Yum China (Part 3): The Future of Yum China

In Part 1 of our Yum China series, we introduced the history and business portfolio of Yum! Brands' China-based spin-off, Yum China, while in Part 2 we examined the company's financial metrics and performance of individual restaurant segments. In this final installment of the series, we discuss management's plans for and key considerations to keep in mind regarding Yum China's future.


Note: we recommend reading Part 1 for context before reading this article


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General Strategies

Management's general strategies for Yum China going forward relate to the execution of the company's value proposition, namely to "[offer] appealing, tasty and convenient food at great prices". These strategies include continued product innovation and the expansion of omni-channel retail, a dedicated focus on delivering value-for-money products and promotion campaigns, as well as a commitment to making continued investments and advancements in digitalization in order to enhance customer convenience and boost consumer loyalty. With these strategies and company-specific strategies discussed in the next section, management aims to grow Yum China's restaurant network to 20,000 stores or more (from 11,788 as of December 2021), both through expanding the company's own-store system and by seeking third-party franchise opportunities.


Product Innovation and Omni-Channel Retail

Yum China has always focused greatly on developing new recipes and menu items to keep existing customers interested and attract new consumers. Going forward, management plans to continue investing in product innovation, with a particular emphasis on catering to local consumer tastes in different regions (food preferences can vary significantly across different regions in China, with certain regions preferring spicy, salty, sweet, or bland), as well as offering a wider range of product options according to different day-part themes (e.g. afternoon tea and late night street food) and targeting different price points (e.g. affordable vs. premium beef burgers and pizzas).


Pizza Hut DayPart Menu
Example of Pizza Hut Menu By Day-Part (Source: Yum China)

Yum China is also broadening its retail channels not only through supporting the rise in food delivery demand as a result of the pandemic, but also by developing convenient ready-to-eat and ready-to-cook hot meals that can be easily consumed at home or in the workplace.


Pizza Hut Omni-Channel Retail Strategy
Pizza Hut Omni-Channel Retail Strategy (Source: Yum China)

Yum China New Retail Products
Yum China - New Retail Products (Source: Yum China)

Value-For-Money Products and Promotion Campaigns

In line with the company's value proposition, Yum China will continue to emphasize and deliver value-for-money products to consumers through the continuation of its KFC and Pizza Hut value campaigns (which were well-received by customers in the past), by expanding the brand's offerings of value combos and buckets for KFC, and by revamping Pizza Hut's menu to include more affordable but innovative food options.


KFC Value Campaigns
KFC Value Campaigns (Source: Yum China)

Pizza Hut New Food Products
Examples of Pizza Hut's New Affordable But Innovative Food Products (Source: Yum China)

Wagyu beef, abalone (Chinese: 鲍鱼), and hairy crab (Chinese: 大闸蟹) are generally considered to be expensive, premium ingredients more commonly found in high-end restaurants.



We think the concept of value-for-money will play an increasingly important role for Yum China going forward. When Yum! Brands first entered the mainland Chinese market in 1987, the average disposable income in China was only RMB1,002, while western food was considered exotic and was almost nowhere to be seen, allowing Yum China to position its brands at a relative premium. However, fast forward 34 years, the average income level in China has risen by 35 times to RMB35,128 in 2021, while rapid urbanization and globalization has filled the country's cities with a myriad of Chinese and international food options across all price points. As KFC and Pizza Hut lose their unique exotic appeal in an increasingly competitive industry, the two brands are becoming perceived as just another affordable food option amongst many to choose from, pushing Yum China to compete based on the relatively low-margin strategy of value-for-money.


Average Disposable Income in China
Data Source: National Bureau of Statistics (click image to enlarge)

Note: the National Bureau of Statistics only reports one national average figure from 2019 onwards without providing an urban versus rural breakdown


Although Yum China does have middle tier restaurants Huang Ji Huang and Little Sheep, neither of the two contribute significantly to total revenue. Looking at the company's coffee initiatives, K-Coffee has gained popularity over recent years through its value-for-money business model, while the performances of emerging COFFii & JOY (which targets the affordable to middle tier market) and Lavazza (which targets the premium market) remain to be seen. We discuss these brands further in the section below.


Embracing Digitalization

One of Yum China's strongest competitive edges thus far is the company's continual efforts to provide a convenient and streamlined ordering and payment process for consumers through the adoption of digital technology. These efforts include the adoption of mobile pre-ordering services via the company's brand applications and embedded WeChat mini programs (essentially a mini application accessible within the WeChat application), as well as the use of standalone digital ordering kiosks (where customers can order using a machine without the need to queue and wait for a cashier to take their orders) and digital table-side ordering (where customers can scan a QR code at their table to place an order). Moreover, Yum China also collaborates with AliPay and WeChat Pay, China's two dominant digital payment processors, to facilitate convenient mobile payments for consumers, with 1,600 KFC stores also supporting facial recognition payments (where AliPay users can use their phones or cameras at the cashier counter to scan their faces as a payment verification method as opposed to inputting a pin or fingerprint scanning).


In 2021, digital orders accounted for 86% of KFC and Pizza Hut company sales, while digital payments comprised 98% of total company sales. We expect management to continue ramping up Yum China's digitalization initiatives to maintain a competitive edge as competition in the quick service restaurant (QSR) space continues to intensify. Additionally, Yum China has been and is planning to continue utilizing its applications and mini programs to enhance customer loyalty by promoting membership subscription programs and privileges that are intended to increase the frequency of spending and average amount spent per receipt at the company's restaurants. As of the end of 2021, KFC and Pizza Hut had 360 million members with member sales accounting for 60% of the two brands' total system (i.e. Yum China operated and franchised) sales.


Brand-Specific Strategies

We now turn to look at management's additional restaurant-specific strategies for each brand.


KFC

As Yum China's most significant and growing revenue driver, management plans to increase KFC's penetration of China's lower tier cities in line with the country's continuing rise in urbanization and income. Currently, KFC has a presence in over 1,600 Chinese cities*, although management believes there are still 1,100 more cities where potential entry looks attractive. As part of the expansion process, Yum China is rolling out smaller store formats that not only meet the lower demand levels of lower tier cities, but can also be used to expand more flexibly in higher tier cities that already have KFC presence. Moreover, smaller stores are imperative to reducing costs, an increasingly important financial factor as Yum China faces declining margins while pursuing its value-for-money strategy.


*Yum China does not use the same definition of "city" as the official definition (see further explanation in Part 1)


Pizza Hut

Since 2017, Yum China has been trying to revitalize Pizza Hut as the brand declined in popularity over preceeding years. Specifically, management attempted to re-position Pizza Hut as a family-friendly, modern and value-for-money restaurant that offers a variety of pizza and premium food products at relatively affordable price points.


Based on our financial analysis in Part 2, the revitalization plan does not seem to be particularly effective thus far, especially considering the brand's mediocre 2021 sales in spite of China's COVID-free economic normality that year.


Taco Bell

Although Taco Bell has been in China since the end of 2016, the brand has not gained very much traction. Hence, management's plan going forward is to make the Taco Bell brand more relevant to Chinese consumers.


Huang Ji Huang and Little Sheep

Given East Dawning's impending closure (see Part 1), Huang Ji Huang and Little Sheep will be the only two remaining restaurants in Yum China's Chinese dining business segment. Both restaurants were particularly hard-hit during the COVID-19 pandemic given their greater reliance on dine-in (since hot pot and simmer pot dishes are typically and more conveniently consumed in-store, see Part 1), while Little Sheep had also already been declining in popularity for many years leading up to the pandemic. Management plans to "strengthen the fundamentals" of Huang Ji Huang and Little Sheep to revive and grow the company's Chinese dining segment going forward.


Given Little Sheep's long term decline, we think it will be challenging to revive the brand again even after the COVID-19 pandemic is over. While selling pre-packaged hot pot seasoning and condiments may still be a viable business for the brand to continue, it could be difficult for such a business to grow to a very large scale given that most Chinese consumers prefer eating hot pot in-store rather than buying the ingredients to cook from scratch at home.


K-Coffee, COFFii & JOY, and Lavazza

Management believes Yum China's coffee initiatives will be a key source of growth for the company going forward. Although China's older generation typically gravitates towards tea, a significant number of young working age consumers are adopting a coffee culture thereby fueling the growth of country's coffee market. Thus far, affordable K-Coffee dominates Yum China's coffee shop segment with 170 million cups sold in 2021, while management is still in the process of refining middle tier COFFii & JOY's business model and building brand awareness for premium joint venture Lavazza coffee shops. As of June 2021, there were more than 7,000 K-Coffee stores across China, in addition to 36 COFFii & JOY stores and 58 Lavazza stores as of year end 2021.


Given the highly competitive nature of the coffee shop industry, we don't anticipate Yum China to have much leeway in terms of pricing, and it is likely that COFFii & JOY will have to pursue a business model similar to those of Yum China's core businesses, i.e. a relatively value-for-money oriented strategy with smaller store formats and lower margins, with at most mid-tier (as opposed to affordable) positioning in terms of pricing. Management also mentions their goal to grow the number of premium Lavazza shops to 1,000 by 2025, although we think this growth rate will be difficult to sustainably accomplish (i.e. without shutting down some of the 1,000 stores in the future).


Concluding Yum China

More than thirty years ago, Yum China (under Yum! Brands) was a key pioneer of western food in China with the launch of the country's first KFC and Pizza Hut stores. Fast forward 35 years, Yum China is now a mature business in a country brimming with local and foreign food choices at all price points. Although Yum China's total revenue and number of stores are still rising, the company's operating income (adjusted for equity re-measurement gains, see Part 1) and cash flows do not share the same upwards growth trajectory, as competitive forces in the food and beverage industry continue to exert downwards pressure on profit margins. In spite of China's COVID-free setting in 2021, Yum China's performance was less than stellar, and it remains to be seen whether or not management will be able to effectively rebound and/or succeed with new growth points once the pandemic is fully over.

 

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