A Tech Company Hiding in Plain Sight: Yum! China $YUMC

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I think Yum! China meets a lot of the criteria of a stock that will compound earnings for the next decade. I like it for 3 main reasons:

  • Long growth runway (China Tailwinds + Market is Not That Saturated + Upside from New Concepts)
    • Targeting 20,000 stores for core brands which is 2x the level today
  • High return on capital business, despite being mostly owned branches as opposed to franchise business model
  • Leader in Technology (core tenant as I think ROIC can go higher)

I know YUMC well from travelling to China. I actually did a college paper on my experience with different fast food brands in Asia; essentially which companies were succeeding with the new Chinese growth story and which weren’t.

YUMC was a leader at the time. Why? Because YUMC has been operating in Asia well ahead of its competitors (KFC first entered China in 1987, Pizza Hut in 1990) and frankly, they got it.

They got that you can’t take a US concept, plant it in China, and expect success. They got that the Chinese may have some similar tastes, but they didn’t grow up eating the same things as Americans. They also didn’t grow up, like I did, with a “Colonel” in a suit in charge of fried chicken chain and ask zero questions about that relationship.

So YUMC changed the items they serve for the local market. They did this well ahead of competitors. It’s been about 7 years since I’ve been to Asia, but I would say the other large chains were still trying to catch up to YUMC. That’s a general theme for this post and what we’ll get to later – innovation.

Invert the issue, too. Do you see many successful Chinese restaurant chains in the US? Not really. The ones you do see are highly Americanized / not Chinese food.

Here’s a snippet from their latest call. Do you think the menus are very similar to US? This is at a Pizza Hut for crying out loud.

For background, YUMC and YUM used to be combined, but YUMC was spun out in 2017. The rationale was that YUMC was more heavily owned restaurants, whereas YUM was mostly franchised. So YUM would become more asset light. At the same time, YUMC could dedicate more resources for growth. At the time of the spin, YUMC had 7,300 restaurants but it now has nearly 10,000. Mgmt says they feel 20,000 is a reasonable long-term target. (I also would mention the spin came around 3-4 years after the bird flu scare in Asia and perhaps YUM wanted to close that chapter / unknown future liability if supply chains get disrupted again).

Long-Runway for Growth

What is also interesting is that at Dec 2016, YUMC had ~7,300 KFC and Pizza Huts. Now, they have 9,000 and the balance (roughly 1,000 stores) are other concepts. These other concepts include Little Sheep (hot pot), COFFii & JOY (a coffee shop), East Dawning (Chinese food) and Taco Bell (theres only 7 Taco Bells in China – they need to ramp that up!).

They also just acquired Huang Ji Huang (a casual dining franchise in simmer pot) and partnered with Lavazza group in coffee (coffee is clearly growing in China – “In 2019, we sold 137 million cups of coffee at KFC, representing a 48% increase from 2018”).

So you’re not only buying a strong brand name of US companies operating in China, you have upside from new concepts. Each of these could probably support 500-1,000+ stores across China.

To put the store count of KFC and Pizza Hut into context, Starbucks has 4,100 stores in China at the end of FY2019. McDonald’s has 2,900 as of June 2020. YUMC is clearly dominant in China. That frankly means they have less of a runway in China with KFC and Pizza Hut, but I’m still optimistic on their other concepts, mentioned previously.

Restaurant chains have a low penetration rate in China, especially in lower-tier cities, with only approximately 332 chain restaurants per million people in 2019 compared to approximately 891 in the United States. While YUMC is “dominant” this indicates a substantial growth opportunity for restaurant chains in China.

Despite the pandemic, YUMC plans to continue ramping store count with a 800-850 target this year. They’ve averaged 2 days a day over the last few years. I’m not saying that will keep the same pace, but I am saying it doesn’t need to for an investor to benefit.

High ROIC Business

I’m very focused on unit economics for any business I study. The gold standard in this for me is Dollar Tree, which in their IPO docs in the 90s stated it cost them about $162k to set up a store and in year one they earned $162k in operating profit. So a 1 year payback period. For investors, understanding that they were earning such high returns + had a long growth runway in stores meant that signing up for the ride was a no brainer (in hindsight).

Now, I wasn’t around to catch Dollar Tree and it seems saturated today. But there are still opportunities. YUMC is targeting 20,000 stores for its core brands, which is double the current amount. Plus, they have a very good payback period.

This all jives with my estimates for returns on invested capital, as shown below (note 2020 is a bit weaker given COVID). As a shareholder, I’d prefer them plow that money back into the business if they can really earn these returns rather than give any back to me. I can’t earn 30-40% returns on my capital, but if you can, please take my money.

I also think YUMC can beat its historical returns for a few reasons (I think upwards of 50%).

The company is opening smaller concepts in tier 3-4 sized cities in China. In fact, 61% of KFC restaurants and 53% of PH restaurants opened in 1H20 were located in tier-3 & below cities as the cash payback levels are much faster. 

Next is that the digital investments it has made will likely lead to higher turns. The restaurant business is all about maximizing turnover. A fine dining restaurant probably can only seat 2-3 sets of customers in any given night, which is why it needs to maximize $/table. Fast food reinvented that with the drive through. The next step is delivery which will further enhance the market YUMC can at any one point and further increase sales per store.

Quick aside here: Honestly, I think brands like YUMC should look at the Uber founder is up to because I think it could accelerate this journey. His idea is that take-out and delivery restaurants probably have too much square footage today (think about the local Chinese joint. People rarely sit inside, instead getting delivery or pickup). What if restaurants shared energy costs and a building and then delivery people went to one central location before they dispatched out to make deliveries. I think it makes a lot of sense, especially for a company like YUMC where a KFC, Pizza Hut, Taco Bell and all their other brands could sit under one roof and cross sell.

Investments in Technology

Now to the meat of the thesis. I’m not sure many other restaurant companies are so point blank about technology and innovation being the forefront of their mission statement. I think Domino’s is the main one that comes to mind, but here is YUMC’s:

Take a look at the slides below. These were items shared by YUMC in March 2019. Talk about being prepared for COVID. When thinking about brands that will come out even stronger from this pandemic, I think YUMC went in with a clear strategy and should come out the other side even better.

Personally, I think you want to invest in companies that come out of a crisis with more market share. What is really interesting is that YUMC’s app now has 268 million members and I thought this quote (and some of the following slides) was really interesting: “Member sales accounted for over 60% in the second quarter. While overall sales declined during the outbreak, our year-on-year member sales grew by double digits.”

Below are some quotes from the earnings calls. I’m not going to provide too much commentary because I think management explains it well (instead I’ll add emphasis).

The thing I would say is that they seem to be well ahead of US counterparts. I think Starbucks in the US gets a lot of credit for their app, but YUMC is clearly using the technology to offer targeted promotions to its members. It also has 10,000 corporate members, so again maximizing turnover, it can target lunches at offices for bulk discounts. Again, part of my thesis is improving economics at each store as well as a long re-investment runway.

“And guess what, we get our mobile ordering before Chinese New Year. We did not know the COVID-19 was coming. And then COVID-19 came, it became a very good platform for takeaway and mobile order. So our mobile order or digital order just increased significantly. And Pizza Hut alone, the digital order for Q2 is 61%. And that, compared to last year’s 29%, it almost doubled. So again, the business model transformed. And for Pizza Hut, when we add the takeaway business, which is very value driven, it’s very much incremental because it’s for 1 person, together with delivery, the non-dining business become more than 40% of our business. So we become less reliant on dine-in business. So that is an example of both short-term and long-term transformations.

“And then I would like to mention the members. We have reached 268 million members. And the members are our digital assets to allow us cross-sell between the brands and between the business within the brands to increase frequency and cross-sell. As I mentioned in my presentation earlier, we saw the doubling of average revenue per active user, and that’s very exciting in the past years and for the coming few years.”

The interesting thing to me as well, to show how far ahead their thinking was, was they acquired a delivery platform called Daojia in early 2017. Now, the market moved to third-party aggregators, so that investment unfortunately didn’t pan out, but they now partner with the other aggregators. They actually acquired a small piece of Metuan which has been a good investment, but the point is clearly the business is being set up to win in the new environment.

“As early as 2010, we identified delivery as a significant growth driver and began to offer delivery services, first through our own delivery platform, and later, in 2015, also through partnering with third-party delivery aggregators to generate traffic. In 2019, we enjoyed one of the highest delivery sales contributions among restaurant chains in China, according to the F&S Report, with such sales accounting for 21% of total Company sales for the same year”

This wouldn’t be an interesting investment without some key concerns:

Pizza Hut in the US is suffering. What’s stopping that from happening in China?

Pizza Hut in the US is suffering from lack of investment and being set up as dine-in stores, whereas “DelCos” are now winning (delivery companies such as Dominos). This, coupled with a menu and offering that needs to be refreshed, is a concern for current operators in the US. The other main concern for Pizza Hut in the US is technology (seriously, the app is horrendous. It’s like a college intern built it).

It’s a different story in China. It seems to me that YUMC is learning from mistakes at YUM. I guess that’s the benefit of owning a large chunk of stores – you quickly can see an issue. If you don’t invest in the brand and turn things around, you’ll suffer much faster than a pure franchisor model.

Any concerns on backlash on the West now that the US and China seem to be in a new Cold War?

This is a hard risk to box. On one hand, I am concerned and think there could be some serious market volatility and even multi-year periods of where Chinese consumers may boycott western brands. A couple positives are that YUMC is basically a Chinese brand at this point (yes, they are American names, but it’s a Chinese company with a Chinese menu essentially…).

The second is YUMC recently sought a secondary IPO on the Hong Kong market, which would help in the case that the US bans Chinese listings on their exchanges. This raised $2.2BN.

As someone reviewing the company, that was a bit frustrating to me as it is dilutive, but at the same time, its more capital to plow into the business. Perhaps they will even use it to slowly acquire US shares – I have no clue. The point is YUMC also has no debt at the moment, so likely could survive a drawdown period.

In the long run, if the tensions subside I think there is upside from optimizing YUMC’s capital structure.

If this is a serious threat to you, then I’d also say watch out owning SBUX and MCD as well as any other global brand.

Bottom line, I think YUMC can compound FCF / share at a 15% CAGR from 2021 through 2028. As you know, this FCF compounding is a significant driver of returns.

I normally don’t build models that far out because its anyone’s guess as to what happens even in the next year. I did so for YUMC basically to sensitize different inputs. My main case assumes Pizza Huts aren’t a driver of any growth and instead growth comes from KFC and new franchise concepts. KFC improving profitability over time which is the main driver of results.

The reason why I really like the story is because there’s upside from factors outside of my model. Clearly, the company has expanded outside of US concepts. This could continue with more M&A or organic initiatives (think McDonald’s when they owned Chipotle, Panera, and oh yeah – they owned Redbox…).

At the same time, the financials may improve more than I expect for a host of reasons: Pizza Hut improving more than I expect, more franchise concepts vs. owned means lower asset intensity and higher FCF conversion, and better cost leverage from expanding to a company with 20,000 locations (I only model getting to 15,000).

The risk / reward skew seems positive in my view.