Yum China: Insider Acquisitions, Valuation Ratios Make Stock Strong Buy (NYSE:YUMC)

Yum China Holdings, Inc. (NYSE: YUMC) offers an attractive buying opportunity after good Q2 2024 results and a significant pool of insider buying activity in the days following the earnings release.

In this article, I will guide you through various aspects of my investment thesis and I will try to convey as directly as possible the various events that motivated my Strong Buy rating.

In addition, I will go through some of the headwinds in Q2 2024, particularly their strategic move with Pizza Hut WOW, which I believe poses a risk to my Strong Buy rating in the event of an economic downturn.

However, given that my time horizon is relatively short (three to 24 months), I think this stock has asymmetric short- to medium-term opportunity.

As always, I’ll start with a company overview section for those readers new to this stock.

Company overview

Yum China is a Shanghai-based company that operates a large number of restaurants in China, focusing on fast food and casual dining.

They have exclusive rights to operate and sub-license the KFC, Pizza Hut and Taco Bell brands in China.

In addition, I own the intellectual property of two brands, Little Sheep and Huang Ji Huang. You may not be familiar with these two names unless you’ve spent time in China recently.

They get most of their revenue through their KFC and Pizza Hut restaurants. To give you an idea of ​​the relative weight of each segment, we’ve included a breakdown of their annual revenues in 2023 below.

Click to enlarge

An author’s compilation of the most recent 10-K.

As a side note, all other segments include revenue from brands like Lavazza, Huang Ji Huang, Little Sheep, Taco Bell, their delivery operations segment and their e-commerce business.

In terms of beneficial ownership (from April 11, 2024) of the company, I must admit that I am disappointed that the total ownership of all directors and executive officers of the company is less than 1%.

However, my investing style relies more on insider buying activity (especially after a recent sell-off) rather than outright ownership of common stock in the company.

If you’re wondering why, it’s because my time frame is relatively short, between three and 24 months most of the time, involving very illiquid call options. Therefore, when I see intra-group buying activity after a share price decline, I have the belief that management thinks the current share price is cheap. (emphasis on current). Otherwise, if insiders own 40% of the company but don’t buy after a sale, they can’t make the same reasoning.

Recent performance

I like to start dinner with the cake, so I’ll cover the headwinds first, despite their decent Q2 2024 results.

My investment style favors high-margin, low-volume companies, mainly during their flexibility during economic downturns. Taking it for granted that fast food restaurants focus more on volumes than increasing margins, I thought I’d go through their strategic initiatives, one of which, the Pizza Hut WOW concept, raised an eyebrow.

This concept was designed to cater to a wider audience, especially solo diners and value-conscious customers. The main idea is that by offering smaller portions and cheaper meals, Pizza Hut WOW would meet the needs of a large audience who prefer to dine alone or who are looking for a quick meal at a cheap price.

Look, I’ll be honest with you, nothing wrong with that. I was born in a socialist country, so ethically I like it. More people are eating more, at more reasonable prices, which means more employees are needed to meet the increased demand.

However, from a purely economic point of view, I don’t think this is good for their net income in the long run, especially in an economic downturn.

Given that operating expenses for their Pizza Hut segment were $460 million, I see the 13.2% margin at risk in the event of a slowdown in the QSR industry.

Just to clarify, I’m not saying there will be a QSR slowdown, but if there is, Pizza Hut’s margins are at risk in my opinion.

Moving on to more positive results, I have to mention that from a revenue perspective, this was a record Q2. Their total revenue was $2.68 billion, up 1% from last year.

Operating profit rose 4% year-over-year, with a total operating margin of 9.9%, also up from the same quarter last year, though only by 20 basis points.

I am also encouraged by the delivery sales of 11% per year. As a side note, almost 90% of their total sales came from digital sales through digital apps to order fast food.

Outlook

Let’s take a quick look at the stock price on a weekly chart.

As a contrarian investor, I like this chart for the following reasons:

• YTD decline (prior to Q2 2023 earnings release) of 33%.
• Looking further, since April 2023 the share price has fallen by over 50%.
• The price has returned to a validated support level (in my view) from 2019.

Okay, the graph looks good, but that’s just the tip of the iceberg.

Let’s move on to the financial statements.

Operating income is up, which is good.

I am also encouraged by the increase in operating margins and net income from 2022.

Quick and current ratios above 1 and debt to assets below 0.5 which is a good indicator that they can manage both their short and long term debt in my opinion.

Quarterly dividends in effect, with a low dividend yield below 2%, TTM. That’s a good sign because they don’t have to give up a significant amount of their free cash flow to pay dividends.

Speaking of cash flows, both operating and free cash flow are increasing.

In terms of valuation, I like the fact that most valuation metrics are below the company’s five-year average. Given that they operate in the Chinese market, I don’t look too closely at the comparison to the broader consumer discretionary sector.

So the weekly chart shows a sell, the financials look decent, and valuation ratios are below the five-year average (great!). I will now focus on insider buying activity.

I thought I’d include a screenshot showing the considerable buying activity within the cluster following the 20% increase in the stock price following the Q2 earnings results (emphasis on after).

Earnings were released on August 5 after the market closed. Insiders started buying between August 13th and 16th.

I’m very encouraged that the five buyouts were done by five different insiders, including the CEO, CFO and GM of their two largest segments.

This is the perfect scenario for my investment style. All the factors I pay attention to are positive. Therefore, I decided to take a bold step and buy call options expiring in January 2025.

If my Strong Buy rating doesn’t pan out, my portfolio will take a hit.

Conclusion

In conclusion, I think Yum China presents a compelling buying opportunity, especially for high-risk, contrarian investors like myself.

Despite the high risk to Pizza Hut’s margins in the event of an economic downturn, the company’s overall financial health is robust, with growing revenue and operating margins and strong cash flows.

Compared to their own five-year average, their valuation ratios look pretty decent to me, indicating that they might be undervalued.

The insider buying activity, especially by top executives, and after a 33% decline in the share price YTD, further strengthens my confidence in the current share price.

Therefore, I maintain a Strong Buy rating, holding call options that expire in January 2025.