News broke earlier this year that Yum China (NYSE:YUMC) -- 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.
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.
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.
Nicholas Rossolillo and his clients own shares of Tencent Holdings and Yum China Holdings, Inc. The Motley Fool owns shares of and recommends Tencent Holdings. The Motley Fool has a disclosure policy.