YUMC-H's share price soared 31% over the past month amidst rapidly improving investor sentiment in China. Restaurant sector would be the prime beneficiary of the government's stimulus bonanza, given the pro- cyclical nature of on-premise consumption. Accordingly, we see further valuation upside for chain restaurant companies. In such a competitive environment, YUMC has a growth trajectory that is principally driven by evolving business model with excellent execution. We also like YUMC's shareholder return initiatives, which provide investors with a margin of safety. Set BUY rating.

Key Factors for Rating

3Q24 preview. Based on our estimation, system sales (ex FX) should see HSD% YoY growth and OPM should rise c.0.5ppt YoY in 3Q24. Guidance and growth strategies. 2024 expansion targets remain intact - 1,500-1,700 new stores (with agile business model and healthy payback) and US$700-850m Capex (with more investments in business intelligence, supply chain & other infrastructure). Three strategic pillars are reducing business complexity, simplifying menu, and uplifting operational efficiency. According to management, operating profit could grow at a HSD%-to-LDD% CAGR from 2023 to 2026.

2Q24: profitability improvement on revenue resilience and operational optimisation. YUMC reported 0.9% YoY top-line growth in 2Q24 to US$2,679m. System sales (ex FX) grew 4% YoY, on the back of accelerated openings, despite 4% YoY SSS decrease, as a whole. Company restaurant margin narrowed 0.6ppt YoY to 15.5% in 2Q24; cost ratio of food and paper, payroll, and occupancy was 31.5% (+0.8ppt YoY), 26.3% (-0.1ppt YoY), and 26.7% (-0.1ppt YoY). As G&A expenses ratio fell 0.8ppt YoY, OPM slightly expanded 0.2ppt YoY to 9.9%. Net profit grew 7.6% YoY to US$212m.

KFC. In 2Q24, KFC reported 5% YoY system sales growth - SSS decreased 3% YoY (ex FX; stemming from 4% YoY same-store transactions increase, offset by 7% YoY average ticket decrease), while store count rose 13% YoY to 9,740 as of 30 June 2024, with 328 net additions (1Q24: 307). Management expects KFC's ticket to be stable in the coming quarters, emphasising that the average ticket of RMB37 was resilient (2Q19: RMB35); however, we assume marginally lower ticket in 2H24-2025, given 1) overall soft consumption sentiment, 2) strategy towards value-for-money proposition, and 3) solicitation of smaller orders, esp. on third- party aggregator's platforms with lower delivery fee. KFC member count was up to 460m, representing 65% of its system sales in 2Q24. Digital order contribution was unchanged at 89%. Company restaurant margin was down 1.2ppts YoY to 16.1% on pricing softness, despite cost tailwinds; operating profit declined 3.3% YoY to US$264m in 2Q24.

Pizza Hut. In 2Q24, PH reported 1% YoY system sales growth - SSS decreased 8% YoY (ex FX; stemming from 2% YoY same-store transactions increase, offset by 9% YoY average ticket drop), while store count rose 14% YoY to 3,341 as of 30 June 2024, with 79 net additions (1Q24: 113). Going forward, PH could further capture market share at the cost of reducing average ticket. PH member count rose to 170m, representing 65% of its system sales, and digital order contribution was 93% in 2Q24. Company restaurant margin expanded 0.9ppt YoY to 13.2%; operating profit increased from US$35m in 2Q23 to US$40m in 2Q24.

n New business initiatives. Each of the two initiatives is in a unique position to underpin the market acceptance, in our view. 1) K Coffee. K Coffee have become available in all KFC stores, and it achieved sales value of >RMB1bn (+26% YoY) and cup volume of 120m (+36% YoY) in 1H24. K Coffee store count jumped from 100 in March to c.300 in July, and is estimated to reach >500 by year-end. We like K Coffee's distinct menu with either "coffee & hot dog combo" at RMB9.9 or other value-for-money innovative SKUs (e.g. iced orange creamy sparkling latte, coffee floats, thick caramel egg tart, etc.), which is the key for a profitable model. Another factor is that under the side-by-side concept, K Coffee can share kitchen with existing KFC stores, effectively driving customer traffic and minimising cost for investments and operations. 2) Pizza Hut WOW. Management views the WOW model as a major breakthrough, and PH WOW store count was >100 in July from the first store in May 2024 and could reach >200 by year-end. The WOW model features simpler operations, good variety, and excellent value-for-money. To be more specific, PH WOW stores provide its target customer base (primarily those solo diners, young and value-conscious users) with fast casual format and lighter service. Initial results seem promising and we expect the WOW model to generate incremental sales and operating profit.

n Continue to leverage strengths in efficiency & cost control. Management reiterated that cost saving is essential and recurring, on ongoing optimisation of store operation (e.g. menu revisions, process digitalisation and automation, etc.) and procurement management. Accordingly, we forecast that YUMC's company (system) restaurant profit margin will stabilise at c.16% and G&A expenses ratio will improve to c.5.0% (2023: 5.8%) in 2024-26.

n Corporate governance and shareholder returns. YUMC announced the CFO change on 6 August 2024. Since October, Mr. Adrian Ding has served as the new acting CFO. Mr. Andy Yeung, the former CFO, will serve as Senior Advisor to the CEO until 28 February 2025. Biography of Mr. Adrian Ding: Mr. Ding joined YUMC in March 2019 as VP of Corporate Finance, and has served as YUMC's CIO since February 2020 and GM of the Lavazza JV since March 2022. Prior to joining YUMC, Mr. Ding worked for Alibaba Group with a focus on strategic investments in TMT sectors, and before that, worked as an investment banker. Mr. Ding also serves as director of Fujian Sunner Development Co., Ltd. Returning excess cash to shareholders through dividends and share repurchases during 2024-26 in a sustainable manner. The Company's cash position is healthy. Currently, the implied 24E total shareholder return equals to nearly 9%.

Key Risks for Rating

Risks: 1) SSSG softness; 2) intensified competition; 3) commodity cost inflation; 4) slower-than-expected pace of store expansion; 5) unsuccessful execution of new initiatives; and 6) forex rate fluctuations.

Valuation

We forecast YUMC's total revenue and EBITDA to register a 3-year CAGR of 6.1% and 8.8% from 2023 to 2026, respectively. Our shareholders' profit forecasts for 2024-25E are US$880m and US$965m, respectively. EPS could reach US$2.34, US$2.68 and US$3.04, up 17.6%, 14.8% and 13.2% YoY, respectively, in 2024- 26, considering the impact of repurchases on the number of shares outstanding. Based on 20.0x 2025E P/E, we set TP for YUMC-H and YUMC-US at HK$418.00 and US$53.60, respectively, both with BUY rating. We list YUMC as our top pick for the Consumer Services (Restaurant & Catering) sector.