Yum China Holdings, Inc. quarterly report, Q2 FY2018

Yum China Holdings, Inc. — Q2 2018 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2018. Amounts are in U.S. dollars unless stated otherwise. Yum China operated 8,198 restaurants, primarily KFC and Pizza Hut, in mainland China. Comparisons below use recast prior-period results following the company’s fiscal-calendar change.

Financial performance

Metric	Q2 2018	Q2 2017	Six months 2018	Six months 2017
Total revenue	$2.068bn	$1.841bn	$4.289bn	$3.767bn
Operating profit	$193m	$171m	$588m	$467m
Net income attributable to Yum China	$143m	$125m	$431m	$329m
Diluted EPS	$0.36	$0.31	$1.08	$0.83
Operating cash flow	Not provided for quarter	Not provided for quarter	$819m	$604m

• Q2 revenue rose 12% as reported and 5% excluding foreign-exchange effects; first-half revenue rose 14% and 5%, respectively. Company sales increased 13% in Q2 and 15% year to date as reported, or 6% in both periods excluding FX.
• Q2 operating profit increased 13% as reported and 5% excluding FX. First-half operating profit increased 26% reported and 16% excluding FX. The first-half result included a $98m noncash gain from remeasuring the previously held Wuxi KFC interest; excluding that gain, adjusted operating profit was $490m, up from $467m.
• Restaurant margin fell to 15.1% from 16.6% in Q2 and to 16.6% from 18.5% year to date. Management cited promotion and product-upgrade costs and wage inflation. Company restaurant wages were affected by reported wage inflation of 6% year to date.
• KFC Q2 system sales grew 5% excluding FX and same-store sales were flat; operating profit rose 2% excluding FX. Pizza Hut same-store sales declined 4%, and operating profit fell 52% excluding FX. First-half Pizza Hut same-store sales declined 5% and operating profit fell 58% excluding FX.
• Q2 basic EPS was $0.37 versus $0.32; first-half basic EPS was $1.12 versus $0.85. First-half adjusted diluted EPS was $0.89 versus $0.83, excluding the after-tax Wuxi remeasurement gain.

Cash, liquidity and capital

• At June 30, cash and cash equivalents were $1.261bn and short-term investments were $278m, compared with $1.059bn and $205m at year-end 2017. Current assets were $2.093bn and current liabilities $1.206bn.
• First-half operating cash flow was $819m; investing cash outflow was $406m, including $230m of capital spending and $88m net cash paid for the Wuxi acquisition. Financing cash outflow was $186m, including $77m in shareholder dividends and $70m in share repurchases. Cash increased by $202m to $1.261bn.
• Total liabilities were $1.629bn. Reported capital lease obligations were $27m; the filing reports no outstanding borrowings at June 30 and says the then-existing $327m of credit facilities was fully available. A further $100m offshore facility was agreed on August 1, 2018.
• The company declared and paid two 2018 dividends of $0.10 per share each during the first half; a further $0.10 dividend was declared August 1, payable in September. The company repurchased 1.9m shares for $73m year to date; $349m remained under its authorization at June 30.

Changes, outlook and risks

• In Q1, Yum China acquired an additional 36% of Wuxi KFC for approximately $98m, raising ownership to 83% and bringing the business into consolidation. The remeasurement gain materially increased reported first-half profit.
• Management said existing cash and expected operating cash flow should fund operations and anticipated capital expenditures for the next 12 months. The filing provides no specific earnings or revenue guidance.
• More than 6,600 restaurants were operated in leased premises. Future minimum operating-lease payments were approximately $3bn at June 30. The company expects the forthcoming lease-accounting standard to materially affect its financial statements, principally by recognizing lease assets and liabilities.
• Management identified ongoing uncertainty from a Chinese tax-authority transfer-pricing audit covering 2006–2015; any assessment, interest or penalties could be material, and the potential impact could not be estimated. A separate potential Chinese indirect-transfer tax relating to the separation from Yum! Brands could also be significant; the tax matters agreement allocates the exposure between the companies.
• The company reported a $197m input VAT credit asset and had not recorded an allowance, expecting future utilization. Recoverability depends on operating results and capital spending. Management also noted uncertainty in local VAT interpretation and potential quarter-to-quarter variation in benefits.
• Most operations and assets are RMB-denominated. The company estimated that a 10% RMB weakening would reduce Q2 operating profit by approximately $18m, assuming no changes in volumes or local-currency prices. Food-cost volatility, wage inflation, competition, food safety, and China-specific regulatory and operating risks are also highlighted.
• ASC 606 was adopted retrospectively from January 1, 2018. It changed upfront franchise-fee recognition to recognition over the franchise term and changed certain franchisee transactions to gross revenue and expense presentation, with no significant net-income impact. The filing says prior periods were recast; assess reported revenue comparisons with this presentation change in mind.

Important facts for investors to verify

• How much of reported first-half earnings growth persists after excluding the $98m Wuxi remeasurement gain, and how Wuxi’s ongoing results contribute after consolidation.
• Whether Pizza Hut’s same-store sales and margin declines stabilize, and whether promotion costs and wage inflation continue to pressure restaurant margins.
• The outcome and possible financial exposure from the SAT transfer-pricing audit and the separation-related indirect-transfer tax indemnity.
• The recoverability and timing of use of the $197m VAT credit asset, and the eventual balance-sheet impact of recognizing operating leases.
• How RMB movements, restaurant expansion, capital spending, dividends and repurchases affect cash generation and liquidity.