2016 Could Be Yum's Year

Yum's investment story is not without its risks, especially in light of macroeconomic uncertainty in China, increased competition from new and established rivals across almost every region, and the recent resurgence in sales trends for key rival McDonald's MCD. While some of these concerns are legitimate, we don't believe the market is giving Yum enough credit for its longer-term free cash flow growth potential.

Direct Way to Play the Long-Term Growth of the Chinese Consumer With 35%-40% of Yum's total operating profit historically coming from China, it's not surprising that the stock's performance has been closely tied to China same-store sales trends. As such, it's clear that stabilizing China same-store sales trends is at the top of management's near-term priorities, which we view as appropriate, since we don't believe a sustainable recovery in the share price is possible without more-stable top-line trends.

Recent results suggest that the China division is still adjusting to an uneven macroeconomic picture, consumers putting more emphasis on value, and evolving competition, including new entrants in the restaurant industry and heavy discounting from online ordering aggregators on Pizza Hut Casual Dining.

While the pace of Yum's recovery in China adds near-term uncertainty, we remain optimistic about Yum China's longer-term opportunities, given a fragmented restaurant industry, a growing Chinese middle class, ongoing urbanization trends, and the market becoming conducive to franchising. Even as Yum laps the OSI supplier food handling issue--which sparked a midteens decline in China comps in the back half of 2014 and early 2015--we find management's guidance calling for Yum China same-store sale growth of 2%-3% as realistic for 2016, with high-single-digit growth at KFC negating high-single-digit declines at Pizza Hut. We also share management's views that heavy discounting from the online aggregators will not be sustainable over a longer horizon, and we believe that increased consumer adoption of online ordering could provide a positive catalyst for KFC's and Pizza Hut's own digital and delivery strategies in China.

The overall pace of China's consumer spending was slowing even before the recent stock market volatility, and we believe China is entering a period of normalized GDP growth in the mid-single-digit range as it transitions away from being a government- and export-driven economy. However, we do not believe that consumption trends will permanently decline as economic growth decelerates. While we believe the devaluation of the yuan in August and December and equity market volatility in the back half of 2015 triggered a pullback in spending--particularly among higher-end consumers and corporations--we think the uneven pace of consumption has more to do with consumer sentiment and less to do with the inability to spend.

We remain constructive on the longer-term spending potential of the Chinese consumer, as China's consumer saving rates remain some of the highest in the world, suggesting that purchasing power will remain intact even during periods of economic volatility. Additionally, several factors position China as one of the most fertile regions for consumer consumption over a longer horizon, including a doubling of China's consuming class to 500 million-600 million over the next decade; an urban population that could eventually exceed 800 million; government regulation changes, including transferable rural property laws that could drive wealth creation and easing of one-birth policies; and technological advances.

Our Yum China same-store sales growth assumptions take into consideration several consecutive years of robust wage growth in the region and the implications for longer-term spending among middle-income consumers, as well as differentiated shopping patterns among Chinese consumers younger than 35. We also believe that worries about China equity market volatility have been overblown, as there has historically been little correlation between market performance and retail spending over an extended period. Despite the slower-than-anticipated sales recovery in the latter part of 2015, we have been impressed by the company's labor productivity efforts at KFC China, which have helped to counteract expense deleverage stemming from the tepid sales trends. With these new productivity measures in place, Yum China's 2016 outlook calling for restaurant margins that will be roughly in line with 2015 (approximately 16%) and 20% over the longer term appears more palatable.

Even under a mid-single-digit GDP growth scenario, we believe China will offer consumer companies a tremendous consumption growth story over the next several decades. We have identified China as one of the most compelling emerging-market environments for consumer spending over a 20-year time frame, owing to favorable demographics, wage growth, expanded direct-to-consumer and digital sales capabilities, and an improving regulatory environment. This is corroborated by research from the Economist Intelligence Unit, Boston Consulting Group, and AliResearch, which estimates that private consumption will grow by $2.3 trillion in China between 2015 and 2020, compared with $2.6 trillion in the United States. Even under slower GDP assumptions, China's consumption growth over the next five years could rival total private consumption in Germany and the United Kingdom by 2020, supporting our long-term positive view on China's consumer and, by extension, on Yum China.

We see three major catalysts driving restaurant spending over the next several decades: wealth creation, urbanization, and shifting attitudes toward spending among China's younger consumers. The average yearly wage in China increased at a 13.7% compound annual rate between 2004 and 2015, according to China's Ministry of Human Resources and Social Security. We think double-digit wage growth is likely to persist over the next few years, which should have a positive impact on disposable income trends in the region.

Urbanization will mark a transition away from agriculture toward industrial, service-based, and technology-related jobs. In March 2014, China's State Council approved plans to move more than 60% of the country's total population to urban locations by 2020, up from approximately 53% today. This will effectively shift 15 million-20 million rural residents--roughly equal to the current size of the New York City metropolitan statistical area--to urban locations every year through the end of the decade. Additionally, as population density and high Internet penetration rates increase, we believe this will lower the incremental cost of shipping for consumer products.

According to the China Institute for Reform and Development, the country currently has a middle-class population of 300 million. With the government's goal to double per capita income among consumers, we expect the middle-class to upper-middle-class population in China to roughly double to approximately 600 million by 2020, with much of the increase taking place in urban centers. This suggests that Yum's China consumer base could conceivably double over the next several years while driving increased engagement levels from guests.

We also believe China's younger population--those under the age of 35--will be instrumental to restaurant spending in China over the next several decades. According to a February 2016 study by Boston Consulting Group, consumption among consumers under the age of 35 is growing at a 14% clip annually, double the 7% consumption growth from China's older generations. We think several factors drive this excess spending. First, we believe younger Chinese consumers are at a compelling intersection of increased disposable income and greater consumer product needs and wants. We also believe that career advancement--and, by extension, a time-strapped consumer--will increase the demand for convenient/takeaway food products. Second, this cohort group tends to be college-educated, has higher mobile-adoption trends, and tends to be more sophisticated at shopping than older counterparts. Lastly, China's consumers typically have greater brand recognition than many of their peers in developed nations, according to the BCG study; we believe this bodes well for Yum China, given that these consumers grew up during KFC's and Pizza Hut's expansion phases in the region.

Yum China's Missteps Due to Unfortunate Timing, Not Brand Impairment At its December investor event, management discussed operation and menu simplicity, targeted value, in-store experience, restaurant format flexibility, and staying digitally relevant in China as corrective measures for Yum China. We anticipate greater contribution from new value platforms and menu simplifications early in 2016, with restaurant formats and digital efforts offering longer-term benefits. Our model assumes that these initiatives will drive same-stores sales growth back to normalized levels in the mid-single-digit range, while also supporting our wide moat rating on a stand-alone basis.

Given the uneven macroeconomic environment and pullback in consumer spending, Pizza Hut Casual Dining faces its own set of issues. In the four-year period before the 2014 and 2015 food supplier incidents, Pizza Hut Casual Dining posted average annual same-store sales growth of 11%, helped by revamping a fourth of its menu every six months. However, recent promotions have not been as effective. As we saw from other companies with exposure to more-affluent Chinese consumers, Pizza Hut was negatively affected by a reduction in parties, dinners, and entertaining in the back half of 2015, particularly during weekdays.

To tackle this issue, Pizza Hut has added weekday value dinner promotions on top of its regularly scheduled menu revamp. Additionally, the chain has been increasing its use of box meals and day-of-the-week specials alongside the launch of new beverage/add-on products, which we believe will improve Pizza Hut's value perception.

Despite its recent struggles, we believe Yum's brand intangible asset--a key factor behind our wide moat rating--remains intact and has not suffered any impairment. We're confident that the in-restaurant changes--including menu changes refocused on the consumer value proposition to make the guest experience more enjoyable--will help to keep KFC and Pizza Hut among the most respected brands in their respective restaurant categories.

In-Restaurant Competition Reflects China's Changing Retail Marketplace The U.S. has seen an explosion in new restaurant growth the past several years, as Amazon's growth has stunted the development of several retail concepts, particularly those in commodified categories. Much of this excess commercial real estate is being filled by leading fast-casual restaurant chains like Chipotle and Panera, but part is also being filled by a class of smaller privately held chains with access to inexpensive capital and favorable leasing terms, aided by landlords that are eager to fill excess real estate.

The fast-casual market hasn't really taken off in China yet, but we are seeing a similar phenomenon in China's real estate market, where the rising popularity of e-commerce has changed the complexion of China's malls. Traditional anchor retail has seen a decline, and restaurant chains are filling the void. Additionally, the rise of the upper-middle-class and affluent consumers has created a new class of willing entrepreneurs and restaurant franchisees; when coupled with an increase in available capital, this has prompted an increase in conventional franchising agreements in the region, something that hadn't existed until just a few years ago.

While the number of restaurant locations is on the rise in China--the number of chain catering locations increased just over 14% per year between 2004 and 2014, according to China's Ministry of Commerce--we've also seen consolidation, with the top 10 chains in China operating roughly 2.5 times as many restaurant locations in 2015 (24,400) as they operated a decade ago (approximately 10,800). We acknowledge that consolidation (and the increased economies of scale that follow for industry leaders) typically leads to greater price competition, which we expect to increase in 2016 as China's consumers become more value-conscious amid uneven macroeconomic conditions. That said, we still like Yum's chances for outperformance during a period of heightened price competition, given its meaningful supply chain and advantages as well as its corrective measures in marketing, value proposition, and digital enhancement.

Online Ordering Aggregators Short-Term Threat but Long-Term Opportunity While we were aware of the upswing in online restaurant ordering and delivery among China's consumers, we underestimated the magnitude of the disruptive impact that these online-to-offline, or O2O, platforms have had, and we would not be surprised to see similar trends take hold in other emerging markets. We believe these competitive threats will remain a disruption for Pizza Hut Casual Dining over the next several months, but they could also provide a tailwind over a longer horizon.

The total impact of O2O services on the broader restaurant industry is relatively small now, but this could change in the years to come. With the increase in wage growth, shift to white-collar jobs that comes with urbanization, and increased consumer acceptance of online ordering and delivery, we expect online takeout ordering to remain a high-growth category over the foreseeable future. Data from third-party China Internet market research provider iResearch suggests that the O2O takeout industry will grow from CNY 18.2 billion to CNY 41.8 billion during the next two years, which strikes us as directionally accurate. Given this in addition to the increased adoption of mobile shopping, we expect mobile O2O transactions to dominate the takeout industry over that time frame, accounting for nearly 80% of all transactions by the end of 2017.

Yum China management recently noted that both KFC and Pizza Hut Casual Dining are listed as major online ordering platforms, but these services account for a very small percentage of the brands' sales at the moment (2% of sales for both). Pizza Hut Home Service generates roughly 30% of its sales from the online aggregators, bringing total Yum China sales derived from online aggregators to less than 5%.

While we expect this channel to remain a disruption to the Pizza Hut Casual Dining brand over the near term, we share management's views that channel shifting could ultimately provide a meaningful tailwind for Pizza Hut Casual Dining in not only China but also many other emerging markets, as customers become accustomed to online ordering platforms (including Pizza Hut Home Service) and one-to-one digital marketing efforts become more pervasive. We also appreciate management's balanced approach to participating with the ordering aggregators, taking preventative measures and structuring arrangements with Pizza Hit Casual Dining and KFC to ensure that they retain customer transaction data from online orders and have a say regarding how the brands are presented on the various platforms. We believe that this customer data will be vital in one-to-one marketing efforts and that it will keep customer orders coming in on Pizza Hut Home Services' own ordering platforms, as opposed to those of the aggregators.

Given its dual threat as a preferred brand for the online aggregating services and its own delivery capabilities (Pizza Hut Home Services), we believe Yum is one of the best-positioned restaurant companies to capitalize on consumers' increasing comfort with placing restaurant orders online.

Yum China Offers Compelling Long-Term Growth and Margin Expansion Opportunities We think management's long-term unit growth target in China of 20,000-plus units is realistic, representing 14 restaurants for every million people in China's population today, versus 57 restaurants per million in the U.S. Management's target of opening 600 new restaurants in China during 2016 is a modest deceleration from the 660 the segment had averaged during the past three years, but in our view, this target appropriately balances macroeconomic uncertainty in the region and more-attractive real estate/leasing terms.

Our model assumes that Yum's China division expands to 14,100 units by the end of 2025, benefiting from a highly fragmented restaurant industry and several other factors, including the potential doubling of China's consuming class over the next five years, rapid urbanization, and changes to government regulation. Our estimates are consistent with management's target of seven units for every million individuals in China, or approximately 10,500 units, based on United Nations' 2020 population forecast for China of 1.4 billion individuals.

We believe the unit growth potential is broad-based across the brand portfolio, with KFC (5,900 units at present) and Pizza Hut (1,900 units) representing the bulk of near-term growth and Pizza Hut Home Service and other concepts (East Dawning and Little Sheep) becoming more meaningful contributors in the later years of our explicit forecast period. Beyond our 10-year explicit forecast period, we believe Yum could ultimately expand to more than 20,000 traditional-format restaurants in China, comprising roughly 15,000 KFC locations and 5,000-plus Pizza Hut Casual Dining and Home Service units. Ultimately, this unit target could also be increased through non-traditional-format openings, including restaurants at major transportation hubs. It will take time to rebuild KFC's brand reputation in China following recent negative publicity tied to poultry suppliers and avian flu concerns. However, we remain optimistic about Yum's China growth potential because of local site-development teams and a wholly owned distribution system. Yum can fully access lower-tier Chinese cities at a time when most rivals are limited to major coastal urban centers.

With expectations of mid- to high-single-digit net unit growth, low- to mid-single-digit comps, subfranchising opportunities, systemwide sales growth in the high single digits, and modest general and administrative expense leverage, we believe management's longer-term Yum China division goals (20% restaurant margins and 15% annual operating income growth) are achievable over a 10-year horizon. Given this, along with the company's ability to repurchase shares as a stand-alone entity, our model is aligned with Yum China's annual earnings per share growth target of 15%, at least over the next several years.

Although we plan to publish our official economic moat and risk ratings and fair value estimate for Yum China closer to the actual separation transaction date in late 2016, for the purpose of this analysis, we assume that Yum China will be assigned a wide moat (backed by its strong brand intangible asset, the franchise system that we expect to develop over the next few decades via subfranchising, and significant economies of scale in the region), resulting in a 10-year period beyond our explicit forecast of excess economic returns. Given our expectation that Yum China will remain debt-free for the foreseeable future, we assume a slightly higher weighted average cost of capital than for the stand-alone Yum Brands, derived solely from our 9% cost of equity assumption (the rate Morningstar assigns to all companies with an average systematic risk profile). Our Yum China model implies a slightly higher Stage II EBI growth assumption than our estimates for the consolidated company (9% versus 6%), given expected unit growth potential and same-store sales drivers.

Based on these assumptions (which include the license fee of 3% of KFC and Pizza Hut system sales paid to Yum Brands), we've arrived at a preliminary stand-alone valuation of $41 per share for Yum China, although this is still subject to the completion of the separation transaction and a formal moat rating review.

We Remain Optimistic About the Yum China Spin-Off and Leverage Recap The company decided that turning Yum China into a trademark license franchisee that pays 3% of system sales from KFC, Pizza Hut Casual Dining, Pizza Hut Delivery, and (in the future) Taco Bell was the optimal corporate structure solution. We agree. The 3% license fee is lower than the 4%-5% typically collected under a traditional franchisee relationship but is comparable with other publicly disclosed retail licensing agreements in China and, coupled with the lack of an initial royalty fee, should encourage greater unit development while opening up the possibility of cash flow returned to Yum China shareholders, even in the first year as a stand-alone company.

By spinning off Yum China into a license franchisee, Yum Brands will move to 96% franchise ownership but with a more diversified and stable cash flow profile. The new structure will move China from 32% of Yum Brands' current operating profit to approximately 14%, providing the new Yum Brands with greater geographic diversity and stability.

As a stand-alone company, Yum China boasts a compelling long-term growth story that will be enhanced by its debt-free capital structure and the management team's ability to focus on the company's growth aspirations and operational improvements.

This transaction will also allow Yum Brands to take leverage to 5 times trailing 12-month EBITDA, in line with other heavily franchised quick-service restaurant peers, while keeping Yum China debt-free for greater financial flexibility. With the extra debt incurred, management plans to return $6.2 billion to shareholders before the transaction takes place in late 2016.

A few details regarding the separation of Yum China still need to be ironed out, but for the time being, management is planning to offer shareholders one share of Yum China for every share of Yum Brands they hold. Both companies are expected to be domiciled and listed in the U.S., though management may also explore a Hong Kong dual listing at some point in the future. Yum China is expected to have a 26% effective tax rate (or 31% if its excess cash is repatriated to the U.S.), while Yum Brands is expected to have a 26%-27% tax rate.

We Don't Expect Yum China Separation to Affect Our Wide Moat Rating Yum China is a mostly self-contained supply chain, distribution, site selection, and advertising ecosystem, and incremental costs incurred by Yum China as a stand-alone company will effectively be offset by reductions at Yum Brands. In our view, Yum has built a wide-moat business in the region through several virtues: its portfolio of strong brand intangible assets; a wholly owned supply chain and distribution system; a proprietary real estate database for approximately 1,000 Chinese cities; more than 1,300 development personnel across the region; and a deep management pipeline with more than 8,000 recruits.

Additionally, we believe that the 2014 restructuring of Yum Brands under its different brands on a global basis--as opposed to its previous structure based on geographies--has helped to sharpen the focus of the different brand-management teams (KFC outside China, in particular) and made these segments less dependent on Yum China. Based on the brand reorganization and Yum China's status as a mostly self-contained supply-chain, distribution, site-selection, and advertising ecosystem, we believe a separation will create only minimal disruption from an operating perspective, without sacrificing meaningful scale.

In most developed nations in North America and Europe, restaurant chains rely on food distributors like Sysco and US Foods to ensure that food is handled properly, from suppliers to restaurant locations. Because China lacked reputable food distributors when the company entered the country, KFC had to develop its own distribution infrastructure, which now encompasses almost 20 logistics facilities, a national consolidation center, and approximately 500 refrigerated trucks. We believe that this endeavor, while costly, was critical for Yum's rapid expansion in the region, allowing for greater menu flexibility and variability. Despite two well-publicized supplier-related incidents in China in 2012 and 2014, we believe Yum's supply chain and distribution network are unrivaled among restaurant operators in the region and are a competitive strength, playing a key role in our proposed wide moat rating for Yum China.

Yum China's products are largely sourced locally (save for certain herbs and spices), which we believe helps to keep costs manageable, positions KFC and Pizza Hut as more "authentic" Chinese brands (despite their obvious Western roots), and strengthens the company's relationships with national and regional government officials. We also believe that Yum China's 2014 program--which featured a broad-based evaluation of the company's entire supply chain, the elimination of more than 1,000 smaller poultry farms in the system, greater food testing at the supplier level, and increased food-safety marketing efforts--helped to fortify the company's supply chain while maintaining its cost advantage moat source.

Yum China's site-selection process, including state-of-the-art site-selection mapping tools and more-flexible go-to-market restaurant and drive-thru buildout strategies, should facilitate the company's unit openings in the country and also have potential applications across the globe. We believe these site-selection tools--in addition to strong relationships with lenders and real estate developers --will be critical when Yum China looks to be more aggressive with subfranchising, something that we expect to become more pronounced over the next 10 years and that plays a role in our longer-term operating margin assumptions.

We believe the company's personnel-development capabilities in China are second to none, promoting a culture where new hires work side by side with experienced ones in established outlets once trained, before moving to new locations. We believe the benefits of Yum China's personnel development are twofold: teaching employees how to interact with customers (and by extension improving the guest experience) and grooming a pipeline of potential managerial and executive talent in the region. We believe these strengths would take significant time and capital for other restaurant competitors to replicate.

New Yum Brands Also Offers Compelling High-Growth Investment Opportunity China gets much of the focus as Yum's single-largest operating profit contributor, but we also see evidence that the consolidation of the KFC, Pizza Hut, and Taco Bell brands at the global level (excluding China and India) is having a positive influence systemwide. Taco Bell remains one of the top innovators in the quick-service restaurant space, and we believe the success of its daypart expansion, mobile engagement, marketing, and product development can have a positive influence across the other brands in the system. As these efforts gain traction, we forecast average unit volume improvement, same-store sales growth, and margin expansion across Yum Brands' underperforming segments.

We also expect several European markets (including France, Germany, and Russia) and emerging economies (such as India, Indonesia, Malaysia, Vietnam, the Philippines, and several African markets) to become increasingly vital drivers of long-term cash flow. While Yum's U.S. operations have experienced mixed results over the past five years amid fierce competition and uneven execution, we believe the company has found a blueprint for sustainable growth through streamlined operations, enhanced value, exterior and interior reimaging, and new menu innovations. Our base-case assumptions call for 19,500 KFC division units by the end of 2025 (compared with 14,600 at the end of 2015, representing roughly 3% annual growth), 17,600 Pizza Hut division locations (versus 13,000 at present, representing 5% annual growth), and 9,000 Taco Bell division units (up from 6,400 today, or almost 4% annual growth).

The Yum China separation transaction will better allow investors to focus on Yum's other markets, which have not received the level of credit they deserve from the market since moving to the brand organization structure at the beginning of 2014. The company has several objectives focused on making the brands easier for consumers to deal with, which underpin our positive long-term outlook for the post-separation Yum Brands. These include greater leverage of social media to drive food innovation, increased use of digital ordering and marketing efforts, and expanded urban market and delivery solutions.

Consolidating our outlooks for the KFC, Pizza Hut, and Taco Bell brands over the next 10 years, we forecast average annual systemwide sales growth of approximately 5%, revenue growth of 4% (which falls below our systemwide sales expectations owing to refranchising at KFC and Pizza Hut), restaurant margins improving from 16% in 2015 to 20% in 2025, and operating margins moving from around 19% in 2015 to the mid-30s by 2025 (again helped by refranchising efforts) for the post-separation Yum Brands.

Our moat rating is subject to review, but for the purposes of this analysis, we assume that the new Yum Brands will also have a wide moat rating, resulting in a 10-year period of excess economic returns beyond our explicit forecast period. Based on management's plans to add $6 billion in incremental debt to Yum Brands during the first half of 2016 and target a blended rate of 5.25% for the entire post-separation debt portfolio--which strikes us as realistic based on current credit market conditions--we assume a moderately lower weighted average cost of capital assumption (8%) than our assumption for the stand-alone pre-separation Yum Brands (8.6%).

Using these assumptions, we arrive at a stand-alone discounted cash flow-derived valuation of $64 per share for the new post-separation Yum Brands. While the total of our stand-alone valuations for Yum China ($41) and Yum Brands ($64) exceeds our current $92 fair value estimate by $13 per share, roughly $11 of the difference can be explained by the "double counting" of the 3% licensing fee paid to Yum Brands from Yum China, with the remaining $2 chalked up to changes in our weighted average cost of capital assumptions based on the new capital structures of each stand-alone company. However, we will wait until Yum Brands' new financing package is in place before making any adjustments to our current consolidated fair value estimate.