EUR 850.00 For Business Accounts Only

Morningstar | KFC Comps and Pizza Hut Margins Suggest Yum China's Long-Term Investment Story Is Back on Track

Wide-moat Yum China's third-quarter update helped to assuage the key concerns coming out of last quarter, with improving sales trends at KFC China and solid margin preservation at Pizza Hut. In fact, we believe the key takeaway for investors is that the company appears to be better aligned under CEO Joey Wat (who assumed the role in March), with reasonable growth strategies for its core brands and nascent opportunities including enhanced digital and delivery capabilities and new stand-alone coffee concept COFFii & Joy. We don't plan to change our $44 fair value estimate and we view the shares as attractive for long-term investors, even against a more competitive and value-focused Chinese restaurant industry backdrop.

KFC comps rebounded from last quarter, posting a 1% increase versus 10% a year ago (two-year comps of 11% were an acceleration from last quarter's 4%). While management called out a "difficult trading environment" several times and the comp lift was largely driven by product innovation and upgraded ticket increases, our concerns about KFC same-store sales trends remaining in negative territory near term may have been premature. We now anticipate low-single-digit growth over the next 12-18 months, driven by new value platforms, daypart/category expansion efforts (coffee and dessert), and greater engagement among loyalty/delivery customers. Pizza Hut comps fell 5%, but the 1% traffic decline represented material improvement versus last quarter's 6% traffic decline. This suggests that Pizza Hut's brand refresh, menu simplification, and value efforts are gaining traction. While we don't expect positive comps at Pizza Hut until 2019, we were encouraged that its restaurant-level margins were resilient (down 60 basis points to 13.8%) compared with the steep declines in the first half of the year due to labor and other operating cost efficiencies. This gives us greater confidence that our five-year consolidated restaurant margin target of 16% is achievable.

In addition to increased optimism regarding near-term initiatives, the three longer-term investment highlights in our last quarterly update note remain firmly in place. First, Yum China's digital assets continue to drive customer retention and average check, with membership enrollment continuing to grow at a healthy clip (up 50% at KFC and 67% at Pizza Hut), sales per member remain healthy despite aggressive industry discounting, and the planned $74 million investment in Meituan Dianping's recent initial public offering being a positive from an order sourcing and data sharing perspective. Second, 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 believe supports our longer-term outlook for 20,000 system locations. Third, Yum China remains a solid capital-allocation play even as new initiatives are put into place, including a 20% increase in its quarterly dividend to $0.12 (representing a yield just north of 1%) and a expansion of its buyback authorization by $850 million to $1.4 billion.

Industry promotional activity is unlikely to abate among KFC's larger rivals over the near term, and we believe Pizza Hut will probably require a few more quarters before reaping the benefits of menu enhancements (streamlined menu, upgraded classic menu items with a focus on mass appeal, and new products), a more targeted everyday value platform, restaurant remodeling activity, and improved delivery capabilities. Still, even with near-term headwinds, our fair value estimate 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) and 2% average comps, restaurant margins improving to around 16% (versus our 2018 outlook of 15.5%), and operating margins around 12% over the same time frame.