YumChina (NYSE:YUMC)

[Snoopy]

Sometimes reading things through a second time can give you a different perspective. I have 'temporarily paused' my previous post 39 while I sort this matter out.

The YUMC 'Consolidated and Combined Statement of Cashflows' (AR2018 p89) show two kinds of dividends.

1/ Cash dividends paid on common stock
2/ Dividends paid to non-controlling interests

YUMC have a non-controlling 47% interest in each of the entities that operate the KFCs in Hangzhou (population 9.018m in 2015, 20 KFC Outlets {Googlemaps 2019}), Suzhou (population 4.330m in 2013, 20 KFC Outlets {Googlemaps 2019}). The now 83% owned Wuxi business (since an additional 36% of shares were added to the 47% percent of shares already held) is the entity that operates KFC in Wuxi (population 6.372m in 2010, 13 KFC outlets {Googlemaps 2019}) is now consolidated, as of the first quarter of FY2018.

From the annual results over the years, I have compiled a partial 'dividend table' below, based on the 'non-controlling interests' of YUMC, alongside the corresponding income.

	2014	2015	2016	2017	2018
Net Income (Non-controlling Shareholders)	($30m)	$5m	$12m	$26m	$28m
Dividends paid to Non-controlling Interests	($4m)	$0m	($7m)	($22m)	($36m)

There isn't much clear logic in this table that I can see. In 2014 a 'dividend' was paid out, despite multi-million dollar losses. The proportion of the dividend paid out doesn't seem to bear much relation to the earnings of any particular year. For the previous 'Buffett Growth Model Spreadsheet', I tried to estimate a 'normalised' non-controlling shareholder dividend. However, I now believe this was the wrong approach. These 'Dividends paid to Non-controlling Interests' can even be a reflection of one off earn out agreements. More details on 'Redeemable Noncontrolling Interests' can be found in AR2018 on p6 and p111. 'Unconsolidated affiliates' operated 14% of all YUMC KFC restaurants at the end of 2018 (p6 AR2018).

Specifically during FY2016, the founders of the 'Little Sheep Hot Pot' concept (a restaurant franchise business now entirely owned by YUMC) were bought out of a minority Little Sheep residual shareholding position.

"The difference between the purchase price of less than $1m, which was determined using a non-fair value based formula pursuant to the agreement governing the redemption rights, and the carrying value of their redeemable non-controlling interest was recorded as an $8m loss attributable to non-controlling interests during the year December 31 2016." (p111 AR2018)

Note that in the above table, the 'dividend' paid out for 2016 was the $1m price, less a fair value adjustment of $8m - for a total 'cash loss' to YUMC of $7m. So the fair value of goodwill adjustment was a cash flow item! This means the value of the goodwill attached to the residually owned 'Little Sheep' shares must have been previously agreed with the minority 'Little Sheep' shareholders as fixed. At least, I think that is the way it worked! I have found US regulated Form 10-K reports have less disclosure and are more difficult to follow than the typical NZX report. But maybe that is just me?

Today the 'non-consolidated entities' reflect certain minority holdings in:

1/ some flagship KFC stores AND
2/ a redeemable non-controlling interest in 'DAOJIA.com.cn' (Daojia)

Daojia is a specialist online takeaway food delivery company. Owning a majority interest of 90% in Daojia (AR2018 p92) is expected to enhance existing digital and delivery capabilities (AR2018 p26). Delivery contributed to 17% of Company Sales on 2018. (AR2018, p25) From what I can gather from the annual reports, 'revenue' from a takeaway food order is booked up front by either KFC or Pizza Hutt. But there seems to be some liabilities payable to the Daojia founders, and now minority shareholders, that are recorded in the YUMC cashflow statements as 'dividends'. Notwithstanding this Daojia lost money over FY2018 (AR2018 p70)

I intend to rework my Buffett Growth Model using my new reinterpreted knowledge.

SNOOPY

[Snoopy]

The YUMC 'Consolidated and Combined Statement of Cashflows' (AR2018 p89) show

2/ Dividends paid to non-controlling interests

YUMC have a non-controlling 47% interest in each of the entities that operate the KFCs in Hangzhou (population 9.018m in 2015, 20 KFC Outlets {Googlemaps 2019}), Suzhou (population 4.330m in 2013, 20 KFC Outlets {Googlemaps 2019}). The now 83% owned Wuxi business (since an additional 36% of shares were added to the 47% percent of shares already held) is the entity that operates KFC in Wuxi (population 6.372m in 2010, 13 KFC outlets {Googlemaps 2019}) is now consolidated, as of the first quarter of FY2018.

More details on 'Redeemable Noncontrolling Interests' can be found in AR2018 on p6 and p111. 'Unconsolidated affiliates' operated 14% of all YUMC KFC restaurants at the end of 2018 (p6 AR2018).

I have found US regulated Form 10-K reports have less disclosure and are more difficult to follow than the typical NZX report. But maybe that is just me?

Today the 'non-consolidated entities' reflect certain minority holdings in:

1/ some flagship KFC stores AND
2/ a redeemable non-controlling interest in 'DAOJIA.com.cn' (Daojia)

Daojia is a specialist online takeaway food delivery company'. Notwithstanding this Daojia lost money over FY2018 (AR2018 p70)

Time to test my theory that 'Dividends paid to non-controlling interests' are from the aggregated in the YUMC accounts 'majority stakes' - that YUMC doesn't own - in KFCs in Hangzhou (population 9.018m in 2015, 20 KFC Outlets {Googlemaps 2019}) and Suzhou (population 4.330m in 2013, 20 KFC Outlets {Googlemaps 2019}).

We can estimate these 'majority owned outside of YUMC' earnings from the price paid for the now 83% owned Wuxi business (since an additional 36% of shares were added by YUMC to the 47% percent of shares already held) in the entity that operates KFC in Wuxi (population 6.372m in 2010, 13 KFC outlets {Googlemaps 2019}). (Wuxi was consolidated, during the first quarter of FY2018). The valuation of the Wuxi restaurants is the clue where we can get at least some 'hard data' from which to make our valuation estimates for the Hangzhou and Suzhou KFC businesses.

AR2018 p92 tells us:

"The completed acquisition of an additional 36% equity interest in an unconsolidated affiliate that operates KFC stores in Wuxi China for a cash consideration of approximately $US98m increasing the company's equity to 83%."

This values the whole Wuxi KFC business at: $US98m/0.36 = $US270m

YUMC has been trading on EBIT multiples of around 20. Taking this measure as a baseline, this would imply an underlying EBIT for Wuxi of $US270m/ 20 = $US13.5m. Those earnings are spread over 13 outlets. But the remaining minority interests in the other two cities comprise 40 outlets. Assuming similar levels of profitability, that means the EBIT for KFCs in Hangzhou and Suzhou would be combined as an 'in the ballpark figure' of:

$US13.5m x 40/13 = $US42m

That breaks down to 0.47 x $US42m = $20m for YUMC shareholders, while the remaining $22m of EBIT belongs to the independent majority owners. YUMC has no term debt and would not withhold any tax payments to the majority shareholders. (In fact in the real world it is the other way around: the majority shareholders in KFC Hangzhou and KFC Suzhou would have to withhold Chinese tax before paying their dividend to minority shareholder YUMC). Yet from a YUMC accounts perspective -IMO-, all of the EBIT for KFC Hangzhou and KFC Suzhou in the YUMC accounts is available to pay the majority shareholders in KFC Hangzhou and KFC Suzhou. So how does that figure of $22m compare to the $36m dividend to non-controlling interests (AR2018 p89) that was paid? It is obviously less, although perhaps by co-incidence it does match the equivalent $22m figure from FY2017, (and that one would have included Wuxi as well).

I have made assumptions in this analysis, for example that the profitability of Wuxi is indicative of the profitability in other centres, that may be untrue. We don't know why the former majority shareholders in Wuxi agreed to sell down to YUMC. Perhaps those Wuxi restaurants were underperforming? While I would have liked to have seen my estimate of earnings at KFC Hangzhou and KFC Suzhou to be closer, it isn't far enough out in the circumstances to disprove my theory. Accordingly I am going to assume that $36m dividend to outside majority shareholders continues into the future. This is likely a high bound guess as it may include up to 1/4 of the Wuxi profits in the first quarter, before those profits were consolidated.

SNOOPY

[SBQ]

You're doing a lot of fancy analysis on YUM, far more than I would ever consider on a stock if I were to buy it. For starters i'm not a fan of using EBITA

China's economy is on the down. Their currency is weakening to the USD. I would look at these factors because they would have a more relevant hit against their balance sheet than to assess by how much dividends they pay.

[Snoopy]

You're doing a lot of fancy analysis on YUM,

Too much speed reading on your behalf SBQ? We are talking about YUMC here, which is an entirely different company from YUM now. YUM is the master franchise holder for KFC, Pizza Hutt and Taco Bell globally. YUMC is the operator of KFC, Pizza Hutt and Taco Bell restaurants within mainland China. YUMC is the Chinese equivalent as 'Restaurant Brands' here in New Zealand.

far more than I would ever consider on a stock if I were to buy it.

Possibly, although maybe not more than if you owned the stock already?

Of course, I am not looking into YUMC just for its own sake. I am interested in it as a 'comparative stick' against which to measure my own holding in 'Restaurant Brands' here in NZ. I am also interested in it as a long term success story on developing a 'western' business in the Chinese market. Because NZ has such a deep trade relationship with China, I think YUMC is a worthwhile case study for those companies in NZ looking to develop their business in China.

For starters i'm not a fan of using EBITA

I was using EBIT (not EBITA) for business unit valuation purposes. That is how business units are valued in most takeover circumstances. Nothing radical about doing that I would have thought.

SNOOPY

[Snoopy]

China's economy is on the down. Their currency is weakening to the USD. I would look at these factors because they would have a more relevant hit against their balance sheet than to assess by how much dividends they pay.

I find it an interesting feature of the 'United States Securities and Exchange Commission' FORM 10-K annual reports that they are forced to disclose risks to an almost absurd degree. Nevertheless, not living in the USA, I find these disclosures useful. Here is what the report says on the current USA vs China trade wars (p34 AR2018).

"The adoption and expansion of trade restrictions and tariffs, quotas and embargoes, the occurrence of a trade war or other governmental action related to tariffs or trade agreements or policies has the potential to adversely impact costs."

I am sure that if this was an NZX report, they would go on to supply some quantitative estimate of these costs. But none was forthcoming. Yet almost all the YUMC restaurant inputs are sourced within China anyway, so I am not too worried.

"In addition changes in trade relations between the United States and China may trigger negative customer sentiment towards western brands in China, potentially resulting in negative impact on our results of operations and financial conditions."

This has happened before, but after two to three years YUMC recovered.

From AR2018 p32

"For example, our results of operations in the third quarter of 2016 ( sales $1,848m) were adversely impacted by an international court ruling in July 2016 regarding claims to sovereignty over the South Chia Sea, which triggered a series of regional protests and boycotts in China, intensified by social media, against a few international companies with well known Western brands."

As far as the currency is concerned, the RMB has been -largely- depreciating against the USD for a long time. So the more recent depreciation over the last few months is nothing new.

In my spreadsheet projected profits, I use the term 'Net Income + Foreign Translation Gain'. Over the past five years these adjustments have been as follows:

	2014	2015	2016	2017	2018
Foreign Currency Translation Adjustment	($51m)	($91m)	($134m)	$142m	($160m)

My base earnings figures on the spreadsheet include these adjustments. Also bear in mind that the number of YUMC outlets grew from 7,983 to 8,484 (+6.3%) over FY2018, and underlying profitability has increased much more than that. That kind of growth is outweighing any currency losses.

SNOOPY