Mass Consumption Part 3 – Coffee and Fried Chicken

I love coffee and I love fried chicken. Normally, I wouldn’t mix these two together but in Part 3 of our mass consumption series, we look at the economics of feeding China’s 1.3bn mouths.

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I know, I know, coffee and fried chicken don’t go well together. I wish the title could have been Beer and Fried Chicken but I have yet to do work on the beer industry so for this week, we will have to focus on the two strange bed fellows of Coffee and Fried Chicken.

I love coffee and I love fried chicken. Every morning, regardless of whether it is a weekday, weekend, rain or shine, I always start my day with a Grande Black Coffee. If one were to talk about an industry with a defensive moat where consumer stickiness is very high, coffee is it for me. If my local Starbucks were to raise prices, I’m stuck.

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On the other hand, although I love fried chicken, I eat it sparingly. When I was a teenager, I could devour a whole bucket of KFC by myself but nowadays, I try to limit myself to splurging once every 6-12 months. It taste good but I feel very guilty afterwards and the indulgence shows up immediately on the scales.

What do they have in common? Making money in China

But what do Coffee and Fried Chicken have in common? They are two of the food companies that have been able to make money in China. Yes, I’m talking about Starbucks and KFC.

In part 3 of our Mass Consumption series, we turn to the largest consumption category. At Rmb1,535, food and tobacco make up 32% of the average spending of the Chinese consumer. Although its growth rate of 4.6% is the second slowest among the various categories, it is still growing nonetheless.

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A Starbucks around every corner?

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Although it may seem like there is a Starbucks around every corner, the actual penetration is still limited, especially in overseas market. At the end of September 2016, including both company operated and licensed stores, there were 15,607 in the Americas. China and Asia Pacific is one of the fastest growing regions but the 6,443 stores is still only 41% that of the Americas. In percentage terms, the America’s have 62% of total stores, China/Asia Pacific 26% and EMEA 11%.

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(Source: Company data for all charts)

In terms of revenue, the skew is even higher. The Americas contributed US$14.8bn or 69% of total revenues. China and Asia Pacific grossed US$2.9bn of revenue or 13% of the total while EMEA made US$1.1bn revenue or 5.3%. Although it may not seem obvious from the below chart, China and Asia Pacific had the fastest revenue growth in FY2016 at 22%, nearly double the 11% growth rate experienced in the Americas.

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By product, beverages make up 58.1% of total revenues. Food make up 16.4% and packaged and single-serve coffees and teas made up 13.4%. From a growth rate perspective, in FY2016, food sales grew 13% y/y, slightly faster than the 11% beverage sales growth.

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The trick is in growing profitably

As we have written previously (see here and here), China’s allure has always been its massive 1.3bn population. But the big pitfall for many companies is how to grow in a profitable manner especially when it is faced with hyper competition.

Starbucks profitability in Americas and China / AsiaPac

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In this regards, Starbucks appears to be successfully juggling between growth and profitability. In absolute terms, Starbucks made US$632mn from the China and Asia Pacific region. This represented a margin of 21.5%, roughly 4pp below the 25.3% operating margin that it makes in the Americas. Even if one were to exclude the 5.1pp by way of income from equity investees, the operating margin of 16.4% is still pretty respectable.

Looking at the cost breakdown, the obvious areas of variance between the Americas and China/Asia Pacific would be in the (i) cost of sales including occupancy costs and (ii) store operating expenses. While the store operating expenses in China / Asia Pacific is much lower than the Americas (26.5% Vs. 33.2%), this is more than offset by the higher occupancy costs (35.6% Vs. 44.1%).

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Last but not least, while China and Asia Pacific’s 22% revenue growth is obviously important, don’t count out the Americas. If we were to consider same-store-sales growth, The Americas are actually doing better at +6% versus China / Asia Pacific at +3%. Notably, the key distinction is in the change in ticket size. In FY2016, the average ticket in the Americas increased by 5% while the average ticket in China / Asia Pacific only rose by 2%. In both cases, the number of transactions within the stores only rose by 1% but that is understandable as more stores are being added around every corner.

Finger licking good

If we are talking about tapping into China’s mass consumption wave, Starbucks was actually pretty late. It opened its first store in 1999 at the China World Trade Building in Beijing. McDonald’s opened its first store in Shenzhen in 1990. The first global brand to go into China was in fact Kentucky Fried Chicken. Yes, Colonel Sanders was the first one to “make a run for the border”  when he opened the first KFC in Beijing back in 1987 (Note: two points if you can tell me where the quoted slogan is from).

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Including sister restaurants like Pizza Hut, Taco Bell and Little Sheep, Yum China now operates 7,562 restaurants in China. This is 14% more than Starbuck’s 6,443 stores in the China / Asia Pacific region.

Over the past five years, the number of KFC and Pizza Huts have increased by 32%. Company operated restaurants make up nearly 80% of restaurants with franchisees and unconsolidated affiliates making up the other 20%.

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Between fried chicken and pizza, KFC is more popular. At the end of 2016, there were 5,224 KFCs, nearly 3x the number of Pizza Huts. Incidentally, both KFC and Pizza Hut have added about 400 stores over the past two years.

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While the number of KFCs outnumber Pizza Hut 3:1, at the top line revenue level, KFC’s US$4,696mn revenue is only 2.6x that of Pizza Hut’s US$1,774mn. Perhaps due to some food scare issue, KFC’s revenues have actually fallen slightly from US$ 4,893mn to US$4,696mn while Pizza Hut’s revenues have increased by 4.5% from US$1,696mn to US$1,774mn.

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What KFC appears to have done much better over the past two years is in boosting its profitability. According to the segmental data, restaurant margins at KFC has increased from 11.4% in 2014 to 15.9% in 2016. By comparison, Pizza Hut’s margins have oscillated from 14.3% in 2014 to 12.3% in 2015 before rebounding to 14.0% in 2016.

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Similar to Starbucks, occupancy costs and other operating expenses are the biggest cost items, eating up around 33.5% of revenues. Interestingly, “Food and paper” is the second largest cost item, accounting for around 28.4% of revenues. I suppose fried chicken is quite greasy and you do need lots of napkins to clean your hands afterwards.

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So what will it be? Chicken or Coffee?

Hmm, that’s a hard one. In nominal terms, although Yum China’s revenue is more than double that of Starbuck’s China / Asia Pacific revenues (US$6,752mn Vs. US$2,939mn), as Starbuck’s China / Asia Pac 21.5% operating margin is double that of Yum China’s 9.5%, their nominal operating profits are actually very comparable. For the fiscal year 2016, Yum China had operating profit of US$640mn while Starbuck’s China / Asia Pac segment earned US$632mn.

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While Starbuck’s US$87bn market cap is much higher than Yum China’s US$15bn, from a valuation perspective, the two are in fact quite similar. Starbuck is currently trading at 30x trailing twelve months PE. Yum China is at 28x. Although both company’s PE may appear high, one must decide if China’s 1.3 billions mouths to feed are worth it.

Decisions, decisions….