An under-appreciated Chinese Stalwart

Geoff Di Felice

Cooper Investors

2019 finished with another busy quarter of travel for the Global Equities team here at Cooper Investors, visiting the US, UK, Spain, Switzerland, China and Japan.

We were in Shanghai on “Singles Day” (so chosen as it falls on 11/11, the number “1” resembling the lone individual) which has become China’s largest shopping event. This year Alibaba alone sold over US$30bn of goods on the day. Whilst this makes for great headlines we are still developing our thinking on what the increasing importance of sales events in China means for the economics of retail platforms and consumer brands.

China is a country that feels like every citizen is in some way an entrepreneur. During meetings we noticed participants would frequently check their phones to get an update on the metrics of their personal ventures’ progress (typically on one of the e-com platforms). This reminds us of Frenchman Duc de la Rochefoucauld-Liancourt’s description of late 18th century America: “He marvelled that every inhabitant seemed to cherish the project of making an ample and rapid fortune… few of them are contented with what they have.”

We take a look here at one consumer brand thriving in this dynamic and digital environment, highlighting a CI Stalwart investment in China.

China’s thriving food delivery industry

The blend of high urban density and low cost labour combined with technology has created ideal conditions for food delivery services in China. This has led to widespread adoption particularly amongst millennials who can order 2-3 meals per day delivered to their offices and homes.

Today penetration rates are around 11% of sales for the entire catering industry. As delivery continues to grow significantly faster than overall food sales, penetration will continue to increase with long term predictions that it could reach 20-40% of industry sales. Therefore, to succeed in China’s food and beverage industry companies must succeed in delivery.

The largest restaurant group in China

Yum China (YUMC) is the largest restaurant group in China operating almost 9,000 restaurants (of which only 9% are franchised) including over 6,000 KFC’s and over 2,000 Pizza Huts. YUMC was fully spun off from YUM! Brands in November 2016, paying a 3% royalty fee on system revenues to its former US parent, in return enjoying exclusive rights to use their brand names in China.

Whilst on the surface YUMC appears to be “just another Master Franchise” our research process highlighted that over YUMC’s 32-year history they have developed an owner-operator culture that is distinct from YUM! Brands and also distinctly Chinese. This has allowed YUMC to create a highly localised customer proposition benefitting from a strong local appetite for chicken and become the clear market leader.

YUMC have succeeded in creating richer and deeper IP than YUM! Brands in a number of important areas. This is particularly evident in Menu Innovation, Delivery (20% of sales) and Digital (over 95% of KFC transactions are completed digitally) where they are arguably now the global leaders. Indeed, in the future we can envision YUM! Brands paying YUMC a fee to access this IP.

Value drivers and innovations

KFC is the key value driver for YUMC, representing ~70% of units, ~90% of profits and given KFCs highly attractive new unit economics, 90% of new units. When most people in Australia think of KFC they typically picture a big bucket of fried chicken. Yet KFC in China has a far broader menu that caters to local tastes, such as serving Congee during breakfast and localising taste profiles to suit regional palates, such as spicier recipes for the Sichuan province. In addition, KFC regularly creates new dishes to stoke consumer demand or adjust to changes in commodity prices.

A recent example of innovation and flexibility was switching to duck wraps and mushroom burgers to offset soaring chicken prices which were indirectly affected by African Swine Flu. YUMC navigated this significant supply chain event with negligible margin erosion.

Management has several exciting value latencies to execute, including: new KFC roll-outs, improvement of Pizza Hut margins and development of new formats (including coffee). In addition to growth opportunities, a net cash balance sheet and strong cash flow profile mean YUMC can provide attractive and growing returns to shareholders through dividends and buybacks.

We believe YUMC is an under-appreciated Chinese Stalwart given a stable, simple and cash generative business model run by a highly driven owner-operator culture. 

Observation not prediction

Cooper invests in companies and industries with a specific value proposition that are performing well or in an early phase of turnaround.

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Geoff Di Felice
Geoff Di Felice
Cooper Investors

Geoff joined CI in March 2014. As a member of the Global Equities teams he focuses on Japanese and other Asian companies.

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