Yum! Brands Earnings Show China Spinoff May Be a Mistake

Yum! Brands was able to stage a big comeback in China at its KFC chain by timing a big promotion to the Chinese New Year. 

Yum! Brands (YUM 0.46%) reported surprisingly strong first-quarter earnings that easily beat analyst expectations as the restaurant operator's China division roared back to life. As a result, the owner of the KFC, Pizza Hut, and Taco Bell chains revised its full-year guidance for core operating profits higher, raising its outlook to 12% from 10%.

While Yum! Brands enjoyed broad-based improvements across all of its divisions -- each segment recorded same-store sales growth in the first quarter -- it was the strength of the China division that garnered the most attention because it was an indication the food quality scandals that had plagued the restaurant operator for the past few years were finally behind it.

Yet with the China business's return to health, will the fast-food chain operator and its investors come to regret the decision to sell or spin off the division?

Slow boat out of China
Having been rocked by multiple food quality scandals in recent years, Yum! Brands bowed to the pressure of private equity firm Corvex Management, which had agitated for the company to divest its Chinese KFC and Pizza Hut operations to reduce its exposure to the region, and return value to shareholders. First the restaurant operator appointed Corvex CEO Keith Meister to its board of directors, then within days announced it was exploring strategic alternatives.

China is Yum! Brands' most important division, accounting for more than half of the company's revenues and more than a third of its operating profits. And whether it sells its China business or spins it off, Yum! Brands will retain an ownership stake in the new entity, so it's not exactly exiting the market. (In addition, it plans on opening its first Taco Bell restaurant in China by the end of the year.) However, it's going to see a greatly diminished contribution from the country.

That will work to its advantage in times of crisis, such as the period it just went through, but Yum! Brands has operated in China for decades largely without incident. Like McDonald's (MCD 0.37%), which is also divesting its Asian business as a result of the same food quality scandal, it appears to have made a hasty decision it will come to regret.

Growth by the buckets
Yum! Brands enjoyed an 11% jump in China's system-wide sales in the first quarter, as same-store sales surged 6%, the strongest gains of any of the restaurant operator's divisions. It marked the third consecutive quarter that comps rose, and was its best showing since the second quarter of 2014, when it was beginning to hit its stride again after recovering from the first food quality scandal.

Of course, there were some caveats to the good news coming out of China. For one, the first quarter includes the Chinese New Year, a celebratory time that is the peak period for the division, and the KFC chain, which accounts for 70% of the 7,200 restaurants it operates there, had a big promotion timed for the event. That was similar to how Yum! Brands got customers to come back after the first scandal -- basically by giving away buckets of chicken.

Also, the results weren't uniform. While the KFC chain enjoyed 12% comp-store growth in China, Pizza Hut saw comps tumble by a like amount, much worse than the 3.7% drop analysts anticipated (the 12% rise at KFC, on the other hand, was well above the 5.5% gain Wall Street had predicted).

A broad swath of improvement
Although Yum! Brands reported relatively good news outside of China too, the issue is that the division has such a central role in how the company performs. Still, Pizza Hut's business seems to be improving thanks to changes the restaurant operator has been implementing, enjoying 5% comps growth in the U.S. And Taco Bell, which has been a star performer for the company, recorded a 1% gain in comps, though that was comparatively weak compared to how it's done in the recent past.

While CEO Greg Creed noted that 2016 "is a transformational year for our company as we remain on track to finalize the separation of our China business by year end," it's not clear that it's a change investors will end up enjoying.