Separation Anxiety? What China Spin-Off Means for Yum! Brands Inc.

Yum! Brands (YUM 0.75%) has been slow to recover from the negative publicity associated with multiple food quality scandals in China. When evidence emerged that suppliers were using expired meat last summer, that was the last straw.

In hopes of a recovery, Yum! announced a dramatic change to regain traction in the market. The operator of KFC, Pizza Hut, and Taco Bell is separating its main growth vehicle -- its China operations -- into a new, publicly traded company. Now the question is, will the split actually unlock the $16 per share of added value that activist investor Keith Meister said it would?

A full transcript follows the video.

Dylan Lewis: Why don't we start out talking about Yum! Brands and some news about the stock?

Vincent Shen: A major announcement just came out before the market opened, that the company will be spinning off its business in China. The initial response has been very positive, like you mentioned. It's up over 4%, last I checked.

Lewis: For listeners that aren't as familiar with Yum!, what's driving management to make such a big decision?

Shen: Ultimately, this all centers around its China division, which makes up about half of revenue and operating profits. The issue there is that China's previous major growth vehicle has seen revenue stagnate over the past two years or so. To illustrate that, for the full year 2012 China's division saw a revenue of about $6.9 billion. Two years later, for full year 2014 it was just over $6.9 billion.

The problem is, there's a huge shift from previously when, in 2011 to 2012 you'll see anywhere from 25% to 35% annual growth.

Lewis: Okay, so there's a big drop off there.

Shen: Big drop off.

Lewis: What's the reason for that shift?

Shen: For investors who don't follow Yum! as regularly, it's just been plagued by terrible publicity as a result of some food-quality scandals.

Lewis: I remember a couple months back when they had some issues with meat sourcing.

Shen: Yes. They get hit back-to-back, really. That's just resulted in this longer slide. In 2012, CCTV reported at the end of 2012 that local a KFC supplier was treating chickens with excess antibiotics after they did some testing in the previous two years. Management forecasted a 25% same-store sales decline as a result from that negative publicity. It actually came down just around 20%, but the pain continued.

Restaurant margin declined 7% points, operating profit fell a very significant 41%. The next quarter was more of the same. Same-store sales were down 20%, margin down 5% points, operating profit plummeted 63%. At that point, it's possible -- they hit it with a lot of marketing to try and get customers back in their stores, but right after that happened there was an avian flu situation, too. So they were hurt by that as well.

It's this ongoing pain that management was feeling from their China division. When things started to pick back up over the next year or so, they got hit again recently -- last summer -- when there were reports that came out that one of their suppliers, this time at an American-owned factory, was basically continuing to use tainted and expired chicken.

As you can imagine, this actually hit McDonald's and Starbucks as well, but same-store sales fell 14%, margin declined 4.6% points, operating profit down 30%. For full year 2015, the most recent quarter, management indicated that same store sales were going to come in slightly negative.

After years of suffering through this really poor recovery, and being hit by these scandals, investors are very unhappy, and management has been going through this long, strategic review, trying to determine what they can do to revitalize that business.

Lewis: Basically, it was issue after issue after issue, and they weren't able to rally long enough to re-instill that consumer confidence.

Shen: Yeah. They were probably picking up some momentum and looking like they would at least return somewhat to their previous growth and their success there, but they got hit by this other scandal.

Lewis: I've seen this name in some of the articles I've been reading about the issues: Keith Meister. Can you talk a little bit about his role in all this?

Shen: He's a bit player here because he's an activist investor from Corvex Management. They're one of Yum! Brands biggest shareholders. I think they have a 5% stake. They made an announcement last week that he had been appointed to the board of directors. He's been very public with his view that Yum! Brands should be spinning off its China business entirely.

He presented that in a speech that he made in May of this year. The stock has traded down about one-quarter since then as a result of its recent earnings reports, but it's kind of interesting to see. Since that slide, he got appointed to the board, and then not even a week later, they're making this announcement and this stock is seeing a big boost as a result.

Lewis: Yeah. This is the nudging of an activist investor.

Shen: Oh, I think it's a huge part of that.

Lewis: OK. What are these two new companies going to look like? What can investors expect?

Shen: Yum! China operates about 6,900 total restaurants, and that's just KFC and Pizza Hut. Taco Bell has no presence in China yet. They're working on it. Under the current structure, those are primarily company owned. What's going to happen is, Yum! Brands overall is targeting over 95% franchise model for their whole network of restaurants. Then Yum! China will just become an overall franchisee, and it will be Yum! Brands' largest one by far.

Yum! Brands overall has 41,000 restaurants worldwide. They've been opening about 2,000 more annually. That's a pretty impressive rate of growth in terms of their number of restaurants, at least.

Lewis: When should we be looking for this deal to close out?

Shen: The deal should be completed by the end of 2016, and CEO Greg Creed described the deal in a way that's not all that surprising. He said, "Following the separation, each stand-alone company will be able to intensify focus on its distinct commercial priorities, allocate its own resources to meet the needs of its business, and pursue distinct capital structures and capital allocation strategies. This will provide a clear investment thesis and visibility to attract a long-term investor base suited to each business."

Not surprisingly, this will give investors their choice to invest in the Yum! Brands model, which is high margin, very stable due to the franchisee model where they're just getting that licensing revenue, and then more of the growth model through Yum! China, assuming they're able to get things back on track.

Otherwise, Creed is going to continue running Yum! Brands, and Micky Pant, who took the senior role for China late last year, is going to keep running that business.