Grabbing a bite of the Fast Food market

Grabbing a bite of the Fast Food market
I initiated a mid conviction position into the secondary offering of Yum China on 10/09/20 at the price of HKD 395.80. I believe there is a strong growth story and recovery in consumer spending in the Chinese market. CEO Joey Wat has already proved to be capable in turning around the aging KFC franchise in China and introduce a culture of innovation, technology integration, and operational efficiencies to grow the franchises.

What I like
Simple understandable free cash flow generative business.
From an operational cash flow perspective,  YumCn has powerful food products and franchises that already have a good track record of success like KFC, Pizza Hut, Taco bell. Unlike most food companies that employ a globalisation strategy and failed to enter target markets (Dunkin in India, Starbucks in Australia), YumCn is focused on glocalisation to adapt its products to local tastes. This is important as Northern Chinese and Southern Chinese had difference in taste and preferences, despite the huge total addressable market. Its brand enjoys certain amounts of foreign prestige in China,  allowing it to protect its pricing power. Unlike the tech industry that simply compete on cost and features, competition cannot substitute the taste and mind share of a product that is linked to memories. A superior chicken product is unlikely to displace the desire for the original recipe

From a capital expenditure perspective, continual innovation is unlikely to be capital intensive as it does not take much money to simply put pork floss on crispy chicken, or cheese and crayfish on the next pizza. Joey Wut noticeably encouraged a bottom up approach on food innovation within the company to generate new product pipeline. With good employee ratings of the company, KFC (service industry) is likely to maintain its streak of success.

Management is skilled at using modern technology to create online subscriptions to offer discounted prices to retail and corporate members, which increase the stickiness of the digital audience, and allows for targeted marketing and seasonal products. Through technology advances, it can better predict and deploy headcount requirements throughout the stores and work on operational inefficiencies to improve margins.

Fast casual restaurants noticeably enjoys operational leverage as it has relative fixed costs (marketing rental and distribution) with marginal incremental variable costs (manpower and food). As long as it continue to succeed and come up with innovative products, it can rapidly clone successful ideas and implement it throughout its restaurants at low incremental costs.

Depressed earnings / margins that is set for recovery
Comparing with earnings in a normalized scenario, I believe the current depressed earnings and margins due to Covid19 are set to recover. KFC outlets are strategically situated at tourism spots in CN and the freeze in domestic tourism hit margins and sales hard. YumCn had managed to shift traffic to its app and online membership with continual offers to increase consumer stickiness on its digital platforms. As China develops its vaccine and local tourism resumes. sales and margins are set to recover.

Well Capitalized and focused expansion plan
Yum Cn went into debt in 2019 and recapitalized itself via secondary offering to raise capital to support its expansion plans. Following up on its strong track record, management  promised a disciplined expansion plan with focus on cost management, and not go on reckless expansion spree which cripples most franchises that suffer from rushed services and lowered service standards.
There is shareholder - management alignment as Management is awarded in long term (4 year) share options and has insider holdings, and is unlikely to cripple the company to pump up the share price  for the next paycheck.

Cons
Possible overpaying if growth story do-sent play out.
Yum Cn raised capital via elevated consumer sentiment in the US market. The HK market noticeably did not share its enthusiasm as the share price dropped below the secondary offering price at the first day of trading. Considering the fact that Secondary offering is based on closing US trading price and not rigged by Goldman, I believe the risk of overpaying is limited provided it can grow to its valuation. Unlike an IPO (Its probably overpriced), YumCn already has a track record of success and audited financial statements that is public-ally available, making the risk of mispricing limited.


Multi-brand strategy may not work out
Due to the vicissitudes of consumer behavior, even if a company has a superior product, consumers tend not to stick to the same food product and rotate to different types. As such, I like the idea of multi-brand company compared to a single product company. Through scuttlebutt analysis, Yum Cn emerging brands (Little Sheep hotpot) does not have a strong advantage in its food products compared to Haidilao, Compared to HaiDiLao, it is targeting a mid-tier pricing in its target market segment. Essentially, I was hoping on KFC to carry the franchise, and Pizza Hut / Taco bell and minor brands  to incrementally increase its presence in CN.

Vulnerable to idiosyncratic risks like Food safety and security
China has overcame the food shortage issues as promised by the government announcements. As the raw ingredients are locally sourced, there is a risk of contamination / diseases that may affect the supply chain and operations of the business. In such an event, operational leverage can work against YumCN and hit the company hard as evidenced by the Chipotle saga in US. With 30 years of operational history in CN however, I believe that this risk is limited as it has proven to navigate successfully through past crisis like SARS / Avian Flu.