Yum China Holdings, Inc. — 2018 Form 10-K
Reporting period: Fiscal year ended December 31, 2018; the filing also provides unaudited fourth-quarter results. Unless noted otherwise, financial amounts are in U.S. dollars.
Business context and reporting period
Yum China is a restaurant operator and franchisor focused on China, principally through KFC and Pizza Hut. At year-end it had 8,484 restaurants: 6,832 company-owned, 841 franchised and 811 operated by unconsolidated affiliates. KFC accounted for 5,910 restaurants and Pizza Hut for 2,240. The company reported operations across more than 1,200 Chinese cities.
Comparative 2017 and 2016 results were recast for ASC 606, which increased reported revenue and expenses for certain franchisee and affiliate transactions without materially changing net income. The company also changed to calendar quarters in 2018 and recast prior quarterly data.
Financial performance and liquidity
| Metric | 2018 | 2017 | Change or context |
|---|---|---|---|
| Total revenue | $8.415 billion | $7.769 billion | Up 8% reported; up 6% excluding foreign-exchange effects |
| Company restaurant sales | $7.633 billion | $6.993 billion | Up 9% reported; up 7% excluding foreign exchange |
| System sales | — | — | Up 5% excluding foreign exchange; same-store sales up 1% |
| Operating profit | $941 million | $778 million | Up 21% reported; up 16% excluding foreign exchange |
| Adjusted operating profit | $855 million | $775 million | Excludes special items |
| Net income attributable to Yum China | $708 million | $398 million | Up 78% reported; up 70% excluding foreign exchange |
| Adjusted net income | $606 million | $559 million | Up 4% excluding foreign exchange |
| Diluted EPS | $1.79 | $1.00 | Adjusted diluted EPS was $1.53 and $1.40, respectively |
| Operating cash flow | $1.333 billion | $884 million | Capital spending was $470 million; cash flow less capital spending was approximately $863 million |
Restaurant profit was $1.199 billion, with a 15.7% restaurant margin, down 1.0 percentage point from 16.7%. KFC’s margin was 17.9% versus 18.0%; Pizza Hut’s fell to 10.3% from 13.9%. Same-store sales rose 2% at KFC and declined 5% at Pizza Hut.
Fourth-quarter 2018 revenue was $1.914 billion, operating profit $84 million, net income attributable to Yum China $74 million and diluted EPS $0.19. Fourth-quarter 2017 included a net loss of $107 million, substantially affected by the Tax Act charge.
At year-end, cash and cash equivalents were $1.266 billion and short-term investments were $122 million. Current assets were $1.952 billion against current liabilities of $1.253 billion. The company reported $418 million of available credit facilities and stated that no amount was drawn as of year-end. Capital lease obligations were $25 million on the balance sheet; contractual operating lease commitments totaled $2.775 billion. The company said cash on hand and expected operating cash flow should fund operations and anticipated capital spending for the next 12 months.
Material changes and unusual items
- Wuxi KFC became consolidated after Yum China acquired an additional 36% interest, raising its ownership to 83%. The transaction generated a $98 million remeasurement gain on the previously held interest and added 157 stores to the company-owned count.
- Reported 2018 net income also reflected a $36 million tax benefit from revising the provisional Tax Act transition-tax estimate. The comparable 2017 period included a $164 million one-time tax charge.
- The company recorded a $27 million unrealized loss on its Meituan equity investment and a $12 million impairment of Daojia intangible assets. Daojia faced declining sales amid intensified delivery-platform competition.
- Adjusted results exclude special items, including the Wuxi remeasurement gain, Daojia impairment and Tax Act adjustment. Reported revenue also includes substantial procurement-related sales to franchisees and unconsolidated affiliates, with related expenses.
- In 2018, the company repurchased $312 million of shares and paid $161 million in dividends. The board raised the repurchase authorization to $1.4 billion; $960 million remained available at year-end. The quarterly dividend increased to $0.12 per share in the fourth quarter.
Outlook, risks and contingencies
The filing gives no specific numerical earnings or revenue guidance. Management describes continued growth through new-store development, product and value innovation, delivery, digital engagement and improved unit economics. It sees long-term potential to grow to three times the 2016 restaurant base over the next two to three decades, while noting that this is an opportunity rather than a near-term forecast. Management cited wage and commodity inflation, promotions and product-upgrade spending as pressures on results.
- China concentration and currency: Substantially all revenue and assets are in China. A 10% weakening of the RMB was estimated to reduce 2018 operating profit by approximately $90 million, assuming no changes in sales volumes or local prices. Currency controls and statutory reserve requirements may restrict cash transfers and dividends.
- Tax matters: Chinese authorities were conducting a national transfer-pricing audit covering related-party transactions from 2006 to 2015. The potential assessment, including interest and penalties, could be material, but the company said it could not estimate the impact. The company also disclosed $22 million of unrecognized tax benefits and approximately $28 million of unrecognized-tax-benefit liabilities excluded from its contractual-obligations table.
- Leases: The company expected to adopt the new lease standard in 2019, recognizing approximately $2.0 billion of right-of-use assets and $2.2 billion of lease liabilities. It expected no material income-statement effect apart from possible additional impairment of right-of-use assets.
- Operating and strategic risks: Food safety, supply disruptions, rising labor and commodity costs, competitive pressure, store-development execution and potential cannibalization could affect sales and margins. Digital sales and operations also depend on cybersecurity, mobile-payment providers and delivery aggregators.
- Licensing and contingencies: KFC, Pizza Hut and Taco Bell operate under a long-term Yum! Brands license requiring a 3% fee on net system sales. The filing warns that license limitations or termination could materially harm the business. It also describes possible indemnity exposure related to the separation and Chinese indirect-transfer tax, though no material legal proceedings were reported at year-end.
The auditor issued unqualified opinions on the financial statements and internal control over financial reporting; management and the auditor concluded controls were effective as of December 31, 2018. The filing nevertheless notes that PCAOB inspection access to audit work performed in China was restricted.
Important facts for investors to verify
- Whether KFC’s positive same-store sales and Pizza Hut’s 5% decline persist, and how Pizza Hut’s margin recovery progresses.
- How much of reported profit growth reflects recurring operations versus the $98 million Wuxi gain and $36 million Tax Act benefit; compare GAAP with adjusted measures.
- The outcome and potential financial exposure of the Chinese transfer-pricing audit, and the final impact of transition-tax regulations.
- Daojia’s operating trajectory, further impairment risk and the company’s returns on digital and delivery investments.
- Cash availability for dividends, repurchases and growth given China repatriation restrictions, operating lease commitments and the planned lease-accounting transition.