Fitch Ratings has affirmed Haidilao International Holding Ltd.'s Long-Term Issuer Default Rating (IDR) and senior unsecured rating at 'BBB-', and revised the Outlook on the Long-Term IDR to Stable from Negative.

Fitch has also affirmed the rating of Haidilao's US dollar senior unsecured notes at 'BBB-'.

The Outlook revision reflects our expectation that Haidilao's operations will recover as consumption picks up following China's reopening. Fitch expects Haidilao to maintain a healthy financial profile with positive free cash flow generation and low leverage, supported by disciplined restaurant expansion and stable profitability. The cost-saving measures carried out in 2022 to improve profitability when restaurant operations were severely disrupted by Covid-19 show Haidilao's ability to manage its cash flow and financial profile under a stress scenario.

The ratings are supported by strong brand recognition and improving restaurant efficiency, which boosts EBITDA expansion. The ratings are constrained by the company's modest scale relative to higher-rated peers and the competitive and fragmented hotpot industry.

Key Rating Drivers

Post-Pandemic Recovery: Fitch expects Haidilao's business to recover in 2023 following the removal of Covid-19 restrictions in China. Its table turnover rate should improve, driven by a boost in customer traffic as consumers increase the frequency of dining out and social gatherings. Closure of underperforming restaurants also supports the recovery in table turnover and reduces cannibalisation. Fitch forecasts Haidilao's table turnover rate to improve towards 3.5x, supporting revenue growth in the mid-teens in 2023.

Stable Profitability: We expect Haidilao to maintain its profitability in 2023 compared with 2022 levels as growth in revenue offsets the impact of gross margin normalisation and higher staff costs. Haidilao's EBITDA margin increased to 13.0% in 2022 from 8.1% in 2021 despite a decline in revenue, mainly due to cost-saving measures. These included increasing the proportion of non-contract staff, lowering fixed salaries and increasing performance-based salaries for manager-level staff, and reducing the amount of food wastage.

We forecast gross margin and staff costs as a percentage of revenue to normalise at 57%-58% and 33%-34%, respectively, in 2023, because some cost-saving measures may not be sustainable once business returns to normal. We expect further increases in operating efficiency to come from improvements in the table turnover rate.

Moderate Expansion: Fitch expects Haidilao to resume restaurant expansion and reopen some suspended restaurants in 2023. The company has said it will take into account the potential impact of cannibalisation among existing restaurants before opening a new restaurant, with profitability as a key consideration. Fitch assumes a double-digit increase in the number of restaurants per year over the next 1-2 years, in line with Haidilao's commitment to curb large-scale expansion until its operating margin recovers.

We expect free cash flow to be positive, supported by an increase in operating cash flow and moderate capex. We expect capex to range from CNY1.9 billion to CNY2.2 billion in 2023 to 2025, including spending on new restaurants, renovation of existing restaurants and headquarters construction.

Limited Impact from Spin-off: Haidilao has completed the spin-off and separate listing of Super Hi on the Hong Kong Exchange in December 2022. Super Hi operates Haidilao's restaurants outside of Greater China. We believe the spin-off of Super Hi has no material credit impact, given its small revenue contribution of about 10% and limited cash flow impact. The spin-off is slightly positive to Haidilao's profitability in the short term, as overseas operations are still loss-making, but it has reduced diversification as all of Haidilao's restaurants are now located in Greater China.

Highly Competitive Environment: The restaurant industry is highly fragmented across different price points and cuisines. Consumer tastes change quickly, and competition is intense with new restaurants brands and concepts constantly being introduced. Fitch expects Haidilao to face challenges remaining popular, which may require the company to maintain high service quality and develop new dishes to keep up with fast-changing consumer tastes.

High Brand Recognition: Haidilao's ratings are supported by its highly recognisable brand among Chinese consumers. Its long operating history, emphasis on the customer experience and continuous menu adjustments to cater to consumer tastes underpin its competitiveness in the hotpot industry. The company has adopted a customer- and employee-centric approach and offers a unique and personalised dining experience, which has helped to differentiate the brand from other restaurants.

Derivation Summary

Haidilao has a smaller scale, less-diversified operations with a single brand, and a geographical focus on one market compared with global restaurant peers.

Darden Restaurants, Inc. (BBB/Stable) is similarly positioned to Haidilao in the casual-dining segment in their respective markets and has some diversification across its brand portfolio. Darden's revenue and margins have recovered strongly from the pandemic, driven by its ability to outperform the broader casual-dining segment, which is facing secular challenges. In comparison, Haidilao's scale is likely to remain smaller and its profitability weaker than that of Darden.

Key Assumptions

Fitch's Key Assumptions Within Our Rating Case for the Issuer

Revenue to grow by the mid teens in 2023 and moderate to mid-single digits in 2025

EBITDA margin of 13% in 2023-2025

Capex of CNY1.9 billion-2.2 billion in 2023-2025

Dividend payout ratio of 40% in 2023-2025

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

EBITDA being sustained at a higher level while maintaining high restaurant productivity, and EBITDAR net leverage being sustained below 2x

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Lack of improvement in restaurant productivity, resulting in muted EBITDA growth

Negative free cash flow, which could, for example, be due to an acceleration in its expansion, leading to EBITDAR net leverage being sustained above 3x (2022: 1.6x)

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Net Cash Position: Haidilao had CNY6.6 billion in cash at end-2022, sufficient to cover its short-term debt of CNY2.4 billion. The company repurchased an aggregate amount of USD302 million of bonds through the open market and a tender offer in 2022.

Issuer Profile

Haidilao is a leading Chinese restaurant brand focusing on hotpot cuisine. It had a network of 1,371 restaurants in Greater China as of end-2022.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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