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YUM CHINA SET TO
SERVE UP GOOD GROWTH
Yum China, the biggest fast-food outlet chain in China, has come a long way since the launch of the first Kentucky Fried Chicken (KFC) in Beijing way back in 1987. It has built up an enviable business – its competitive advantages of brand quality and cost efficiency are firmly entrenched, and, in our view, the company has many more years of good growth ahead.
Yum China, a Shanghai-based restaurant company that either owns, operates or franchises KFC, Pizza Hut and Taco Bell in China, is the country’s largest quick-service outlet chain by a wide margin. It was spun off from American restaurant giant Yum! Brands in 2016, becoming a publicly traded company in its own right.
Western fast-food restaurants first forayed into China in November 1987, when KFC opened its first outlet on Tiananmen Square in Beijing – three years before McDonald’s entered the ‘Middle Kingdom’ market. So successful was the KFC launch that this particular restaurant soon became the busiest KFC in the world. Since then, the number of KFC restaurants in China has ballooned and now tops 11 000.
The Sanlam Global High Quality Fund has been an investor in Yum! Brands for many years and, more recently, Yum China. It is important to understand the differences between the two businesses – whereas Yum! Brands takes a percentage of all revenues generated by its franchisees and operators globally, including Yum China, the latter gets its hands dirty with the actual work of running the restaurants.
How does the unglamorous work of operating fast-food outlets in China align with our philosophy of investing in high-quality businesses? We focus on two factors: growth potential and a strong economic moat.
In our view, Yum China has many years of strong growth ahead. The Chinese restaurant market is now worth around US$700 billion and is growing. Underpinning this growth are long-term secular trends: smaller family sizes, continued urbanisation and rising disposable incomes.
To supplement this overall market growth, we believe that chain restaurants like those operated by Yum China will take share from independent players over the coming years. In China, only 18% of restaurant spend takes place at chain outlets, compared to 61% in the US and 34% across the globe. Chain restaurants have size and financial advantages that give them an edge. For example, Yum China has a fully digitalised supply chain, meaning it is better able to guarantee access to and the safety of ingredients – an advantage that independents are many years away from matching.
To further capture market share, Yum China is expected to open considerably more restaurants over the coming years. From a current level of just over 15 000 outlets, management has guided to 20 000 by the end of 2026. In our view, this is entirely feasible. In China, the largest restaurant brand is KFC, and there are seven KFC restaurants serving every one million people. In Japan, McDonalds is the biggest brand, with 24 outlets per million. KFC therefore still has some way to go in China.
An important feature of our investment process is to examine the competitive position of the businesses that we analyse. The term ‘economic moat’ was coined by Berkshire Hathaway’s Warren Buffett to describe the ability of a business to fend off the competition. The wider the ‘moat’, the more a company can earn supernormal profits for longer. In our view, Yum China’s moat is significant and is predicated on the strength of its brand as well as the cost advantages it has over competitors.
The traditional quick-service restaurant model introduced to China by KFC all those years ago in 1987 was popular from the outset. However, the brand later abandoned its US model of limited menu, low prices and an emphasis on takeaways, and gradually transformed into an ‘authentic’ Chinese brand. This meant different tastes and flavours, and a different ambiance in the stores.
These changes have served the company well. According to Nielsen, KFC is the most beloved quick-service restaurant in China, with 60% of surveyed consumers picking it as their preferred choice. In the same survey, Pizza Hut was found to be the most beloved Western casual dining restaurant (i.e. providing some table service), faring significantly better than pizza rivals Domino’s and Papa John’s.
To complement the strength of its brands, Yum China has a significant cost advantage over rivals, most of which are mom-and-pop restaurants. Yum China’s superiority in size allows it to wield significant influence over suppliers, ensuring access to food and other raw materials at predictable and competitive prices.
The company has also been able to generate repeat sales with the use of an app and membership programme. At last count, KFC had more than 380 million members signed up to its rewards app. This has enabled it to collect vast amounts of data that can be used to entice further sales through tailored and personalised promotions.
Yum China’s size has also allowed it to build up an unrivalled food distribution network, including 33 logistic facilities, six consolidation centres and a fleet of more than 1 200 refrigerated trucks. Although it has been costly to build out over many years, this network has enabled the company to grow rapidly.
Of course, no investment is without risk, and Yum China is no different. The Chinese economy is currently labouring under the weight of a property bubble unwind. Even with the recently announced stimulus being pumped into the consumer economy, gross domestic product (GDP) growth will likely not exceed 5% this year, a level unheard of just a few years ago. Under these conditions it is possible that consumers may forego their chicken and pizza, and decide to save their renminbi for another day.
Having said this, Yum China remains very well positioned for when the macro environment does recover. It has a net cash position on the balance sheet and will continue to buy back shares to support earnings per share. The company has returned around US$4 billion to shareholders since 2016 and intends to return US$3 billion more by the end of 2026 (versus a market cap of US$16 billion).
Running a chain of restaurants is a challenging undertaking, with the margins often low for smaller, lower-quality operators. However, Yum China has built up an enviable business over many years and, in our view, its advantages of brand quality and cost efficiency are firmly entrenched. We believe the company has many more years of good growth ahead – good news for both fried chicken lovers and shareholders.
We constantly challenge the norm. Our investment process is a thorough and diligent one.
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