Playing chicken

When the Chinese embassy in Belgrade was hit by US bombers in May 1999, anti-American protests quickly erupted across China. Thousands took to the streets in Beijing, throwing stones, paint and eggs at the American embassy to express their ire over an airstrike that claimed the lives of three Chinese nationals. Four KFC restaurants in the country were also trashed by angry mobs.

Then in 2016, following the dismissal by an international tribunal of China’s territorial claims in the South China Sea, groups of nationalistic Chinese unfurled banners outside a dozen KFC outlets calling for a boycott. “Eating American KFC is a loss of face for our ancestors,” read one.

As one of the earliest US brands to set up shop in the Middle Kingdom, KFC is a symbol of American culture, which makes it a convenient punchbag for Chinese consumers when relations with Uncle Sam sour. In the past, the company navigated politically-charged moments by emphasising how much it is a ‘Chinese company’, based on its use of local suppliers and labour.

Such localisation, which is also evident in an evolving menu that features Chinese dishes like congee and hotpot, has for the most part served KFC well. Opening its first store in central Beijing in 1987, KFC and its owner Yum China has become a behemoth with over 10,000 outlets across the country. Will this strategy once again cushion the business impact on the biggest restaurant group in China as a new Sino-US ‘Cold War’ brews?

Are Sino-US tensions hurting Yum China’s business?

Yum China’s latest effort to make itself more ‘local’ has seen it seek a $2.2 billion secondary listing in Hong Kong. In its prospectus, the New York-listed firm notes that the escalating conflict between China and the US is weighing on the fast-food chain’s future. From the perspective of its management, the impact is threefold.

First, the occurrence of a trade war, or expansion of trade restrictions, could “adversely impact” its operating costs and those of its suppliers. That in turn could hamper its business and financial condition.

Second, it highlighted how the executive orders signed by Donald Trump to prohibit US companies from “any transaction” with WeChat could put its business in limbo (the ban is imminent and could take effect this month). “A significant portion of our digital ordering, digital payment, marketing and loyalty programme operations runs on WeChat,” said the company, adding that the ultimate scope of these restrictions, and the resultant impacts, are unclear partly because the US Department of Commerce has yet to specify the types of transactions on WeChat that the executive orders might ban (see WiC509).

Third, Yum China is concerned that the China-US stand-off may trigger negative customer sentiment towards American brands in China. A survey of 2,000 adult Chinese shoppers last October found that 78% would rather shun American brands and opt for local labels, with half citing “patriotism” as a factor, according to AlixPartners, a US consulting firm.

Has the impact been reflected in the sales numbers?

Reeling from the coronavirus outbreak, Yum China reported a 52% year-on-year decline in its net income to $194 million in the first half, as revenue skidded by 17% to $3.7 billion. The figures, according to CEO Joey Wat, were not reflective of Sino-US tensions, which she described as “not a big concern” even though they have cast a cloud over Yum China’s business.

Investors in Yum China saw a bleaker picture. Its US-listed stock retreated nearly 11% this month, while its IPO in Hong Kong was underwhelming, with Bloomberg, a media group, calling it “the worst stock debut in more than a year among billion-dollar listings in Hong Kong”. Offered at HK$412 apiece, or 12% below the maximum target price, Yum China’s shares were 52 times subscribed by retail investors, a ratio that beat nearly two-thirds of the flotations in the city this year. However, the stock fell 5% on its first trading day last week. As of this morning, the shares still hovered below the offering price.

This disappointing debut is in direct contrast to the performance of other New York-listed Chinese stocks that have opted for a secondary offering in Hong Kong since Alibaba’s homecoming last November (see WiC476). On their first day of trading on the city’s bourse Alibaba was up 6.5%, NetEase 6% and JD.com 3.5%. Likewise JD.com was 179 times oversubscribed by retail investors, while video games publisher NetEase registered a multiple of 360 (see WiC499).

It’s obviously unfair to pit Yum China against internet stocks, which tend to garner loftier valuations. However, trading at 35 times its trailing earnings with a market capitalisation of HK$169 billion ($21.8 billion) this week, Yum China does not look favourably valued even when compared with other restaurant operators listed in Hong Kong.

Hotpot chain Haidilao, despite having a far smaller footprint of 935 outlets in China, has a market value of HK$303 billion, or 116 times its past earnings. The price-to-earnings multiple for Jiumaojiu, a Chinese restaurant chain with 328 shops, stands at 108 times. Best known for its sauerkraut fish dish offered under the brand Tai Er, Jiumaojiu recorded a 56% first-day “pop” in its share price even though its flotation took place in January, when Covid-19 was spreading quickly across China.

In a year when interest rates have been low and liquidity loose, market commentators attribute some of Yum China’s lacklustre performance to an unexpected misfortune in its fundraising schedule.

Just days before its bookbuilding began, over HK$671 billion in margin financing, the largest since 2009 for an IPO in Hong Kong, had already been pledged to the massively popular listing of Nongfu Spring, China’s leading bottled water company, the Hong Kong Economic Journal reported. That left mom-and-pop investors with less cash to scramble for another deal, especially when its bidding price was one of the highest in the Hong Kong bourse’s history.

Nasdaq’s slump in the same week also hurt market sentiment, causing the discount of Yum China’s new issue to its US-traded stock – fixed initially at 5% – to narrow.

How has Yum China been doing?

On July 29 the company celebrated the opening of its 10,000th store in China in the city of Bo’ao in Hainan province. The milestone was reached nearly a year ahead of schedule after a period of rapid expansion in 2019, during which an average of three new stores were opened daily. In April the acquisition of Huang Ji Huang, a Chinese-style ‘simmer pot’ franchise, added 640 shops, as Yum China tried to keep itself on track to meet its goal of adding 800-850 new stores for the current year (see WiC465).

The group has a presence in over 1,400 Chinese cities through eight brands – predominantly KFC outlets but also via Pizza Hut, Taco Bell, East Dawning, Little Sheep, COFFii & JOY, and Lavazza.

Yum China’s renewed growth spurt began in late 2016, following the spin-off from its US parent Yum Brands in New York, and a pre-IPO share sale worth $460 million to Chinese investors including Ant Group and Primavera Capital, a Beijing-based private equity firm (see WiC339).

Micky Pant, the then CEO of Yum, tried to win over investors by highlighting how the fundraisings would leave the debt-free Chinese entity with $900 million of cash in hand and provide ammunition for growing the group to around 20,000 restaurants.

That prospect attracted a $17.6 billion buyout offer from a consortium comprising Hillhouse Capital, KKR and China Investment Corp in 2018, according to Reuters, which was rejected by Yum.

The expansion in its Chinese footprint, paradoxically, has been accompanied by a slower rate of growth in its financials. Between 2017 and 2019, the group’s revenue growth slowed from above 6% to 4%, while growth in operating profit likewise declined from 20% to 7%. The increase in same-store sales slipped from 4% to 3%.

Although the company managed to stay profitable in the first half – even when the coronavirus outbreak forced 33% of its stores to be closed at its peak – Yum China’s margins were inevitably squeezed.

“Sales were primarily impacted by significantly reduced traffic at transportation and tourist locations, delayed and shortened school holidays and resurging regional infections,” the company said in its earnings report for the April-June period, noting that the recovery has been uneven across China’s regions.

The implication is that its business has become a lot more reliant on delivery and takeaway, which accounted for half its total sales in the second quarter.

This adaptation of Yum China’s model also means fiercer competition (hence the narrowing in margins), as its offerings now face greater rivalry from hundreds of thousands of other takeaway food options on delivery platforms such as Meituan and Ele.me.

What are the structural challenges?

Yum China’s flagship brand KFC is currently the largest fast food restaurant chain in China with a 4.9% market share. In the casual dining segment Pizza Hut commands 2.7% of the market, also making it a top two player. However, several other brands in the portfolio have struggled.

The challenge is best exemplified by the Chinese eatery brands owned by Yum China. Little Sheep, a hotpot chain which it acquired in 2009, saw its shop numbers plunge to 260 from over 700 at its peak. The drastic changes that Yum China introduced at Little Sheep, such as more standardised management and a restructuring of its supply chain, have failed to arrest its decline, let alone boost growth.

East Dawning, another Chinese food chain set up in 2004, only has 11 stores. More recently it has been repositioned as an eatery predominantly located in bustling transportation hubs, such as high-speed train stations.

“Yum China is exceptional in its ability to achieve efficiency through scale, standardisation and replication. However, the same formula is not easy to apply on Chinese cuisine, which is notable for its huge varieties,” noted China Business Network, a local media source, explaining why Yum China has been struggling to make its Chinese food restaurants a success.

As a result, KFC and Pizza Hut remain the mainstay of Yum China, and together constituted 92% of the group’s revenue in 2019. The two brands are still the focus of Yum China’s penetration into lower-tier cities, as well as into motorway services areas and petrol stations. By the end of June, there were seven of these co-branded food outlets in facilities operated by state-owned oil majors Sinopec and CNPC.

The risk of depending on such brands – with KFC traditionally associated with fatty fried food and pizza also high in carbs – is the changing preference of Chinese consumers, who are getting to become more health conscious, sophisticated and fickle about their food. That shift helps to explains why Yum China is now betting part of its growth on China’s rising coffee culture (see WiC496).

Aside from offering cheaper brews for the more cost-conscious customers at KFC outlets, Yum China is also accelerating its buildout of artisanal coffee brand COFFii & JOY and partnering with Italy’s Lavazza. Last year the company sold more than 137 million cups of coffee at KFC, up 48% from 2018.

But don’t expect the diversification away from Colonel Sanders’ chicken drumsticks, hot wings and other American fare to be rapid. So if relations continue to sour with the US – particularly as Washington seems ever keener to alter the status quo in its relations with Taiwan – the risks for Yum China of reprisals from a Chinese consumer boycott of KFC restaurants rise. Maybe that’s what weighs most heavily on the stock as we enter the final weeks of America’s presidential campaign, with an incumbent who seems capable of anything when it comes to riling Beijing…

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