Yum China Holdings, Inc.

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

Yum China Holdings, Inc. operates as a restaurant chain operator in China, with a primary focus on quick-service restaurants (QSRs) like KFC and Pizza Hut, encompassing both company-owned and franchised locations.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview:

Yum China Holdings, Inc. (YUMC) is the largest restaurant company in China in terms of system sales, with 14,647 restaurants across more than 1,900 cities as of December 31, 2023. The company’s operations primarily consist of KFC, Pizza Hut, and other emerging brands. KFC, representing the biggest part of their business, is known for its American-style fried chicken, while Pizza Hut has a wide variety of pizzas, pasta, and Italian dishes.

Revenue Distribution:

  • KFC: Generates a larger portion of YUMC’s revenue. The brand’s widespread popularity across China, strong menu innovation, and focus on digital ordering channels have helped sustain its revenue growth.
  • Pizza Hut: Generates the next biggest portion of revenue for YUMC. This brand is trying to become a family focused restaurant with more innovative menu.
  • Other Emerging Brands: Include brands like Lavazza, Little Sheep, Huang Ji Huang, and Taco Bell. Though relatively small compared to KFC and Pizza Hut, these brands contribute to the company’s expansion and offer access to a wider consumer base.

Industry Trends:

  • Growth in China’s Restaurant Industry: The restaurant industry in China is growing, driven by the rising middle class, urbanization, and increased spending on dining out.
  • Digitalization: Consumers increasingly use digital channels for ordering, payments, and engagement, pushing companies to prioritize their digital presences. * YUMC has been investing heavily into its digital presence including its mobile apps and loyalty programs. As of 2023, the company had 470 million app members. * YUMC also partners with delivery companies to ensure smooth and timely delivery.
  • Preference for Localized Flavors: While American QSR brands are popular, there’s also a strong consumer preference for localized menus that appeal to Chinese palates. Companies such as YUMC have adapted their menus to include Chinese flavors. * For example, KFC has introduced items like congee, while Pizza Hut has some dishes that have local flavors.
  • Increased Competition: Both domestic and international QSR brands are fighting for market share in the competitive Chinese market. The fast-food market is extremely fragmented as shown by market share and presence of competitors.
  • Rising Costs: Rising labor and food costs have created some challenges for many companies in the industry.

Competitive Landscape:

  • YUMC faces competition from a variety of domestic and international QSR brands, including McDonald’s, local food chains, and diversified casual-dining restaurants, and cafes.
  • It also faces competition from new and growing digital first players in the food delivery space.
  • The fragmented fast food market allows for new entrants to make their presence known, but the competition for customers remains intense.

What Makes YUMC Different?:

  • Scale and Penetration: YUMC has a large presence in China, and it uses its scale to have higher levels of efficiency than its competitors.
  • Strong Brand Recognition: KFC and Pizza Hut are well-known and popular brands in China, which give YUMC an advantage in attracting customers.
  • Localized Menu: YUMC has a localized menu that is tailored to Chinese tastes and flavors, which helps its brands gain more customers.
  • Digital Innovation: YUMC has also shown that it is quick to adopt digital trends to enhance customer experience and generate revenue.
  • Extensive Delivery Networks: The company has built an extensive delivery networks that can give its business a further competitive advantage.

Financials Analysis:

  • Revenue Growth: Yum China has continued to show revenue growth year after year as it expands the number of restaurants in its portfolio. As can be seen in 2021, the company’s sales increased by more than 19% YoY.
  • Margins: YUMC has maintained gross margins around 20-25 percent during the past years. However, inflation and high competition may cause future earnings to be slightly lower than its historical values.
    • Yum China’s revenue, costs, and profits in China, are heavily affected by the fluctuations of the yuan, which may change depending on the decisions made by the Chinese Government.
  • Capital Expenditure: YUMC makes large investments every year to grow its brand. In 2023, the company invested over $788 million to grow its capital assets.
  • Debt: Overall, the company has good debt to equity ratio that is usually below 1x. As of December 31, 2022, Yum China’s debt amounted to $193 million with a debt-to-equity ratio of 0.2x. This is comparatively low compared to many of its industry peers.
  • Cash Flow: YUMC has had great free cash flow over the past years.
    • Their net cash from operating activities was $1.14 billion for the year ended in 2022.
    • The net cash used in investing activities was $855 million for the year ended in 2022
    • And the net cash used for financing activities was $371 million.
  • Acquisitions: YUMC has a history of using acquisitions to grow revenues and market share, however these acquisitions have been largely focused on improving or adding value to their own core business. The company has acquired both domestic and international companies that are within or adjacent to their existing business.

Moat Rating: 3 / 5 * Brand Recognition: KFC and Pizza Hut are recognized and preferred brands for the majority of Chinese consumers. * Scale Advantages: The company’s scale allows it to operate more efficiently and to also use its vast network to bring high quality products in a faster manner. * Switching Costs: While switching costs are not very high compared to other industries, loyalty programs and convenience have encouraged consumer retention, providing a moderate switching cost moat. * Intangible Assets: The long-term success of the company can be partly attributed to unique recipe that can’t be easily replicated or copied by other companies. *However, the moat is not as wide as you can expect from a business with multiple brands, as competitors can also easily penetrate the market and compete on prices.

Risks to the Moat and Business Resilience:

  • Intense Competition: A major risk factor is the extreme competition in China. Local QSR chains, fast-food restaurants, and street vendors are competitors. Also, there are various food delivery apps that have penetrated and disrupted the market with lower prices. YUMC has to constantly innovate, improve its operations, and offer a good experience in order to stay relevant.
  • Economic Fluctuations: The company’s operations are subject to fluctuations in China’s overall economy, including inflation, shifts in consumer spending, and changes in the job markets.
  • Changes in Consumer Preferences: YUMC needs to be aware of changing tastes and adapt to remain relevant. Consumer preferences are prone to change quickly and if the company fails to keep up, it could harm the earnings and value.
  • Food Safety Issues: In the past, there have been several food safety related issues in China, and this puts YUMC at risk if it is caught in such a scenario. Any major food scandal could damage their credibility and put the business at risk.
  • Regulatory Issues: Chinese regulations are constantly changing and could impact the companies operations and growth plans. Such laws could result in delays in openings and new regulations which would further affect YUMC’s business. * For example, in the past Chinese government’s policy restricting online gaming have created a negative impact on companies in the digital industry.

Understandability Rating: 2 / 5

  • While the core business concept of YUMC – quick service restaurants – is relatively easy to grasp, there are several factors that add complexity to understanding its operation including its complex financials and the impact of Chinese government policies on the company’s results.
  • Moreover, the structure of YUMC, with its numerous brands and operations across China, requires a solid knowledge base for the investor to fully understand.
  • In addition, different levels of reporting on the different business units make the valuation of the business hard, as YUMC’s revenue is derived from a variety of its brands each with different geographies. The impact of acquisitions and changes in business is hard to model and understand.

Balance Sheet Health Rating: 4 / 5

  • YUMC has a healthy balance sheet with little debt in comparison to equity. As mentioned, the company has debt-to-equity ratio of 0.2x.
  • The company has a lot of cash in its books with over $1.1 billion in cash.
  • The company is not very prone to risk from debt and is in a good position to take advantage of good investments.
  • Their operating cash flows are strong which further strengthens its balance sheet.

Recent Concerns & Controversies:

  • COVID-19 related Issues: As of 2022, there were some short-term impacts due to COVID-19 as lockdowns made it difficult for the company to function, but they rebounded with 17.5% system sales growth in Q4 of 2022 and 2023 has shown further recovery and growth.
  • Decline in ROIIC: As of the latest earnings report, the company is seeing a decline in their returns on invested capital due to increased competition from other restaurants and growing costs of sales.
  • Impact of China’s Economy: While YUMC operates primarily in China, it is also significantly impacted by any slowdown of the local economy, and faces regulatory risk and the potential for policy uncertainty as the Chinese government tries to reach its objectives.
  • Changes in Senior Management: Several senior executives including the CEO, CFO, CMO, and COO have resigned during the past 2 years. The instability in its senior management may negatively affect future operational performance.

In conclusion, YUMC has a solid business model with some unique competitive advantages. It has a good revenue distribution, along with significant investments in digital and delivery channels. While its financials and balance sheet are healthy, it faces some risks including stiff competition from local players, changes in consumer taste, and rising operational costs.