There's only one thing you need to know to understand why two hedge fund operators dumped a ton of money into restaurant operator Yum! Brands (NYSE:YUM): China.
China accounted for 48% of Yum! Brand's total first-quarter revenue and 38% of its operating profit. Those percentages were down, though, from full-year 2014 when the nation represented 52% of Yum! sales and 46% of operating profit. While its recent results remain weighed down by the impact of the company's second food scandal in China in as many years, this is still its largest operating segment and the one with the most potential for future growth.
Riding the Orient Express
Both Corvex Management and Third Point Capital have taken substantial positions in the restaurant operator. Corvex's position is valued at about $1.5 billion; Third Point hasn't released its tally just yet but said it bought a "significant stake." Both specifically cited China's growth potential as the reason for taking their positions.
Although some 600 million people comprise China's middle class, the market researchers at McKinsey & Co. say the ones to watch are those it terms Generation 2, or G2, which make up a third of the middle class population. In 2012 they accounted for 15% of all urban consumption, but that is expected to more than double to 35% over the next decade.
Of equal importance, according to McKinsey, is these consumers' ability to shape the economic landscape: "G2 consumers will be almost three times as numerous as the baby-boomer population that has been shaping US consumption for years."
A powerful force for change
By 2022, more than three-quarters of China's urban consumers are expected to earn between $9,000 and $34,000 a year. Ernst & Young expects the Chinese middle class to swell to more than 1 billion people by 2030.
These consumers are already making their impact felt on companies. For example, tech giant Apple credited China's middle-class consumers with propelling its earnings higher this past quarter. It sold 61.2 million iPhones in the first quarter, 40% more than a year ago, but China experienced the biggest surge in sales -- 72% growth year over year.
For Yum! Brands, the potential is equally enormous. Of the more than 41,000 restaurants it operates globally, nearly 6,850 are located in China. The KFC chicken chain represents 72% while Pizza Hut makes up most of the rest.
Establishing a forward operating base
While China has long produced much of the meat it consumes -- it's the world's largest consumer of pork and second only to the U.S. in the consumption of chicken -- the increasing urbanization of its population means fewer people are raising their own livestock and more are purchasing their food elsewhere.
That's part of the reason U.S. poultry producers such as Tyson Foods (NYSE:TSN) and Cargill have established extensive meat production facilities in China. Yum! Brands' KFC division in China is a Tyson customer. With greater urbanization and its accompanying increase in consumer income, there is a large potential for increased growth by building out more restaurants.
Yum! Brands opened 171 new restaurants in China in the first quarter for an average of three per day (according to Tyson's fiscal 2013 fact book, chain restaurants were opening new locations at a rate of one every 18 hours that year).
But it's not merely tapping into this lucrative demographic that attracted Corvex Management and possibly Third Point Capital. Corvex founder Keith Meister wants Yum! Brands to spin off the China division, which he believes could create an additional $16 per share of value for investors, and could trade between $40 and $70 per share on its own.
While Yum! Brands often franchises its operations, in China Meister says there's no well-developed franchise market, which opens the restaurant operator to a different set of risks than it faces elsewhere in the world. Other analysts have also suggested spinning off its China division would help it "de-risk" its operations.
Although Third Point's Daniel Loeb hasn't specifically endorsed that plan, he said Yum! Brands is poised to move past the food scandal woes that have weighed down the stock, which "set the stage for a dramatic profit recovery over the next 12 to 24 months, and change the public market narrative around long-term shareholder value-creation for the company."
For its part, Yum! Brands thanked the activist investors for their input, but said it is focused on getting "our China business back on track." The outside interest seems to acknowledge the importance Yum! Brands has placed on the division.
A stabilizing force
Yum! Brands' China business does appear to be stabilizing: While same-store sales fell 12% in the first quarter, that's better than the 16% decline it experienced in the fourth quarter of 2014. Restaurant margins are also improving and it is looking for the recovery "to unlock approximately $600 million of operating profit."
As part of a larger whole, or spun off on its own, Yum! Brands' China division remains the key to its future stock potential, and investors might just want to imitate the actions of these two hedge fund players.
Follow Rich Duprey's coverage of all the restaurant industry's most important news and developments. He has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.