Yum China’s Growth Potential: A Deep Dive

Yum China (NYSE) represents a high-quality business with a solid competitive advantage in the Chinese dining market, driven primarily by its KFC and Pizza Hut brands. Despite its current negative market sentiment, the company holds strong growth potential, particularly in lower-tier cities with significant untapped opportunities. This positions Yum China for sustained high growth over the long term, making it a compelling investment once market conditions stabilize.

Recent Financial Performance

• Growth and Expansion: Since its spin-off from Yum Brands in 2016, Yum China has doubled its store count from 7,500 to approximately 15,000 by the end of FY 2023. This expansion, particularly in lower-tier cities, has driven revenue growth to $11 billion.
• Store Growth: In FY 2023, Yum China opened 1,697 new stores, with half in lower-tier cities. The company plans to expand to 20,000 stores by the end of FY 2026, focusing on these lower-tier markets.
• Earnings Performance: Despite recent stock underperformance, Yum China exceeded consensus EPS expectations in FY 2023 ($2 vs. $1.92) and Q1 FY24 ($0.72 vs. $0.65), indicating strong operational performance.

Strategic Growth Initiatives

• Lower-Tier City Expansion: Lower-tier cities in China represent 70% of the population but have low penetration rates for fast food chains. This market is expected to see significant consumption growth, from $2.3 trillion in 2018 to $6.9 trillion by 2030, driven by the rising middle class.
• Market Penetration: Yum China’s strategic focus on these lower-tier cities aligns with historical growth patterns seen in higher-tier cities, suggesting a sustainable growth trajectory.

Valuation and Market Sentiment

• Current Valuation: Trading at a forward P/E ratio of approximately 15, Yum China appears undervalued compared to its growth potential. A dividend discount model (DDM) valuation estimates a target price of $37.1 per share, implying an upside of 18.5%.
• Dividend Policy and Share Buybacks: Yum China has committed to a $3 billion repurchase/dividend plan within 2024-2026, reflecting management’s confidence in the company’s performance and attractive valuation. The company raised its quarterly dividend by 23% to $0.16 per share and repurchased $680 million in shares in FY24 Q1.

Investment Risks

• Foreign Exchange Risk: The devaluation of the Chinese Yuan against the USD poses a risk, affecting revenue growth when converted to USD.
• Market Competition: The competitive landscape in China’s restaurant market remains fierce. Emerging brands within Yum China’s portfolio, such as Lavazza, are still being tested.
• Macro and Micro Factors: Broader market risks, including economic and political uncertainties in both the US and China, can impact investor sentiment and stock performance.

Conclusion

Yum China holds strong growth potential, particularly in the underpenetrated lower-tier cities of China. Despite its current undervaluation and an 18.5% estimated upside, the prevailing market risks suggest that now may not be the optimal time to invest. Monitoring broader market conditions and waiting for stabilization may provide a more attractive entry point for this fundamentally strong business.

Recommendation: Yum China is a “Hold” at present, with a potential “Buy” rating once broader market risks subside and sentiment improves.