Yum China Earnings: Higher Labor Cost Weighed on Margins; We Lower Our Fair Value Estimate to $80

While third-quarter earnings were below our and Refinitiv’s consensus estimates, we maintain our long-term view on wide-moat Yum China YUMC. We reduce our fair value estimate by 4% to $80 (HKD 626) to reflect higher labor expenses in the near term, but still expect Yum China to offset cost inflation and expand margins over the long run. Our fair value estimate implies a 2024 price/earnings multiple of 30 times. We continue to view Yum China’s shares as undervalued and believe the market is overlooking: 1) Yum China’s restaurant expansion opportunities in China’s growing fast-food industry; and 2) more operating leverage once same-store sales return to 2019 levels.

In the third quarter, revenue grew 9% year over year or 15% on a constant-currency basis. Growth in restaurant sales was primarily due to new restaurant openings, while same-store sales remain depressed at just 90% of 2019 levels. Despite double-digit sales growth, Yum China did not deliver the level of margin expansion that we were hoping to see. Adjusted operating profit in the third quarter increased only 3% year over year or 10% on constant currency. Even if we exclude last year’s coronavirus-related relief and this year’s currency headwinds, adjusted operating profit grew just 21%, materially short of our estimate of 40%-plus growth. Management attributed the elevated cost structure to wage inflation and normalized staffing levels compared with 2022, which we have now baked into our near-term forecasts. After fine-tuning our model, we lower Yum China’s earnings forecasts by 16% for 2023 and 22% for 2024.

Yum China noted a decline in consumer demand starting from late September through October. We interpret this as a reflection of broader industry trends rather than a specific issue with the company as it aligns with reports from other restaurant operators in China. That said, if macroeconomic conditions continue to weaken, there could be more downside to Yum China’s near-term revenue and margins.