Rating Action Overview

• Haidilao International Holding Ltd. is likely to remain a leader in China's hot pot market, given its good brand recognition, service quality, and profitability. The company's limited geographic and brand diversity, as well as risks associated with its rapid expansion temper these strengths.
• We believe the China-based company will fully fund new store openings with operating cash flow, ensuring continuing low leverage.
• We are assigning our 'BBB' long-term issuer credit rating to Haidilao and our 'BBB' long-term issue rating to the company's senior unsecured notes.
• The stable outlook reflects our expectation that Haidilao will gain market share in China's hot pot sector and have double-digit annual revenue growth over the next two years. We expect the company's debt leverage to peak in 2020 and remain below 1.5x from 2021.

Rating Action Rationale

We expect Haidilao to maintain its leadership in China's hot pot market owing to its strong brand equity and good control over its table turnover.  Hot pot is a popular dining-out option in the Chinese cuisine segment, accounting for about 15% of China's Chinese renminbi (RMB) 4.6 trillion catering service market. Haidilao's good dining experience and personalized services underpin its high brand awareness and customer loyalty. The company had an average table turnover rate of 4.8x in 2019; a rate of above 3x is healthy, in our view. Another contributing factor is that many of Haidilao's restaurants are open 24 hours. Moreover, given the company's popularity, it can often obtain less-than-market rent, adding to its profit margin.

Haidilao is likely to maintain its service levels. This strength is particularly important in a fast-growing market like China where food and service consistency can be difficult to maintain. Haidilao owns and operates its restaurants. Store managers are assessed on operating metrics including customer satisfaction, employee efforts, and food safety. Employees with high potential are then identified and incentivized to help initiate new store expansions. This apprentice process helps the company to maintain its service quality despite rapid expansion.

Haidilao's supply-chain network should help it to secure supply and manage product quality, including food safety, which is a major concern in China.  To ensure competitive prices, the company obtains supplies from more than two qualified suppliers for each major food ingredient. The top five suppliers of the main ingredients are mostly Haidilao's related parties, and also provide warehousing and storage. We expect the company to reduce its use of related-party suppliers. The contribution from its top five suppliers decreased to 30% in 2019 from over 80% in 2017.

Haidilao's rapid expansion plan comes with some execution risk, in our opinion.  The company plans to expand its new store footprint by about 20% annually over the next two years. It is looking to increase store density in higher-tier cities--where long waiting times have hurt customer experience--and expand into more lower-tier cities where consumption upgrades drive demand. We believe Haidilao faces risks of cannibalization of existing stores and lack of disciplined execution. The company is also expanding internationally. However, Haidilao's service culture and management process may not translate as well internationally, especially in new markets.

Haidilao's brand and geographic concentration tempers its business strengths.  The company generates more than 90% of its revenue from Haidilao branded restaurants, and 90% from mainland China. While Haidilao is opening restaurants with new brands and cuisines, such as U-Ding Maocai, revenue contribution from these restaurants are not yet meaningful. The company's international expansion could also help reduce the geographic concentration.

Haidilao will remain exposed to high competition and changing customer tastes. The top five players in China account for less than 10% of market share. While we believe the hot pot restaurant concept will endure, customers will inevitably change how and what they want in their hot pots. Haidilao will need to stay abreast of fluctuating consumer taste and adapt appropriately. The hot pot market also attracts numerous new entrants with different concepts and service style and quality. Haidilao will need to execute well to continue to fend off these newcomers.

We expect COVID-19 disruptions to temporarily hurt Haidilao's credit metrics.  The company closed its stores from January 26 to March 12, and recovery has been gradual since the reopening. In July 2020, Haidilao's table turnover rate recovered to above 75% of pre-pandemic levels. We expect operations to return to normal toward the end of 2020, resulting in an improvement in credit measures. The debt leverage (ratio of debt to EBITDA) is likely to increase to 1.7x-2.0x in 2020, from 0.4x in 2019, and fall to 0.8x-0.9x by end-2021.

Haidilao will likely generate positive free operating cash flow despite the rapid store expansion.  We forecast the company will spend RMB3 billion-RMB4 billion annually on new store openings over the next two years. Nonetheless, we believe Haidilao will adjust its pace of expansion according to market conditions to protect its financial strength. A quick ramp-up of new stores (typically full ramp-up within two quarters) will support healthy operating cash flows. We expect Haidilao to generate RMB3.0 billion-RMB3.5 billion of free operating cash flow annually in the next two years, and maintain a 20% dividend payout ratio. We believe the company will also maintain a measured approach toward acquisitions.

Outlook

The stable outlook reflects our expectation that Haidilao will gain market share and record healthy revenue and profit growth in the next three to five years. We expect the company to recover from COVID-19-related disruptions and maintain a ratio of debt to EBITDA at below 1.5x from 2021.

Downside scenario

We could lower the rating if Haidilao's debt-to-EBITDA ratio exceeds 1.5x for a sustained period owing to a deterioration in free operating cash flow. This could happen if the recovery from COVID-19 disruptions takes longer than we expect or the company undertakes substantial debt-funded acquisitions without meaningful cash flow contribution.

Separately, we could downgrade Haidilao if its competitive advantages weaken, possibly due to missteps in the execution of its aggressive expansion plan, slippage in the quality of its service and offering, and deterioration in its operating efficiency.

Upside scenario

We could raise the rating if Haidilao improves its brand and geographic diversification, such that it generates a meaningful proportion of revenue from non-Haidilao brands and from overseas operations. This implies that the company is able to expand revenue at an above-industry average rate or increase margins for an extended period.

Company Description

Haidilao is the largest player in China's hot pot restaurant market and is listed on the Hong Kong stock exchange. As of end-2019, the company owned and operated 768 restaurants--716 in mainland China and 52 overseas. It served more than 244 million customers in 2019, with 54.73 million enrolled in its membership program. Haidilao was listed on Hong Kong stock exchange on Sept. 26, 2018.

Our Base-Case Scenario

• China's real GDP to grow 2.1% in 2020 and 7.0% in 2021, compared with 6.1% in 2019.
• China's restaurant market to be hurt by the economic slowdown as consumers cut discretionary spending. The country's hot pot segment to sustain higher-than-GDP growth and outperform other catering segments in the next two years.
• Haidilao's revenue growth to drop to 4%-6% in 2020 due to COVID-19 related closures and disruptions, and recover to 75%-80% in 2021, from 57% in 2019. We estimate growth in store footprint of about 20% annually over the next two years. Store expansion and the normalization of operations post COVID-19 will drive growth in 2021.
• Table turnover rate to decline to 3.0x-4.0x in 2020 and improve in 2021, compared to 4.8x in 2019. The rate could drift lower in the longer term, compared with the past three years (5.0x in 2017 and 2018; 4.8x in 2019), owing to dilution from the company's active expansion strategy.
• Gross margin to contract slightly to 51%-53% in 2020 due to COVID-19-related health and cost increases, and recover to 52%-54% in 2021, similar to 53% in 2019. Gross margin to remain stable in the long run. The company's brand equity allows it to bargain for lower rentals.
• EBITDA margin to decline to 12%-14% in 2020, and increase to 18%-19% in 2021, from 18.8% in 2019. Staff costs as a percentage of revenue to spike in 2020 due to lost revenue from suspension of restaurant operations during first quarter in 2020, and remain at about 30% from 2021.
• Operating cash flow to decline to RMB2 billion-RMB2.5 billion in 2020 due to weaker revenues and working capital outflow of about RMB750 million because of COVID-19. Operating cash flow to recover to RMB7.5 billion-RMB8 billion in 2021 as revenue growth and working capital inflow recovers.
• Capital expenditure to be RMB4.5 billion-RMB5 billion over the next 12-24 months, including RMB500 million-RMB1 billion of maintenance capital expenditure, RMB3 billion-RMB4 billion for new store expansion, and RMB300 million-RMB500 million for the new headquarters.
• Acquisition spending to be RMB100 million-RMB150 million, for acquiring other restaurant brands aiming to expand cuisine types and geographic footprint.
• Dividend payout ratio that we assume to be 20% in 2020 and 2021.

Table 1

Liquidity

We assess Haidilao's liquidity as strong. We expect the company's ratio of liquidity sources to uses to exceed 1.5x over the 12-24 months from June 30, 2020. The ratio should remain above 1x even if EBITDA declines by 30%.

We expect Haidilao to be able to absorb high-impact, low-probability events without refinancing. Moreover, we believe the company has solid bank relationships, prudent risk management, and high standing in the equity market.

Principal liquidity sources include:

• Cash and cash equivalents of RMB2.2 billion as of June 30, 2020.
• Funds from operations of RMB5 billion-RMB6 billion over the 12 months to June 30, 2021.

Principal liquidity uses include:

• Working capital outflows of RMB200 million over the 12 months to June 30, 2021.
• Capital expenditure of RMB4.5 billion-RMB5.0 billion over the period, mainly for expansion of new restaurants and for restaurant maintenance and renovation.
• Acquisition spending of RMB100 million-RMB150 million over the same period.
• Dividend payout of RMB300 million over the same period.

Issue Ratings - Subordination Risk Analysis

Capital structure

As of June 30 2020, Haidilao's capital structure consisted of RMB720 million in secured bank borrowings and RMB2.6 billion in unsecured bank borrowings at its subsidiaries.

Analytical conclusions

We rate Haidilao's senior unsecured notes 'BBB', the same as the issuer credit rating, because of the company's minimal financial risk. We believe Haidilao's low leverage limits the possibility of any noteholders being significantly disadvantaged relative to other lenders.

Ratings Score Snapshot

Issuer Credit Rating: BBB/Stable/--

Business risk: Fair

• Country risk: Moderately High
• Industry risk: Intermediate
• Competitive position: Fair

Financial risk: Minimal

• Cash flow/Leverage: Minimal

Anchor: bbb

Modifiers

• Diversification/Portfolio effect: Neutral (no impact)
• Capital structure: Neutral (no impact)
• Liquidity: Strong (no impact)
• Financial policy: Neutral (no impact)
• Management and governance: Fair (no impact)
• Comparable rating analysis: Neutral (no impact)

Stand-alone credit profile: bbb

Related Criteria

• General Criteria: Group Rating Methodology, July 1, 2019
• Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments, April 1, 2019
• Criteria | Corporates | General: Reflecting Subordination Risk In Corporate Issue Ratings, March 28, 2018
• Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Dec. 16, 2014
• General Criteria: Methodology: Industry Risk, Nov. 19, 2013
• General Criteria: Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013
• Criteria | Corporates | General: Corporate Methodology, Nov. 19, 2013
• General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities, Nov. 13, 2012
• General Criteria: Principles Of Credit Ratings, Feb. 16, 2011
• General Criteria: Stand-Alone Credit Profiles: One Component Of A Rating, Oct. 1, 2010

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