Consumption Trends Power Yum China

Yum China YUMC was spun off as an independent, publicly traded company in October 2016, although it is still a trademark licensee of Yum Brands YUM . Sales trends have been uneven at times amid macroeconomic uncertainty, a changing competitive set, evolving consumer views regarding health and wellness, and executional missteps, but we still view Yum China as a wide-moat-rated business thanks to its powerful brand intangible asset in the region, as well as unparalleled distribution infrastructure and local site development teams.

We find longer-term division goals of high-single-digit system sales, 17% restaurant margins (after the 3% of systemwide sales licensing fee paid to Yum Brands), and midteens earnings per share growth realistic, based on favorable China consumer demographic trends and the operating leverage inherent in the business model.

We view Yum China as one of the most direct ways for investors to play the Chinese consumer's increased spending power, and we think the firm's opportunities for market share and unit expansion in the highly fragmented Chinese restaurant market are being overlooked. In this market, the top five chains represent roughly 6% of China's approximately 5 million restaurants (based on data from IBISWorld), as well as future opportunities for conventional franchising.

We're also optimistic about Yum China's various same-store sales drivers, including value platforms, menu simplifications, alternative restaurant formats such as kiosks, enhanced digital marketing efforts (underscored by more than 93 million loyalty program members, making it one of the largest consumer loyalty programs in the world), unrivaled delivery capabilities (representing 13% of sales at company-owned locations), and nascent brand expansion opportunities in Taco Bell and Little Sheep. In our view, the dual catalyst of improving China comps--which we expect to be the key driver of stock performance--and meaningful cash returned to shareholders through share repurchases and a potential dividend (backed by the roughly $964 million in cash and equivalents on the balance sheet as of December 2016) will be too much for the market to overlook in the next several years.

Despite Recent Challenges, We're Optimistic for the Long Term
Although Yum China has faced its share of challenges in recent years, we've assigned it a wide economic moat rating based on its portfolio of strong brand intangible assets; a wholly owned supply chain and distribution system that should facilitate the development of a larger franchisee system over the next several decades; 1,300-plus development personnel across the region and a deep management pipeline with more than 8,000 recruits; and a proprietary real estate database for more than 1,000 Chinese cities. We appreciate market concerns about Yum China's ability to adjust to an uncertain macroeconomic picture in the region, a consumer more focused on value, an evolving competitive set (including a rise in competition from local chains and the impact on Pizza Hut casual dining due to heavy discounting from online ordering aggregators), and a three-year span of top-line volatility stemming from two high-profile supplier-related incidents. While competition and an evolving consumer could create volatility in future results, we remain optimistic about Yum China's longer-term opportunities, given a still-fragmented restaurant industry, a growing Chinese middle class, ongoing urbanization trends, and the market becoming increasingly conducive to franchising.

We like the focus on operation and menu simplicity, a more value-oriented core menu, an improved in-store experience for consumers, restaurant format flexibility, and staying digitally relevant in China. We saw some contribution from new value platforms and menu simplifications in 2016 and expect new restaurant formats and digital efforts to drive longer-term benefits. Coupled with the fact that Yum China's brands continue to lead several “most preferred brand” surveys in China (based on company data and our own analysis), we expect these initiatives to drive same-store sales back to normalized growth in the mid-single-digit range over the medium term while supporting our wide moat rating.

China is probably entering a period of normalized GDP growth in the mid-single-digit range as it transitions away from being a government- and export-driven economy. However, we do not believe that consumption trends will permanently decline as economic growth decelerates. While equity market and currency volatility can create periods of uneven spending—as we've seen in the past few years--we remain constructive on the longer-term spending potential of the Chinese consumer. There are several reasons we view China as one of the most fertile regions for consumer consumption over a longer horizon, including a doubling of China's consuming class to 500 million-600 million people over the next decade; expectations that double-digit wage growth is likely to persist over the next few years, which should have a positive impact on disposable income trends in the region; an urban population that could eventually exceed 800 million; government regulation changes, including migrant worker and transferable rural property laws that could drive wealth creation and easing of one-birth policies; and technological advances.

We also believe China's younger population--those under 35--will be instrumental to restaurant spending in China over the next several decades. According to a February 2016 study by Boston Consulting Group, consumption among those in China under 35 is growing at a 14% clip annually, double that of the 7% consumption growth of older generations. We attribute this gap to several factors. First, we believe younger Chinese consumers find themselves at a compelling intersection of supply (increased disposable income through wage rate increases and career advancement) and demand (greater consumer product needs via family creation and greater willingness to embrace Western brands). We also believe that career advancement--and, by extension, time-strapped consumers--will increase the demand for convenient/takeaway food products, which bodes well for Yum China's breakfast daypart expansion plans and gives us another reason to forecast low- to mid-single-digit same-store sales growth throughout our 10-year explicit forecast period. Second, this cohort group tends to be college-educated, quick to adopt mobile-ordering trends, and more sophisticated at shopping than older counterparts. Finally, China's consumers typically have greater brand recognition than many of their peers in developed nations, according to the Boston Consulting Group study; we believe this bodes well for Yum China, given that these consumers grew up during KFC's and Pizza Hut's expansion phases in the region.

Distribution and Development Set Yum Apart
In most developed nations in North America and Europe, restaurant chains rely on food distributors like Sysco and U.S. Foods to ensure food is handled properly between suppliers and restaurant locations. Because China lacked reputable food distributors when Yum Brands entered the country, the company had to develop its own distribution infrastructure, which now encompasses more than 20 logistics facilities, a national consolidation center in Shanghai, and a fleet of more than 500 refrigerated trucks. We believe that these efforts, while costly, were critical to Yum China's rapid expansion, allowing for greater menu flexibility and variability. Despite two well-publicized supplier-related incidents in China at the end of 2012 (China's state television station reported that certain poultry suppliers in Shandong province had fed chickens excess amounts of antiviral drugs and hormones) and in mid-2014 (Shanghai Husi Food--a subsidiary of U.S.-based OSI Group--was accused of selling expired products to restaurant companies), we believe Yum's supply chain and distribution network are unrivaled among restaurant operators in the region and act as a cost advantage moat source underpinning our wide moat rating.

Yum China's products are largely sourced locally, save for certain herbs and spices, which we believe helps to keep costs manageable and positions KFC and Pizza Hut as more “authentic” Chinese brands despite their obvious Western roots, while strengthening the company's relationships with national and regional government officials. We also believe that Yum China's Operation Thunder in 2014--which featured a broad-based evaluation of the company's entire supply chain, the elimination of more than 1,000 smaller poultry farms in the system, greater food testing at the supplier level, and increased food-safety marketing efforts--helped to fortify the company's supply chain while maintaining its cost advantage moat source.

Yum China has a sophisticated site-selection process, including state-of-the-art mapping tools and more-flexible go-to-market restaurant and drive-thru buildout strategies, which should facilitate its unit expansion opportunities in the region. We also believe these site-selection tools--in addition to strong relationships with lenders and real estate developers--will be critical when Yum China looks to be more aggressive with subfranchising, something that we expect to become more pronounced over the next 10 years (we believe franchise locations could represent as much as 20% of Yum China's total locations, compared with 9% today). We believe this move will help to drive consolidated segment operating margins to the mid- to high teens over the next several years.

With Yum China's ambitious unit growth plans, staffing (and, by extension, wage growth) can be an issue. However, we believe the company's personnel-development capabilities in China are second to none, promoting a culture where new hires work side by side with experienced ones in established outlets once trained, before moving to new locations. We believe the benefits of Yum China's personnel-development functions are twofold: (1) teaching employees how to interact with customers--an often-overlooked quality among quick-service restaurant operators--thus improving the guest experience; and (2) grooming a pipeline of potential managerial and executive talent. We believe these strengths would take significant time and capital for other restaurant competitors to replicate.

The popularity of online marketplaces has changed the complexion of China's retail real estate landscape, much as it has in many developed markets. Traditional anchor retail has seen a decline, and restaurant chains are filling the void. Additionally, the rise of upper-middle-class and affluent consumers has created a new class of willing entrepreneurs and restaurant franchisees; when coupled with an increase in available capital, this has prompted an increase in conventional franchising agreements in the region, something that hadn't existed until just a few years ago.

While the number of restaurant locations is on the rise in China--the number of chain “catering” locations increased just over 14% per year between 2004 and 2014, according to China's Ministry of Commerce--we've also seen consolidation in the industry, with the top 10 chains in China operating roughly 2.5 times as many restaurant locations in 2015 (24,400) as they operated a decade ago (approximately 10,800). Consolidation and the increased economies of scale that follow for industry leaders typically lead to greater price competition, and we expect this to continue in the years to come as China's consumers remain value-conscious amid uneven macroeconomic conditions. That said, we like Yum's chances for outperformance during a period of heightened price competition, given its meaningful supply chain advantages as well as the marketing, value proposition, and digital enhancement corrective measures.

Although Yum China faces potential executional and operational risks after the spin-off, as a stand-alone company it boasts a compelling long-term growth story that will be enhanced by its debt-free capital structure and management's ability to focus on growth and operational improvements. Although Yum China has $964 million in cash and equivalents as of December 2016 and we expect it to remain debt-free for the foreseeable future, we've assumed a slightly higher weighted average cost of capital assumption than for the stand-alone Yum Brands, derived solely from our 9% cost of equity assumption (the rate Morningstar assigns to all companies with an average systematic risk profile). Over a longer horizon, as the new Yum China board meets and refines its capital priorities, we would not be surprised to see the company add leverage by tapping the capital markets in both the United States and China, which could be used to finance unit expansion and remodeling activity, repurchase shares, or initiate a dividend.