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  1. #31
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    Default Developing a Business In China

    "Over the past three decades, we have built a significant lead not just in number of outlets, but also in brand awareness and loyalty, proprietary consumer know-how in individual provinces and city tiers, a national supply-chain network, product innovation and quality processes, a motivated and highly-educated workforce and a long-tenured and passionate local management team. We believe that these competitive strengths are difficult to replicate."

    The above is a quote from the 'Yum China' listing prospectus p69. It is referring to the roll out of KFC and Pizza Hut in China. But if you read the paragraph, it is clear that it can apply to any new 'western' product that is rolled out for sale in China. With one exception - the very first sentence. There aren't many western products that have a thirty year history in China and are still on a successful growth path. So what can we learn from 'Yum China' story about the way other consumables might be successfully rolled out across the country with the fastest growing middle class in Asia? A lot I think.

    Over the years Yum China has built:

    1/ An increasing number of distribution outlets.
    2/ Brand Awareness and Loyalty.
    3/ A motivated and highly educated workforce.
    4/ A long tenured and passionate local management team.

    We can regard the above as key 'check points' for any foreign consumables business, making a success of itself in China.

    A local management team is important because it means that a company that follows such a recipe can adapt to local tastes. That doesn't necessarily mean the core product needs changing. But it might mean resizing the quantity of what you sell and adopting the distribution systems to get the product to the end line customer in a more convenient and timely way. By using the above recipe, 'Yum China' have been able to integrate into Chinese popular culture and consumers' daily lives.

    How fast has Yum China managed to grow in terms of outlets? Some day I hope to be able to fill in more gaps in the table below. But here is a flavour of what has happened.

    Year No. Of Outlets
    1987 1
    2005 1,792
    2010 3,906
    2015 7,176
    2017 7,983

    From 1987 to 2017, this gives us a 30 year annual compounding growth rate of:

    1(1+g)^30 = 7983 => g=0.35

    In round figures the business has grown by 35% every year for 30 years! This includes the early stage of the growth cycle where growth was higher. Perhaps more indicative of what we might see from now on is what has happened over the last two years:

    7176(1+g)^2 = 7983 => g=0.05, or 5% per year.

    That is nevertheless a strong underlying growth rate, as it excludes inflation.

    Continuing to quote from the listing prospectus:

    "The development and growth of our business has benefited from China's rapidly growing middle class and increasing urbanization. The size of the middle class is expected to continue to grow significantly. According to a 2012 McKinsey study, between 2002 and 2022, the number of middle class and affluent households is expected to increase by 283 million. A significant portion of this growth will be driven by upper middle class households, which are expected to increase from 2% of total households in 2002 to 54% by 2022, or an increase of 188 million households. The Company will continue to focus on this core consumer segment and on serving China's growing middle class."

    What the McKinsey report says about the distribution of middle class households is equally interesting:

    "According to the McKinsey study referenced above, in 2002 87% of the middle class lived in coastal China and only 13% of the middle class lived in inland provinces. By 2022 it is expected that only 61% of the middle class will live in coastal cities as the middle class expands more rapidly in inland cities. Likewise, according to the same study, by 2022 it is expected that 39% of the middle class will live in cities with a population of more than one million."

    The response from Yum China, is to target new trade zones and build more new restaurants further inland. This includes targeting those 'small' (sic) cities with a population of 'only a million'.

    There are interesting parallels with the development of quick service restaurants in China, and China's milk market.

    https://www.theguardian.com/environm...hirst-for-milk

    Dried milk powder first appeared in small shops in China in the early 1980s, about the same time the first KFC in Beijing opened.

    "In a little over 30 years, milk has become the emblem of a modern, affluent society."

    We could say the same about the arrival of KFC in China. (KFC had a somewhat more up market image in China than it has in the west!)

    China has the ambition of tripling its milk production. Yum China has a plan to triple the number of quick service restaurant outlets in China.

    "As populations urbanise, they have always moved up the food chain, making the transition from diets largely based on grains and vegetable staples to ones in which meat, dairy, fats and sugars feature more prominently. China has followed the same trajectory."

    One way to interpret that is to say that 'KFC' and 'milk' are driven by the same trend to urbanisation.

    "By the end of the 90s, the eastern cities of China were booming, and people were consuming more dairy foods, but a gap was growing between there and the interior, where people were much poorer and still drank little milk."

    This is exactly the same geographic spread of sales as reported in period by Yum China.

    In response to the melamine milk contamination scandal:

    "Consumers remain deeply suspicious about the safety of local food, fearing adulteration, residues from the overuse of agrochemicals, toxins from the pollution of ground water and air by industrial waste and excessive use of antibiotics. Many affluent parents still only buy foreign brands of milk for their young children."

    Here we have yet another parallel with foreign owned chain restaurants. The food isn't necessarily better than the local offering. But hygiene standards are much more consistent.

    "The Chinese Communist Party is obsessed with feeding this enormous population – it will go on growing until at least 2030. The reason it bangs on about food security and food safety is that it’s a potential source of instability. People come out on the streets about it."

    This indicates that despite the risks of investing in a country with absolute autocratic control, companies that 'feed the masses' with verifiably quality controlled food, will likely remain politically favoured. This is a security blanket, both for imported milk and imported restaurant concepts.

    In summary, I think there are real lessons to be learned here for those NZ listed food businesses selling their product into China. Perhaps the most important being that despite the tailwinds some investors see, the positive progress will probably be interrupted by scandals and setbacks along the way. Rather than panic and pull out, savvy investors can take these as discounted investment entry points to take advantage of what seems to be a relentless longer term upwards trend.

    SNOOPY
    Last edited by Snoopy; Yesterday at 10:37 PM.
    To be free or not to be free. That is the cash-flow question....

  2. #32
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    Default

    So Snoopy, after all this analysis, have you invested? I've opened an account with Hatch, might buy a few YUMC to get started.

  3. #33
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    Default

    Quote Originally Posted by Cricketfan View Post
    So Snoopy, after all this analysis, have you invested? I've opened an account with Hatch, might buy a few YUMC to get started.
    Hi Cricketfan,

    Yum China was a spin off from the parent franchise holder for KFC, Pizza Hut and Taco Bell, YUM Brands, which I held. So in a sense my 'Yum China' shares 'fell into my lap' at spin off time, and I have held them since. It has been a wild ride, mostly upwards, after that. Yum China was long touted as having big growth potential within YUM Brands. I was a little surprised, although happy enough, when it was carved out as a separate listed entity, two and a half years back. Back in the early 2000s, if you forgive the baseball analogy, Yum China was sold as being in the second innings in a ten inning ball game. To carry the analogy through, I would say we are in about the fourth innings now. So plenty of growth within China is still to come, albeit at a growth rate slower than in those earlier heady days.

    As you have read on this very thread, I have researched Yum China extensively in recent months. I think it is a better company than I had thought it was, before I started my big read up. Like Restaurant Brands in NZ, they are cursed with the task of rolling out 'Taco Bell', the Mexican restaurant brand, in their own territories - a brand that hasn't really resonated outside of the Americas so far. I hope they make a go of it. But in the short term Taco Bell is a loss making distraction, with just a couple of test stores open in Shanghai.

    Another 'distraction' is the new 'COFFii & JOY' café brand, an apparent attempt to head off the likes of Starbucks expansion into China. The 'COFFii & JOY' brand has been developed 'in house' at Yum China. Potentially we have another growth arm to exploit. However the reality is there were only 15 'COFFii & JOY' outlets at EOFY2018 end, When you operate close to 8,000 restaurants in total, this is not material. For now, I am sure that 'COFFii & JOY' is yet another loss making distraction. But in the future? Incidentally, YUM China are not quite the novices in the coffee market that some might think. KFC sold over 90 million cups of freshly ground coffee and generated revenue of over RMB1 billion in 2018.

    I am convinced Yum China is a very good company. I particularly like the fact that they can open a KFC restaurant and have all incremental expenditure needed to do that paid back within a couple of years. But successful investment is not just about sharemarket investors buying good companies. What investors need is to buy good companies at good value prices. I see Yum China last traded at $US45.24. Based on last years (2017) results, this represents an historical PE ratio of:

    $45.24 / $1.52 = 29.8

    This is very high. I would like to wait to see the full results from last year released, to see if such a lofty PE ratio could be justified. Right now, I won't be investing more money into Yum China.
    If I was a new investor, I would be waiting for something negative to happen that caused the YUMC share price to fall a bit (bearing in mind YUMC is very strong at its core and the SP should bounce back), and allow a more favourable investment entry price. YUMC has had a series of mishaps outlined earlier on this thread, that dragged their reputation down, for a while at least. The next mishap could be next week. But it could be five years away. I feel right now that YUMC is a better measuring stick to hold up against 'Restaurant Brands' as a determiner of value, rather than a sure fire investment in its own right.

    SNOOPY

    discl: hold RBD, YUMC, YUM
    Last edited by Snoopy; 22-04-2019 at 04:00 PM.
    To be free or not to be free. That is the cash-flow question....

  4. #34
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    Default BT2/ Increasing 'eps' trend (2018 perspective) [one setback allowed]

    Quote Originally Posted by Snoopy View Post
    FY2013 FY2014 FY2015 FY2016 FY2017 FY2018e
    Operating Profit (excluding Impairments (1)) $384m $354m $488m $640m $785m $941m
    subtract Insurance Payouts ($25m) ($5m) ($3m)
    adjust Corp Jet Disposal $15m ($2m)
    adjust Foreign Currency Adjustments $5m $4m $3m $0m $?m
    subtract Wuxi KFC equity revaluation ($98m)
    add Duojia Intangible Write Off $12m
    add Interest Earned $5m $14m $8m $11m $25m $36m
    Equals Adjusted Normalised EBT $389m $348m $510m $649m $810m $891m
    subtract Tax at 27% (2) $105m $94m $137m $175m $219m ($241m)
    subtract Foreign unrepatriated earnings Tax (3) ($20m)
    Equals Adjusted Normalised NPAT {A} $284m $254m $372m $474m $591m $630m
    Shares on Issue EOFY {B} 363.758m 363.758m 363.758m 383.344m 388.860m 392m
    eps {A}/{B} {C} 78.1c 69.8c $1.02 $1.27 $1.52 $1.61
    Share Price 31 March (following) {D} NA NA NA $27.20 $41.50 $40.52 (4)
    PE Ratio (D)/(C) NA NA NA 21.4 27.3 25.2

    Notes

    1/ Significant impairment write offs for the 'Little Sheep' casual dining concept occurred in 2013 and 2014. YUMC own the intellectual property of the 'Little Sheep' brand. 'Little Sheep' had its foundation in Inner Mongolia, China. It specialises in 'Hot Pot' cooking popular in in China, especially in the winter months. 'Little Sheep' has more than 280 restaurants operating. A wholly-owned business that sells seasoning to retail customers is part of the 'Little Sheep' operation. But total turnover at 'Little Sheep' is less than 1.5% of the turnover of YUMC.

    2/ The US corporate tax rate up to 31st December 2017, for the last few years, has been 35%. Looking at Note 17 on Income Tax in AR2017, the actual tax paid by YUMC on operations has been less than this. For the years 2017, 2016 the 'Statutory rate differential attributable to foreign operations' was 8.4% and 7.5%. I have rounded this off to 8%, subtracted the 8% from the 35% US statutory rate and come up with 27%. This is still above the 25% Chinese Corporate Income tax rate, and I cannot explain the difference.

    3/ The 'deemed repatriation of accumulated and distributed foreign earnings' tax saw a provision of $164m made in the YUMC accounts for FY2017. But this tax bill is to be spread out over eight years. Because it is in integral part of the Trump tax reforms, I do not feel that it should be recorded as a one off. Therefore I am recording a $20m charge every year from 2018 to 2025 inclusive.

    4/ Share price at 5th February 2019. 31st March date still in the future when table was compiled.

    Conclusion: Pass Test
    I had to do a rush job of the 2018 results before the FY2018 Annual Report was released. That was to facilitate a comparison with 'Restaurant Brands' immediately post the 75% takeover offer from 'Finaccess'. Now that I have the actual YUMC report in my 'hot little paws', I can produce the 'definitive audited version' of these accounts.

    Re-reading the accounts I notice something odd. 'Other Income' appears to have been subtracted from 'Operating Expenses' (AR2018 Form 10-k, p56). The 'Operating Expenses' that are used to calculate 'Operating Profit' ...

    To use the terminology in the Annual Report

    "Total Revenues" (p62) - "Total Cost & Expenses net" (p56) = "Operating Profit" (p62)

    ...have already been adjusted for! 'Minority Owned Equity Accounted Profit', 'the Wuxi KFC equity revaluation', 'Insurance payouts', 'Provision reversal for Aircraft Sales losses' and 'Foreign Currency Adjustments' etc. etc. have all been dealt with. Yet 'Decreasing Expenses' has the same effect as 'Increasing Profits'. So I still need to subtract 'Other Income' from 'Operating Income' to produce a 'Normalised Operating Income' with three exceptions.

    1/'Other Income' does include equity accounted income, and I feel that should be included in the Normalised result. These equity accounted but unconsolidated affiliates are largely minority owned KFC restaurants. So I think it is appropriate not to 'subtract again' the equity accounted income component of 'Other Income', when I finally create my 'Normalised Operating Profit'. To give some idea of the scale of these profits, I have listed them below.

    FY2013 FY2014 FY2015 FY2016 FY2017 FY2018
    Equity Income from Unconsolidated Affiliates $26m $30m $41m $54m $65m $65m

    2/ 'Other Income' also includes 'Foreign Exchange Net Loss or Gains'. These losses or gains are generally on contractual arrangements not taken out as a form of money speculation. They are the result of money market events not foreseeable when the underlying contract was taken out. Consequently they should remain removed when considering normalised profits. To give some idea of the scale of these foreign exchange gains or losses , I have listed them below.

    FY2013 FY2014 FY2015 FY2016 FY2017 FY2018
    Foreign Exchange Gains or (Losses) ($1m) ($4m) ($5m) ($3m) $0m ($11m)

    3/ The FY2016 result has been corrected to account for the fact that had the separation occurred prior to the actual October 2016 separation date, then there would have been an extra franchise fee due to the parent YUM Brands. However, since we are now interested in 'Yum China' as a separate entity this correction is realistic and the extra charge should not be removed.

    FY2016
    Incremental adjustment to YUM licence fee expense $17m

    My 'Normalised Profit' calculation table appears below:

    FY2013 FY2014 FY2015 FY2016 FY2017 FY2018
    Operating Profit (excluding Impairments (1)) $384m $354m $488m $640m $785m $941m
    less Poultry Supply Lost: Insurance Recovery ($25m) ($5m) ($3m)
    add Provision for Losses on Aircraft sales $15m
    less Reversal of Aircraft Sale Provision ($2m)
    less Business Combination Contingency Reversal ($3m)
    less Equity Gain Consolidating Wuxi ($98m)
    add Duojia Intangible Write Off $12m
    add Interest Earned $5m $14m $8m $11m $25m $36m
    Equals Adjusted Normalised EBT $389m $343m $506m $646m $807m $891m
    subtract Tax at 27% (2) ($105m) ($93m) ($137m) ($174m) ($218m) ($241m)
    subtract Foreign unrepatriated earnings Tax (3) ($16m)
    Equals Adjusted Normalised NPAT {A} $284m $250m $369m $472m $589m $634m
    Shares on Issue EOFY {B} 363.758m 363.758m 363.758m 383.344m 388.860m 392m
    eps {A}/{B} equals {C} 78.1c 68.7c $1.01 $1.23 $1.51 $1.62
    Share Price 31 March (following) {D} NA NA NA $27.20 $41.50 $44.91
    PE Ratio (D)/(C) NA NA NA 22.1 27.5 27.7

    Notes

    1/ Significant impairment write offs for the 'Little Sheep' casual dining concept occurred in 2013 and 2014. YUMC own the intellectual property of the 'Little Sheep' brand. 'Little Sheep' had its foundation in Inner Mongolia, China. It specialises in 'Hot Pot' cooking popular in in China, especially in the winter months. 'Little Sheep' has more than 280 restaurants operating. A wholly-owned business that sells seasoning to retail customers is part of the 'Little Sheep' operation. But total turnover at 'Little Sheep' was less than 1.5% of the turnover of YUMC.

    2/ The US corporate tax rate up to 31st December 2017, for the last few years, has been 35%. Looking at Note 17 on Income Tax in AR2017, the actual tax paid by YUMC on operations has been less than this. For the years 2017, 2016 the 'Statutory rate differential attributable to foreign operations' was 8.4% and 7.5%. I have rounded this off to 8%, subtracted the 8% from the 35% US statutory rate and come up with 27%. This is still above the 25% Chinese Corporate Income tax rate, and I cannot explain the difference.

    3/ The 'deemed repatriation of accumulated and distributed foreign earnings' tax saw a provision of $164m made in the YUMC accounts for FY2017. After further consideration in FY2018, this provision was adjusted down by $36m to a total of $128m. But this tax bill is to be spread out over eight years (AR2017, p76). Because it is in integral part of the Trump tax reforms, I do not feel that it should be recorded as a one off. Therefore I am recording a $16m charge every year from 2018 to 2025 inclusive.


    Conclusion: Pass Test

    SNOOPY
    Last edited by Snoopy; Yesterday at 07:21 AM.
    To be free or not to be free. That is the cash-flow question....

  5. #35
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    Default BT3/ ROE > 15% for five years (2018 perspective) [one setback allowed]

    Quote Originally Posted by Snoopy View Post

    FY2013 FY2014 FY2015 FY2016 FY2017 FY2018e
    Adjusted Normalised NPAT {A} $284m $254m $372m $474m $591m $630m
    Shareholder Equity EOFY {B} $2,344m $1,945m $1.979m $2,443m $2,859m $2,873m
    ROE {A}/{B} 12.1% 13.1% 18.8% 19.4% 20.7% 21.9%

    Conclusion: Pass Test
    FY2013 FY2014 FY2015 FY2016 FY2017 FY2018
    Adjusted Normalised NPAT {A} $284m $250m $369m $472m $589m $634m
    Shareholder Equity EOFY {B} $2,344m $1,945m $1.979m $2,443m $2,859m $2,976m
    ROE {A}/{B} 12.1% 12.9% 18.6% 19.3% 20.6% 21.3%

    Conclusion: Pass Test

    SNOOPY
    Last edited by Snoopy; Yesterday at 10:41 PM.
    To be free or not to be free. That is the cash-flow question....

  6. #36
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    Default BT4/ Ability to raise Net Profit margin above inflation rate (2018 perspective)

    Quote Originally Posted by Snoopy View Post
    FY2013 FY2014 FY2015 FY2016 FY2017 FY2018e
    Adjusted Normalised NPAT {A} $284m $254m $372m $474m $591m $630m
    Revenue {B} $6,905m $6,934m $6.909m $6,752m $7,144m $7,774m
    Net Profit Margin {A}/{B} 4.11% 3.66% 5.38% 7.02% 8.27% 8.10%

    Inflation in China is around 2%. The smallest gain in margin has been from FY2016 to FY2017. 2% of 7.02% (margin for FY2016) is 0.14 percentage points. That means as long as the FY2017 margin is greater than 7.02% + 0.14% = 7.16%, then our requirement is satisfied. They actual margin is 8.27%, so our requirement is met, and has been met over the FY2017/FY2016, FY2016/FY2015 and FY2015/FY2014 'year on year' comparisons. The decrease in margin over the latest year does not invalidate this company's ability to increase margins for an extended period over the last five years.

    Conclusion: Pass Test
    FY2013 FY2014 FY2015 FY2016 FY2017 FY2018
    Adjusted Normalised NPAT {A} $284m $250m $369m $472m $589m $634m
    Revenue {B} $6,905m $6,934m $6.909m $6,752m $7,144m $7,774m
    Net Profit Margin {A}/{B} 4.11% 3.66% 5.38% 7.02% 8.27% 8.16%

    Inflation in China is around 2%. The smallest gain in margin has been from FY2016 to FY2017. 2% of 7.02% (margin for FY2016) is 0.14 percentage points. That means as long as the FY2017 margin is greater than 7.02% + 0.14% = 7.16%, then our requirement is satisfied. They actual margin is 8.27%, so our requirement is met, and has been met over the FY2017/FY2016, FY2016/FY2015 and FY2015/FY2014 'year on year' comparisons. The decrease in margin over the latest year does not invalidate this company's ability to increase margins for an extended period over the last five years.

    Conclusion: Pass Test

    SNOOPY
    Last edited by Snoopy; Yesterday at 10:50 PM.
    To be free or not to be free. That is the cash-flow question....

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