Fitch Ratings has published Haidilao International Holding Ltd.'s first-time Long-Term Issuer Default Rating (IDR) and senior unsecured rating of 'BBB'.
The Outlook on the Long-Term IDR is Stable. Fitch has also assigned a rating of 'BBB' to Haidilao's proposed US dollar senior unsecured notes, which it plans to use to expand its restaurant network, pay research and development costs and for general working-capital purposes.
The ratings reflect Haidilao's strong brand recognition as the largest Chinese cuisine restaurant-chain globally. Haidilao's well-known brand and customer-centric approach have supported its rapid expansion while maintaining stable operating metrics, such as table turnover rate and restaurant-level profit margin. However, scale is a constraint, as higher-rated issuers have substantially higher fund flow from operation (FFO) generation.
Capex for Haidilao's rapid restaurant expansion has led to negative free cash flow (FCF), but Fitch expects the expansion to be at a controlled pace, such that the net cash position is maintained. In addition, FFO adjusted net leverage should remain at a consistent level starting in 2021 as the scale of its operation increases relative to its expansion.
KEY RATING DRIVERS
Strong Brand Recognition: Fitch thinks Haidilao's brand is highly recognisable among Chinese consumers, supported by a loyal customer base and positive word-of-mouth. The company has adopted a customer-centric approach and its unique and personalised dining experience has helped to differentiate the brand from other restaurants. The high degree of customer satisfaction encourages repeat visits and offers visibility of the company's growth prospects.
Leading Position: Haidilao is the largest Chinese cuisine restaurant-chain globally by revenue, with 935 restaurants as of end-June 2020. Hot pot is a popular style of Chinese cuisine and Haidilao is the clear leader among hot-pot brands in China, with around 4x the market share of the next-largest competitor. Chain restaurants tend to have low penetration within the full-service subsector, which leaves room for consolidation, with the brand offering consistent service quality and food safety.
Unique Operating Model: Haidilao's bottom-up approach assures a high level of customer satisfaction and promotes an understanding of the local market. Staff are trained through an apprenticeship programme that develops Haidilao's talent pool and determines who can manage each restaurant. Managers are given a high degree of autonomy to make decisions and customise the experience at the individual restaurant level and their compensation is aligned with restaurant profit, which encourages innovation to improve performance.
This approach also improves the scalability of the company's operation, as staff are familiar with the corporate culture and local environment, improving customer satisfaction and thereby mitigating execution risk from rapid expansion.
Efficient Operations: Haidilao's restaurant productivity has contributed to its high profitability, with a restaurant-level margin of 18% or higher supported by a high turnover rate and low rental expense/revenue ratio. Its margin has been maintained despite the higher costs related to new restaurant openings. We believe a larger restaurant network can improve Haidilao's economies of scale and bargaining power, helping it secure favourable pricing from suppliers and landlords.
Rapid Expansion: We expect the expansion of Haidilao's restaurants to be its primary growth driver over the next few years, supported by the stable performance of existing restaurants. The company had 935 restaurants at end-June 2020, compared with only 273 in 2017. We think there is potential to capture more traffic in Haidilao's existing cities and to further expand into lower tier cities, despite the already fast expansion pace. We think the company's operating model can flexibly adapt to market demand, mitigating the risk of overexpansion.
Stable Leverage: Fitch expects FFO adjusted net leverage to remain below 2x from 2021, with increased FFO generation from a larger revenue base coupled with stable to improving profitability and a fast payback period for new restaurants. Investment in the new headquarters will add to capex, but an enlarged business scale should result in lower capital intensity in 2021-2022, compared with 15%-19% during rapid expansion in 2018-2019, and FCF being neutral starting in 2021.
Recovering from Pandemic: Fitch expects the company's operating performance to recover in 2H20, following city lockdowns due to the coronavirus pandemic. Profit was down in 1Q20 when a large number of restaurants were temporarily closed during the lockdown period, while it continued to incur certain fixed costs, such as staff salaries and rental expenses. Haidilao's affected restaurants in China resumed business during 2Q20.
The company's strong brand recognition limited the 1H20 revenue drop of about 16% yoy, which was lower than the 33% fall in China's overall dining industry. We expect customer traffic to revert to close to pre-pandemic levels in 2H20 and for profitability to recover accordingly.
Justified Related-Party Transactions: We believe there is a reasonable economic rationale for Haidilao's large related-party transactions and we do not consider these to be a constraint on its rating. The transactions are primarily for supplying raw materials and consumables and represented about 24% of the company's total purchases in 2019, which was a drop from more than 80% in 2017 prior to the company's listing. We think the arm's length nature of the company's pricing agreements and diverse suppliers will help control corporate-governance risk.
DERIVATION SUMMARY
Haidilao's scale and FFO generation is within the range for global restaurant peers rated in the 'BBB' range. Haidilao has a smaller scale, but has a higher revenue potential than peers in Western countries, such as the US. Rating downgrades and Outlook revisions for US restaurants reflect the significant business interruption caused by the pandemic and a drop in discretionary spending that could extend well into 2021.
The ratings on Starbucks Corporation (BBB/Negative) are supported by the company's strong brand and leadership in the global coffee market, but the company's leverage has increased due to its shareholder-friendly policies and debt issuance. Starbucks has a stronger business profile, but Haidilao has higher growth potential and a net cash position that provides sufficient capital for its expansion plans.
Darden Restaurants, Inc. (BBB-/Negative) is similarly positioned to Haidilao in the casual-dining segment in its respective markets and has some diversification across its brand portfolio, but the company faces increased competition from the rapidly expanding fast-casual restaurant segment and a drop in brick-and-mortar retail traffic. Casual dining is also more economically sensitive and is likely to take longer to recover from the pandemic. In contrast, Haidilao benefits from increasing consumption within China, further penetration through its strong brand recognition and a net cash position, which justifies its one-notch higher rating.
KEY ASSUMPTIONS
Fitch's Key Assumptions Within Our Rating Case for the Issuer
Revenue growth of 1% yoy in 2020 due to the impact of the pandemic in 1H20, accelerating to 49% in 2021 yoy with normalised full-year operations and new restaurant openings, then moderating to 20% in 2022
EBITDA margin at 8% in 2020 amid lower revenue, particularly in 1H20, recovering to 13%-14% in 2021-2022
Capital intensity of 15% in 2020, to moderate in 2022
Dividend payout of 30% of net income in 2020-2022
RATING SENSITIVITIES
Factors that could, individually or collectively, lead to positive rating action/upgrade:
No positive rating action is expected until the company achieves a longer track record of operations and larger scale while remaining FCF positive
Factors that could, individually or collectively, lead to negative rating action/downgrade:
Weakened brand strength, which will be evident from declining revenue or deterioration in restaurant productivity
Sustained negative FCF beyond 2020, leading to loss of the net cash position (relative to unadjusted debt) or FFO adjusted net leverage above 2.0x for a sustained period (2019: 0.4x)
Higher proportion of related-party transactions without reasonable business justification or transparency
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
Strong Liquidity: Haidilao maintained a net cash position following its IPO in 2018. The company had CNY3.4 billion of readily available cash and CNY1.3 billion of short-term bank products as of end-June 2020, which is more than sufficient to cover its short-term bank borrowings of CNY3.0 billion. In addition, the company has unutilised banking facilities of around CNY4.0 billion at end-June 2020, including onshore and offshore funding.
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
RATING ACTIONS
ENTITY/DEBT RATING
Haidilao International Holding Ltd. LT IDR BBB Publish
senior unsecured
LT BBB New Rating
senior unsecured
LT BBB Publish
VIEW ADDITIONAL RATING DETAILS
Additional information is available on www.fitchratings.com
HAIDILAO INTERNATIONAL HOLDING LTD. 
