Yahoo Finance Why Investors Are Skeptical About Yum Brands Stock
Last week's announcement that Yum Brands would spin off its lucrative China division into a separate publicly traded company in 2016 is raising doubts among investors about the short- and medium-term benefits of holding YUM stock (YUM), and in investing in the new company amid Beijing's economic struggles.
"It does not solve the issues that they're having in China, dealing with slowing sales and slowing earnings growth there," says Jack Russo, senior consumer analyst for St. Louis-based Edward D. Jones & Co., which has a "hold" recommendation on the stock.
"But what it does do, it does separate the two businesses. It will allow the management teams of each business to focus more intently on their individual business units. And it separates a high-growth business -- a potentially high-growth business in China -- from a lower-growth business, which is what you'll see in the non-China segment," he says.
YUM stock's earnings woes. YUM stock, already wounded by a worse-than-expected earnings report, continued to tumble following the Oct. 20 announced spinoff of the company's China operation, which accounts for half of the company's revenue and a third of its operating revenue. Yum owns KFC, Taco Bell and Pizza Hut restaurants.
Moody's Investors Service downgraded Yum's senior unsecured notes from Baa3 to Ba1, citing the company's announcement that it is "committed to returning substantial capital to shareholders in conjunction with the separation."
This will likely make its interest costs of future financings go up and will also put them in a highly leveraged category, which could unnerve investors. To gain a higher rating, Yum would need to show "a demonstrated and sustained improvement in same-store sales, specifically at KFC China, while showing continued improvement in operating performance in the U.S. and international divisions," according to Moody's.
Yum, which opened its first Chinese KFC in 1987, once saw its revenue in the country rising as high as 35 percent in 2011. But since 2012, Yum in China faced a series of public relations nightmares, mostly about chicken.
It started when CCTV reported a supplier was treating chickens with excess antibiotics and growth hormones. In 2014, the avian flu scared customers away, and last summer, a supplier was accused of selling expired meat to Yum and other chains, leading to consecutive and unpredictable disappointments: a fourth-quarter revenue decline of 16 percent in 2014 and a 12 percent drop in the first quarter of this year.
"Obviously, the more of those you have, it pings your brand. And I think the challenge in operating in China is you're going to have those issues," says Jerry Braakman, chief investment officer of First American Trust in Santa Ana, California.
In August, Yum replaced its head of China operations with Mickey Pant, a former chief executive of KFC with a strong marketing background. By the third quarter, the company reported year-over-year growth, but in the single digits -- less than its projection of 10 percent growth. It took hits throughout September with same-store sales in China that were weaker than expected.
On Oct. 7, Yum disappointed Wall Street by reporting same-store growth of 2 percent when investors were expecting 9.6 percent growth. The stock tumbled by more than 16 percent as investors fled, setting the stage for Yum's board of directors to add activist investor Keith Meister, the founder of Corvex Management, on Oct. 15.
Meister had been urging the spinoff of the China division for months and has a 5 percent stake in Yum, valued around $1.5 billion.
The China division. Yum operates 6,900 restaurants in China, including 4,900 KFC eateries that maintain a special menu that includes hoisin sauce for the Chinese palate.
"I think the KFC brand has really hit on because the Chinese diet consists highly of chicken," Braakman says. "Their menu in China is completely different than it is in the U.S. And so, it uses more local ingredients, has local products," that appeal to the Chinese patrons.
As the Chinese population becomes more accustomed to eating cheese, Pizza Hut has also become a presence with 1,400 restaurants.
Taco Bell, Yum's strongest domestic brand, has no presence in China but has an exclusive option to open in the country. Yum says it is on pace to open 700 new restaurants in China this year, and plans to eventually have 20,000 locations.
Although the Chinese economy is faltering, Yum expects its consuming class to double from 300 million in 2012 to more than 600 million by 2020, "providing a strong tail wind to the growth of Yum China."
The transition to make Yum China a separate, publicly traded franchise is to be completed by the end of 2016, with Yum's India business merging with the global entity. The immediate response to the announcement was a 1.8 percent hike in the share price of YUM stock, although shares returned to their downward trajectory by the end of the week.
Yum's long-term prospects. In a statement, Meister says the spinoff will help establish the right corporate and capital structure to maximize long-term shareholder value.
Much will depend on how freely Chinese consumers spend their money. Typically, the Chinese have a saver mentality. "What we're seeing in China is that the consumer trends are decelerating. So it's not to say that China isn't growing, but there's really just a new paradigm in China, where we can no longer expect double-digit growth year after year," says Andrew Duguay, senior economist at Prevedere, a data analytics company in Columbus, Ohio.
The Organisation for Economic Co-Operation and Development predicts a 6.7 percent growth rate through 2016, which looks relatively paltry compared with the 12 percent growth in years past, but stunning compared with the 3 percent growth U.S. rate. "Those expecting China to be the goose with the golden egg -- that's no longer the case from a global economic perspective," Duguay says.
Some indicators beyond GDP include the sales of movie tickets, cars, mobile phones and homes, which show about 4 percent growth, according to the New York research firm Sanford Bernstein.
"Eating out in China is still a relative luxury," Russo says, "so it's important that the economy shows a little bit of improvement from where it is now, and that the consumer remains confident. And I think right now that's being challenged a little bit."
Longer-term Yum investors tend to like the long-term urbanization story and the unfolding of China's development. But shorter-term investors are keeping a close eye on the export economy, Braakman says.
"There's issues in there: in the transparency of their economy; in the balance sheets of their banks; they've had a huge investment in their infrastructure. So all these are headwinds that are propped up, obviously by a strong export economy and the positive current trade balance. But if those things ever get challenged, then you could have not just a short, but a medium-term challenge to a company like Yum," he says.
"But over the long term, past three to five years, I think they're going to continue to benefit from that demographic shift as they continue to urbanize," he adds.
In China, it might be beneficial for KFC to renew its focus on healthier food.
"In terms of the fast-food business in general, I think there is a general tendency towards more healthy food, a healthy diet. That's becoming a new trend, so that they probably have to come up with some new menus," says Chen Zhao, co-director of global macro research at Brandywine Global.
And in the U.S., eyes will be on how well Yum reinvigorates its Taco Bell brand and how strongly it competes with Chipotle Mexican Grill (CMG), in much the same way that McDonald's Corp. (MCD) competes with Shake Shack (SHAK).
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