The service industry is thriving, and chain brands are in their prime time.

Scaled chain brands are emerging, and there is still room for growth compared to overseas markets. Over the past 5-10 years, we have observed an increasing number of scaled chain brands emerging, and many brands have continued to expand their stores during the pandemic: According to Euromonitor data, the number of chain restaurant stores in China increased from 224,000 in 2014 to 636,000 in 2023, nearly doubling; compared with mature overseas markets, local brands, especially service brands, still have room for improvement. Compared to the "Made in China" catching up with Europe and America, reducing the gap, there are only 5 Chinese companies with a market value of over ten billion US dollars in the non-essential consumer service category (vs. 27 in the United States), and specifically in the hotel/ catering/cruise/healthcare service sub-industries, there are only 1/2/0/1 Chinese companies with a market value of over ten billion US dollars, compared to 3/9/2/8 in the United States, Chinese service chain enterprises still have a large space to be released.

The service industry has become the largest engine of economic growth and will continue to thrive. With China's per capita GDP and disposable income growing from 46,912/20,167 yuan in 2014 to 89,358/39,218 yuan in 2023, the growing demand for a better life by the people has promoted the rapid growth of the tertiary industry. According to the National Bureau of Statistics, the proportion of the added value of the tertiary industry has steadily increased over the past decade, reaching 54.6% in 2023, and has been over 50% for 9 consecutive years, contributing to economic growth vitality. However, China's current service industry share (about 53%) is still lower than the global level, and even lower than the United States' 77.6% in 2021, and the United Kingdom's 72.2% in 2022. Looking forward, as consumer habits are formed and service supply is effectively improved, we expect the service industry to continue to thrive.

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Referring to the development stage and experience of mature overseas consumer markets, we believe that China's service industry has growth potential and investment value in the future.

► In the US consumer market, service brands are the next opportunity after product brands tend to mature. The stage where product brands in the US consumer industry achieved higher growth and stock price returns was mostly before 2000: the food and beverage industry expanded in scale before 1950, and overseas expansion became a new stimulus during 1950-1970; the retail industry leader integrated offline channel resources from 1970 to 2000, using scale advantages and quality control to build large supermarket complexes and develop rapidly; the beauty and personal care industry leaders were mostly established after 1960, enjoying the globalization dividend and relying on strong brand power to go global. After 2000, the product format was constrained by changes in demand and supply saturation, and mostly entered a stable growth stage; after the basic needs for warmth and material consumption desires were satisfied, spiritual and experiential needs drove the service industry to heat up significantly after 2000, with more listed companies and higher stock price returns in the catering, hotel, and tourism industries.

► In the Japanese catering market, the expansion of the market value of the sector also confirmed that it can bring considerable investment returns. After the economic bubble burst in the 1990s, Japanese catering stores went from large-scale comprehensive development to a segmented development stage. The total market value of the catering sector increased from about 11 billion US dollars in 1995 to about 52.1 billion US dollars in 2023. This is partly due to the increase in the number of listed companies (from 42 in 1995, doubling to 97 in 2023), and more importantly, it comes from the investment return dividend that can be enjoyed in the secondary market. The return rate CAGR of the Japanese catering sector from 1996 to 2023 is about 4.4% (compared to the Nikkei 225 index's return rate CAGR of about 1.9% during the same period).

► In the 2023 Global Top 100 Brands list released by Interbrand, service brands can also have high value.

Coordination on both the supply and demand sides, the chain format is expected to continue to grow and develop.

The chain format has two major characteristics: standardization and branding, and the advantages are further expanded compared to single entities.

Chain vs. single entity: static comparison, the chain has two major advantages of standard model and brand effect. 1) Standardization helps the chain format to have certain advantages over single stores in supply chain, store management, and other dimensions: chain brands usually adopt unified raw material procurement, logistics distribution, inventory management, and other measures in the same or similar areas, helping stores to reduce operating costs while maintaining the stability of supply quality, forming a certain scale effect; in addition, the chain brand's more standardized store expansion process, single store model, and business advice provide strong help to stores. We believe that its existing experience and standardized system are expected to help single stores reduce operating pressure. 2) The brand effect of the chain format may help it effectively accumulate consumer trust and improve profitability: we believe that the chain format, based on a unified store image display and online traffic publicity, is expected to continuously strengthen consumer awareness of the brand, thereby bringing a certain low-cost traffic attraction ability and premium ability, and to some extent, improve profitability.► Taking hotels as an example, chain brands can bring better operating performance and payback period. We have made hypothetical calculations on the single-store models of single hotels and chain franchise hotels. We found that chain hotels may have higher occupancy rates than single hotels based on better product quality and a more widely covered membership system, which in turn brings more outstanding RevPAR performance; although franchise chain brands need to pay a certain franchise fee, their corresponding room-to-person ratio, consumables and other costs are lower, which helps to boost their profit level. Dynamic comparison, the switch from the era of extensive development to the new normal of lean growth, the advantages of chain brands are expected to be further magnified. In the past, in the era of high growth of extensive development, the requirements for efficiency and refined management were not so high, and both chain and single-store operations could achieve good results. As we gradually enter an era of more normalized growth, on the one hand, single-store operations face more challenges in sustainable profitability, and on the other hand, some chain companies continue to consolidate their own capabilities and gradually expand their cost advantages compared to single stores and small and medium-sized chains. Therefore, we may see a further increase in the chain rate and concentration. Demand side: Community gathering provides a basis for chain formats, and changes in consumption habits help chains become more popular The gradual increase in urbanization rate brings a demand basis, and community business may become one of the "growth cornerstones" of chain formats. 1) Data from the National Bureau of Statistics show that China's urbanization rate has increased from 37.7% in 2001 to 66.2% in 2023. We believe that the continued increase in urban population density may stimulate the continuous growth of consumer demand and provide a demand basis for the development of chain formats. 2) Compared with the United States and Japan, we found that Chinese urban residents have stronger aggregation attributes, which in turn gave rise to a more unique community organization form and community business model. According to Qicheng Capital's research data, the living area of ​​10,000 households in China is about 1-1.5 square kilometers, which is smaller than that of Japan (about 3 square kilometers) and the United States (about 10-30 square kilometers), while the average household population in China exceeds that of the United States and Japan; at the same time, 1 square kilometer of residential area in my country roughly corresponds to about 1 billion yuan of disposable income and 500 million yuan of purchasing power. We believe that different types of venues such as community commerce centered on residential and working areas may become the "growth foundation" of chain formats. Changes in consumer habits on the C-end may help make chain formats more popular. 1) Consumers are becoming more rational and pragmatic: Deloitte's "2023 China Consumer Insights and Market Outlook White Paper" survey shows that more than 90% of consumers compare prices and use coupons during shopping, and only about 6% of consumers say they rarely compare prices before making a purchase. 2) Product quality and function have always been the core of consumers' attention: According to the "2022 McKinsey China Consumer Survey Report", whether consumers buy food or non-food products, they will focus on the quality and efficacy of the products. 3) Brand awareness is one of the important factors that influence consumers' purchasing decisions: McKinsey's research shows that "whether the brand is well-known" and "whether the brand is reliable" are important factors for consumers to consider when choosing products (28% of consumers will consider whether the brand is reliable when purchasing food products; 33% of consumers will consider whether the brand is well-known when purchasing non-food products). We found that consumers still have a certain pursuit of high-quality products, but they have developed in a more rational and objective direction when making purchasing decisions, and pay attention to brand endorsement. We believe that more mature chain stores can usually provide consumers with products with certain "quality-price ratio" advantages. Based on the established brand value, store products under the chain format may be more popular with consumers. The gradually mature and rigorous organizational management form escorts the expansion of the chain format. We believe that the direct sales model may lay the foundation for the brand and product tone of the enterprise in the early stage of the life cycle, but with subsequent expansion, the franchise model may become an effective organizational management method to expand brand awareness and regional coverage. Specifically, we believe that the franchise model promoted by brands with brand power and relatively high-quality management systems may achieve a win-win situation between brands and franchisees: 1) For brands, cooperation with franchisees can avoid the problem of high operating costs under the heavy asset model to a certain extent; at the same time, the overall self-management under the direct operation model limits the management radius of the headquarters, while the franchise model can give play to the self-driving force at the end of the organization, and can also effectively activate the funds and property resources of franchisees, thereby accelerating the speed of store expansion and raising the ceiling of store opening. 2) For franchisees, chain brands with competitive advantages can bring them brand traffic, supply chain (for example, catering brands provide supply chain resources for stores) and store management (for example, hotel brands output management experience for stores and send store managers). In addition, brands are gradually getting rid of negative awareness such as "quick tricks" and "cutting leeks" in franchise management, and have conducted more standardized explorations. On the basis of the gradual improvement of management tools and management concepts as mentioned above, we have noticed that in recent years, more and more brands have been opened to franchising from direct operation, such as Heytea, Haidilao, Jiu Mao Jiu, Helens, etc. have successively announced the opening of franchising, and the organizational management matrix of chain enterprises has become increasingly rich. Investment perspective dismantling service brand chain: category differences, growth space and investment timing selection Category selection: "large space + wide audience + low threshold + scale" may be the common elements of advantageous tracks The business logic of the category itself determines its track width, and pays attention to the advantageous tracks with wide audience, low threshold and easy scale under large space. In the service brand chain, we believe that the major sub-categories may have great differences in the specific business logic level, and the categories with outstanding underlying business logic can often broaden their track width and are expected to breed large-cap companies that can cross cycles. We have detailed the following analysis of several major service chain categories (hot pot, Western fast food, Chinese fast food, coffee, tea, hotels, medical institutions, educational institutions, car services, and beauty services), and tried to summarize the framework from the perspectives of supply and demand, and compared and analyzed the advantages and disadvantages of the development of each segment of the service chain industry, and the opportunities for leading companies to expand the market space: ► [Perspective 1] Based on demand-side considerations, we believe that: 1) The growth space of the track and the development potential of the market determine the opening and growth ceiling of leading companies in the industry to a certain extent. 2) Categories with a wide audience, low price and high frequency, stronger stickiness, and lower fashion risks are more attractive.From a comprehensive perspective, we believe that industries such as hotels and catering, which benefit from a broader consumer base and low-price, high-frequency consumption, have a relatively broad market space. However, it is also important to note that the demand side of the catering category changes rapidly, facing a higher "fashion risk." At the same time, we believe that medical institutions, beauty services, and educational institutions have high stickiness and higher customer transaction values among specific groups, and are also worth paying attention to.

**Perspective Two**: Based on the supply side, we believe that 1) policy requirements, capital investment, and site selection, which are the thresholds for opening stores, can directly affect the speed at which leading brands open stores and determine their ceiling for store expansion. Generally, industries with lower requirements for hardware environment, less necessary investment, and lower policy thresholds have a lower difficulty in increasing the number of stores within the track. 2) Industries with lower scaling difficulties are more likely to nurture large enterprises, and tracks with lighter assets, lower dependence on labor, lower comprehensive management difficulty of stores, and lower supply chain management difficulty mean easier scaling.

From a comprehensive perspective, we believe that the thresholds for opening stores and the difficulty of scaling in the catering, hotel, and automotive service industries are relatively low.

**Perspective Three**: The size of the demand-side market space and the difficulty of supply-side scaling replication will ultimately be reflected in indicators such as chain rate, net profit margin, and payback period. Advantageous tracks may have relatively higher chain rates, higher net profit margins, and faster payback periods. For direct-operated brands, the profitability of stores is directly related to the company's overall profit level; for franchised brands, the profitability of stores and the payback period directly affect the enthusiasm of franchisees, which in turn affects the scale and profitability of the headquarters.

Considering the above three perspectives, we believe that catering and hotels are the tracks in the service chain format that are relatively most likely to nurture large companies. At the same time, it is also possible to pay attention to other service chain formats such as medical institutions, educational institutions, automotive services, and beauty services, where some excellent companies have the opportunity to achieve rapid growth on a low base as the chain rate increases. Specifically for the catering category, we believe that beverages (coffee and tea drinks) and Western fast food are relatively better than hot pot and Chinese fast food, and are even better than most other catering categories.

There are also differences between the catering and hotel formats: the payback period for catering is shorter and the stability is weaker, while the life cycle of hotels is longer and the stability is stronger. Based on the relatively smaller single-store investment, most catering brands have a shorter payback period compared to hotel brands (we estimate that the average payback period for industry leaders in Western fast food, freshly made tea drinks, and coffee industries is about 2/1-2/1-2 years, while the average payback period for hotel leaders is about 3-5 years). However, at the same time, catering brands also face more uncertainties, with the demand side having the fashion risk of consumers constantly trying new things and changing tastes, and the supply side having more intense competition due to lower thresholds and shorter leases (generally 3-5 years for catering vs. 8-10 years for hotels), leading to weaker stability for franchisees to continue joining the same brand under the franchise model. Therefore, generally speaking, the life cycle of hotel brands is longer than that of catering, and the changes in the pattern are relatively slower.

Taking tea drinks as an example to deconstruct its value chain, assuming a tea drink priced at 15 yuan, with a franchise store gross margin of 65% and a tea brand enterprise supply gross margin of 30%, the total industry chain gross margin of the two links can reach 75.5%, allowing participants in the two links to achieve a relatively considerable profit margin level on the basis of a not very high end price.

Looking for future chain brands with thousands of stores: core competitiveness and winning rules

The comprehensive strength of product, operation, brand, and organization + iteration ability is the core.

Core competitiveness evaluation system: product, operation, brand, and organizational iteration ability. The company continuously hones the above capabilities to form a strong internal strength, in order to achieve continuous customer acquisition, reasonable profit levels, and a healthy and sustainable store expansion.► Strong Product Power: The direct driving force for consumers to choose a brand is the foundation of brand development. In service consumption, product and service quality, as well as price, are all important factors affecting consumer satisfaction. With the development of platforms such as Dianping and Xiaohongshu, the information asymmetry between merchants and consumers is being reduced. The quality of products and services will directly affect brand reputation, and during the stage where consumers tend to be more rational, products with "value for money" will have greater resilience for development. For chain brands, outstanding demand insight ability, product development capability, and supply chain management ability are indispensable elements to support high-quality products and services.

► Strong Operational Strength: It determines the profitability of a single store and the development strategy of the store, which is the basis for the brand's continuous and healthy scale expansion. High consistency in product and service delivery and good single-store profitability rely on: 1) streamlined and standardized SOP design for stores, reducing store operation and maintenance difficulty, and ensuring consumer experience; 2) an active and efficient human resource management system to motivate employees and alleviate the rigidity of labor costs; 3) flexible application of digital tools to achieve efficient supply chain management, accumulate and analyze operational data to support company's business decisions. Store development strategies mainly include expansion strategies and store location selection. Reasonable planning of store opening speed and flexible location selection are beneficial for increasing brand exposure and saving rental costs.

► Strong Brand Momentum: Establishing consumer cognition is the deep moat of the brand. The establishment of brand momentum needs to be based on strong product power and strong operational strength, continuously conveying and strengthening the brand concept to establish a unique consumer brand cognition. In addition, marketing channels are also the main ways for companies to establish brand momentum. According to Deloitte's "2023 China Consumer Insights and Market Outlook White Paper," short video platforms, brand official websites, social media, and review and evaluation apps are important channels that influence consumer decisions, second only to the experience of shopping malls/physical stores.

► Organizational Iteration Ability: After the brand expands in scale, it is necessary to implement personnel refinement, adjust organizational structures, etc., in a timely manner to adapt to the development rhythm. The content of organizational iteration includes: 1) personnel refinement, including internal personnel iteration and continuous learning for self-iteration by managers, to maintain the company's high market sensitivity and choose reasonable development strategies; 2) organizational structure adjustment, after the company develops to a certain scale, there may be problems such as organizational rigidity and low operational efficiency, which need to be adjusted in time according to the development rhythm; 3) adjustment and strengthening of corporate culture and values to unify the internal development direction and reduce talent loss.

The ability to adapt to different development stages is essential for doing well, growing big, and living long. Compared with the manufacturing industry, the chain format may not have a strong scale effect, and even at a certain stage, there may be diseconomies of scale, which are specifically manifested as: 1) the increase in headquarters and store personnel may lead to low labor efficiency; 2) when entering new markets, there may be problems such as differences in regional consumer habits (such as taste preferences, customs, etc.) and low brand awareness; 3) store location selection depends on resource endowment, and there may be high rental costs and location competition during the scale expansion process; 4) the supply chain may be limited by the supply radius (such as the coverage radius of central kitchens, warehouses, etc.). Therefore, continuously improving the ability to adapt to different development stages, keeping up with the scale or leading the scale, is the key to doing well, growing big, and living long.

Simply reducing "quality" or "price" is not a sustainable way.

In recent years, as we gradually enter an era of more normalized growth and consumers become more rational, we have observed that some brands with high premiums that have developed rapidly in the past have encountered certain challenges. Price reduction promotions and fierce competition are endless. Our view on these dynamic changes is:

► Consumer demand is rich, diverse, and multi-level, and brands with reasonable profit margins and low, medium, and high price segments all have their market. Of course, corresponding to the income structure, generally speaking, the lower the price segment, the larger the market size. If you want to seek continuous growth, it is sometimes necessary to appropriately expand the price segment and expand the population. Of course, if the positioning span is large, there may be challenges in consumer cognition, the company's own genes, and organizational capabilities.

► The business of cost-effectiveness is more likely to form a positive cycle. The business of cost-effectiveness has a relatively low unit price, and most of them are essential scenarios. The target consumer group range is larger, and it is easier to expand the scale. As the scale expands, the scale effect will bring the thinning of raw material costs and headquarters expenses, which will enhance the company's profitability. Moreover, the company has the ability to continuously strengthen the supply chain construction to consolidate the cost-effectiveness advantage (maintaining low prices while improving product quality), forming a positive cycle of scale, cost-effectiveness, and profitability.

► Consumer power repair is weaker than expected: If the overall consumer spending level is still under pressure in the future, and the degree of consumer confidence recovery is insufficient, it may lead to the traffic and sales volume of offline chain enterprises not meeting expectations, and may not generate the expected benefits.► Intensified competition in the chain business format: If the competitive landscape within various sub-sectors of the offline chain business format gradually deteriorates, standing out in the fierce competitive environment and achieving sustainable business growth will become a significant challenge. If the pace of corporate expansion is slower than expected, it may miss the opportunity to seize high-quality resources, reduce corporate influence, and consequently, the industry's competitiveness and long-term profitability may not meet expectations.

► Failure of enterprises to enhance management capabilities to cope with change: As the scale of chain enterprise outlets continues to grow, the requirements for employee management and expansion methods will be further enhanced, testing the existing management models and efficiency. If management efficiency and quality decline during rapid scale expansion, it will impact the company's brand image and business performance.