Operator of KFC and Pizza Hut chains in China reported its best restaurant margins in four years, lifted by a ‘perfect storm’ of factors, some temporary and others long-term

Key Takeaways:

  • Yum China reported its restaurant margin rose to 18.8% in the third quarter from 12.2% a year earlier, marking its best performance of that metric since 2018
  • The KFC and Pizza Hut operator for China reported a return to revenue growth in the third quarter, but cautioned the country’s Covid-controls intensified in October

By Doug Young

It may not sound sexy to your average Joe diner, but there was one clear superstar in the latest earnings report from restaurant operator Yum China Holdings Inc. (YUMC.US; 9987.HK): the company’s margins.

Specifically, it was the company’s eye-popping restaurant margin that reached a four-year high that was the pride and joy of top managers of the operator of KFC and Pizza Hut restaurants in China in the company’s third-quarter results released earlier this week. The margin – which came in at 18.8% for the quarter, versus 12.2% a year earlier – was all the more impressive against the backdrop of a difficult operating environment in China lately due to the country’s strict Covid-control measures.

Margin talk also dominated the company’s quarterly analyst call, where it was the subject of numerous questions. Management explained that despite the challenging environment, the big improvement was the product of a sort of “perfect storm” of factors, which we’ll detail shortly. That means the figure is likely to come down in the fourth quarter, since some of those factors were one-off, while others should have a longer-term impact.

“I think there’s a lot of questions about margin today,” mused CFO Andy Yeung on the call, responding to the first several questions on the topic. “Obviously, we’re very pleased with our margin performance in the third quarter. … Looking forward, I think you can expect some of these fundamental changes (that led to the big margin improvement) would stay and some of these temporary measures may subside over time.”

Whether those factors were temporary or permanent, investors seemed to like the overall picture. Yum China’s shares rose 7.6% the day after the announcement, and continued to rise over the next few days. After adding in a one-day rally at the week’s start when rumors of a major relaxation in China’s Covid-control measures circulated, the stock finished up 14% in the four days through Thursday.

The stock has also gotten a recent boost by its inclusion in a program that made its Hong Kong-traded shares available to Chinese mainland investors starting Oct. 24. Since then the daily volume for its Hong Kong shares has risen notably, coming in nearly every day above its previous typical average of 1 million to 2 million shares per day. 

The company’s latest report was all the more impressive coming after a terrible second quarter for Yum China and most of its peers, which were hamstrung by some of the country’s strictest virus-control measures since the start of the pandemic in 2020. Those included a citywide lockdown of Shanghai, China’s commercial capital and Yum China’s headquarters, in April and May.

An easing of control measures in July and August was one factor behind Yum’s strong margins for the quarter. That could easily change in the current quarter, as control measures picked up notably in October. Other temporary measures behind the margin improvement included government rental relief to assist store operators during the period. And the third quarter is always one of the strongest each year for sales, whereas the fourth is usually slower.

But on a longer-term basis, the company benefited from lower labor costs by using technology to better schedule its staffing and automate functions like ordering. It also lowered its cost of sales through efforts like large-scale procurement and streamlining production, and is opening more stores in a smaller format that tends to be higher-margin, especially in lower-tier cities.

Delivery nation

One of the biggest factors behind the better margins was Yum China’s ongoing shift to off-premises dining, which is typically much more profitable than in-store eating. From our position in Shanghai, we can safely report that delivery service has become all the rage in China these past few years, fueling the rise of internet majors like Meituan (3690.HK) and Alibaba’s (BABA.US; 9988.HK) Ele.me. Covid-controls have accelerated the takeaway trend by often banning in-store dining at many restaurants while still allowing take-out.

As those trends accelerated, Yum China said its delivery orders grew 19% in the third quarter year-on-year, accounting for 38% of the company’s sales mix during that period – up from 20% before the pandemic in 2019. Off-premises dining accounted for almost two-thirds of sales during the quarter, up from about 50% two years ago.

“Our ability to capture off-premises demand not only enabled us to effectively serve customers but also cushion store closure impact due to Covid conditions,” said Yum China CEO Joey Wat on the call.

Next, we’ll step back and look at some of the other headline figures that also show how Yum China rebounded in the third quarter from the depths of this year’s earlier downturn. Its overall revenue rose 5% year-on-year to $2.68 billion, marking a return to growth after a 13% decline in the previous quarter. The latest margin improvement fueled a near-doubling in the company’s profit to $206 million, again returning to strong growth after a 54% decline in the second quarter.

Yum China’s same-store sales were flat year-on-year for the quarter, again rebounding from a 16% decline in the previous quarter. And while flat never sounds that impressive, it was notable for easily beating a 16% year-on-year same-store sales decline that Starbucks (SBUX.US) also reported for its China operation this week in its latest three-month quarter through Oct. 2.  

Yum China doesn’t typically provide revenue guidance for the next quarter, though it pointed out that “entering the fourth quarter things (were) getting worse with new infections.” It said it had to close or limit operations for 1,400 stores in October alone, far more than the 900 stores affected by similar limitations in September and around 400 in July and August.

While the outlook for its stores in operation was less certain, the company said it is still on track to meet its target of opening a net 1,000 to 1,200 new stores this year. That would imply a burst of activity in the next two months, since the company had only opened a net 621 new stores this year through the end of September.

From a valuation perspective, investors are relatively bullish on Yum China, giving it a price-to-earnings (P/E) ratio of 27 after this week’s rally, ahead of the 24 times for Yum Brands! (YUM.US), its former U.S. parent before Yum China was spun off as a separate company in 2016. Yum China’s ratio is also ahead of the 24 for Starbucks, though it trails McDonald’s (MCD.US) at 35 times. 

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