1. Is the company undervalued?
EV/EBIT: 23.2
EV/Sales: 1.83
Price/Book: 2.62
Yum China is a strong franchise with attractive unit economics and a long runway for growth. Unfortunately, investors have to pay a premium today in order to participate in that growth. Moreover China’s strict Covid policies will likely be a drag on margins and expansion efforts near term. Nonetheless investors could still achieve satisfactory returns, as the stock isn’t priced for perfection.
2. Can I easily explain what the company does?
Yes, they sell fast food in China. KFC and Pizza Hut account for ~91% of their restaurants.
3. Does the cash flow statement line up with income statement?
Yes, cashflows have been consistently higher than reported earnings:
Most of their excess cash went towards capital expenditures, dividends, acquisition costs, and share repurchases. I’m always weary of acquisitions, which in this case was for a catering service company. Candidly I have no idea if this will create or destroy value for shareholders. However I will say that it appears on the surface to make sense. Although I would prefer if management stuck to organic growth opportunities. Especially because KFC and Pizza Hut offer superb ROIC. For example the payback period is 2 years on a KFC and 3 years for a Pizza Hut. I seriously doubt this acquisition comes close to those metrics and for that reason I would be cautious if management starting doing more outside purchases.
4. Is the Balance Sheet Healthy?
Total Cash: $4B
Total Debt: $2.84B
Current Ratio: 1.98
FORTRESS BALANCE SHEET NEXT QUESTION!!!!
5. How profitable is the business?
Gross Margins: 14.27%
Operating Margins: 7.45%
Net Margins: 10.05% (This is overstated)
At first glance $YUMC looks like a shitco, however elevated expansion costs are the root cause for optically low margins. In fact, EBIT margins have averaged north of 9% historically. Management also thinks they can hit low double-digit margins in the future, by reducing the footprint of their restaurants and leaning on technology. This reminds me a lot of Dominos pizza play book, which I think is a clever strategy and why $YUMC is a decent quality business.
6. What is the company’s growth potential?
8-yr Revenue CAGR: 4.44
8-yr Operating Profit CAGR: 4.18
8-yr FCF CAGR: 9.49%
Again, the trailing data is not painting a great picture for $YUMC. Although I will say these numbers would be much better if 2014 and 2015 were stripped out. On a go forward basis $YUMC has excellent growth prospects. They are no where near full saturation and can keep adding restaurants for at least another decade. For reference, Yum China anticipates increasing their restaurant count by ~10% in 2022.
7. Is management rewarding shareholders?
$YUMC currently offers investors a 1.15% dividend and have a $1B share repurchase program in place. However with $900M in expected CAPEX next year, it’s unlikely that management executes any meaningful buybacks. Assuming 10% growth, I would anticipate $300M retuned back to shareholders next year (net of SBC). This works out to a 1.7% total shareholder yield, which doesn’t exactly knock my socks off. Nevertheless, that a respectable number for a company growing at double digits.
8. How does the company stack up against their peers?
I couldn’t find an apples-to-apples competitor that separated out their Chinese business, so for that reason I’m skipping this question.
9. What’s the counter argument?
The bear argument is that delisting concerns and Covid-19 lockdowns will cause the stock to tank.
Regarding delisting, I think this is the biggest nothing burger in the history of nothing burgers. Both the SEC and Chinese regulators have made accommodating statements in recent months. Moreover even if a delisting occurred, ADR shares would be moved to an OTC exchange rather than turned into vaporware. Frankly I’m an Alibaba bag holder so there’s a bit of bias on my end, but nothing stated above is untrue.
On the other hand I think Covid lockdowns are a legitimate concern. China has completely shut down major cities in the last few weeks. I would anticipate a guide down in Yum China’s next earnings call as a result. However the long term thesis remains unchanged and restaurants will eventually be opened up in new markets.
10. Is there something I think the market may be missing?
I don’t think there’s anything the market is missing per se. With that said I do believe Mr. Market is over discounting delisting anxieties. As previously mentioned, a delisting has ZERO impact on the intrinsic value of $YUMC. If these irrational fears persist, investors might be able to scoop up Yum China at below a market multiple.
Final Thoughts:
My base case is as follows 12% EBIT growth annually, a 1.7% total shareholder yield per year, and an 18X EV/EBIT exit multiple in 5 years. This works to a ~9% expected return per annum, which is rather unimpressive. Realistically I would want a 15X EBIT multiple to seriously entertain owning the stock, but I’m doubtful that comes to fruition. Unfortunately not every stone you turn over leads to riches, but I’m glad I took a look at the company and who knows crazier things have happened in the stock market.
***Disclosure: I have no position in the security mentioned above, nor do I have any plans to purchase within the next 72 hours. This article is intended for educational purposes only and in no way should be interpreted as investment advice