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Morningstar | Competition Sets Stage for Near-Term Softness, but Yum China Still Offers Long-Term Growth Story

By most measures, Yum China's second-quarter update was a disappointment. While we had forecast soft results at Pizza Hut as it embarks on what we view to be a multiyear turnaround process, the sharp deceleration in KFC top-line trends (flat comps, including a 4% decrease in transactions) due to softness in consumer spending, new store cannibalization in some markets, and heightened promotional activity from rivals (namely McDonald's) caught us by surprise and could signal weaker results over the next 12-18 months. While we're planning to trim our $47 fair value estimate by $3 based on tempered near-term sales and margin expectations, we still view Yum China as an attractive play for longer-term investors due to investments behind its wide-reaching digital/delivery platform, menu simplification efforts, restaurant format upgrades, and advanced distribution infrastructure, each of which contributes to our wide-moat rating.

Clearly, the threat of consumer spending pressures and competitive issues make for a tough sales pitch to investors, especially with last week's rumors of a potential buyout by a consortium led by Hillhouse Capital apparently dying down. Still, we believe there are several reasons for long-term investors to stick with this name. One, Yum China's digital assets continue to drive customer retention and average check, with membership enrollment continuing to grow at a healthy clip (up 59% at KFC and 80% at Pizza Hut) and sales per member continuing climb. Two, new unit returns remain healthy--payback periods are roughly two years for KFC and three to four years for Pizza Hut--which we partly attribute to Yum China's delivery platform and support our longer-term outlook calling for 20,000 system locations. Three, Yum China remains a solid capital allocation play even as new initiatives are put into place, including the potential to increase its $0.10 quarterly dividend (currently yielding 1%) and a buyback authorization exceeding $400 million.

Industry promotional activity is unlikely to abate among KFC's larger rivals over the near term, and we believe Pizza Hut will likely require 12-18 months before reaping the benefits of menu enhancements (streamlined menu, upgraded classic menu items with a focus on mass appeal, and new products like Pizza Air), a more targeted everyday value platform, restaurant remodeling activity, and improved delivery capabilities. Still, even with near-term headwinds, our updated fair value estimate still assumes 7%-8% currency-neutral average annual top-line growth the next five years, driven by 7% unit growth (even after accounting for additional store closures to "rejuvenate" Pizza Hut). We also assume 2% average comps, restaurant margins improving to the low 16s (versus our full-year 2018 outlook of 15.6%, which is a slight decline from previous five-year targets in the mid 16s due to near-term promotional activity pressures and Pizza Hut reinvestment activity), and operating margins around 12% range over the same time frame.

For additional insights regarding China macroeconomic trends, please see Morningstar's Aug. 1 piece "Trade Tensions Create Cliffhanger of China's Economy."