Yum China:A beneficiary of lower tier city recovery;Buy

YUMC likely to benefit from better consumer sentiment in lower-tier cities

    With CCI picking up in lower tier cities since 4Q16, backed by betteremployment expectations and a recent property price surge in those markets,we expect this will help YUMC’s SSS in lower-tier cities over the next fewquarters. CCI (overall) historically leads catering sales (above a designated size)by two to three months. Meanwhile, we believe tier 1/2 cities will continue toenjoy steady growth, helped by a product mix shift, day parts increase andstore efficiency. Maintaining Buy.

    Time to get the country mouse going

    In lower-tier cities, western fast food is still viewed as premium and itsperformance is linked to economic cycles. It is a beneficiary of consumptionupgrades, and to a certain extent wealth effects. KFC/MCD’s SSSg is highlycorrelated with consumers’ income growth in lower-tier cities. However, with amore widespread network in lower-tier cities (KFC covers 1,100 cities vs.MCD’s 400+), we believe YUMC will benefit from the lower-tier city recovery.

    City mouse to build its core

    We believe the improvement in consumer sentiment, which started earlier intier 1/2 cities, will continue into 2017 as witnessed in KFC’s better-than-groupaverage for the East China segment (based on its JV partner Jinjiang’sdisclosure). Management’s focus on higher tier cities is skewed towardsproduct mix upgrades (e.g. offering premium coffee and USD4 ice cream),optimizing its network (e.g. moving to transportation hubs) and storeefficiency, in our view.

    Our target price of USD31.48 offers 20%+ potential upside

    Our primary valuation methodology is DCF, employing a COE of 9.2%, beta of0.95 and a terminal growth rate of 2%. This produces a fair value estimate ofUSD31.48/share, implying a 2017/18E P/E of 24x/22x. Key downside risks areintense competition, consumer preference changes, failure to pass on costincreases and a failure to optimize its store portfolio.