Yum China’s Leading Supply and Distribution Platform Positions It Well in Attractive China Market

Senior Equity Analyst

Ivan Su

The COVID-19 pandemic provided Yum China the opportunity to accelerate store openings at more favorable lease terms. The company added more than 3,700 locations from 2020 to 2022, equivalent to a 36% increase from 2019. Now that China’s zero-COVID-19 policy is in the rearview mirror, we expect these new restaurants to not only deliver significant incremental revenue but also be accretive to the overall margins. Over the next several years, we expect Yum China to speed up new unit openings. We share management's view that there remain plenty of expansion opportunities in lower-tier cities—evidenced by nearly 1,200 Chinese cities still with no KFC presence. 

Over the longer term, we believe there are several opportunities for Yum China to gain a share in the fragmented, USD 700 billion Chinese restaurant market. In China, chains account for roughly 18% of restaurant spending compared with 61% in the U.S. and 34% across the globe. Our conviction in rising fast food penetration is underpinned by three long-term secular trends: longer working hours for urban consumers; rapidly rising disposable income; and ever-smaller family sizes. Coupled with strong brand recognition and an unrivaled supply chain, Yum China is set to be the prime beneficiary of growing Chinese fast-food spending. We're also optimistic about Yum China's various top-line drivers, including value platforms, menu innovations, new restaurant formats, enhanced digital marketing efforts (underscored by 300 million loyalty program members), unrivaled delivery capabilities, and nascent brand expansion potential in Lavazza, Taco Bell, and Huang Ji Huang.

At its 2021 investor day, Yum China management committed a five-year budget of USD 1 billion-USD 1.5 billion to technology and digital development. We believe the company is beginning to reap the fruits of its investments. We believe a significant amount of cost savings will be passed through to the bottom line simply because these investments at scale are not likely to be replicated by competitors. This underpins our forecast for operating margin expansion over the long term.

Business Strategy & Outlook

Our wide moat rating is predicated on Yum China’s intangible assets in the form of a well-known brand name, consistent menu innovations, and digital capabilities, as well as cost advantages stemming from buying scale and sourcing through its industry leading supply chain infrastructure. Historic adjusted returns on invested capital (including goodwill) support this thesis, averaging at 36% over that past six years, noticeably outpacing our 8.8% cost of capital estimate. Additionally, we forecast the company’s average annual adjusted ROICs will exceed its weighted average cost of capital over the next 20 years as required for our wide moat rating. We estimate Yum China’s ROICs to average 47% over the next 10 years.

Yum China’s intangible assets are based on strong brand recognition. KFC was the first to introduce the traditional quick-service restaurant model to China when it opened its first location in Tiananmen Square in 1987, a time when Western-style fast-food was unknown to the country. While we believe KFC’s initial success could be largely attributed to novelty, the brand later abandoned its U.S. model (a limited menu, low prices, and an emphasis on takeout) and gradually transformed itself to become the “authentic” Chinese brand through offering abundance of flavors and an inviting ambience to local consumers. The brand has since become the largest player in China’s rapidly growing fast-food industry, with roughly 5% market share, twice that of wide-moat McDonalds. According to data from Euromonitor, the company is also, by far, the largest player in the Chinese quick-service chicken (around 63% share) and pizza (around 45% share) categories. According to a brand image tracking study by AC Nielsen, KFC is the most beloved quick-service restaurant, with 60% of surveyed Chinese consumers picking it as their most preferred choice, well ahead of McDonald’s 34%. Pizza Hut, likewise, is the most preferred western casual dining restaurant (providing some table service), significantly ahead of other pizza peers like wide-moat Domino’s and Papa John’s. 

We believe Yum China, especially the KFC brand, would not have got to where it is today without consistent menu innovations. KFC China’s menus typically include 50 items, significantly more than those in the United States. The firm runs a 27,000-square-foot innovation center in Shanghai, serving as the backbone to menu innovations. In China, KFC introduces about 60 new products every year (most are limited time offers), compared with just half of that in the U.S. Some of KFC China’s past groundbreaking products include Old Beijing Chicken Roll introduced in 2000, Sichuan Style Beef Wrap in 2008, Crayfish Grilled Chicken Burger in 2017, and Sichuan Style Skewers in 2019. We contend that the firm has maintained a good balance between scale and operational flexibility in launching new products, enabling it to adhere to local/regional/emerging taste preferences, effectively reducing the risk of consumer fatigue. And the firm’s more than two decades-long track record in coming up with a new "story" and photogenic menu offerings while still adhering to its convenience roots gives us strong confidence that the business can maintain a competitive edge over peers for many years to come. 

Furthermore, we also like how the company is using technology to foster brand loyalty and drive more consistent traffic. As of the end of 2022, KFC had 380 million members on its rewards app. This has facilitated the shift of sales to various digital platforms (around 90% of sales were digital in 2022) and enabled the company to collect a vast amount of consumer data. Through analyzing this data, the group is trying to lock in its customers through personalized menu creations based on each diner’s past order history and local tastes. These AI-powered menus are highly tailored to individual preferences (that is, those who tend to eat healthy will see soup and salad as first options on menu), so they reduce the time people spent ordering, elevating the overall restaurant experience. The AI-driven menu is also promoting sides and drinks to diners, leading to larger tickets while also reducing labor needs and increasing order accuracy. According to Yum China, its AI-powered menu, which was introduced in January 2019, has already boosted average per-order spending by one percent for the same year—the equivalent of about USD 840 million worth of fried chicken and pan pizzas. According to a study we conducted in 2018, a successful loyalty program will, on average, see members visit twice as many visits as non-members, with top performers pushing four times. We believe loyalty member/nonloyalty transactions is an important ratio for restaurants, as it suggests that effective loyalty programs can drive more consistent traffic (especially when there is a period of flat to declining industry traffic).

In addition to intangible assets, Yum China also possesses cost advantages that allow it to offer superior price and quality combination. Unlike other developed markets, 82% of China’s USD 700 billion restaurant industry consists of nonchains—mom and pop restaurants (the same figure is 46% in the U.S. 50% in Japan, and 60% in South Korea). Yum China stands out with system sales of USD 10 billion in 2022, positioning it as the largest restaurant group in China with 2% market share, about twice the shares of second place McDonald’s. Because food retail is generally regarded as a thin margin business, running of restaurants (especially for quick-service restaurant) is very much a business of scale. Our analysis suggests that an average operator will see restaurant-level margins grow from roughly 10% to 21% from a standalone location to an established, mature operator. Being the largest restaurant group, Yum China certainly possesses economies of scale, thus wielding considerable influence over suppliers, ensuring access to food and other raw materials at predictable, competitive prices. 

Moreover, we also believe Yum China’s supply chain and distribution network are unrivaled among restaurant operators in the region, and that they are complementary to the cost advantage moat source underpinning our wide moat rating. In most developed nations in North America and Europe, restaurant chains rely on food distributors like narrow-moat Sysco and no-moat U.S. Foods to ensure that food is handled properly, from suppliers to restaurant locations. Because China lacked reputable food distributors when the company entered the country in the 1990s, KFC had to develop its own distribution infrastructure, which now encompasses 33 logistics facilities, six consolidation centers, and a fleet of more than 2,100 refrigerated trucks. We believe that this endeavor, while costly at first, is critical for Yum China's rapid expansion, allowing for greater menu flexibility and variability. 

Yum China's products are sourced almost all locally (except for certain herbs and spices), which helps to keep costs manageable, positions KFC and Pizza Hut as more "authentic" Chinese brands (despite their obvious Western roots), and strengthens the company's relationships with national and regional government officials. We 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. Since restaurant sourcing costs are considered confidential information, companies generally do not talk about them in great detail, thus making side-by-side comparison difficult. But on a high level, Yum China did say that its supply chain is run at a unit cost 50% lower than industry average, forming a material cost advantage over smaller peers. Going forward, Yum China’s cost advantage will be supported by continued store expansion into lower-tier cities.

Wide

Economic Moat

Yum China Hlds

Yum China Holdings, Inc. engages in the operation and management of restaurants and fast food chains. It operates through the following segments: Kentucky Fried Chicken (KFC), Pizza Hut, and All Other Segments. The KFC segment operates restaurant chain. The Pizza Hut segment covers the Pizza Hut casual dining and Pizza Hut home service. The All Other segment includes Little Sheep, Huang Ji Huang, COFFii and JOY, East Dawning, Taco Bell, E-commerce business, and Lavazza. The company was founded in 1987 and is headquartered in Shanghai, China.

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