Yum China Holdings, Inc. annual report, FY2017

Yum China Holdings, Inc. — 2017 Form 10-K

Reporting period: Fiscal year ended December 31, 2017. This is an annual filing; fourth-quarter figures are included below where relevant. Amounts are U.S. dollars unless stated otherwise.

Business context and reporting period

Yum China operates KFC, Pizza Hut, East Dawning, Little Sheep and Taco Bell restaurants in mainland China, and acquired a controlling interest in delivery platform Daojia in 2017. It reported 7,983 system restaurants at year-end, including 6,307 company-operated units, 891 operated by unconsolidated affiliates and 785 franchised units. The company separated from Yum! Brands in October 2016, so 2016 comparisons include pre-separation combined results and may not be fully comparable with 2017 as an independent public company.

Financial and operating highlights

Metric	2017	2016
Total revenue	$7,144 million	$6,752 million
Operating profit	$785 million	$640 million
Net income attributable to Yum China	$403 million	$502 million
Diluted EPS	$1.01	$1.36
Adjusted net income	$564 million	$472 million
Adjusted diluted EPS	$1.42	$1.28
Adjusted EBITDA	$1,249 million	$1,127 million
Operating cash flow	$884 million	$866 million
Capital spending	$415 million	$436 million

Revenue increased 6% as reported (8% excluding foreign-exchange effects); system sales increased 6% reported and 8% excluding foreign exchange. Same-store sales grew 4% overall, 5% at KFC and 1% at Pizza Hut.
Restaurant profit was $1,173 million; restaurant margin rose to 16.8% from 15.3% in 2016. Management attributed improvement to sales growth, operating efficiencies and the VAT retail-tax reform benefit, partly offset by wage, promotion and commodity costs.
KFC revenue was $4,998 million and operating profit $807 million. Pizza Hut revenue was $2,092 million and operating profit $157 million. All Other Segments recorded an operating loss of $5 million.
Fourth-quarter revenue was $2,228 million versus $1,978 million a year earlier; operating profit was $71 million versus $58 million. Net income attributable to Yum China was a loss of $90 million, or diluted loss per share of $0.23, versus income of $88 million and diluted EPS of $0.23 in Q4 2016.

Liquidity, cash flow and capital

At year-end, cash and cash equivalents were $1,059 million and short-term investments were $205 million. Current assets were $1,802 million against current liabilities of $1,017 million.
Total liabilities were $1,399 million. The company reported $28 million of capital lease obligations; it had RMB1.7 billion (approximately $261 million) of credit facilities, fully available at year-end. The filing does not identify outstanding borrowings under those facilities.
Cash flow from operations of $884 million exceeded capital spending of $415 million. Investing activities used $557 million, including investment purchases and the Daojia acquisition; financing activities used $185 million, including $128 million of share repurchases and $38 million of dividends.
Operating lease commitments totaled $3,120 million, including $481 million due within one year. The company expected lease-accounting changes to materially affect its balance sheet upon adoption.
The board authorized a $550 million repurchase program; $128 million had been used and $422 million remained at December 31, 2017. The company paid a $0.10-per-share dividend in December and declared another $0.10 dividend in February 2018.

Material changes and unusual items

Reported net income fell 20% year over year, principally because the company recorded a provisional $163.9 million tax expense from the U.S. Tax Act. This included an estimated $129.8 million transition tax on deemed repatriation, $4.5 million from deferred-tax remeasurement and a $29.6 million valuation allowance. Excluding the tax charge, management said 2017 net income increased 24% excluding foreign exchange.
The reported effective tax rate rose to 47.0% from 23.5%; the adjusted effective tax rate was 26.9%. The Tax Act calculations were provisional and could be revised during the permitted measurement period.
Management cited the Chinese VAT reform, effective for the restaurant sector from May 2016, as a contributor to margin gains. A $176 million input VAT credit asset was recorded at year-end; recovery depends on future taxable activity and estimates.
Daojia was acquired during Q2 for $36.7 million cash consideration plus a $25 million capital contribution. It contributed less than 1% of 2017 revenue; its China internet-delivery operations include a VIE structure whose enforceability and regulatory treatment are uncertain.
Pizza Hut Casual Dining and Home Service were combined into one reportable segment in 2017; comparative segment data were recast without changing consolidated results. Pizza Hut achieved its first positive same-store sales growth since 2013, according to management.

Outlook, management commentary and risks

Management’s strategy emphasizes new-unit growth, stronger same-store sales, product and digital innovation, delivery, remodels and improved unit economics. The company opened 691 net new units in 2017 and intends to increase the franchise-owned share over time; roughly 10% of restaurants were franchised at year-end. The filing provides no specific numerical earnings or revenue guidance.

Key operating risks include food safety incidents, supplier disruptions, commodity and labor inflation, increased competition, restaurant-site availability, lease renewals and the possibility that new units underperform or cannibalize existing sales.
Substantially all operations and earnings are in China. Currency movements, government controls on remittances, evolving regulation and consumer or economic slowdowns could affect results and the parent company’s access to cash. A 10% RMB weakening was estimated to reduce 2017 operating profit by approximately $77 million, assuming no other changes.
The company pays Yum! Brands a license fee equal to 3% of net system sales for licensed brands. Termination or limitation of the master license, or failure to meet brand standards, could materially affect the business.
A Chinese national transfer-pricing audit covers related-party transactions for 2006–2015. The potential assessment, including interest and penalties, could not be estimated; the company said significant developments were reasonably possible within 12 months.
Other material exposures include potential indemnification obligations related to the spin-off and Chinese indirect-transfer tax, statutory restrictions on China-subsidiary distributions, and the Daojia VIE’s regulatory status. No material legal proceedings were reported at year-end; management said existing matters were not expected to have a material adverse effect.
Management and the auditor concluded internal control over financial reporting was effective at year-end; Daojia was excluded from the assessment because it was immaterial. CEO Micky Pant was scheduled to transition to senior adviser and vice chairman on March 1, 2018, with Joey Wat succeeding him as CEO.

Important facts for investors to verify

Reconcile reported and adjusted earnings, especially the provisional $163.9 million Tax Act charge and any subsequent revisions.
Track the transfer-pricing audit, the $176 million VAT credit’s recoverability, and the final tax treatment of the spin-off and indirect transfers.
Assess whether KFC and Pizza Hut can sustain same-store sales growth and margins amid wage inflation, promotions, commodity volatility and competition.
Review Daojia’s integration, contribution to delivery growth and exposure arising from its VIE arrangements.
Evaluate cash access and distributions from China, currency sensitivity, lease obligations and the effect of future lease-accounting adoption.
Confirm actual debt outstanding, repurchase activity, dividend capacity and the comparability limits of pre-separation financial results.