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Morningstar | Yum China's 2019 Investor Day Reinforces Its Competitive Positioning, New Growth Opportunities

While Yum China's 2019 investor day offered few incremental long-term financial targets, it did reinforce our wide moat rating and positive long-term bias. We continue to view Yum China as the cleanest way to gain exposure to the growth of the Chinese middle class the next decade, presenting a compelling combination of free cash growth and capital allocation while avoiding certain risks tied to Chinese e-commerce and retail names. We're planning to raise our $48 fair value estimate by a few dollars after the event to account for better-than-expected first-quarter sales trends and specialty coffee opportunities. While top-line trends could still be uneven the next few quarters due to more difficult comparisons and a promotional Chinese restaurant industry, we still see the stock as a solid long-term play.

In our view, investors should have four takeaways from the event. One, management showcased multiple restaurant formats across all brands and trade zones that should better enable unit growth (and make a 2021 target of 10,000 total units achievable) while facilitating digital/delivery sales. Two, Pizza Hut's revitalization is a work in progress, but we believe there are signs that menu simplification, value pricing, new restaurant formats, and expanded delivery capabilities are having a positive impact and should better position the brand for margin expansion in the years to come (which we see as requisite for reaching its longer-term target of consolidated restaurant margins of 17%). Three, with its existing store footprint, site selection expertise, supply chain, delivery, and loyalty program assets, we see Yum China as uniquely positioned to be a major player in the $4.5 billion Chinese specialty coffee market, which we expect to grow in the midteens the next several years. Four, returning $1.5 billion to shareholders from 2019-22--and multiple levers to drive this target higher--add capital allocation to an already attractive growth investment story.

Based on management's presentations, we're planning to fine-tune some of our near-term model assumptions, but our longer-term assumptions generally remain intact. Over the next five years, we expect 8% systemwide sales growth and 6% currency-neutral average annual revenue growth. Our forecast assumes 6% system unit growth (with our model calling for 10,400 restaurants by 2021, versus management's investor event target of 10,000) and 2% average annual same-store sales growth due to menu simplicity, a more value-oriented core menu, daypart expansion, increased emphasis on healthier/better-for-you products, new restaurant formats, and increased digital and delivery relevance but also heavy industry promotional activity. We forecast restaurant margins to rebound from 15.5% in 2018 to just over 17% by 2023 (consistent with management's longer-term blended average of 17%), with food/occupancy expense leverage and store portfolio optimization plans at Pizza Hut (which is likely to include closing unproductive stores and greater use of smaller-format locations) offset by value, menu, and technology investments. We expect operating margins around 12% over the same period, which implies 11% annual growth (consistent with management's outlook calling for double-digit growth) and assumes a modestly more franchised business model, including the announcement of a partnership with Sinopec and China National Petroleum Corp. to open 100-plus gas station restaurant locations over the next three years. Our model assumes average annual adjusted earnings per share growth in the low teens and free cash flow in the midteens the next five years, which should be more than enough to fund (and potentially expand upon) management's goal of returning $1.5 billion to shareholders through dividends and buybacks the next three years.

While it's easy to get lost in negative headlines about China GDP trends and trade wars, we believe the investor day event also served as a reminder that the Yum China story still works in an environment where China GDP growth rates slow to the 4%-4.5% range the next several years (driven by household consumption trends as opposed to government or export activity). Based on estimates from iResearch, China is expected to surpass the U.S. as the world's largest restaurant market, with $990 billion in sales by 2023. This compares to our forecast of roughly $974 billion in restaurant sales in the U.S., which we've estimated by extrapolating our forecasts from our October 2018 Consumer Observer "The Restaurant Industry Is Evolving--Your Key Performance Benchmarks Need to, Too." This translates into average annual China restaurant industry growth of 8% the next several years, which we believe looks achievable based on high-single-digit to low-double-digit wage growth in many cities; the continued rotation into higher-paying service, manufacturing, and technology jobs; solid personal balance sheets and access to consumer credit; and increasing consumer demand for convenience.

Heading into the investor day event, we were concerned that KFC comps might dip into slightly negative territory in the first quarter of 2019 as the company lapped successful Chinese New Year sales efforts the past several years. However, management noted that the brand "maintained solid growth momentum and its Chinese New Year performance surpassed the positive results the past three years" (where first-quarter comps were 5% (2018), 1% (2017), and 12% (2016) respectively). While restaurant margins are expected to come under pressure during the first half of 2019 due to elevated poultry prices and ongoing value promotions, we believe the positive first-quarter momentum underscores the potential of new value platforms, daypart/category expansion (coffee and dessert), technology-levered restaurant formats that drive greater throughput (transactions per hour up 15% since 2013), loyalty/subscription plans, and improved delivery speed (85% of delivery transactions fulfilled in under 30 minutes) that should keep comps in the low single digits in 2019. Over the next five years, we forecast 8% system sales growth for KFC (5% unit growth, 3% average annual comps), restaurant margins improving from 18% to just over 19%, and operating profit growth in the high single digits (implying 16%-17% margins in 2023 and representing 9% annual growth).

While there has been progress, Pizza Hut will likely require additional time before fully reaping the benefits of menu enhancements (streamlined menu, upgraded classic menu items with a focus on mass appeal, new dough types, and upgraded dessert and drink platforms), a more targeted everyday value platform, restaurant remodeling and a smaller core restaurant format (down 30% the past three years), and improved delivery capabilities. Still, our model continues to forecast system sales growth accelerating from essentially flat in 2019 to the high single digits the next five years, driven by 6%-7% unit growth (which balances store closures but also acceleration of new restaurant format openings), 1.5% average annual comps, restaurant margins exceeding 11% in 2023 (versus 2018 restaurant margins of 10.3%), and operating margins reaching the 7% range over the same time frame.

Much of the discussion regarding China's specialty coffee market has focused on Starbucks' ambitious growth plans and Luckin's aggressive expansion the past year, but coffee is a rapidly growing category in China and we would not overlook Yum China's potential to be a major player. With CNY 1 billion in coffee sales in 2018 ($151 million using an average Chinese renminbi/U.S. dollar exchange rate of 6.613 for 2018), Yum China accounts for a relatively small percentage of China's $4.5 billion industry (based on estimates from Euromonitor and McKinsey). However, with its existing store footprint, site selection expertise, supply chain, delivery, and loyalty program competitive advantages, we expect the company to be a market share gainer as the industry grows to $7.5 billion-$8 billion over the next five years. We believe the company's two-pronged approach--including increased sales of K Coffee (coffee sold at KFC) and accelerating units for new stand-alone coffee concept Coffii & Joy--make Yum China well-suited to cater to multiple audiences (value-focused mass consumption and more-affluent young professionals) and need states (delivery/convenience and upscale coffeehouse experience).

With respect to delivery, we're intrigued by management's Delivery 3.0 plans, which will see the company integrate its delivery assets to provide a "trade zone focused, multi-brand platform that will optimize delivery services and improve efficiency." We believe this effort will make the company more competitive in the high-growth China restaurant delivery market (which is expected to grow 15% annually the next five yeas to roughly $55 billion), but will also help to accelerate Pizza Hut's turnaround efforts while providing a springboard for more nascent brands like Coffii & Joy and Taco Bell.