failed because of] a lack of the kind of well-developed system that KFC possesses which oversees every detail of the business, from making the product, to service, to site, to staff training and management.”  Basically, they lacked the experience of managing a chain business.

So why did KFC succeed?  Warren Liu who worked at the company wrote “KFC in China.  Secret Recipe for Success” and provides a good picture as to why and how the company succeeded when global competitors failed to achieve a similar level of success.  Reasons include:

• Good timing.  It was 9 years after the official launch of China’s economic reforms, 5 years ahead of Deng’s historic journey to southern China, and 3 years ahead of MCD’s entry.
• Product.  The Chinese really like Chicken (the 2^nd most popular protein after pork) and deep-fried.  The KFC bucket is about sharing and this is closer to the Chinese culture (vs individual services).
• Stores.  The stores themselves were an experience with color and clean toilets (something we take for granted today wasn’t as common in ’87).
• The “Taiwan gang”.  Management had experience in QSR and was from Taiwan.  This meant they knew the customs, history, culture, and language much better than teams that came from abroad (including Hong Kong and Singapore which were popular hire cities for non-Chinese competitors).
• Brand positioning.  KFC was an American brand with Chinese characteristics” which helped the brand to be accepted.
• Localization.  Local items were introduced into the menu.  The company was also faster to market with new items at higher frequency than competitors.  There is a culture of new product innovation where items go through a test kitchen and a process developed over decades.
• Infrastructure.  According to Liu, “Distribution/logistics is one of the most important competitive differentiators enjoyed by KFC China.  With [these] resources completely and directly under its own control, KFC has been able to go further and faster into the Chinese inland in an attempt to aggressively expand its market reach, and to do so far more efficiently and cost-effectively than the competition.”
• Supplier base that was willing to invest in themselves to satisfy KFC’s demands and be rewarded with large contracts.
• When Pizza Hut was also established, there was resource sharing among the brands.  This resulted in savings on labor and admin costs, volume discounts, the ability to negotiate favorable joint lease agreements.  Successful new items were also interchangeable between brands (eg. roast wings start at Pizza Hut and ended up on KFC menu as well).
• Good/smart Public relations.  The company built relationships with locals, government and the community.  This is not only done via philanthropy and special events but also by welcoming outside views.  In 2000, they invited Chinese health experts and government offices to join the established “KFC Food Health Consultative Committee” and in 2005 issued the “Proposal for New Fast Food” to address health concerns.
• Flexibility.  Management is flexible and adapts the business to the environment and current market conditions.  They are not afraid to make the necessary changes to help the company succeed.

The early success continues to help the company to this day.  Consider that staff is a bottleneck to growth.  In order to properly expand a chain business, you need trained staff that is familiar with how the restaurant is run.  This improves customer service, raises revenues and reduces costs.  With more stores, the company has more “graduates” at all levels of the business.  

The already established relationships with the local governments help the company add new brands/concepts and expand elsewhere.  There is power in being such a large employer – almost half a million employees that include locals in managerial positions (even the CEO is from Fuzhou).  

While I haven’t tried the food in China, there are numerous online reviews which are quite positive.  From a March 2019 Business Insider article:

• “…I usually layer on condiments. I didn’t touch one with this chicken. There was plenty of flavor and it was far less greasy than KFC fried chicken in the US.”

• Chicken bowl (like Japanese donburi): “Surprisingly, the skin was still crispy. The meat tasted very fresh.”
• “…I opted for the humble egg tart… This might have been the best egg tart I’ve had in China — and I’ve had it in Hong Kong and Macau, where the dish originates. A sacrilege, I know. The pie crust was perfectly flaky, while the eggy middle was creamy with a light glaze of sugar over the top.”
• The peach oolong tea was the clear winner here. It was very lightly sweetened. Overall, KFC in China was lightyears better than in the US. The food tasted fresher, less greasy, and more thought out. Usually after eating KFC, I feel bloated and like I’m oozing oil. I felt great after eating KFC in China.

This is a sharp contrast to my own local KFC (in Cyprus) where the service was poor, there were no local dishes and a clear lack of technology which is present at KFC China.  And while my local KFC was clean, well air-conditioned and had a young kid’s play area there were few people at the place.

Finally, the long presence in China has resulted in the company facing several different types of crisis (political, diseases, bad publicity, etc).  Examples are listed below.  The company has a crisis management system in place since the mid-90s and so I expect that their past experiences will help them face future problems.

• 1999 – Chinese embassy bombed in Yugoslavia by the U.S.
• 2003 – SARS
• 2004 – Avian Flu
• 2005 – Sudan 1 red-dye & Avian Bird Flu. (-20% in sales and profits).
• 2012 – China’s state television station CCTV reported that chickens were fed excess amounts of antiviral drugs and hormones. 
• 2014 – Supplier accused of selling expired products to restaurant companies.

Management

The CEO is Joey Wat whom Forbes China placed in 3^rd place among the country’s top 100 businesswomen.  She has held various positions within Yum China for the last 5 years and became CEO in 2018.  Previously she worked for a decade at AS Watson of Hutchinson Group (1,500 store retailer) as head of strategy and before that at McKinsey.

In an interview with Forbes she summed up her business approach in eight words: “Good food, good fun, internal beauty, external beauty”.  According to Wat more than half the food items are from an oven while 80-90% of breakfast items are not fried.  You can tell Wat’s excitement over the food if you listen to her tone during the conference call.  The 2Q19 transcript below doesn’t do it justice:

“We launched the premium burger, basically, the import beef burger and salted egg yolk shrimp burger. So these burger are sold at RMB 25. We never sold burger at such high price. RMB 25 is very high price that we price, but they are very popular, and guess what, we’re going to continue. And it will continue, continue the LTO, then it might have a chance to get on our permanent menu.  So a lot of amazing product coming. And we have — typically have 12 months pipeline already in our plan because given the scale of the business, if we don’t have the plan, we are not doing a good job. Similar idea for Pizza Hut, but the pipeline for Pizza Hut is coming.  Just to advertise, Pizza Hut this week, we are selling Canadian snow crab pizza, fantastic.  So when I get to talk about product, I got very excited.”

Fun to her regards marketing which includes the philanthropy as well the focus on digital marketing and spend.  External beautiful refers to money spent to make the stores and staff look good because “When you renovate a store, the people that are the happiest aren’t the customers. It’s the staff, because they work there every day, and they feel proud to work in a newly renovated store.”  While internal beauty is the way the business is run and we get a feel from this again from the 2Q19 transcription above.  Furthermore, over the last 2 years there is a consistency in the communication, and narrative in investor presentation and conference calls.

The company initiated a dividend in 4Q16 and has a $1.4 billion repurchase authorization.  $312m worth of shares were bought in 2018 and $128m in 2017.  The company announced that it has plans to return $1.5 billion in dividends and buybacks over the next 3 years while investing around $500m per year.  

Self-Disruption

In 2015, the brand was described by millennials “as a middle-aged businessman in a middle-age crisis”.  Instead of being disrupted the company decided to self-disrupt.  They invested in technology and a loyalty program.  Within the 1^st year over 80 million signed up to their ‘Super App’ which now has over 235 million members.  The app has helped drive business on off-peak days, as well as increase spend (2.1x increase) and frequency (2.4x increase) overall.  Digital orders were up from 33% of sales in 4Q17 to 51% of sales in 4Q18 while digital payments are at 85% vs 39% two years ago. 

China has hundreds of millions of gamers, so they partnered with the China’s award-winning gaming giant Onmyoji and created an exclusive KFC China game.  Like Pokémon Go, it uses location-based services and AR to encourage players to meet in-store to play together.  They also partnered with the world’s biggest online game, League of Legends. Unique features were developed for KFC which included: a) A button to order your KFC food from within the game itself, b) A ‘gamer’ menu focused on food that can be eaten with one hand, c) Themed restaurants that featured “League of Legends” experiences and branding.  This resulted in a 5% overall increase in customers and 35% uplift in sales in themed stores.

What surprised me is that the company appears to be constantly working on new ways to engage consumers.  Such as the new KPro healthy food concept that sells salads, juices and paninis instead of fried chicken, or their fully automated desert station, facial recognition (smile to pay) and Dumi (the world’s 1^st AI service robot).   See the short video on Dumi:  https://vimeo.com/213047278

Growth Opportunity

The upside in YUMC comes from the multiple ways to grow.  Firstly, total consumption is expected to grow in the low double digits.  This is driven by the labor participation rate and rising incomes.  The labor force participation rate is high, both overall and amongst women.  As the chart shows women’s share of the labor force is higher than several developed and emerging economies.  Urban household annual incomes are on the rise with the “mainstream” group ($16-34k) expected to rise from 6% of households to 51% by 2020 while those with income below $16k will drop from 92% in 2010 to only 43% by 2020.

The population of China is around 1.4 billion compared to ~327m in the USA and ~508m in Europe so naturally the restaurant market size should grow and is actually expected to be the largest by 2023.  The total restaurant market is expected to rise to $990 billion or grow at 8% vs 3% in the USA and 2% in Europe.  In comparison, the USA and Europe’s market sizes are expected to reach 970 billion and 580 million respectively.  These projections could even be considered conservative if we consider that when reached, Americans will still be spending 4x as much and the Europeans 1.6x as much on restaurants.  Online food delivery is expected to grow at even higher rates as online penetration increases.

Unlike the rest of the world, within the restaurant market, the independents dominate.  Only 9% are chains in China versus 35% in Taiwan, 36% in HK and 27% in the world overall.  So not only will the market increase, but also the chain market can be expected to gain market share.  Furthermore, quick service restaurant (QSR) penetration in China is lower as a % of the overall food service market.  

Yum China brands KFC and Pizza Hut are also underpenetrated with only 21 restaurants per million inhabitants in Shanghai and ~5 per million across China.  In comparison both developed and emerging countries have penetrations of 23-37 YUM restaurants per million.  All else equal, population size and 23 restaurants penetration would imply 32k restaurants compared to under 9k today.

Growth opportunities do not end there.  The company has been using multiple store formats and has been targeting all parts of daily consumption (i.e. breakfast menu, afternoon tea) to raise sales.  In March 2019, YUMC announced a strategic partnership with Sinopec and China National Petroleum to develop franchise restaurants at the two companies’ gas stations with a 3-year target to open 100 stores.  The firms collectively operate over 50,000 gas stations.  And of course, there is growth from the development of additional brands.  One such brand is Coffii & Joy which in the rapidly growing coffee market.  There is the obvious opportunity of low penetration in China, but there is also the upgrade potential.  Instant coffee is 13% of worldwide consumption vs 87% for freshly ground coffee.  In China it’s the opposite with instant coffee at 84% so the opportunity is twofold.

Lastly though the use of technology and big data, the company can increase sales and reduce costs.  Sales are increased through engagement with consumers and personalizing the experience.  A simple example is trade-up offers based on profile and order history.  Savings have come about through an increase in the percentage of digital orders and the reduction in cash orders.  Further disruption can come about in the future by serving clients the food directly (currently there is a fully automated dessert station in Suzhou).

Valuation

In August 2018, Yum China rejected an all-cash buyout offer at $46.  The consortium that included KKR, Baring Private Equity Asia and the Chinese sovereign wealth fund China Investment Corp made an offer that was at a 42% premium to where the stock trade.  Fast forward a year later the stock trades just below that level which I consider a floor.  In 2Q19, management raised guidance for new stores to 800-850 from 650 as they are accelerating the development of multiple brands.  The long-term guidance is high single digit system sales growth, a double-digit operating profit growth and a 17% restaurant margin.  For stores the plan is to have 10,000 by 2021 and 20,000 longer term.  Based on the growth opportunity that appears realistic if not conservative.

Assuming a single digit growth of ~7-8% in EBITDA (vs historical 9% and thus below LT guidance and below analysts estimate per Bloomberg), $1.5 billion return via dividends and buybacks, CAPEX of ~525m, 5% dividend increase, and a 11.5x multiple, implies a target price of ~$63 (with dividends ~$65).  So essentially an entry at around current prices implies a low double-digit return. 

Comparables below imply a value of $80-85.

Conclusion

This is a play on China with an established market leader that I believe can be a compounder.  They are multiple ways for the firm to grow with any headwinds being opportunities for investors to get long the stock.  This is for long time horizon investors who can increase returns by adding on weakness.  It is only 1% of my portfolio and that is how I intend to play this.  There are several things that could weaken the stock at any time in the future such as failed product launches, diseases, increased chicken prices, bad publicity, expansion errors, etc.