Yum China Holdings, Inc. — Q1 2018 Form 10-Q
Business context and reporting period. The filing covers the three months ended March 31, 2018, compared with the three months ended March 31, 2017; prior periods were recast to align with the company’s new calendar-quarter fiscal year. Yum China operated 8,112 restaurants, primarily KFC and Pizza Hut, across China. Unless noted otherwise, financial amounts below are in US$ millions.
Financial performance
| Metric | Q1 2018 | Q1 2017 | Change / context |
|---|---|---|---|
| Total revenues | $2,221 | $1,926 | +15% |
| Company sales | $2,016 | $1,738 | +16% reported; +7% excluding foreign exchange |
| Operating profit | $395 | $296 | +33%; includes a $98 Wuxi KFC remeasurement gain |
| Adjusted operating profit | $297 | $296 | Excludes the remeasurement gain |
| Net income attributable to Yum China | $288 | $204 | +41% |
| Diluted EPS | $0.72 | $0.52 | Adjusted diluted EPS: $0.53 vs. $0.52 |
| Restaurant profit / margin | $361 / 17.9% | $354 / 20.4% | Margin down 2.5 percentage points |
| Adjusted EBITDA | $417 | $396 | As defined by the company |
| Operating cash flow | $551 | $336 | Increase attributed mainly to higher net income and inventory-payment timing |
| Capital spending | $111 | $112 | Investing cash outflow was $267, including the Wuxi acquisition |
Segments and operating indicators. KFC system sales grew 9% excluding foreign exchange, same-store sales grew 5%, and operating profit rose 21% to $296. Pizza Hut system sales declined 1% excluding foreign exchange, same-store sales declined 5%, and operating profit fell 61% to $34; its restaurant margin declined to 10.5% from 19.7%. Total system sales grew 6% excluding foreign exchange and same-store sales grew 3%. Company restaurant count increased 6% year over year to 8,112 total units across company-owned, franchise and unconsolidated-affiliate locations.
Balance sheet, cash and liquidity
- At March 31, 2018, cash and cash equivalents were $1,318 and short-term investments were $276, versus $1,059 and $205, respectively, at year-end 2017.
- Total current assets were $2,121 and current liabilities were $1,220. Total assets were $4,894; total liabilities were $1,691.
- The filing reports $29 of capital lease obligations and no outstanding borrowings under its credit facilities. Available facilities totaled approximately $339, with terms of one to three years.
- Cash increased by $259 during the quarter. Investing activities used $267; financing activities used $51, including $39 of dividends paid.
- Management said existing cash and expected operating cash flow should be adequate for operations and anticipated capital expenditures over the next 12 months. The company had no credit rating and noted that future capital-market access is not assured.
Material changes, outlook and risks
- Wuxi KFC acquisition: Yum China acquired an additional 36% interest, raising ownership to 83% and bringing the business into consolidation. The transaction generated a $98 noncash remeasurement gain on its previously held interest; the gain accounts for much of the reported operating-profit increase. The acquisition was described as immaterial.
- Operating trends: Management attributed company sales growth, excluding foreign exchange, to same-store sales gains and unit growth. KFC benefited from sales growth, while Pizza Hut faced same-store sales declines and higher promotion, product-upgrade and wage costs. Wage inflation was cited at 5% for KFC and 6% for Pizza Hut.
- Accounting and comparability: The company adopted ASC 606 retrospectively. It now recognizes franchise upfront fees over the franchise term and presents certain franchisee transactions gross as principal; the change did not materially affect net income. The company also changed to four calendar quarters, recasting prior periods.
- Tax and contingencies: The effective tax rate was 26.6%, down from 30.0%, primarily due to less estimated repatriation of current-year earnings to the U.S. A Chinese transfer-pricing audit covering 2006–2015 could result in additional tax, interest and penalties; the potential impact could not be reasonably estimated. A potential Chinese indirect-transfer tax related to the separation from Yum! Brands could also be significant, with allocation governed by the tax matters agreement. The company had approximately $2 million of franchisee guarantees outstanding.
- Other risks: The company cited exposure to RMB movements, food-cost volatility, Chinese regulatory and tax uncertainty, labor costs, competition, food safety, and dependence on its China operations and brand-license arrangements. A 10% RMB weakening was estimated to reduce quarterly operating profit by approximately $37 million, assuming no other changes.
- Outlook and capital returns: No specific earnings or sales guidance was provided. Management described expected cash resources as sufficient for the next 12 months. The board declared a $0.10-per-share dividend payable in June 2018; a $550 million share-repurchase authorization remained in place, with no shares repurchased in the quarter.
- Future accounting: The company expects adoption of the lease standard in Q1 2019 to materially affect its balance sheet, principally through recognition of right-of-use assets and lease liabilities. Future minimum operating-lease payments were approximately $3 billion at March 31, 2018.
Important facts for investors to verify
- Separate the $98 million Wuxi remeasurement gain from recurring performance: adjusted operating profit was essentially flat year over year.
- Track whether Pizza Hut’s same-store sales and restaurant margin recover, and whether KFC’s growth can offset higher operating costs.
- Assess the eventual outcomes and potential cash exposure from the Chinese transfer-pricing audit and the indirect-transfer tax matter.
- Review the scale and timing of lease liabilities expected under the new lease standard, given approximately $3 billion of operating-lease commitments.
- Monitor RMB sensitivity, VAT-credit recoverability (a $189 million input VAT asset), and the company’s capacity to fund dividends, investment and growth without borrowing.