Yum China Holdings (YUMC 3.01%) has gone where few have gone before. The company has built a supply chain in a fragmented market to set itself up for large-scale expansion. Here's how it works.
Taking advantage where others cannot
Historically, small-scale full-service restaurants have held the lion's share of the market in China. The sit-down mom-and-pop restaurant market is fragmented throughout the country. As such, so are restaurant suppliers, making it difficult for chains to source food and other supplies at full scale.
While others saw the fragmented nature of the market as a barrier, Yum China saw an opportunity. Over the last several years, the company has built out its supply distribution network to get locally sourced food and supplies to its expansive collection of fast-food restaurants. The network includes 25 logistic centers and five consolidation centers in China.
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As a large-scale buyer, Yum China has some muscle with suppliers. Because it represents a large portion of a supplier's business, the company can push for volume discounts, and thus margins expand. For instance, its gross margin in 2014 was 16.9% and 21% in 2019 before COVID struck.
Aside from fueling Yum China's expansion plans, the network has added operational leverage. Because the cost of the current network is up front, there is little additional cost when sales grow.
Yum China's supply network could be a material competitive advantage over mom-and-pop restaurants and chains that don't have the backing to develop their own logistics system. In addition, the network can plug in acquisitions and create significant synergies.
In 2020, the company bought the casual dining chain Huang Ji Huang franchise and its 640 locations. The acquisition followed its earlier buyout of the Little Sheep hot-pot restaurants.
Is Yum China a buy?
Yum China stock has been down considerably over the last year because of a double whammy: Growth stocks and Chinese stocks have had a rough go of it during the past several months.
After a 33% drop in the stock over the last year, it trades at a trailing-12-month price-to-earnings multiple of 22. The current valuation compares favorably to its five-year average of 29. Though the valuation may be appealing, Chinese economic growth could be slowing. For instance, due to COVID-related shutdowns, the Organization for Economic Cooperation and Development has cut its GDP growth estimate for China to 3% for 2022, down from the 4.5% growth estimate in December.
Though it's easy to paint a pessimistic picture for the near term for Yum China, the long-term future might look brighter. The company plans to add 45 to 50 new consolidation centers and logistic centers to increase the number of cities it can cover from over 1,500 to over 2,700.
In addition, China is lifting the latest wave of shutdown restrictions, and the long game for fast food in China could be strong. Analysts expect the Chinese fast-food market to grow by 8% through 2027.
You may want to watch for economic growth to return in the country. Yum China is taking steps to set the stage for long-term growth and margin expansion.
