November 17th, 2017 Students: Tingliang Guo, Mohan Ru, David Wang Company: Yum China Holdings Inc (NYSE: YUMC) Action: Long Price Target: $58 (39% upside) Overview Action: Long | Price Target: $58 | Upside: 39% Yum China Holdings Inc (NYSE: YUMC) Core Brands (96% of sales): KFC (70% of sales): ~5100 stores ✓ The largest restaurant company in China Pizza Hut (26% of sales): ~2000 stores ✓ Brands includes KFC, Pizza Hut, Little Sheep, Taco Bell, East Dawning ✓ Earliest restaurant chain to adopt digital payment in China ✓ Spin off from Yum! Brands (YUM) on Nov 1, 2016 ✓ After the separation from YUM, YUMC will pay a 3% license fee to YUM for the right to sublicense KFC and PH intellectual property in China Other Brands (4% of sales): ✓ Joint headquarters: Shanghai, China and Plano, TX USA ✓ ~420,000 employees and ~7,300 restaurants over 1000 cities Capitalization Trading Stats Target Price Share Price (11/10) 41.73 52 Week Hi / Lo 43.5 / 25.5 Target Price $ 58 Total Shares Outs. 385 Implied Valuation Market Cap 16,055 2018 EV / EBITDA 11.1x Consensus Us (-): Cash (1,477) 2019 EV / EBITDA 10.2x 2018 EV / EBITDA 15.7x 13.5x 2019 EV / EBITDA 14.7x 11.0x (+): Debt - 2018 P / E 25.4x (+): Minority Interest 70 2018 P / E 35.9x 28.2x 2019 P / E 22.7x Enterprise Value 14,648 2019 P / E 32.1x 21.7x 1 Source: Company Information, Capital IQ The Western-Style QSR1 Industry in China Highly fragmented industry, rapid growth, KFC dominant, cashless QSR industry in China is highly fragmented Rapid, sustainable sales growth KFC largest chain by unit count, followed by McDonald’s Digital + delivery key to competing 2 Source: Company report, McKinsey & Company 1.QSR – Quick Service Restaurant Why Yum China? 1 Store count grows at high-single-digit in a rapidly growing, under-penetrated market (especially in lower-tier cities), increasing margins with operating leverage 2 SSSg improves to mid-single-digit with best-in-class integrated digital + delivery ecosystem – the Domino’s model 3 Local, experienced, and focused management could deliver additional upside from Pizza Hut turnaround 3 1 Historical store growth impressive, but potential even greater Still low penetration in a young, rapidly richer, and urbanizing economy China’s QSR industry in 10x under-indexed Lower-tier cities further below average No of Fast Food Chain / MM population, 2016 # of Western QSR / MM population 12 1400 1,263 1200 10 927 1000 8 694 800 6 600 524 Avg = 351 340 4 400 267 223 172 78 2 200 42 17 8 4 0 0 South South Korea Taiwan Japan India Hong Kong Kong Hong Thailand Malaysia Vietnam USA China Philipines Indonesia Singapore 24,072 14,926 12,343 10,771 9,671 7,578 5,105 2,279 Avg GDP of City Tiers QSR penetration correlated with GDP per capita, suggesting China has huge potential to grow GDP per Capita 70,000 USA 60,000 Singapore 50,000 6.0% GDP GAGR => Hong Kong Store # up 10x Japan 40,000 in 10 years Taiwan South Korea 30,000 20,000 China, 2027 China Malaysia Thailand 10,000Vietnam India Philipines 0 0% 5% 10% 15% 20% 25% Chain Restaurants as % Total Restaurant 4 Source: Worldbank, Statista, Broker Research 1 Why does growth matter? Business has significant operating leverage • Large fixed cost base (eg Significant Operating Leverage Store Count significant driver of cash flow rent) creates significant operating leverage. Growth Costs as % of Revenue Store Count & Restaurant Margins is important to cash flow growth 39% 8000 18% • Expansion into 2nd and 3rd 7000 16% tier cities likely to further 37% lower % occupancy costs, as 6000 14% lower rents support same 35% 12% menu pricing and traffic 5000 10% 33% 4000 8% 3000 31% 6% 2000 4% 29% 1000 2% 27% 0 0% 2013 2014 2015 2016 25% Store Count Growth 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 1Q15 Restaurant Margin Occupany Costs Food and Paper Cash Flow % of Revenue 5 Source: company infomrmation 2 YUMC has the most integrated digital ecosystem in QSR KFC – Leader in digital: - KFC iOS App ranks No 3 in Food and Drink Category (top 2 apps are aggregators). Downloaded 30 million times - Top two QSR brands are KFC and Pizza Hut Benefits: - Deliver SSSg without need to remodel / expand store - Higher margins from savings on labor and other opex - Customer loyalty: 33% of KFC sales comes from KFC members, helped by the launch of KFC Super App - Potential new business model (eg high speed rail sale) 6 Source: aso100.com, company information 2 Why does digital matter in China? The Amazon – retail effect: digital is necessity China's Cashless Revolution - In 2016, China’s mobile payments hit $9 trillion, roughly 80 times the size of America’s $112 billion market - China’s mobile payment lead due to lack of alternatives (such as convenient credit card) and low denomination of paper currency - Digital strategy lynchpin to success in China, where availability of mobile channels can drive purchase decisions, especially young consumers 7 Source: iResearch, Wall Street Journal 2 Why does digital matter? Case Study - Domino's Pizza in US The Internet of Pizza – just the latest digital topping for Domino’s (NYSE:DPZ) - Domino’s builds customer loyalty and lowers costs with best- in-class digital tech in US - Between 2006 and 2008 Domino’s Pizza was in crisis – negative SSSg and plummeting sales - Launched app April 2011 - digital sales surpass $ 1 billion within one year. SSSg improves to 10% by 2010 - Immense shareholder value from successful strategy In US Market 8 Source: Domino’s Pizza company information 3 Strong potential upside from Pizza Hut New management experienced with turnarounds - Under Joey Wat since 2014, KFC KFC SSSg rebounded from food scandals under Ms. Wat staged impressive turnaround after being hit by food safety Joey Wat took charge of KFC scandals - Joey became YUMC COO in Feb 2017 and will be CEO in March 2018 • KFC’s SSSG improved - Significant knowledge transfer to from -14% in FY13 to 3% Pizza Hut with replicable in FY16 turnaround strategies • KFC’s restaurant margin o Focus on food: slimdown of increased from 11.4% in menu to focus on hits and local FY13 to 16.3% in FY16 favorites Pizza hut is rapidly moving digital following KFC playbook Pizaa Hut SSSg turns positive o Moving to digital: Pizza Hut launched app in July 2017 and has synchronized membership with KFC o New models: store and image upgrade, Bistro - Long-term effort with short-term pain: investors remain in show-me mode. Potential upside as results prove 9 Source: company information 3 How much difference does Pizza Hut turnaround make? Key to Maintain Restaurant Margins Sensitivty of 2019 EBITDA to Pizza Hut Turnaround Pizza Hut Restaurant Margin in 2018 1554.9064 12.0% 14.0% 16.0% 18.3% 20.0% 22.0% -2.4% 1,693 1,736 1,779 1,829 1,865 1,908 -0.4% 1,731 1,774 1,817 1,866 1,903 1,946 Pizza Hut 1.6% 1,770 1,813 1,856 1,905 1,942 1,985 Avg SSSg 3.6% 1,810 1,853 1,896 1,945 1,982 2,025 2018 5.6% 1,850 1,893 1,936 1,985 2,022 2,065 7.6% 1,892 1,935 1,978 2,027 2,064 2,107 9.6% 1,935 1,978 2,021 2,070 2,107 2,150 11.6% 1,979 2,022 2,065 2,114 2,151 2,194 Sensitivty of Share Price to Pizza Hut Turnaround (Based on 2019 EV / EBITDA) Pizza Hut Restaurant Margin in 2018 12.0% 14.0% 16.0% 18.3% 20.0% 22.0% -2.4% 52.1 53.4 54.6 56.0 57.1 58.3 -0.4% 53.2 54.4 55.7 57.1 58.1 59.4 Pizza Hut 1.6% 54.3 55.6 56.8 58.2 59.2 60.5 Avg SSSg 3.6% 55.5 56.7 57.9 59.3 60.4 61.6 2018 5.6% 56.6 57.9 59.1 60.5 61.5 62.8 7.6% 57.8 59.1 60.3 61.7 62.7 64.0 9.6% 59.1 60.3 61.5 62.9 64.0 65.2 11.6% 60.3 61.5 62.8 64.2 65.2 66.5 10 Valuation – Base Case How we differ from consensus Our View Consensus Difference 2017E 2018E 2019E 2020E 2017E 2018E 2019E 2020E 2017E 2018E 2019E 2020E Revenue 7,062 7,922 9,160 10,637 Revenue 7,035 7,552 8,059 8,647 Revenue 0.4% 4.9% 13.7% 23.0% % Growth 4.5% 12.2% 15.6% 16.1% % Growth 4.2% 7.3% 6.7% 7.3% % Growth EBITDA 1,331 1,555 1,905 2,174 EBITDA 1,196 1,332 1,428 1,576 EBITDA 11.3% 16.7% 33.4% 38.0% % Margin 18.8% 19.6% 20.8% 20.4% % Margin 17.0% 17.6% 17.7% 18.2% % Margin EPS 1.76 2.06 2.69 3.12 EPS 1.42 1.62 1.81 2.14 EPS 24.0% 27.3% 48.4% 45.8% % Growth 29.0% 17.2% 30.2% 16.1% % Growth 4.0% 14.1% 11.7% 18.2% % Growth Key assumptions: - Store count CAGR: 7% for KFC, 10% for Pizza Hut, hitting managements LT target of 20k stores in 10 years - SSSg: gradual increase on digital + delivery leverage, with KFC converging to Domino’s current SSSg in the next two years - Margins: assume slight leverage on occupancy costs (expansion into lower-tier cities) and labor costs (digital channels) - Capex: assume baseline per-store capex on new stores and remodeling 11 Valuation – Base Case Getting to target price Methodology Metric Multiple Target Price ($/sh) 2019 EV / EBITDA $1,905MM 11.0x 58 2019 P / E $988MM 23.0x 59 SOTP 2019 EV / EBITDA 9.0x - 14.0x 68 DCF 59 DCF + Idle cash deployment 64 Target price based on 2019 EV / EBITDA multiple, with sense check against other relative and intrinsic methodologies - EBITDA x most appropriate 1) capital structures differ significant due to different franchise vs.