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Yum! Brands to Let China Business Go Solo

By Rich Duprey - Oct 21, 2015 at 2:30PM

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A disappointing, troubled segment makes it easier for the restaurant operator to finally let go.

Yum! Brands will carve its China business off into an independent company, which is mostly comprised of KFC and Pizza Hut.

That didn't take long. Just days after appointing to the board of directors a hedge fund operator who advocated spinning off its business in China, restaurant operator Yum! Brands (YUM -2.37%) announced it will do just that.

Orienting itself for growth
As China accounts for more than half of Yum! Brands' revenues and a third of its operating profits, the separation is going to have a significant impact on future results. But because it also reduces the risk of being overly exposed to the region, particularly as China suffers from an economy that is slowing faster than many had anticipated, the end result may be more beneficial.

Yum! Brands' third-quarter earnings caught many investors and analysts by surprise as the owner of Taco Bell, KFC, and Pizza Hut said its business in China was recovering more slowly than expected. Having suffered its second food scandal in as many years last year, customers weren't returning to its chicken restaurants nearly as fast as they did before, and management was forced to concede it wouldn't hit its earnings growth targets. Instead of the 10% growth it planned, it said per-share earnings would only grow in the low single digits.

Consider the impact the supplier scandal had on McDonald's (MCD -1.70%), which also has a large presence in China, though not nearly as widespread as Yum! Brands. It earnings took only a small hit and with 14,000 domestic restaurants, it remains a much more U.S. focus chain, though it does have 35,000 stores worldwide.

The addition of Keith Meister of Corvex Management to the Yum! Brand board, though, signaled change was coming to the restaurant operator.

Hedging its bets
Earlier this year, Corvex established a significant stake in Yum! Brands of about 5% of company stock worth about $1.5 billion. At the time, he advocated it spin off the China division, believing it could create an additional $16 per share of value for investors and could trade between $40 and $70 per share on its own.

There's some reason for that hypothesis, because China's so-called Generation 2, or the generation born after the mid-1980s, comprise a third of the country's middle class. The market researchers at McKinsey & Co. say they account for 15% of all urban consumption but are expected to more than double to 35% over the next decade.

The equivalent of baby boomers, China's Generation 2 promises to be a powerful force in shaping the country's economy for years to come.

Like the baby-boomer generation that shaped U.S. consumption for years, G2 consumers will be almost three times as numerous -- and a potent force determining the direction of the Chinese economy.

But that economy is coming in for a harder landing than many imagined. China admits its economy is slowing, and data just released showed the world's second largest economy expanded at a rate of just 6.9% in the third quarter, its slowest pace in six years. Some analysts are skeptical, though, and suggest the real expansion rate was just 4% because the official numbers undervalue real estate, retailing, and other services.

Go your own way
Yum! Brands has long bet on China's growth such that an investment in the restaurant operator was actually an investment in China. It's why some believed Yum! Brands spinning off its Taco Bell division was the better option as it aligned its operations with management's preferred strategy.

The Mexican food chain is almost wholly based in the U.S., with virtually all of its revenues generated here. While Yum! Brands was slowly expanding the concept, it's clear Taco Bell didn't fit in with KFC or Pizza Hut, both of which have a substantial presence in China.

But there are some anomalies in China that don't correspond with its operations elsewhere. For example, Yum! Brands has over 41,000 restaurants in more than 125 countries around the world, and and most of them are franchised -- in the U.S., 91% of its restaurants across all three concepts are franchisee-owned. But in China, Yum! Brands owns most of the restaurants. Of the 6,867 restaurants it has there, 80% are company-owned.

Yum! Brands hopes to unlock significant shareholder value by spinning off its China division, which it believes can grow to as many as 20,000 restaurants, a three-fold increase from today.

By spinning off the China division, Yum! Brands says it will become more of a pure play on franchising as it is targeting having at least 95% of its restaurants owned and operated by franchisees by the end of 2017.

 Investors still need to be mindful that a franchise-based model isn't a panacea. McDonald's is facing a franchisee revolt as corporate headquarters churns out new ideas that the businesses owners are expected to pay for. With falling sales, agitation mounts over expenses that are imposed from the top down.

All aboard the Orient Express
For the newly independent division, which will be called Yum! China, the restaurant operator believes it can grow to as many as 20,000 restaurants in the future. The division delivered $6.9 billion in sales last year, suggesting it could be a $20 billion business in the years to come.

Whether it was China that was spun off or Taco Bell, the move makes sense. It allows the individual businesses and management teams to focus on their core strengths without having to compete for scarce resources within the company.

Management may have resisted the idea for as long as possible, but with business suffering the vagaries associated with a newly capitalistic society amid a slowing economy, spinning off the China division now was the right move to make.

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