Yum China Holdings, Inc. — Q3 2018 Form 10-Q
Reporting period: Quarter and year to date ended September 30, 2018. Unless otherwise stated, financial amounts are in US$ millions. The company changed to calendar quarters in 2018 and recast prior periods for comparability. Revenue comparisons also reflect retrospective adoption of ASC 606, which changed presentation of certain franchise-related transactions without significant impact on net income.
Business context
Yum China operates, franchises or holds interests in restaurants in mainland China, principally KFC and Pizza Hut. It reported more than 8,300 restaurants at quarter-end. KFC and Pizza Hut are its two reportable segments; East Dawning, Little Sheep, Taco Bell and Daojia are included in All Other Segments.
Financial performance and liquidity
| Metric | Q3 2018 | Q3 2017 | YTD 2018 | YTD 2017 |
|---|---|---|---|---|
| Total revenue | $2,212 | $2,130 | $6,501 | $5,897 |
| Operating profit | $269 | $264 | $857 | $731 |
| Net income attributable to Yum China | $203 | $176 | $634 | $505 |
| Diluted EPS | $0.51 | $0.44 | $1.59 | $1.27 |
| Restaurant profit margin | 17.6% | 18.0% | 16.9% | 18.3% |
| Operating cash flow | — | $1,173 | $985 |
Revenue increased 4% in Q3 and 10% year to date as reported; excluding foreign-exchange effects, increases were 6% for both periods. Reported Q3 net income rose 15%; year-to-date net income rose 26%, but included a $98 million pretax, nonrecurring gain from remeasuring the previously held Wuxi KFC interest upon acquisition. Excluding special items, YTD operating profit was $759 million versus $728 million, and adjusted diluted EPS was $1.41 versus $1.26. Adjusted EBITDA was $379 million for Q3 and $1,125 million YTD.
At September 30, cash and cash equivalents were $1,334 million and short-term investments were $198 million, versus $1,059 million and $205 million at year-end 2017. Current assets were $2,046 million and current liabilities $1,192 million. Total liabilities were $1,603 million, including $26 million of capital lease obligations. The company reported that its $389 million of credit facilities were fully available, with no facility borrowings outstanding. YTD capital spending was $359 million.
YTD investing cash outflow was $527 million, including the Wuxi KFC acquisition, Meituan investment and capital spending. Financing cash outflow was $318 million, including $115 million of dividends paid and $161 million of share repurchases shown in the cash flow statement. The company declared $0.30 per share in dividends during the first nine months.
Material changes and segment trends
- KFC: Q3 system sales grew 6% excluding FX and same-store sales grew 1%; operating profit rose 4% excluding FX. YTD operating profit rose 6% excluding FX. Restaurant margin was 19.2% in Q3, down 0.4 percentage points year over year.
- Pizza Hut: Q3 system sales declined 2% excluding FX and same-store sales declined 5%. Q3 operating profit was approximately flat excluding FX, but YTD operating profit declined 40% excluding FX. YTD restaurant margin fell 4.5 percentage points to 11.8%.
- Consolidated: Q3 system sales grew 4% excluding FX while same-store sales declined 1%; YTD system sales grew 4% excluding FX and same-store sales were flat. Restaurant margin declined 0.4 percentage points in Q3 and 1.4 points YTD.
- The restaurant base grew 6% to 8,313 units year over year. Company sales growth was driven largely by net unit growth. Management cited promotion and product-upgrade costs and wage inflation as pressures on restaurant profitability; KFC wage inflation was 6% YTD and Pizza Hut’s was 6% YTD.
Outlook, risks and unusual items
The filing gives no specific earnings or revenue guidance. Management said operating cash and funds on hand should be adequate for operations and anticipated capital expenditures for the next 12 months. It also noted that access to capital markets is uncertain; the company had no credit rating at the time of filing. The board increased the repurchase authorization to $1.4 billion after quarter-end and declared a $0.12-per-share dividend, estimated at approximately $46 million.
- Tax and regulatory exposure: A Chinese SAT transfer-pricing audit covers related-party transactions from 2006–2015. The potential impact cannot be reasonably estimated; an adverse assessment, including interest and penalties, could materially affect results, financial position and cash flows. A separate potential Chinese indirect-transfer tax relating to the 2016 separation could also be significant; the tax matters agreement allocates any liability between Yum China and YUM.
- VAT asset: The company recorded a $205 million input VAT credit asset and had not provided an allowance, expecting future utilization. Recovery depends on operating results, capital spending and tax rules; the company said interpretation and implementation remain uncertain.
- Lease accounting: The company expected adoption of the new lease standard in 2019 to materially affect its financial statements. Future minimum operating-lease payments were approximately $3 billion as of September 30, 2018.
- Currency and market risks: Substantially all assets and most operating results are in RMB. Management estimated Q3 operating profit would have been about $27 million lower if the RMB weakened 10% against the U.S. dollar, assuming no other changes. Food commodity costs, labor, competition, food safety, cyber risks and China-specific regulatory conditions were also identified as risks.
- Unusual items and investments: The $98 million Wuxi KFC remeasurement gain increased YTD reported profit. The company acquired an additional 36% of Wuxi KFC, raising its interest to 83% and allowing consolidation. It also invested $74 million in Meituan shares; future fair-value changes will affect income.
Important facts for investors to verify
- Whether KFC’s unit-led growth can offset weaker same-store sales and margin pressure, and whether Pizza Hut’s sales and margins recover.
- How much YTD earnings growth remains after excluding the $98 million Wuxi KFC gain; compare GAAP results with the company’s adjusted measures.
- Progress and potential exposure from the SAT transfer-pricing audit, the separation-related indirect-transfer tax matter and recovery of the VAT credit asset.
- The balance-sheet and operating effects of adopting lease accounting, given approximately $3 billion of operating-lease payments.
- RMB sensitivity, commodity and wage inflation, and the cash available after dividends, repurchases, acquisitions and capital spending.