UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q
(Mark One)
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2019
OR
☐
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to _________________
Commission file number 001-37762
Yum China Holdings, Inc.
(Exact Name of Registrant as Specified in Its Charter)
Delaware
81-2421743
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification No.)
7100 Corporate Drive
Plano, Texas 75024
United States of America
Yum China Building
20 Tian Yao Qiao Road
Shanghai 200030
People’s Republic of China
(Address, Including Zip Code, of Principal Executive Offices)
(469) 980-2898
(Registrant’s Telephone Number, Including Area Code)
Not Applicable
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading
Symbol(s)
Name of each exchange on which registered
Common Stock, par value $0.01 per share
YUMC
New York Stock Exchange
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
Accelerated filer
Non-accelerated filer
Smaller reporting company
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
The number of shares outstanding of the registrant’s common stock as of October 30, 2019 was 375,908,592 shares.
INDEX
Page
No.
Part I.
Financial Information
Item 1 – Financial Statements
3
Condensed Consolidated Statements of Income – Quarters and Years to Date Ended September 30, 2019 and 2018
Condensed Consolidated Statements of Comprehensive Income – Quarters and Years to Date Ended September 30, 2019 and 2018
4
Condensed Consolidated Statements of Cash Flows – Years to Date Ended September 30, 2019 and 2018
5
Condensed Consolidated Balance Sheets – September 30, 2019 and December 31, 2018
6
Notes to Condensed Consolidated Financial Statements
7
Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations
30
Item 3 – Quantitative and Qualitative Disclosures About Market Risk
49
Item 4 – Controls and Procedures
Part II.
Other Information
Item 1 – Legal Proceedings
50
Item 1A – Risk Factors
Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds
Item 6 – Exhibits
51
Signatures
52
2
PART I – FINANCIAL INFORMATION
Item 1.
Financial Statements
Condensed Consolidated Statements of Income (Unaudited)
(in US$ millions, except per share data)
Quarter Ended
Year to Date Ended
Revenues
9/30/2019
9/30/2018
Company sales
$
2,097
2,008
6,112
5,912
Franchise fees and income
38
36
113
110
Revenues from transactions with franchisees and
unconsolidated affiliates
172
159
496
461
Other revenues
12
9
26
18
Total revenues
2,319
2,212
6,747
6,501
Costs and Expenses, Net
Company restaurants
Food and paper
651
610
1,896
1,775
Payroll and employee benefits
455
430
1,371
1,296
Occupancy and other operating expenses
619
615
1,804
1,841
Company restaurant expenses
1,725
1,655
5,071
4,912
General and administrative expenses
117
119
340
334
Franchise expenses
19
55
Expenses for transactions with franchisees and
167
156
488
454
Other operating costs and expenses
20
17
Closures and impairment (income) expenses, net
(1
)
14
15
Other income, net
(17
(10
(48
(143
Total costs and expenses, net
2,019
1,943
5,940
5,644
Operating Profit
300
269
807
857
Interest income, net
10
29
28
Investment gain
—
39
Income Before Income Taxes
322
279
875
885
Income tax provision
(87
(67
(226
(227
Net income – including noncontrolling interests
235
212
649
658
Net income – noncontrolling interests
24
Net Income – Yum China Holdings, Inc.
223
203
623
634
Weighted-average common shares outstanding
(in millions):
Basic
377
384
378
386
Diluted
388
394
389
398
Basic Earnings Per Common Share
0.59
0.53
1.65
1.64
Diluted Earnings Per Common Share
0.58
0.51
1.60
1.59
See accompanying Notes to Condensed Consolidated Financial Statements.
Condensed Consolidated Statements of Comprehensive Income (Unaudited)
(in US$ millions)
Net income - including noncontrolling interests
Other comprehensive income, net of tax of nil:
Foreign currency translation adjustments
(96
(98
(95
(156
Comprehensive income - including noncontrolling
interests
139
114
554
502
Comprehensive income - noncontrolling interests
8
23
Comprehensive Income - Yum China Holdings, Inc.
131
108
531
483
Condensed Consolidated Statements of Cash Flows (Unaudited)
Cash Flows – Operating Activities
Depreciation and amortization
343
Amortization of operating lease right-of-use assets
251
Closures and impairment expenses
Gain from re-measurement of equity interest upon acquisition
(39
Equity income from investments in unconsolidated affiliates
(56
(52
Distributions of income received from unconsolidated affiliates
Deferred income taxes
46
Share-based compensation expense
21
Changes in accounts receivable
(2
Changes in inventories
(22
Changes in prepaid expenses and other current assets
(13
Changes in accounts payable and other current liabilities
118
184
Changes in income taxes payable
32
41
Changes in non-current operating lease liabilities
(280
Other, net
(32
(36
Net Cash Provided by Operating Activities
1,045
1,173
Cash Flows – Investing Activities
Capital spending
(310
(359
Purchases of short-term investments
(619
(513
Maturities of short-term investments
366
513
Acquisition of business, net of cash acquired
(91
Investment in equity securities
(74
(3
Net Cash Used in Investing Activities
(553
(527
Cash Flows – Financing Activities
Repayment of short-term borrowings assumed from acquisition
Repurchase of shares of common stock
(207
(161
Cash dividends paid on common stock
(136
(115
Dividends paid to noncontrolling interests
(25
(29
Net Cash Used in Financing Activities
(368
(318
Effect of Exchange Rates on Cash, Cash Equivalents and Restricted Cash
(26
(53
Net Increase in Cash, Cash Equivalents and Restricted Cash
98
275
Cash, Cash Equivalents and Restricted Cash - Beginning of Period
1,266
1,059
Cash, Cash Equivalents and Restricted Cash - End of Period
1,364
1,334
Supplemental Cash Flow Data
Cash paid for income tax
185
157
Condensed Consolidated Balance Sheets
12/31/2018
(Unaudited)
ASSETS
Current Assets
Cash and cash equivalents
1,355
Short-term investments
364
122
Accounts receivable, net
79
80
Inventories, net
317
307
Prepaid expenses and other current assets
141
177
Total Current Assets
2,256
1,952
Property, plant and equipment, net
1,506
1,615
Operating lease right-of-use assets
1,893
Goodwill
256
266
Intangible assets, net
97
116
89
Investments in unconsolidated affiliates
74
81
Other assets
539
491
Total Assets
6,710
4,610
LIABILITIES, REDEEMABLE NONCONTROLLING INTEREST
AND EQUITY
Current Liabilities
Accounts payable and other current liabilities
1,566
1,199
Income taxes payable
82
54
Total Current Liabilities
1,648
1,253
Non-current operating lease liabilities
1,729
Non-current finance lease liabilities
25
Other liabilities
195
355
Total Liabilities
3,595
1,633
Redeemable Noncontrolling Interest
1
Equity
Common stock, $0.01 par value; 1,000 million shares authorized; 394 million
shares and 392 million shares issued at September 30, 2019 and December
31, 2018, respectively; 376 million shares and 379 million shares
outstanding at September 30, 2019 and December 31, 2018, respectively
Treasury stock
(664
(460
Additional paid-in capital
2,423
2,402
Retained earnings
944
Accumulated other comprehensive loss
(109
Total Equity – Yum China Holdings, Inc.
3,025
2,873
Noncontrolling interests
103
Total Equity
3,114
2,976
Total Liabilities, Redeemable Noncontrolling Interest and Equity
Notes to Condensed Consolidated Financial Statements (Unaudited)
(Tabular amounts in US$ millions)
Note 1 – Description of the Business
Yum China Holdings, Inc. (“Yum China” and, together with its subsidiaries, the “Company,” “we,” “us” and “our”) was incorporated in Delaware on April 1, 2016. The Company separated from Yum! Brands, Inc. (“YUM” or the “Parent”) on October 31, 2016 (the “separation”), becoming an independent publicly traded company as a result of a pro rata distribution (the “distribution”) of all outstanding shares of Yum China common stock to shareholders of YUM. On October 31, 2016, YUM’s shareholders of record as of 5:00 p.m. Eastern Time on October 19, 2016 received one share of Yum China common stock for every one share of YUM common stock held as of the record date. Yum China’s common stock began trading “regular way” under the ticker symbol “YUMC” on the New York Stock Exchange on November 1, 2016.
The Company owns, franchises or has an ownership in entities that own and operate restaurants under the KFC, Pizza Hut, East Dawning, Little Sheep, Taco Bell and COFFii & JOY concepts (collectively, the “Concepts”). In connection with the separation of the Company from YUM, Yum! Restaurants Asia Pte. Ltd., a wholly-owned indirect subsidiary of YUM, and Yum Restaurants Consulting (Shanghai) Company Limited (“YCCL”), a wholly-owned indirect subsidiary of Yum China, entered into a 50-year master license agreement with automatic renewals for additional consecutive renewal terms of 50 years each, subject only to YCCL being in “good standing” and unless YCCL gives notice of its intent not to renew, for the exclusive right to use and sub-license the use of intellectual property owned by YUM and its subsidiaries for the development and operation of the KFC, Pizza Hut and, subject to achieving certain agreed-upon milestones, Taco Bell brands and their related marks and other intellectual property rights for restaurant services in the People’s Republic of China (the “PRC” or “China”), excluding Hong Kong, Taiwan and Macau. In exchange, we pay a license fee to YUM equal to 3% of net system sales from both our Company and franchise restaurants.
We own the intellectual property of East Dawning, Little Sheep and COFFii & JOY and pay no license fee related to these Concepts.
The Company also owns a controlling interest in the holding company of DAOJIA.com.cn (“Daojia”), an established online food delivery service provider in China.
In addition, the Company started a new e-commerce business in 2017, offering a wide selection of products including electronics, home and kitchen accessories, and other general merchandise to customers directly through the Company’s e-commerce platform.
Note 2 – Basis of Presentation
Our preparation of the accompanying Condensed Consolidated Financial Statements in conformity with Generally Accepted Accounting Principles in the United States of America (“GAAP”) requires us to make estimates and assumptions that affect reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.
We have prepared the Condensed Consolidated Financial Statements in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The Condensed Consolidated Financial Statements include all normal and recurring adjustments considered necessary to present fairly our financial position as of September 30, 2019, results of our operations and comprehensive income for the quarters and years to date ended September 30, 2019 and 2018, and cash flows for the years to date ended September 30, 2019 and 2018. Our results of operations, comprehensive income and cash flows for these interim periods are not necessarily indicative of the results to be expected for the full year. These statements should be read in conjunction with the consolidated financial statements and notes thereto defined and included in the Company’s Annual Report on Form 10-K as filed with the SEC on February 27, 2019.
Through the acquisition of Daojia in 2017, the Company also acquired a variable interest entity (“VIE”) and subsidiaries of the VIE effectively controlled by Daojia. There exists a parent-subsidiary relationship between Daojia and its VIE as a result of certain exclusive agreements that require Daojia to consolidate its VIE and subsidiaries of the VIE because Daojia is the primary beneficiary that possesses the power to direct the activities of the VIE that most significantly impact its economic performance and has the obligation to absorb substantially all of the profits and all of the expected losses of the VIE. The acquired VIE and its subsidiaries were considered immaterial, both individually and in the aggregate. The results of Daojia’s operations have been included in the Company’s Condensed Consolidated Financial Statements since the acquisition date.
During the first quarter of 2018, the Company completed the acquisition of an additional 36% equity interest in an unconsolidated affiliate that operates KFC stores in Wuxi, China (“Wuxi KFC”), for cash consideration of approximately $98 million, increasing the Company’s equity interest to 83%, allowing the Company to consolidate the entity. The acquisition was considered immaterial. We began consolidating Wuxi KFC upon the completion of acquisition.
Recently Adopted Accounting Pronouncements
In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842) (“ASU 2016-02” or “ASC 842”), which increases transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The FASB subsequently issued amendments to clarify the implementation guidance. The Company adopted these standards on January 1, 2019, using a modified retrospective method for leases that exist at, or are entered into after, January 1, 2019, and has not recast the comparative periods presented in the Condensed Consolidated Financial Statements. Additionally, we elected the package of practical expedients that allowed us to not reassess: (1) whether any expired or existing contracts are or contain leases, (2) lease classification for any expired or existing leases and (3) initial direct costs for any expired or existing leases. We also elected the hindsight practical expedient to determine the reasonably certain lease term for existing leases.
Upon the adoption of ASC 842, the Company recognized right-of-use (“ROU”) assets and lease liabilities of approximately $2.0 billion and $2.2 billion, respectively, for operating leases of the land and/or building of our restaurants and office spaces based on the present value of lease payments over the lease term. In addition, an impairment charge of $60 million (net of related impact on deferred taxes and noncontrolling interests) on ROU assets arising from existing operating leases as of January 1, 2019 was recorded as an adjustment to retained earnings, as the additional impairment charge would have been recorded before adoption had the operating lease ROU assets been recognized at the time of impairment.
The following table summarizes the effect on the Consolidated Balance Sheet as a result of adopting ASC 842.
December 31, 2018
Effect of adoption
January 1, 2019
(a)
138
1,913
1,614
1,997
(b)
(c)
(d)
(4
487
1,969
6,579
LIABILITIES, REDEEMABLE NONCONTROLLING
INTEREST AND EQUITY
320
(e)
1,519
1,573
1,860
(f)
(148
(g)
207
2,032
3,665
Common stock
(60
(h)
884
2,813
(i)
100
(63
2,913
Total Liabilities, Redeemable Noncontrolling Interest
and Equity
Represents the current portion of prepaid rent reclassified to operating lease ROU assets.
Represents the net result of capitalization of operating lease payments and reclassification of prepaid rent, initial direct cost, deferred rent accrual and lease incentives, and offset by impairment of operating lease ROU assets that existed prior to the date of adoption.
Represents initial direct cost, favorable lease and non-current prepaid rent reclassified to operating lease ROU assets.
Represents the deferred tax impact related to impairment of operating lease ROU assets.
Represents recognition of the current portion of operating lease liabilities, offset by the reclassification of accrued rental payments and the current portion of deferred rent accrual to operating lease ROU assets.
Represents recognition of the non-current operating lease liabilities.
Represents reclassification of the non-current portion of deferred rent accrual and lease incentives to operating lease ROU assets.
Represents an impairment charge on operating lease ROU assets arising from existing operating leases as of January 1, 2019, net of related impact on deferred taxes and noncontrolling interests, with a corresponding reduction to the carrying amount of operating lease ROU assets. The impairment charge was recorded for those restaurants under operating leases with full impairment on the long-lived assets before January 1, 2019, as the additional impairment charge would have been recorded before January 1, 2019 had the operating lease ROU assets been recognized at the time of impairment.
Represents impairment of operating lease ROU assets attributable to noncontrolling interests.
In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”). The new guidance allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act (the “Tax Act”) and will improve the usefulness of information reported to financial statement users. ASU 2018-02 is effective for the Company from January 1, 2019, with early adoption permitted. We adopted the standard on January 1, 2019, and such adoption did not have a material impact on our financial statements.
In June 2018, the FASB issued ASU 2018-07, Compensation – Stock Compensation (Topic 718) Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”). The new guidance largely aligns the accounting for share-based awards issued to employees and non-employees. Existing guidance for employee awards will apply to nonemployee share-based transactions with limited exceptions. The new guidance also clarifies that any share-based payment awards issued to customers should be evaluated under ASC 606, Revenue from Contracts with Customers. ASU 2018-07 is effective for the Company from January 1, 2019, with early adoption permitted. We adopted the standard on January 1, 2019, and such adoption did not have a material impact on our financial statements.
Certain prior period items in the Condensed Consolidated Financial Statements have been reclassified to conform to the current period’s presentation to facilitate comparison.
Note 3 – Revenue Recognition
The Company’s revenues primarily include Company sales, Franchise fees and income and Revenues from transactions with franchisees and unconsolidated affiliates.
Company Sales
Revenues from Company-owned restaurants are recognized when a customer takes possession of the food and tenders payment, which is when our obligation to perform is satisfied. The Company presents sales net of sales-related taxes. We also offer our customers delivery through both our own mobile applications and third-party aggregators’ platforms. For delivery orders placed through our mobile applications, we use our dedicated riders, while for orders placed through third-party aggregators’ platforms, we use our dedicated riders, or, in limited cases, third-party aggregators’ delivery staff. With respect to delivery orders delivered by our dedicated riders, we control and determine the price for the delivery service and generally recognize revenue, including delivery fees, when a customer takes possession of the food. When orders are fulfilled by the delivery staff of third-party aggregators, who control and determine the price for the delivery service, we recognize revenue, excluding delivery fees, when control of the food is transferred to the third-party aggregators’ delivery staff. The payment terms with respect to these sales are short-term in nature.
We recognize revenues from prepaid stored-value products, including gift cards and product vouchers, when they are redeemed by the customer. Prepaid gift cards sold at any given point generally expire over the next 36 months, and product vouchers generally expire over a period up to 12 months. We recognize breakage revenue, which is the amount of prepaid stored-value products that is not expected to be redeemed, either (1) proportionally in earnings as redemptions occur, in situations where the Company expects to be entitled to a breakage amount, or (2) when the likelihood of redemption is remote, in situations where the Company does not expect to be entitled to breakage, provided that there is no requirement for remitting balances to government agencies under unclaimed property laws. The Company reviews its breakage estimates at least annually based upon the latest available information regarding redemption and expiration patterns.
Our privilege membership programs offer privilege members rights to multiple benefits, such as free delivery and discounts on certain products. For certain KFC and Pizza Hut privilege membership programs offering a pre-defined amount of benefits that can be redeemed ratably over the membership period, revenue is ratably recognized over the period based on the elapse of time. With respect to Pizza Hut family privilege membership program offering members a mix of distinct benefits, including a welcome gift and assorted discount coupons with pre-defined quantities, consideration collected is allocated to the benefits provided based on their relative standalone selling price and revenue is recognized when food or services are delivered or the benefits expire.
Franchise Fees and Income
Franchise fees and income primarily include upfront fees, such as initial fees and renewal fees, and continuing fees. We have determined that the services we provide in exchange for upfront fees and continuing fees are highly interrelated with the franchise right. We recognize upfront fees received from a franchisee as revenue over the term of the franchise agreement or the renewal agreement because the franchise rights are accounted for as rights to access our symbolic intellectual property in accordance with ASC 606. The franchise agreement term is generally 10 years for KFC and Pizza Hut, and five or 10 years for Little Sheep. We recognize continuing fees, which are based upon a percentage of franchisee sales, as those sales occur.
Revenues from Transactions with Franchisees and Unconsolidated Affiliates
11
Revenues from transactions with franchisees and unconsolidated affiliates consist primarily of sales of food and paper products, advertising services and other services provided to franchisees and unconsolidated affiliates.
The Company centrally purchases substantially all food and paper products from suppliers for substantially all of our restaurants, including franchisees and unconsolidated affiliates, and then sells and delivers them to the restaurants. The performance obligation arising from such transactions is considered distinct from the franchise agreement as it is not highly dependent on the franchise agreement and the customer can benefit from the procurement service on its own. We consider ourselves the principal in this arrangement as we have the ability to control a promised good or service before transferring that good or service to the franchisees and unconsolidated affiliates. Revenue is recognized upon transfer of control over ordered items, generally upon delivery to the franchisees and unconsolidated affiliates.
For advertising services, the Company often engages third parties to provide services and acts as a principal in the transaction based on our responsibilities of defining the nature of the services and administering and directing all marketing and advertising programs in accordance with the provisions of our franchise agreements. The Company collects advertising contributions, which are generally based on a certain percentage of sales from substantially all of our restaurants, including franchisees and unconsolidated affiliates. Other services provided to franchisees and unconsolidated affiliates consist primarily of customer support and technology support services. Advertising services and other services provided are highly interrelated to franchise right, and are not considered individually distinct. We recognize revenue when the related sales occur.
Loyalty Programs
Each of the Company’s KFC and Pizza Hut reportable segments operates a loyalty program that allows registered members to earn points for each qualifying purchase. Points, which generally expire 18 months after being earned, may be redeemed for future purchases of KFC or Pizza Hut branded products or other products for free or at a discounted price. Points cannot be redeemed or exchanged for cash. The estimated value of points earned by the loyalty program members is recorded as a reduction of revenue at the time the points are earned, based on the percentage of points that are projected to be redeemed, with a corresponding deferred revenue liability included in Accounts payable and other current liabilities on the Condensed Consolidated Balance Sheets and subsequently recognized into revenue when the points are redeemed or expire. The Company estimates the value of the future redemption obligations based on the estimated value of the product for which points are expected to be redeemed and historical redemption patterns, including an estimate of the breakage for points that members will never redeem. The Company reviews its breakage estimates periodically based upon the latest available information regarding redemption and expiration patterns.
Disaggregation of Revenue
The following table presents revenue disaggregated by types of arrangements and segments:
Quarter Ended 9/30/2019
KFC
Pizza Hut
All Other
Segments(a)
Corporate and
Unallocated(a)
Combined
Elimination
Consolidated
1,546
540
35
Revenues from transactions
with franchisees and
16
147
(9
1,598
542
40
148
2,328
Quarter Ended 9/30/2018
1,452
548
34
136
(6
1,501
550
137
2,218
Year to Date Ended 9/30/2019
4,495
1,588
104
48
425
(28
4,648
1,595
428
6,775
Year to Date Ended 9/30/2018
4,248
1,640
47
395
27
4,399
1,643
71
397
6,510
As COFFii & JOY and our e-commerce business became operating segments starting from the first quarter of 2019, revenue by segment information for prior quarters has been recast to align with the change in segment reporting. Additional details on our reportable segments are included in Note 13.
Accounts Receivable
Accounts receivable mainly consist of trade receivables and royalties from franchisees and unconsolidated affiliates, and are generally due within 30 days of the period in which the corresponding sales occur and are classified as Accounts receivable on the Condensed Consolidated Balance Sheets. Our provision for uncollectible receivable balances is based upon pre-defined aging criteria or upon the occurrence of other events that indicate that we may not collect the balance due. Additionally, we monitor the financial condition of our franchisees and record provisions for estimated losses on receivables when we believe it is probable that our franchisees will be unable to make their required payments. While we use the best information available in making our determination, the ultimate recovery of recorded receivables is also dependent upon future economic events and other conditions that may be beyond our control. Trade receivables that are ultimately deemed to be uncollectible, and for which collection efforts have been exhausted, are written off against the allowance for doubtful accounts.
13
Costs to Obtain Contracts
Costs to obtain contracts consist of upfront license fees that we paid to YUM prior to the separation in relation to initial fees or renewal fees we received from franchisees and unconsolidated affiliates, as well as license fees that are payable to YUM in relation to our deferred revenue of prepaid stored-value products and customer loyalty programs. They meet the requirements to be capitalized as they are incremental costs of obtaining contracts with customers and the Company expects to generate future economic benefits from such costs incurred. Such costs to obtain contracts are included in Other assets on the Condensed Consolidated Balance Sheets and are amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the assets relate. Subsequent to the separation, we are no longer required to pay YUM initial or renewal fees that we receive from franchisees and unconsolidated affiliates. The Company did not incur any impairment losses related to costs to obtain contracts during any of the periods presented. Costs to obtain contracts were $9 million and $8 million at September 30, 2019 and December 31, 2018, respectively.
Contract Liabilities
Contract liabilities at September 30, 2019 and December 31, 2018 were as follows:
Contract liabilities
Deferred revenue related to prepaid stored-value products
73
Deferred revenue related to customer loyalty programs
Deferred revenue related to upfront fees
37
Total
140
127
Contract liabilities consist of deferred revenue related to prepaid stored-value products, customer loyalty programs and upfront fees. Deferred revenue related to prepaid stored-value products and customer loyalty programs is included in Accounts payable and other current liabilities on the Condensed Consolidated Balance Sheets. Deferred revenue related to upfront fees that we expect to recognize as revenue in the next 12 months is included in Accounts payable and other current liabilities, and the remaining balance is included in Other liabilities on the Condensed Consolidated Balance Sheets. Revenue recognized that was included in the contract liability balance at the beginning of each period amounted to $35 million and $21 million for the quarter ended September 30, 2019 and 2018, respectively, and $56 million and $39 million for the years to date ended September 30, 2019 and 2018, respectively. Changes in contract liability balances were not materially impacted by business acquisition, change in estimate of transaction price or any other factors during any of the periods presented.
The Company has elected, as a practical expedient, not to disclose the value of remaining performance obligations associated with sales-based royalty promised to franchisees in exchange for franchise right and other related services. The remaining duration of the performance obligation is the remaining contractual term of each franchise agreement. We recognize continuing franchisee fees and revenues from advertising services and other services provided to franchisees and unconsolidated affiliates based on a certain percentage of sales, as those sales occur.
Note 4 – Earnings Per Common Share (“EPS”)
The following table summarizes the components of basic and diluted EPS (in millions, except per share data):
(for basic calculation) (a)
Effect of dilutive share-based awards (a)
Effect of dilutive warrants (b)
Weighted-average common and dilutive potential
common shares outstanding (for diluted calculation)
Share-based awards excluded from the diluted EPS computation (c)
As a result of the separation, shares of Yum China common stock were distributed to YUM’s shareholders of record as of October 19, 2016 and included in the calculated weighted-average common shares outstanding. Holders of outstanding YUM equity awards generally received both adjusted YUM awards and Yum China awards, or adjusted awards on shares of common stock of either YUM or Yum China in their entirety. Any subsequent exercise of these awards, whether held by the Company’s employees or YUM’s employees, would increase the number of common shares outstanding. The incremental shares arising from outstanding equity awards are included in the computation of diluted EPS, if there is dilutive effect.
Pursuant to the investment agreements dated September 1, 2016, Yum China issued to strategic investors two tranches of warrants on January 9, 2017, with each tranche initially providing the right to purchase 8,200,405 shares of Yum China common stock, at an exercise price of $31.40 and $39.25 per share, respectively, subject to customary anti-dilution adjustments. The warrants may be exercised at any time through October 31, 2021. The incremental shares arising from outstanding warrants are included in the computation of diluted EPS, if there is dilutive effect when the average market price of Yum China common stock for the period exceeds the exercise price of the warrants.
These outstanding stock appreciation rights, restricted stock units and performance share units were not included in the computation of diluted EPS because to do so would have been antidilutive for the quarters and years to date presented.
Note 5 – Equity
Changes in Equity and Redeemable Noncontrolling Interest (in millions)
Accumulated
Common
Additional
Other
Redeemable
Stock
Paid-in
Retained
Comprehensive
Treasury Stock
Noncontrolling
Shares
Amount
Capital
Earnings
Income (Loss)
Interests
Interest
Balance at June 30, 2019
2,417
1,193
(600
3,078
Net Income
Foreign currency translation
adjustments
(92
Comprehensive income
Cash dividends declared
($0.12 per common share)
(45
Repurchase of shares of
common stock
(64
Exercise and vesting of
share-based awards
Share-based compensation
Balance at September 30, 2019
(18
Balance at June 30, 2018
391
2,388
751
(221
93
3,096
($0.1 per common share)
(38
(94
Balance at September 30, 2018
2,393
916
(14
(315
99
3,083
(Loss) Income
Balance at December 31, 2018
392
($0.36 per common share)
Dividends declared
(34
(5
(204
Cumulative effect of accounting
change
Balance at December 31, 2017
2,375
77
2,842
(151
Acquisition of business
($0.3 per common share)
(33
(167
Share Repurchase Program
On February 7, 2017, we announced that our Board of Directors authorized a $300 million share repurchase program. On October 4, 2017, the Board of Directors increased Yum China’s existing share repurchase authorization from $300 million to an aggregate of $550 million. On October 30, 2018, the Board of Directors further increased the share repurchase authorization to an aggregate of $1.4 billion. The Company repurchased 4.9 million and 4.6 million shares of Yum China common stock at a total cost of $204 million and $167 million for the years to date ended September 30, 2019 and 2018, respectively. The total cost includes $2 million and $6 million to be settled subsequent to September 30, 2019 and 2018, respectively, for shares repurchased with trade dates on or prior to September 30, 2019 and 2018, respectively. As of September 30, 2019, $756 million remained available for future share repurchases under the authorization.
Note 6 – Items Affecting Comparability of Net Income and Cash Flows
Gain from Re-Measurement of Equity Interest Upon Acquisition
In the first quarter of 2018, the Company completed the acquisition of Wuxi KFC. In connection with the acquisition, the Company also recognized a gain of $98 million from the re-measurement of our previously held 47% equity interest at fair value using discounted cash flow valuation approach and incorporating assumptions and estimates that were not observable in the market. Key assumptions used in estimating future cash flows included projected revenue growth and operating expenses, which were based on internal projections, historical performance of stores and the business environment, as well as the selection of an appropriate discount rate based on weighted-average cost of capital and company-specific risk premium. The gain was not allocated to any segment for performance reporting purposes.
Meituan Dianping (“Meituan”) Investment
In the third quarter of 2018, the Company subscribed for 8.4 million, or less than 1%, of the ordinary shares of Meituan, an e-commerce platform for services in China, for a total consideration of approximately $74 million, when it launched its initial public offering on the Hong Kong Stock Exchange in September 2018. The Company accounted for the equity securities at fair value with subsequent fair value changes recorded in our Condensed Consolidated Statements of Income. The fair value of the investment in Meituan is determined based on the closing market price for the shares at the end of each reporting period. As of September 30, 2019, the fair value of the investment was $86 million. The unrealized gain of $12 million and $39 million was included in Investment gain in our Condensed Consolidated Statements of Income during the quarter and year to date ended September 30, 2019, respectively.
Transition Tax
We completed the evaluation of the impact on our transition tax computation based on the final regulations that were released by the U.S. Treasury Department and the Internal Revenue Service (“IRS”) and became effective in the first quarter of 2019, and recorded an additional amount of $8 million for the transition tax accordingly. See Note 12 for additional information.
Note 7 – Other Income, net
Equity income from investments in unconsolidated
affiliates
56
Gain from re-measurement of equity interest upon
acquisition(a)
Foreign exchange impact and other
(7
(8
143
As a result of the acquisition of Wuxi KFC in the first quarter of 2018, as disclosed in Note 2, the Company recognized a gain of $98 million from the re-measurement of our previously held 47% equity interest at fair value, which was not allocated to any segment for performance reporting purposes.
Note 8 – Supplemental Balance Sheet Information
Accounts Receivable, net
Accounts receivable, gross
Allowance for doubtful accounts
Prepaid Expenses and Other Current Assets
Receivables from payment processors and aggregators
Dividends receivable from unconsolidated affiliates
Prepaid rent
42
Other prepaid expenses and current assets
76
66
Property, Plant and Equipment
Buildings and improvements
2,099
2,121
Finance leases, primarily buildings
Machinery, equipment and construction in progress
1,191
1,201
Property, plant and equipment, gross
3,316
3,348
Accumulated depreciation
(1,810
(1,733
Other Assets
VAT assets
232
226
Land use right
130
86
Long-term deposits
69
64
Costs to obtain contracts
Restricted cash
Others
Accounts Payable and Other Current Liabilities
Accounts payable
563
Operating leases liabilities
360
Accrued compensation and benefits
199
200
Accrued capital expenditures
112
96
Accrued marketing expenses
94
Other current liabilities
128
115
Other Liabilities
Accrued income tax payable
67
Deferred income tax liabilities
58
65
31
Deferred rental accrual
144
Other non-current liabilities
44
Reconciliation of Cash, Cash equivalents, and Restricted Cash for Condensed Consolidated Statements of Cash Flows
Cash and cash equivalents as presented in Condensed Consolidated Balance Sheets
Restricted cash included in Other assets (a)
Cash, Cash Equivalents and Restricted Cash as presented in Condensed Consolidated
Statements of Cash Flows
Restricted cash included in Other assets within our Condensed Consolidated Balance Sheet represents amounts deposited into an escrow account pursuant to a definitive agreement entered in August 2019 to acquire a controlling interest in the Huang Ji Huang group, a leading Chinese-style casual dining franchise business. Subject to the satisfaction of closing conditions, the acquisition is expected to close in early 2020. The acquisition is considered immaterial.
Note 9 – Goodwill and Intangible Assets
The changes in the carrying amount of goodwill are as follows:
Company
Segments
Balance as of December 31, 2018
Goodwill, gross
648
238
Accumulated impairment losses(a)
(382
Goodwill, net
Effect of currency translation adjustment
Balance as of September 30, 2019
638
229
Accumulated impairment losses represent Little Sheep goodwill impairment.
Intangible assets, net as of September 30, 2019 and December 31, 2018 are as follows:
Gross Carrying
Amount(a)
Amortization
Accumulated impairment losses
Net Carrying Amount
Definite-lived intangible
assets
Reacquired franchise
rights
(108
150
(100
Daojia platform
Customer-related assets
Others(b)
180
(122
(12
(120
63
Indefinite-lived intangible
Little Sheep trademark
53
Total intangible assets
231
248
Changes in gross carrying amount include the effect of currency translation adjustment.
Decrease in Others during year to date ended September 30, 2019 is primarily due to the reclassification of favorable lease assets, with a gross carrying amount of $7 million and accumulated amortization of $5 million, to right-of-use assets upon adoption of ASC 842.
Amortization expense of definite-lived intangible assets was $3 million and $7 million for the quarters ended September 30, 2019 and 2018, respectively, and $13 million and $20 million for the years to date ended September 30, 2019 and 2018, respectively. As of September 30, 2019, expected amortization expense for the unamortized definite-lived intangible assets is approximately $3 million for the remainder of 2019, $12 million in 2020, $12 million in 2021, $12 million in 2022 and $3 million in 2023.
Note 10 – Leases
As of September 30, 2019, we operated more than 8,900 restaurants, leasing the underlying land and/or building. We generally enter into lease agreements with initial terms of 10 to 20 years. Most of our lease agreements contain termination options that permit us to terminate the lease agreement early if the restaurant’s unit contribution is negative for a specified period of time. We generally do not have renewal options for our leases. Such options are accounted for only when it is reasonably certain that we will exercise the options. The rent under the majority of our current restaurant lease agreements is generally payable in one of three ways: (i) fixed rent; (ii) the higher of a fixed base rent or a percentage of the restaurant’s sales revenue; or (iii) a percentage of the restaurant’s sales revenue. Most leases require us to pay common area maintenance fees for the leased property. In addition to restaurants leases, we also lease office spaces, logistics centers and equipment. Our lease agreements do not contain any material residual value guarantees or material restrictive covenants.
Prior to the adoption of ASC 842, operating leases were not recognized on the balance sheet of the Company, but rent expenses were recognized on a straight-line basis over the lease term. Upon adoption, right-of-use assets and lease liabilities are recognized upon lease commencement for operating leases based on the present value of lease payments over the lease term. This is consistent with the historical recognition of finance leases, which was unchanged upon adoption of ASC 842. Variable lease payments that do not depend on a rate or index are expensed as incurred. The Company has elected not to recognize right-of-use assets or lease liabilities for leases with an initial term of 12 months or less; we recognize lease expense for these leases on a straight-line basis over the lease term. In addition, the Company has elected not to separate non-lease components (e.g., common area maintenance fees) from the lease components.
In limited cases, we sublease certain restaurants to franchisees in connection with refranchising transactions or lease our properties to other third parties. The lease payments under these leases are generally based on the higher of a fixed base rent or a percentage of the restaurant’s annual sales revenue. Income from sublease agreements with franchisees or lease agreements with other third parties are included in Franchise fees and income and Other revenue, respectively, within our Condensed Consolidated Statements of Income. The impact of ASC 842 on our accounting as a lessor was not significant.
Supplemental Balance Sheet
Account Classification
Assets
Finance lease right-of-use assets
Total leased assets
1,907
Liabilities
Current
Operating lease liabilities
Finance lease liabilities
Non-current
Total lease liabilities
2,113
Summary of Lease Cost
Quarter
Ended
Year to Date
Operating lease cost
351
Occupancy and other operating expenses,
G&A or Franchise expenses
Finance lease cost
Amortization of leased assets
Interest on lease liabilities
Interest expense, net
Variable lease cost
265
or Franchise expenses
Short-term lease cost
Occupancy and other operating expenses or
G&A
Sublease income
(21
Franchise fees and income or Other revenues
Total lease cost
605
Supplemental Cash Flow Information
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows from operating leases
120
361
Operating cash flows from finance leases
Financing cash flows from finance leases
Right-of-use assets obtained in exchange for new lease liabilities(a):
Operating leases
217
Finance leases
This also includes noncash transactions resulting in adjustments to the lease liability or ROU asset due to modification or other reassessment events.
Lease Term and Discount Rate
Weighted-average remaining lease term (years)
7.1
12.0
Weighted-average discount rate
6.1
%
5.8
Summary of Future Lease Payments and Lease Liabilities
Maturities of lease liabilities as of September 30, 2019 were as follows:
Amount of
Operating
Leases
Finance Leases
Remainder of 2019
133
134
2020
458
2021
416
419
2022
358
2023
295
298
Thereafter
931
952
Total undiscounted lease payment
2,591
2,625
Less: imputed interest (b)
512
Present value of lease liabilities
2,089
As most of our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at the lease commencement date in determining the imputed interest and present value of lease payments. We used the incremental borrowing rate on January 1, 2019 for operating leases that commenced prior to that date.
As of September 30, 2019, we have additional lease agreements that have been signed but not yet commenced, with total undiscounted minimum lease payments of $121 million. These leases will commence between the fourth quarter of 2019 and 2023 with lease terms of 1 year to 20 years.
Future minimum lease payments under non-cancellable leases as of December 31, 2018 were as follows:
Commitments
Finance
2019
466
469
440
443
336
339
278
864
22
886
2,775
2,812
At December 31, 2018, the present value of minimum payments under finance leases was $27 million, after deducting imputed interest of $10 million. The current portion of finance lease obligations was $2 million as of December 31, 2018, and was classified in Accounts payable and other current liabilities.
Note 11 – Fair Value Measurements
The Company’s financial assets and liabilities primarily consist of cash and cash equivalents, short-term investments, accounts receivable and accounts payable, and the carrying values of these assets and liabilities generally approximate their fair value.
The Company accounts for its investment in the equity securities of Meituan at fair value, which is determined based on the closing market price for the shares at the end of each reporting period, with subsequent fair value changes recorded in our Condensed Consolidated Statements of Income.
The following table is a summary of our financial assets measured on a recurring basis or disclosed at fair value and the level within the fair value hierarchy in which the measurement falls. The Company classifies its cash equivalents, short-term investments and investment in equity securities within Level 1 or Level 2 in the fair value hierarchy because it uses quoted market prices or alternative pricing sources and models utilizing market observable inputs to determine their fair value. No transfers among the levels within the fair value hierarchy occurred during the quarter ended September 30, 2019.
Fair Value Measurement or Disclosure
at September 30, 2019
Balance at
September 30,
Level 1
Level 2
Level 3
Cash equivalents:
Time deposits
Money market funds
284
Total cash equivalents
942
Short-term investments:
Total short-term investments
Other assets:
1,392
370
1,022
at December 31, 2018
December 31,
2018
570
Fixed rate debt securities(a)
153
949
379
1,118
426
692
Classified as held-to-maturity investments and measured at amortized cost.
Non-Recurring Fair Value Measurements
In addition, certain of the Company’s restaurant-level assets (including operating lease ROU assets, property, plant and equipment), goodwill and intangible assets, are measured at fair value based on Level 3 on a non-recurring basis, if determined to be impaired. In the determination of fair value of restaurant level assets, the Company considered the highest and best use of the assets and used unobservable inputs (Level 3), such as reasonable sales growth and margin improvement assumptions in generating after-tax cash flows or the price market participants would pay to sublease the ROU assets for other use.
The following table presents amounts recognized from all non-recurring fair value measurements using Level 3 inputs during the quarters and years to date ended September 30, 2019 and 2018. These amounts exclude fair value measurements made for restaurants that were closed or refranchised prior to those respective period-end dates.
ROU impairment prior to the
adoption of ASC 842(a)
Retained Earnings
Incremental restaurant-level
impairment upon adoption of
ASC 842(b)
Closure and impairment expenses, net
Restaurant-level impairment(c)
101
ROU impairment prior to the adoption of ASC 842 represents an impairment charge on operating lease ROU assets arising from existing operating leases as of January 1, 2019. After netting with the related impact on deferred taxes of $19 million and the impact on noncontrolling interests of $3 million, we recorded a cumulative adjustment of $60 million to retained earnings in accordance with the transition guidance for the new lease standard. For those restaurants under operating leases with full impairment on their long-lived assets (primarily property, plant and equipment) before January 1, 2019, an additional impairment charge would have been recorded before January 1, 2019 had the operating lease ROU assets been recognized at the time of impairment.
Reflect incremental restaurant-level impairment upon adoption of ASC 842 in the first quarter of 2019. We performed an additional impairment evaluation of long-lived assets of restaurants, which includes operating lease ROU assets, and property, plant and equipment.
Restaurant-level impairment changes resulted primarily from our semi-annual impairment evaluation of long-lived assets of individual restaurants that were being operated at the time of impairment and had not been offered for refranchising.
Note 12 – Income Taxes
87
227
Effective tax rate
26.9
24.2
25.8
25.7
The higher effective tax rate for the quarter ended September 30, 2019 was primarily due to additional accrued tax on Global Intangible Low Taxed Income (“GILTI”). The higher year to date effective tax rate was primarily due to an additional adjustment of $8 million on transition tax pursuant to the Tax Act recorded in the first quarter of 2019 and additional accrued tax on GILTI, offset by non-taxable gain related to the investment in equity securities of Meituan.
In December 2017, the U.S. enacted the Tax Act, which included a broad range of tax reforms, including, but not limited to, the establishment of a flat corporate income tax rate of 21%, the elimination or reduction of certain business deductions and the imposition of tax on deemed repatriation of accumulated undistributed foreign earnings. The Tax Act impacted Yum China in two material aspects: (1) in general, all of the foreign-source dividends received by Yum China from its foreign subsidiaries are exempted from taxation starting from the tax year beginning after December 31, 2017 and (2) Yum China recorded additional income tax expense in the fourth quarter of 2017, including an estimated one-time transition tax on its deemed repatriation of accumulated undistributed foreign earnings and additional tax related to the revaluation of certain deferred tax assets.
We completed our analysis of the Tax Act in the fourth quarter of 2018 according to guidance released by the U.S. Treasury Department and the IRS as of December 2018 and made a reversal to provisional amount in the amount of $36 million for the transition tax recorded in 2017 accordingly. The U.S. Treasury Department and the IRS released the final transition tax regulations on January 15, 2019, which were published in the Federal Register and became effective on February 5, 2019. We completed the evaluation of the impact on our transition tax computation based on the final regulations released in the first quarter of 2019 and recorded an additional amount of $8 million for the transition tax accordingly.
The Tax Act requires a U.S. shareholder to be subject to tax on GILTI earned by certain foreign subsidiaries. We have elected the option to account for current year GILTI tax as a period cost as incurred, and therefore included it in estimating the annual effective tax rate.
We are subject to reviews, examinations and audits by Chinese tax authorities, the IRS and other taxing authorities with respect to income and non-income based taxes. Since 2016, we have been under a national audit on transfer pricing by the STA in China regarding our related party transactions for the period from 2006 to 2015. The information currently requested by tax authorities focuses on our franchise arrangement with YUM. To address the requests, we have submitted information to the extent it is available to the Company. It is reasonably possible that there could be significant developments, including expert review and assessment by the STA, within the next 12 months. The ultimate assessment will depend upon further review of the information provided and ongoing technical and other discussions with the STA and in-charge local tax authorities, and therefore it is not possible to reasonably estimate the potential impact. We will continue to defend our transfer pricing position. However, if the STA prevails in the assessment of additional tax due based on its ruling, the assessed tax, interest and penalties, if any, could have a material adverse impact on our financial position, results of operations and cash flows.
Note 13 –Segment Reporting
We have two reportable segments: KFC and Pizza Hut. Starting from the first quarter of 2019, our newly developed COFFii & JOY concept and e-commerce business became operating segments, as their financial results started being regularly reviewed by the Company’s chief operating decision maker. Accordingly, our six non-reportable operating segments, reflecting the operations of East Dawning, Little Sheep, Taco Bell, Daojia, COFFii & JOY and our e-commerce business, are combined and referred to as All Other Segments, as those operating segments are insignificant both individually and in aggregate. Segment financial information for prior quarters has been recast to align with this change in segment reporting. There was no impact on the consolidated financial statements of the Company as a result of this change.
Corporate
and
Revenue from external
customers
1,597
Inter-segment revenue
4,647
62
KFC(b)
264
788
759
106
All Other Segments
(16
Unallocated revenues from transactions with franchisees
and unconsolidated affiliates(c)
Unallocated Other revenues
Unallocated expenses from transactions with franchisees
(145
(135
(421
(392
Unallocated Other operating costs and expenses
Unallocated and corporate G&A expenses
(42
Unallocated Other income (loss)(d)
Interest income, net(a)
Investment gain(a)
Impairment Charges
KFC(e)
Pizza Hut(e)
KFC(f)
2,992
1,745
939
558
164
132
Corporate and Unallocated(g)
2,615
2,175
Amounts have not been allocated to any segment for performance reporting purposes.
Includes equity income from investments in unconsolidated affiliates of $19 million and $17 million for the quarters ended September 30, 2019 and 2018, respectively, and $56 million and $52 million for the years to date ended September 30, 2019 and 2018, respectively.
Primarily includes revenues and associated expenses of transactions with franchisee and unconsolidated affiliates derived from the Company’s central procurement model whereby the Company centrally purchases substantially all food and paper products from suppliers and then sells and delivers to restaurants, including franchisees and unconsolidated affiliates. Amounts have not been allocated to any segment for purposes of making operating decisions or assessing financial performance as the transactions are deemed corporate revenues and expenses in nature.
The amount for the year to date ended September 30, 2018 primarily includes gain from re-measurement of the previously held equity interest in connection with the acquisition of Wuxi KFC (See Note 2).
Primarily includes store closure impairment charges, incremental restaurant-level impairment charges as a result of adopting ASC 842 and restaurant-level impairment charges resulting from our semi-annual impairment evaluation (See Note 11).
Includes investments in unconsolidated affiliates.
Primarily includes cash and cash equivalents, short-term investments, investment in equity securities, and inventories that are centrally managed.
Note 14 – Contingencies
Indemnification of China Tax on Indirect Transfers of Assets
In February 2015, the Chinese State Taxation Administration (“STA”) issued Bulletin 7 on Income arising from Indirect Transfers of Assets by Non-Resident Enterprises. Pursuant to Bulletin 7, an “indirect transfer” of Chinese taxable assets, including equity interests in a Chinese resident enterprise, by a non-resident enterprise, may be recharacterized and treated as a direct transfer of Chinese taxable assets, if such arrangement does not have reasonable commercial purpose and the transferor has avoided payment of Chinese enterprise income tax. As a result, gains derived from such an indirect transfer may be subject to Chinese enterprise income tax at a rate of 10%.
YUM concluded and we concurred that it is more likely than not that YUM will not be subject to this tax with respect to the distribution. However, there are significant uncertainties regarding what constitutes a reasonable commercial purpose, how the safe harbor provisions for group restructurings are to be interpreted and how the taxing authorities will ultimately view the distribution. As a result, YUM’s position could be challenged by Chinese tax authorities resulting in a 10% tax assessed on the difference between the fair market value and the tax basis of the separated China business. As YUM’s tax basis in the China business is minimal, the amount of such tax could be significant.
Any tax liability arising from the application of Bulletin 7 to the distribution is expected to be settled in accordance with the tax matters agreement between the Company and YUM. Pursuant to the tax matters agreement, to the extent any Chinese indirect transfer tax pursuant to Bulletin 7 is imposed, such tax and related losses will be allocated between YUM and the Company in proportion to their respective share of the combined market capitalization of YUM and the Company during the 30 trading days after the separation. Such a settlement could be significant and have a material adverse effect on our results of operations and our financial condition. At the inception of the tax indemnity being provided to YUM, the fair value of the non-contingent obligation to stand ready to perform was insignificant and the liability for the contingent obligation to make payment was not probable or estimable.
Guarantees
From time to time we have guaranteed certain lines of credit and loans of franchisees and unconsolidated affiliates. As of September 30, 2019, guarantees on behalf of franchisees were immaterial and no guarantees were outstanding for unconsolidated affiliates.
Legal Proceedings
From time to time, the Company is subject to various lawsuits covering a variety of allegations. The Company believes that the ultimate liability, if any, in excess of amounts already provided for these matters in the Condensed Consolidated Financial Statements, is not likely to have a material adverse effect on the Company’s results of operations, financial condition or cash flows. Matters faced by the Company from time to time include, but are not limited to, claims from landlords, employees, customers and others related to operational, contractual or employment issues.
Note 15 – Subsequent Events
On October 29, 2019, the Company announced that the Board of Directors declared a cash dividend of $0.12 per share, payable as of the close of business on December 17, 2019 to stockholders of record as of the close of business on November 26, 2019. The total estimated cash dividend payable is approximately $45 million.
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
References to the Company throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations (this “MD&A”) are made using the first person notations of “we,” “us” or “our.” This MD&A contains forward-looking statements, including statements with respect to the ongoing transfer pricing audit, the retail tax structure reform, our growth plans, future capital resources to fund our operations and anticipated capital expenditures, share repurchases, our ability to pay dividends and the impact of new accounting pronouncements not yet adopted. See “Cautionary Note Regarding Forward-Looking Statements” at the end of this Item 2 for information regarding forward-looking statements.
Introduction
Yum China Holdings, Inc. is the largest restaurant company in China, with over 8,900 restaurants as of September 30, 2019. Our growing restaurant base consists of China’s leading restaurant brands and concepts, primarily the KFC and Pizza Hut brands, as well as brands such as East Dawning, Little Sheep, Taco Bell and COFFii & JOY. Following our separation from YUM, we obtained the exclusive right to operate and sub-license the KFC, Pizza Hut and, subject to achieving certain agreed-upon milestones, Taco Bell brands in China, excluding Hong Kong, Taiwan and Macau (the “PRC” or “China”), and we own the intellectual property of the East Dawning, Little Sheep and COFFii & JOY concepts outright. We were the first major global restaurant brand when we entered China in 1987 and we have developed deep operating experience in the market. We have since grown to become one of China’s largest restaurant developers with locations in over 1,300 cities as of September 30, 2019.
KFC is the leading quick-service restaurant (“QSR”) brand in the PRC in terms of system sales and number of restaurants. As of September 30, 2019, KFC operated over 6,300 restaurants in over 1,300 cities across China. During the first quarter of 2018, the Company completed the acquisition of an additional 36% interest in an unconsolidated affiliate that operates KFC stores in Wuxi, China (“Wuxi KFC”), increasing the equity interest to 83% and allowing the Company to consolidate the entity.
Pizza Hut is the leading casual dining restaurant (“CDR”) brand in China in terms of system sales and number of restaurants. As of September 30, 2019, Pizza Hut operated over 2,200 restaurants in over 500 cities.
Overview
We intend for this MD&A to provide the reader with information that will assist in understanding our results of operations, including metrics that management uses to assess the Company’s performance. Throughout this MD&A, we discuss the following performance metrics:
•
The Company provides certain percentage changes excluding the impact of foreign currency translation (“F/X”). These amounts are derived by translating current year results at prior year average exchange rates. We believe the elimination of the F/X impact provides better year-to-year comparability without the distortion of foreign currency fluctuations.
System sales growth reflects the results of all restaurants regardless of ownership, including Company-owned, franchise and unconsolidated affiliate restaurants that operate our Concepts, except for non-Company-owned restaurants for which we do not receive a sales-based royalty. Sales of franchise and unconsolidated affiliate restaurants typically generate ongoing franchise fees for the Company at a rate of approximately 6% of system sales. Franchise and unconsolidated affiliate restaurant sales are not included in Company sales in the Condensed Consolidated Statements of Income; however, the franchise fees are included in the Company’s revenues. We believe system sales growth is useful to investors as a significant indicator of the overall strength of our business as it incorporates all of our revenue drivers, Company and franchise same-store sales as well as net unit growth.
Effective January 1, 2018, the Company revised its definition of same-store sales growth to represent the estimated percentage change in sales of food of all restaurants in the Company system that have been open prior to the first day of our prior fiscal year. We refer to these as our “base” stores. Previously, same-store sales growth represented the estimated percentage change in sales of all restaurants in the Company system that have been open for one year or more, and the base stores changed on a rolling basis from month to month. This revision was made to align with how management measures performance internally and focuses on trends of a more stable base of stores.
Company Restaurant profit (“Restaurant profit”) is defined as Company sales less expenses incurred directly by our Company-owned restaurants in generating Company sales. Company restaurant margin percentage is defined as Restaurant profit divided by Company sales. Within the Company sales and Restaurant profit analysis, Store Portfolio Actions represent the net impact of new unit openings, acquisitions, refranchising and store closures, and Other primarily represents the impact of same-store sales as well as the impact of changes in restaurant operating costs such as inflation/deflation.
In addition to the results provided in accordance with GAAP throughout this MD&A, the Company provides measures adjusted for Special Items, which include Adjusted Operating Profit, Adjusted Net Income, Adjusted Earnings Per Common Share, Adjusted Effective Tax Rate and Adjusted EBITDA, which we define as net income including noncontrolling interests adjusted for income tax, interest income, net, investment gain or loss, depreciation and amortization, and other items, including store impairment charges and Special Items. The Special Item for the year to date ended September 30, 2019 represents the impact from the U.S. Tax Cuts and Jobs Act (the “Tax Act”). The Special Item for the year to date ended September 30, 2018 represents a gain recognized from the re-measurement of our previously held equity interest in Wuxi KFC at fair value upon acquisition, as described in Note 2. The Company excludes impact from Special Items for the purpose of evaluating performance internally. Special Items are not included in any of our segment results. In addition, the Company provides Adjusted EBITDA because we believe that investors and analysts may find it useful in measuring operating performance without regard to items such as income tax, interest income, net, investment gain or loss, depreciation and amortization, and other items, including store impairment charges and Special Items. These adjusted measures are not intended to replace the presentation of our financial results in accordance with GAAP. Rather, the Company believes that the presentation of these adjusted measures provides additional information to investors to facilitate the comparison of past and present results, excluding those items that the Company does not believe are indicative of our ongoing operations due to their nature.
All Note references in this MD&A refer to the Notes to the Condensed Consolidated Financial Statements. Tabular amounts are displayed in millions of U.S. dollars except percentages and per share and unit count amounts, or as otherwise specifically identified. Percentages may not recompute due to rounding. References to quarters are references to the Company’s fiscal quarters.
Quarters and Years to Date Ended September 30, 2019 and 2018
Results of Operations
Summary
The Company has two reportable segments: KFC and Pizza Hut. Starting from the first quarter of 2019, our newly developed COFFii & JOY concept and e-commerce business became operating segments, as their financial results started being regularly reviewed by the Company’s chief operating decision maker. Accordingly, our six non-reportable operating segments, reflecting the operations of East Dawning, Little Sheep, Taco Bell, Daojia, COFFii & JOY and our e-commerce business, are combined and referred to as All Other Segments, as those operating segments are insignificant both individually and in aggregate. Segment financial information for prior quarters has been recast to align with this change in segment reporting. There was no impact on the consolidated financial statements of the Company as a result of this change. Additional details on our reportable operating segments are included in Note 13.
Quarterly highlights:
% Change
System Sales(a)
Same-Store Sales(a)
Net New Units
(Reported)
(Ex F/X)
+10
+3
+9
+12
+16
+1
+2
(30
All Other Segments(b)
+13
+29
+18
+8
+7
+11
+14
Year to date highlights:
+4
(11
NM refers to changes over 100%, from negative to positive amounts or from zero to an amount.
System sales and same-store sales percentages as shown in tables exclude the impact of F/X.
Sales from non-Company-owned restaurants, for which we do not receive a sales-based royalty, are excluded from system sales and same-store sales.
As of September 30, 2019, the Company operated over 8,900 units, predominately KFC and Pizza Hut restaurants, which are the leading QSR and CDR brand, respectively, in mainland China. Given our strong competitive position, a growing economy and a population of approximately 1.4 billion in mainland China, the Company has rapidly added KFC and Pizza Hut restaurants.
As compared to the third quarter of 2018, Company sales in the third quarter of 2019 increased 4%, or 8% if excluding the impact of F/X. Company sales for the year to date ended September 30, 2019 increased 3%, or 9% if excluding the impact of F/X. The quarter and year to date increase in Company sales, excluding the impact of F/X, was driven by net unit growth and same-store sales growth.
The increase in Operating profit for the quarter, excluding the impact of F/X, was primarily driven by same-store sales growth, net unit growth, labor efficiency and utilities savings, partially offset by wage and commodity inflation, and higher promotion and product upgrade costs.
The year to date decrease in Operating profit, excluding the impact of F/X, was primarily due to the negative impact from lapping a gain recognized from re-measurement of our equity interest in Wuxi KFC upon acquisition in the first quarter of 2018, wage and commodity inflation, higher promotion and product upgrade costs, and higher G&A expenses, partially offset by the positive impact from same-store sales growth, net unit growth and labor efficiency.
The Consolidated Results of Operations for the quarters and years to date ended September 30, 2019 and 2018 are presented below:
% B/(W) (a)
Reported
Ex F/X
43
45
Restaurant profits
372
353
1,041
1,000
Restaurant Margin %
17.7
17.6
0.1
ppts.
17.0
16.9
NM
(31
Net Income - including
noncontrolling interests
Net Income - noncontrolling
Net Income - Yum
China Holdings, Inc.
Diluted Earnings Per Common
Share
Adjusted Operating Profit
Adjusted Net Income - Yum
631
560
Adjusted Diluted Earnings
Per Common Share
1.62
1.41
Adjusted Effective Tax Rate
24.9
Adjusted EBITDA
407
1,156
1,125
Represents the period-over-period change in percentage.
33
Performance Metrics
System Sales Growth
System Sales Growth, excluding F/X
Same-Store Sales Growth (Decline)
)%
Unit Count
% Increase
Company-owned
7,171
6,711
Unconsolidated affiliates
863
802
Franchisees
883
800
8,917
8,313
Special Items
Special Items, along with the reconciliation of the most directly comparable GAAP financial measures to the adjusted financial measures, are presented below.
Detail of Special Items
Special Items, Operating Profit
Tax Expenses on Special Items(b)
(24
Impact from the Tax Act(c)
Special items, net income – including noncontrolling
Special items, net income – noncontrolling interests
Special Items, Net income – Yum China Holdings, Inc.
Weighted-average diluted shares outstanding (in millions)
Special Items, Diluted Earnings Per Common Share
(0.02
0.18
Reconciliation of Operating Profit to Adjusted
Reconciliation of Net Income to Adjusted Net Income
Net Income - Yum China Holdings, Inc.
Special Items, Net Income – Yum China Holdings, Inc.
Adjusted Net Income - Yum China Holdings, Inc.
Reconciliation of EPS to Adjusted EPS
Special Items, Basic Earnings Per Common Share
0.19
Adjusted Basic Earnings Per Common Share
1.67
1.45
Adjusted Diluted Earnings Per Common Share
Reconciliation of Effective Tax Rate to Adjusted
Effective Tax Rate
Effective tax rate (See Note 12)
Impact on effective tax rate as a result of Special
Items(b)(c)
0.9
(0.1
Adjusted effective tax rate
As a result of the acquisition of Wuxi KFC in the first quarter of 2018, the Company recognized a gain of $98 million from the re-measurement of our previously held 47% equity interest at fair value, which was not allocated to any segment for performance reporting purposes. (See Note 2).
The tax expense was determined based upon the nature, as well as the jurisdiction, of each Special Item at the applicable tax rate.
We completed the evaluation of the impact on our transition tax computation based on the final regulations that were released by the U.S. Treasury Department and the IRS and became effective in the first quarter of 2019, and recorded an additional amount of $8 million for the transition tax accordingly.
Net income, along with the reconciliation to Adjusted EBITDA, is presented below.
Reconciliation of Net Income to Adjusted EBITDA
Net Income — Yum China Holdings, Inc.
Net Income — noncontrolling interests
105
Store impairment charges
Segment Results
% B/(W)
Restaurant profit
311
845
Restaurant margin %
20.1
19.2
18.8
19.0
(0.2
G&A expenses
(20
135
Expenses for transactions
Closures and impairment
expenses, net
(46
Same-Store Sales Growth
4,925
4,500
536
498
6,324
5,800
Company Sales and Restaurant Profit
The changes in Company sales and Restaurant profit were as follows:
Income (Expense)
Store
Portfolio
Actions
F/X
Cost of sales
(444
(477
Cost of labor
(297
(311
Occupancy and other
operating expenses
(432
(447
321
(241
(1,281
(105
75
(1,403
(879
(942
70
(1,305
The increase in Company sales and Restaurant profit for the quarter, excluding the impact of F/X, was primarily driven by same-store sales growth, net unit growth, labor efficiency and utilities savings, partially offset by higher labor costs mainly due to wage inflation of 5% and commodity inflation of 3%.
The year to date increase in Company sales and Restaurant profit, excluding the impact of F/X, was primarily driven by same-store sales growth, net unit growth, lower depreciation expenses and lower advertising expenses, partially offset by commodity inflation of 4%, higher labor costs mainly due to wage inflation of 6% and higher promotion costs.
The increase in Franchise fees and income for the quarter, excluding the impact of F/X, was primarily driven by net unit growth and same-store sales growth of unconsolidated affiliates and franchisees.
The year to date increase in Franchise fees and income, excluding the impact of F/X, was primarily driven by same-store sales growth and net unit growth of unconsolidated affiliates and franchisees, partially offset by the impact of the acquisition of Wuxi KFC.
G&A Expenses
The quarter and year to date increase in G&A expenses, excluding the impact of F/X, was primarily driven by higher compensation costs mainly due to merit increases and higher performance-based compensation.
The quarter and year to date increase in Operating profit, excluding the impact of F/X, was primarily driven by the increase in restaurant profit, partially offset by higher G&A expenses.
68
197
193
11.4
13.8
(2.4
12.4
11.8
0.6
(73
(81
(income) expenses, net
78
System Sales (Decline) Growth
System Sales Growth (Decline), excluding F/X
2,165
2,180
90
2,255
2,215
(163
(170
(130
(140
(179
(168
(86
(486
(484
(410
(420
(551
(487
The increase in Company sales for the quarter, excluding the impact of F/X, was primarily driven by same-store sales growth and store portfolio actions. The decrease in Restaurant profit for the quarter, excluding the impact of F/X, was primarily driven by higher promotion costs and higher labor costs mainly attributable to wage inflation of 5%, partially offset by Company sales growth and commodity deflation of 3%.
The year to date increase in Company sales and Restaurant profit, excluding the impact of F/X, was primarily driven by same-store sales growth, store portfolio actions, labor efficiency, commodity deflation of 2% and utilities savings, partially offset by higher promotion costs and higher labor costs mainly attributable to wage inflation of 5%.
The quarter and year to date increase in G&A expenses, excluding the impact of F/X, was primarily driven by higher compensation costs due to higher performance-based compensation, merit increases and lower government incentive received, partially offset by lower cost allocation associated with development activities.
The decrease in Operating profit for the quarter, excluding the impact of F/X, was primarily driven by the decrease in restaurant profit and higher G&A expenses.
The year to date increase in Operating profit, excluding the impact of F/X, was primarily driven by the increase in restaurant profit and lower closure and store impairment expenses, net.
All Other Segments reflects the results of East Dawning, Little Sheep, Taco Bell, Daojia, COFFii & JOY and our e-commerce business.
(6.6
3.7
(10.3
(7.4
(0.5
(6.9
Other operating costs
and expenses
(40
(84
Operating Loss
Same-Store Sales Decline
The quarter and year to date increase in Company sales, excluding the impact of F/X, was primarily driven by higher sales generated from our e-commerce business and the launch of the COFFii & JOY concept.
The quarter and year to date increase in Other revenue and Other operating costs and expenses, excluding the impact of F/X, was primarily driven by inter-segment revenue transactions generated from our e-commerce business and Daojia.
Corporate and Unallocated
Other revenue
145
421
Corporate G&A expenses
92
Other unallocated
income (losses) (See Note 13)
Income tax provision (See Note
12)
(2.7
The increase in Revenues from transactions with franchisees and unconsolidated affiliates for the quarter, excluding the impact of F/X, was mainly driven by system sales growth of franchisees and unconsolidated affiliates.
The year to date increase in Revenues from transactions with franchisees and unconsolidated affiliates, excluding the impact of F/X, was mainly driven by system sales growth of franchisees and unconsolidated affiliates and an increase in the selling prices of food and paper products due to commodity inflation, partially offset by the impact from the acquisition of Wuxi KFC.
The change in Corporate G&A expenses for the quarter and year to date, excluding the impact of F/X, was mainly driven by higher compensation costs and higher government incentives received.
Other Unallocated Income
The year to date decrease in Other unallocated income, excluding the impact of F/X, was primarily due to a gain of $98 million recognized from the re-measurement of our previously held equity interest in Wuxi KFC at fair value upon acquisition in the first quarter of 2018.
Investment Gain
The Investment gain represents the unrealized gain related to our investment in equity securities of Meituan Dianping (“Meituan”). See Note 6.
Income Tax Provision
Our income tax provision includes tax on our earnings at the Chinese statutory tax rate of 25%, withholding tax on repatriation of earnings outside of China and U.S. corporate income tax, if any. Our effective tax rate was 26.9% and 24.2% for the quarters ended September 30, 2019 and 2018, respectively, and 25.8% and 25.7% for the years to date ended September 30, 2019 and 2018, respectively. The higher effective tax rate for the quarter ended September 30, 2019 was primarily due to additional accrued tax on GILTI. The higher year to date effective tax rate was primarily due to an additional adjustment of $8 million on transition tax pursuant to the Tax Act recorded in the first quarter of 2019 and additional accrued tax on GILTI, offset by non-taxable gain related to the investment in equity securities of Meituan.
Significant Known Events, Trends or Uncertainties Expected to Impact Future Results
Tax Examination on Transfer Pricing
PRC Value-Added Tax (“VAT”)
Effective May 1, 2016, the Chinese government implemented reform to its retail tax structure, which is intended to be a progressive and positive shift to more closely align with a more modern service-based economy. Under this reform, a 6% output VAT replaced the 5% business tax (“BT”) previously applied to certain restaurant sales. VAT was imposed on goods and services at the rates of 17%, 13%, 11% and 6%. Input VAT would be creditable to the aforementioned 6% output VAT. Effective from July 1, 2017, the 13% VAT rate primarily applicable to certain agricultural products was reduced to 11%. Effective from May 1, 2018, the VAT rates of 17% and 11% were lowered to 16% and 10%, respectively. Effective from April 1, 2019, the VAT rates of 16% and 10% were further lowered to 13% and 9%, respectively. These rate changes impact our input VAT on all materials and certain services, mainly including construction, transportation and leasing. However, the impact on our operating results is not expected to be significant.
Entities that are VAT general taxpayers are permitted to offset qualified input VAT paid to suppliers against their output VAT upon receipt of appropriate supplier VAT invoices on an entity-by-entity basis. When the output VAT exceeds the input VAT, the difference is remitted to tax authorities, usually on a monthly basis; whereas when the input VAT exceeds the output VAT, the difference is treated as an input VAT credit asset which can be carried forward indefinitely to offset future net VAT payables. VAT related to purchases and sales which have not been settled at the balance sheet date is disclosed separately as an asset and liability, respectively, on the Condensed Consolidated Balance Sheets. At each balance sheet date, the Company reviews the outstanding balance of any input VAT credit asset for recoverability based on its forecasted operating results. We evaluate the recoverability of the net VAT credit asset based on our estimated operating results and capital spending, which inherently includes significant assumptions that are subject to change.
As of September 30, 2019, an input VAT credit asset of $232 million and payable of $7 million were recorded in Other assets and Accounts payable and other current liabilities, respectively, on the Condensed Consolidated Balance Sheets. The Company has not made an allowance for the recoverability of the input VAT credit asset, as the balance is expected to be utilized to offset against VAT payables more than one year from September 30, 2019. Any input VAT credit asset would be classified as Prepaid expenses and other current assets if the Company expected to use the credit within one year.
We have been benefiting from the retail tax structure reform since it was implemented on May 1, 2016. However, the amount of our expected benefit from this VAT regime depends on a number of factors, some of which are outside of our control. The interpretation and application of the new VAT regime are not settled at some local governmental levels. In addition, the timetable for enacting the prevailing VAT regulations into national VAT law, including ultimate enacted VAT rates, is not clear. As a result, for the foreseeable future, the benefit of this significant and complex VAT reform has the potential to fluctuate from quarter to quarter.
Foreign Currency Exchange Rate
The reporting currency of the Company is the US$. Most of the revenues, costs, assets and liabilities of the Company are denominated in Chinese Renminbi (“RMB”). Any significant change in the exchange rate between US$ and RMB may materially affect the Company’s business, results of operations, cash flows and financial condition, depending on the weakening or strengthening of RMB against the US$. See “Item 3. Quantitative and Qualitative Disclosures About Market Risk” for further discussion.
Consolidated Cash Flows
Our cash flows for the years to date ended September 30, 2019 and 2018 were as follows:
Net cash provided by operating activities was $1,045 million in 2019 as compared to $1,173 million in 2018. The decrease was primarily driven by timing of payments for inventory.
Net cash used in investing activities was $553 million in 2019 as compared to $527 million in 2018. The increase is mainly due to higher cash outflow related to short-term investment activities in 2019, lapping cash outflow in 2018 related to the acquisition of Wuxi KFC and the investment in Meituan’s ordinary shares, and offset by lower capital expenditure in 2019.
Net cash used in financing activities was $368 million in 2019 as compared to $318 million in 2018. The increase was primarily driven by an increase in the number of shares repurchased and cash dividends paid to stockholders in 2019.
Liquidity and Capital Resources
Historically we have funded our operations through cash generated from the operation of our Company-owned stores and from our franchise operations and dividend payments from our unconsolidated affiliates.
Our ability to fund our future operations and capital needs will depend on our ongoing ability to generate cash from operations. We believe our principal uses of cash in the future will be primarily to fund our operations and capital expenditures, distributions to our stockholders and share repurchases as well as any acquisition or investment we may make. We believe that our future cash from operations, together with our access to funds on hand and capital markets, will provide adequate resources to fund these uses of cash and that our existing cash and net cash from operations will be sufficient to fund our operations and anticipated capital expenditures for the next 12 months.
If our cash flows from operations are less than we require, we may need to access the capital markets to obtain financing. Our access to, and the availability of, financing on acceptable terms and conditions in the future or at all will be impacted by many factors, including, but not limited to:
our financial performance;
our credit ratings;
the liquidity of the overall capital markets; and
the state of the Chinese, U.S. and global economies as well as relations between the Chinese and U.S. governments.
There can be no assurance that we will have access to the capital markets on terms acceptable to us or at all.
Generally our income is subject to the Chinese statutory tax rate of 25%. However, to the extent our cash flows from operations exceed our China cash requirements, the excess cash may be subject to an additional 10% withholding tax levied by the Chinese tax authority, subject to any reduction or exemption set forth in relevant tax treaties or tax arrangements.
Dividends and Share Repurchases
Our Board of Directors has authorized an aggregate of $1.4 billion under our share repurchase program. Yum China may repurchase shares under this program from time to time in open market or privately negotiated transactions, including block trades, accelerated share repurchase transactions and the use of Rule 10b5-1 trading plans. For the year to date ended September 30, 2019, the Company repurchased $204 million, or 4.9 million shares, of common stock under the repurchase program. The Company repurchased $167 million, or 4.6 million shares, of common stock under the repurchase program for the year to date ended September 30, 2018.
For the quarters to date ended September 30, 2019 and 2018, we paid cash dividends of approximately $45 million and $38 million, respectively, to our stockholders through quarterly dividend payments of $0.12 and $0.10 per share, respectively.
On October 29, 2019, the Board of Directors declared a cash dividend of $0.12 per share, payable as of the close of business on December 17, 2019 to stockholders of record as of the close of business on November 26, 2019. The total estimated cash dividend payable is approximately $45 million.
Our ability to declare and pay any dividends on our stock may be restricted by applicable Chinese laws. The laws, rules and regulations applicable to our Chinese subsidiaries permit payments of dividends only out of their accumulated profits, if any, determined in accordance with applicable Chinese accounting standards and regulations. Under Chinese law, an enterprise incorporated in China is required to set aside at least 10% of its after-tax profits each year, after making up previous years’ accumulated losses, if any, to fund certain statutory reserve funds, until the aggregate amount of such a fund reaches 50% of its registered capital. As a result, our Chinese subsidiaries are restricted in their ability to transfer a portion of their net assets to us in the form of dividends. At the discretion of the Board of Directors, as an enterprise incorporated in China, each of our Chinese subsidiaries may allocate a portion of its after-tax profits based on Chinese accounting standards to staff welfare and bonus funds. These reserve funds and staff welfare and bonus funds are not distributable as cash dividends.
Borrowing Capacity
As of September 30, 2019, the Company had credit facilities of RMB 2,930 million (approximately $410 million), comprised of onshore credit facilities of RMB1,500 million (approximately $210 million) in aggregate and offshore credit facilities of $200 million in aggregate.
The credit facilities had remaining terms of one year or less as of September 30, 2019. Each credit facility bears interest based on the prevailing rate stipulated by the People’s Bank of China or London Interbank Offered Rate (LIBOR) administered by the ICE Benchmark Administration. Each credit facility contains a cross-default provision whereby our failure to make any payment on a principal amount from any credit facility will constitute a default on other credit facilities. Some of the credit facilities contain covenants including, among other things, limitations on certain additional indebtedness and liens, and certain other transactions specified in the respective agreement. Some of the onshore credit facilities contain sublimits for overdrafts, non-financial bonding, standby letters of credit and guarantees. As of September 30, 2019, we had outstanding bank guarantees of RMB 76 million (approximately $11 million) to secure our lease payment to landlords for certain Company-owned restaurants. The borrowing capacity under the credit facilities was therefore reduced by the same amount, while there were no borrowings outstanding as of September 30, 2019.
Off-Balance Sheet Arrangements
See the Guarantees section of Note 14 for discussion of our off-balance sheet arrangements.
New Accounting Pronouncements
See Note 2 for details of recently adopted accounting pronouncements.
New Accounting Pronouncements Not Yet Adopted
In June 2016, the FASB issued ASU 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which requires measurement and recognition of expected versus incurred credit losses for financial assets held. In November 2018, the FASB issued ASU 2018-19: Codification Improvements to Topic 326, Financial Instruments-Credit Losses to clarify the implementation guidance. ASU 2016-13 is effective for the Company from January 1, 2020, with early adoption permitted. The adoption of this standard may result in a change of our provision policy primarily for accounts receivable, but we do not expect the adoption of this standard to have a material impact on our financial statements.
In August 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement (“ASU 2018-13”), which amended the fair value measurement guidance by modifying the disclosure requirements. ASU 2018-13 is effective for the Company from January 1, 2020, with early adoption permitted. We do not expect the adoption of this standard to have a material impact on our financial statements.
In August 2018, the FASB issued ASU 2018-15, Intangibles—Goodwill and Other—Internal-Use Software: Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (“ASU 2018-15”), which aligns the requirements for capitalizing implementation costs in a cloud computing arrangement service contract with those for an internal-use software license. ASU 2018-15 is effective for the Company from January 1, 2020, with early adoption permitted. We do not expect the adoption of this standard to have a material impact on our financial statements.
In November 2018, the FASB issued ASU 2018-18, Collaborative Arrangements (Topic 808), Clarifying the Interaction between Topic 808 and Topic 606 (ASU 2018-18) (“ASU 2018-18”), which clarifies that transactions in a collaborative arrangement should be accounted for under ASC 606 when the counterparty is a customer for a distinct good or service. The amendment also precludes an entity from presenting consideration from a transaction in a collaborative arrangement as revenue if the counterparty is not a customer for that transaction. ASU 2018-18 is effective for the Company from January 1, 2020, with early adoption permitted. We do not expect the adoption of this standard to have a material impact on our financial statements.
Cautionary Note Regarding Forward-Looking Statements
Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. These statements often include words such as “may,” “will,” “estimate,” “intend,” “seek,” “expect,” “project,” “anticipate,” “believe,” “plan,” “could,” “target,” “predict,” “likely,” “should,” “forecast,” “outlook,” “model,” “continue,” “ongoing” or other similar terminology. Forward-looking statements are based on our expectations, estimates, assumptions or projections concerning future results or events as of the date of the filing of this Form 10-Q. Forward-looking statements are neither predictions nor guarantees of future events, circumstances or performance and are inherently subject to known and unknown risks, uncertainties and assumptions that could cause our actual results and events to differ materially from those indicated by those statements. We cannot assure you that any of our assumptions are correct or any of our expectations, estimates or projections will be achieved. Numerous factors could cause our actual results to differ materially from those expressed or implied by forward-looking statements, including, without limitation, the following:
Risks related to our business and industry, such as (a) food safety and food-borne illness concerns, (b) significant failure to maintain effective quality control systems for our restaurants, (c) significant liability claims, food contamination complaints from our customers or reports of incidents of food tampering, (d) health concerns arising from outbreaks of viruses or other diseases, (e) the fact that we derive substantially all of our revenue from our operations in China, (f) the fact that the operation of our restaurants is subject to the terms of the master license agreement with YUM, (g) the fact that our success is tied to the success of YUM’s brand strength, marketing campaigns and product innovation, (h) shortages or interruptions in the availability and delivery of food and other supplies, (i) fluctuation of raw materials prices, (j) our inability to attain our target development goals and the potential cannibalization of existing sales by aggressive development, (k) risks associated with leasing real estate, (l) inability to obtain desirable restaurant locations on commercially reasonable terms, (m) labor shortages or increases in labor costs, (n) the fact that our success depends substantially on our corporate reputation and on the value and perception of our brands, (o) the occurrence of security breaches and cyber-attacks, (p) failure to protect the integrity and security of our customer or employee personal, financial or other data or our proprietary or confidential information that is stored in our information systems or by third parties on our behalf, (q) failures or interruptions of service or security breaches in our information technology systems, (r) the fact that our business depends on the performance of, and our long-term relationships with, third-party mobile payment processors, delivery aggregators, internet infrastructure operators and internet service providers, (s) failure to provide timely and reliable delivery services by our restaurants, (t) our growth strategy with respect to COFFii & JOY may not be successful, (u) challenges and risks related to our new e-commerce business; (v) the anticipated benefits of the acquisition of Daojia may not be realized in a timely manner or at all, (w) the Chinese government may determine that the VIE structure of Daojia does not comply with Chinese laws on foreign investment in restricted industries, (x) our inability or failure to recognize, respond to and effectively manage the accelerated impact of social media, (y) litigation and failure to comply with anti-bribery or anti-corruption laws, (z) U.S. federal income taxes, changes in tax rates, disagreements with taxing authorities (including with respect to the transfer pricing audit) and imposition of new taxes, (aa) changes in consumer discretionary spending and general economic conditions, (bb) competition in the retail food industry, (cc) loss or failure to obtain or renew any or all of the approvals, licenses and permits to operate our business, (dd) our inability to adequately protect the intellectual property we own or have the right to use, (ee) YUM’s failure to protect its intellectual property, (ff) seasonality and certain major events in China, (gg) our failure to detect, deter and prevent all instances of fraud or other misconduct committed by our employees, customers or other third parties, (hh) changes in accounting standards and subjective assumptions, estimates and judgments by management related to complex accounting matters, (ii) failure of our insurance policies to provide adequate coverage for claims associated with our business operations, (jj) failure by us to maintain effective disclosure controls and procedures and internal control over financial reporting in accordance with the rules of the SEC and (kk) unforeseeable business interruptions;
Risks related to doing business in China, such as (a) changes in Chinese political policies and economic and social policies or conditions, (b) uncertainties with respect to the interpretation and enforcement of Chinese laws, rules and regulations, (c) changes in trade relations between the United States and China, including the imposition of new or higher taxes on goods imported from the United States, (d) fluctuation in the value of the Chinese Renminbi, (e) limitations on our ability to utilize our cash balances effectively due to governmental control of currency conversion and payments of foreign currency, (f) changes in laws and regulations, (g) reliance on distributions by our operating subsidiaries in China to fund offshore cash requirements, (h) potential unfavorable tax consequences resulting from our classification as a China resident enterprise for Chinese enterprise income tax purposes, (i) uncertainty regarding indirect transfers of equity interests and enhanced scrutiny by Chinese tax authorities, (j) difficulties in effecting service of legal process, enforcing foreign judgments or bringing original actions in China against us, (k) inability to use properties due to defects caused by non-registration of lease agreements related to certain properties, (l) risk in relation to unexpected land acquisitions, building closures or demolitions, (m) potential fines for failure to comply with law and (n) restrictions on our ability to make loans or additional capital contributions to our Chinese subsidiaries due to Chinese regulation of loans to, and direct investment in, Chinese entities by offshore holding companies and governmental control of currency conversion;
Risks related to the separation and related transactions, such as (a) not achieving all of the anticipated benefits, (b) incurring significant tax liabilities if the distribution does not qualify as a transaction that is generally tax-free for U.S. federal income tax purposes and the Company could be required to indemnify YUM for material taxes and other related amounts pursuant to indemnification obligations under the tax matters agreement, (c) being obligated to indemnify YUM for material taxes and related amounts pursuant to indemnification obligations under the tax matters agreement if YUM is subject to Chinese indirect transfer tax with respect to the distribution, (d) limitations on our ability to engage in strategic transactions as a result of the separation, (e) our inability to satisfy financial reporting and other requirements to which we are subject as an independent publicly traded company, (f) limited experience of our management in managing a public company, (g) inability to access capital markets on acceptable terms, (h) increased administrative and other costs incurred by virtue of our status as an independent public company, (i) limitations on our ability to compete with YUM and other restrictions on our operations contained in the master license agreement, (j) failure by YUM to perform its obligations under the transaction agreements that we entered into with it as part of the separation, (k) potential indemnification liabilities owing to YUM pursuant to the separation and distribution agreement and there being no assurance that the indemnity provided by YUM with respect to certain liabilities in connection with the separation will be sufficient to insure us against the full amount of such liabilities, (l) the possibility that a court would require that we assume responsibility for obligations allocated to YUM under the separation and distribution agreement, (m) potential liabilities due to fraudulent transfer considerations and (n) actual or potential conflicts of interest of certain of our executive officers and directors because of their previous positions at YUM.
In addition, other risks and uncertainties not presently known to us or that we currently believe to be immaterial could affect the accuracy of any such forward-looking statements. All forward-looking statements should be evaluated with the understanding of their inherent uncertainty. You should consult our filings with the Securities and Exchange Commission (including the information set forth under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018) for additional information regarding factors that could affect our financial and other results. You should not place undue reliance on forward-looking statements, which speak only as of the date of the filing of this Form 10-Q. We are not undertaking to update any of these statements, except as required by law.
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Foreign Currency Exchange Rate Risk
Changes in foreign currency exchange rates impact the translation of our reported foreign currency denominated earnings, cash flows and net investments in foreign operations, virtually all of which are denominated in RMB. While substantially all of our supply purchases are denominated in RMB, from time to time, we enter into agreements at predetermined exchange rates with third parties to purchase certain amount of goods and services sourced overseas and make payments in the corresponding local currencies when practical, to minimize the related foreign currency exposure with immaterial impact on our financial statements.
As substantially all of the Company’s assets are located in China, the Company is exposed to movements in the RMB foreign currency exchange rate. For the quarter ended September 30, 2019, the Company’s Operating profit would have decreased by approximately $29 million if the RMB weakened 10% relative to the US$. This estimated reduction assumes no changes in sales volumes or local currency sales or input prices.
Commodity Price Risk
We are subject to volatility in food costs as a result of market risks associated with commodity prices. Our ability to recover increased costs through higher pricing is, at times, limited by the competitive environment in which we operate. We manage our exposure to this risk primarily through pricing agreements with our vendors.
Investment Risk
In September 2018, we invested $74 million in Meituan’s ordinary shares. The equity investment is recorded at fair value, which is measured on a recurring basis and is subject to market price volatility. See Note 6 for further discussion on our investment in Meituan.
Item 4.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 as of the end of the period covered by this report. Based on the evaluation, performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (the “CEO”) and the Chief Financial Officer (the “CFO”), the Company’s management, including the CEO and the CFO, concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.
Changes in Internal Control Over Financial Reporting
There were no changes with respect to the Company’s internal control over financial reporting during the quarter ended September 30, 2019 that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.
PART II – Other Information
Information regarding legal proceedings is incorporated by reference from Note 14 to the Company’s Condensed Consolidated Financial Statements set forth in Part I of this report.
Item 1A.
Risk Factors
We face a variety of risks that are inherent in our business and our industry, including operational, legal and regulatory risks. Such risks could cause our actual results to differ materially from our forward-looking statements, expectations and historical trends. There have been no material changes from the risk factors disclosed in Part I, Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2018, which was filed with the SEC on February 27, 2019.
Unregistered Sales of Equity Securities and Use of Proceeds
On February 7, 2017, we announced that our Board of Directors authorized a $300 million share repurchase program. On October 4, 2017, the Board of Directors increased Yum China’s share repurchase authorization from $300 million to an aggregate of $550 million. On October 30, 2018, the Board of Directors further increased the share repurchase authorization to an aggregate of $1.4 billion. The authorizations do not have an expiration date.
The following table provides information as of September 30, 2019 with respect to shares of Yum China common stock repurchased by the Company during the quarter then ended:
Period
Number of
Repurchased
(thousands)
Average
Price Paid
Per Share
as Part of
Publicly
Announced
Plans or
Programs
Approximate
Dollar Value
of Shares
that May Yet
Be
under the
(millions)
7/1/19-7/31/19
495
44.45
798
8/1/19-8/31/19
44.09
776
9/1/19-9/30/19
438
45.69
756
1,431
44.70
Item 6.
Exhibits
Exhibit
Number
Description of Exhibits
3.1
Amended and Restated Certificate of Incorporation of Yum China Holdings, Inc. (incorporated by reference to Exhibit 3.1 to Yum China Holdings, Inc.’s Current Report on Form 8-K filed on November 1, 2016).
3.2
Amended and Restated Bylaws of Yum China Holdings, Inc. (incorporated by reference to Exhibit 3.2 to Yum China Holdings, Inc.’s Current Report on Form 8-K filed on November 1, 2016).
10.1
Post-Termination Agreement, effective October 16, 2019, by and between Yum China Holdings, Inc. and Jacky Lo (incorporated by reference to Exhibit 10.1 to Yum China Holdings, Inc.’s Current Report on Form 8-K filed on September 6, 2019).
10.2
Employment Letter, effective September 16, 2019, by and between Yum China Holdings, Inc. and Andy Yeung (incorporated by reference to Exhibit 10.2 to Yum China Holdings, Inc.’s Current Report on Form 8-K filed on September 6, 2019).
10.3
Yum China Holdings, Inc. Change in Control Severance Plan(incorporated by reference to Exhibit 10.1 to Yum China Holdings, Inc.’s Current Report on Form 8-K filed on October 2, 2019).
31.1
Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) of Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
31.2
Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) of Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
32.1
Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
32.2
Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
101.INS
XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document *
101.SCH
Inline XBRL Taxonomy Extension Schema Document *
101.CAL
Inline XBRL Taxonomy Extension Calculation Linkbase Document *
101.LAB
Inline XBRL Taxonomy Extension Label Linkbase Document *
101.PRE
Inline XBRL Taxonomy Extension Presentation Linkbase Document *
101.DEF
Inline XBRL Taxonomy Extension Definition Linkbase Document *
Cover Page Interactive Data File - the cover page XBRL tags are embedded within the Inline XBRL document *
*
Filed or furnished herewith.
SIGNATURES
Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
(Registrant)
Date:
November 8, 2019
/s/ Xueling Lu
Controller and Principal Accounting Officer