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It's unlikely that too many people were disappointed by YUM! Brands' (NYSE: YUM ) announcement on April 26 that it had made a preliminary offer to acquire China's Little Sheep Group, an Inner Mongolia-based operator of 184 hot pot restaurants with 296 more franchises in China (and a handful in North America). YUM! Brands investors have to be happy -- the company may end up with a fast-growing restaurant concept that's shown the legs to expand nationwide in China. Little Sheep owners should be happy, too -- while a formal offer h as not yet been announced, it's likely to be a rich premium to the current, very reasonable share price.
I, however, am disappointed. Not only was Little Sheep on the short list of the most promising ideas we were going to visit next month during our annual Global Gains research trip to China, but we had a meeting with management all lined up in Baotou City -- a meeting that has since been canceled.
While it's difficult to analyze the merits of this deal without knowing the price YUM is going to pay, if it goes through, YUM will be adding a heck of a business to its portfolio, further solidifying the company as one of the top ways to play the growing Chinese consumer market.
Some background on Little Sheep
Like eating fondue, Mongolian hot pot is a social experience where diners skewer their raw food and cook it in a -- surprise, surprise -- hot pot in the middle of the table. And while China has more than its share of delicious regional cuisines, Little Sheep Hot Pot has started to successfully expand its concept outside of Inner Mongolia -- an achievement that has eluded so many other Chinese consumer businesses. Sales in 2010 were up more than 22% for the company thanks to better than 8% same-store sales growth. This included clear traction in Beijing and early traction in Shanghai -- China's two largest urban markets.
The reason this matters is because Inner Mongolia has a population of just 23 million, whereas China has a population of more than 1.3 billion. Assuming the market could support one restaurant for every 100,000 people, getting outside of Inner Mongolia means that the company could potentially open 13,000 locations as opposed to just 230. That's the difference between a growth story that's over and a growth story that's just beginning.
YUM, like I do, clearly sees a growth story that's just beginning and one that will help the Kentucky-based company achieve its goal of opening some 20,000 units in mainland China. What's more, given its operating expertise and franchising track record, YUM is likely to be able to accelerate Little Sheep's growth and help make the company more profitable. That's because YUM already has a relationship with Little Sheep through a 27.2% ownership stake and board presence, so it knows what it's getting into.
As always, there are pitfalls
But before you go out and back up the proverbial truck buying YUM shares, there are two realities to be aware of. First, the reason YUM made a provisional -- and not formal -- offer for Little Sheep is because it needs myriad regulatory approvals from the Chinese government. That can be a byzantine process, particularly when it comes to foreign ownership of local business. China's Ministry of Commerce, for example, famously blocked Coca-Cola's (NYSE: KO ) bid to acquire China Huiyuan Juice in 2009 citing anti-monopoly policy -- a somewhat ridiculous ruling given the breadth of beverage choices in China. But the Chinese government is seemingly loath to let successful domestic brands with multinational potential end up in the hands of Western companies so early in their growth cycles.
Second, know that YUM stock is expensive. Following our research trip to China last summer, our Global Gains team recommended YUM at $40 as a core holding in our Chinese Consumer Basket, citing its growth potential in the Middle Kingdom. The stock is since up more than 33% for precisely that reason, helping that basket, which also includes Natural Beauty, Winner Medical (Nasdaq: WWIN ) , and China Mass Media (NYSE: CMM ) , return 15.4% overall -- almost 10 percentage points ahead of the relevant Xinhua 25 Index (NYSE: FXI ) . While the eventual acquisition of Little Sheep would likely raise our fair value estimate, there are too many unknowns, including price and outcome, to bake that in just yet. Savvy investors looking for China consumer exposure should wait to buy YUM between $40 and $45.
The Global View
Yet even if you're not interested in owning shares of YUM or Little Sheep, this is a deal worth watching to see whether China will grant the necessary regulatory approvals. That's because there's enormous potential for cross-border investment between the U.S. and China to happen over the next 10 to 20 years. According to a recent report by the Woodrow Wilson International Center for Scholars, China might invest $1 trillion to $2 trillion in the U.S. by 2020 if allowed -- creating jobs and funding technological advances. Similarly, by bringing capital and expertise to China, U.S. companies such as YUM can help that country accelerate its development cycle.
Politicians in both countries, however, remain wary of one another and their objectives, and there are political forces in both countries preventing the free flow of capital and information. These barriers are strengthened when the Chinese government rejects Coca-Cola or the U.S. rejects Chinese companies, as it did when CNOOC (NYSE: CEO ) bid on Unocal in 2005, from acquiring assets in the United States. Ultimately, we will get to a point where business activity between the two countries is more seamless, and it would be helpful if our politicians made that happen sooner rather than later.