Please ensure Javascript is enabled for purposes of website accessibility

Why I'm Cheering Yum China's Rejection of a $17.6 Billion Offer

By Nicholas Rossolillo - Updated Aug 29, 2018 at 3:46PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The Chinese investment firms' lowball isn't enough for a world-class restaurant operator.

News broke earlier this year that Yum China (YUMC -0.10%) -- the country's sole licensee of KFC, Pizza Hut, and Taco Bell -- was in talks to be taken private. Share prices rallied on the rumor in July, and they are rallying again after The Wall Street Journal cited sources saying the restaurant chain rejected an offer of $46 share. Even though that would be a 43% premium to the last trading price before the original news broke, Yum China's decision to reject the bid is in the best interests of long-term shareholders.

Restaurant chains under pressure

Yum China, which was spun off from former parent Yum! Brands in late 2016, has done well during its short stint as an independent enterprise. The reasoning behind the separation went something like this: An independent company in China would be in a better position to adapt its menu to the unique Chinese consumer, in addition to having more flexibility to expand its store base, food delivery options, and digital rewards programs in the fast-growing Chinese economy. So far, so good.

YUMC Chart

Data by YCharts.

However, after a strong run in 2017 in which over 700 new stores were opened and sales at existing locations increased 4%, share prices have been under pressure in 2018 as results have been more muted. The Pizza Hut chain has been the biggest drag on performance as management is still struggling to revamp the brand among Chinese diners. Paired with a competitive restaurant industry, average per-store profit margins have slightly dipped this year at both KFC and Pizza Hut.

With this short-term weakness, private investors saw an opportunity. A consortium of firms led by Hillhouse Capital -- known for its early backing of Chinese video game giant Tencent -- approached Yum China about taking the company private. Given the company's promising road map for expansion, Hillhouse and its partners want in on this growth.

A close-up picture of fried chicken strips.

Image source: Getty Images.

Why staying public makes sense

I, for one, am happy Yum China rebuffed the $46 per share offer. Though it would be a nice double-digit bump from current trading levels, it seriously undervalues the long-term potential of the company. 

Yum China is already the country's largest restaurant chain, but China's middle class is still developing. As of the end of the second quarter of 2018, there were 8,198 KFCs, Pizza Huts, Taco Bells, and a handful of other local brands in the stable. That's 494 new openings in just the last 12 months alone. Taco Bell just made its debut in Shanghai last year and has only three stores so far. With consumer reception of "Mexican food" trending positively, Taco Bell represents another avenue for growth in the years ahead.

Overall, management plans on building out a network of 20,000 stores -- more than double the current count. Not only is that a lot more revenue coming in, the fast pace of expansion means current profitability is taking a hit. Once that pace slows, there is a lot of value Yum China can unlock in the bottom line.

The company's leadership team supports its thesis for 20,000 stores by way of comparison. During its 2017 investor day last fall, the company noted the 15,000 Yum! Brand restaurants in the U.S., a market with one-quarter the population of China. Plus, the Chinese restaurant industry is still highly fragmented -- 91% of stores operate independently versus only 47% in the U.S. Thus the company sees a market ripe for consolidation of some of its small competition.

Headwinds are creating some challenges to achieving those long-term targets, but selling out now -- even at a better than 40% premium to recent lows -- seems wrong. For those thinking about Yum China a decade from now, management forgoing a bonus at this time for a bigger payoff down the road makes a lot of sense to me.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Yum China Holdings, Inc. Stock Quote
Yum China Holdings, Inc.
$42.15 (-0.10%) $0.04

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
S&P 500 Returns

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/23/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.