Why other U.S. companies won’t imitate Yum’s China spinoff
Is Yum Brands’ planned spin-off of its stumbling China business the beginning of a trend, or a one-off move by a company under pressure from a couple activist investors concerned with short-term gains?
To answer the question, you have to consider the position that Yum is in, and what it is getting in return for listing its China business–a business responsible for over half its annual revenues and, last year, almost half its operating profit.
First, what it is getting in return: One of the activist investors, Keith Meister, a Carl Icahn protégé who bought shares earlier this year around the same time as noted hedge fund activist Daniel Loeb, says the spinoff could boost Yum’s stock price by $16 a share. “The separation of these two businesses gives shareholders the choice to own a growing annuity-like franchise cash flow stream, as well as the leading restaurant concept in a country with the fastest-growing consumer class,” Meister told Reuters. The China business has been struggling over the past couple years and been seen as weighing down Yum’s share price. Slice off the China business, Meister’s thinking goes, and investors value the rest of the business higher.
Nevermind that analysts from Goldman Sachs are skeptical that the deal unlocks any value. Traders seemed to be on Meister’s side yesterday, sending the stock up almost 2% on the spinoff news.
Second: What is Yum’s position in China? Not as strong as it used to be.
Sales have stagnated the last two years for reasons almost entirely the fault of Yum. KFC and Pizza Hut locations in China (Taco Bell isn’t in the country) were hit last year by a food safety scandal after food supplier OSI Group was accused of sending expired meat to McDonalds, KFC, Starbucks, and other Western chains in China. Being the largest foreign fast food chain China, KFC received a lot of heat in the coverage of the scandal, and deservedly so. At the time, Richard Brubaker, founder of consultancy Collective Responsibility and adjunct professor of sustainability at the China-Europe International Business School in Shanghai, told me that Yum had more than 1,000 meat suppliers in the country. China’s food safety inspections are notoriously weak, so Brubaker blamed Yum and others for not ensuring their suppliers were following the rules. “If you know the government is not up to par, it’s on you,” he told me. After the scandal broke, Yum stopped using the supplier and said in a statement, “We will not tolerate any violations of government laws and regulations from our suppliers.”
It’s not as if KFC didn’t have experience in tough foreign markets: In South Africa, for instance, KFC only uses free-range chickens after customers demanded it.
The Yum China business also recently replaced a retiring executive, Sam Su, who built KFC into the biggest Western chain in China. Consultants in Beijing consider Su the country’s best executive.
So it’s fair to say Yum has lost some of its sparkle in China, a place an executive called “an absolute gold mine for us” in 2003, the WSJ notes.
But down cycles hit any business operating anywhere. Nike, for instance, which earns 10% of revenues in China and counts the country as its biggest growth market, went through a terrible stretch in 2013 when huge inventory surpluses resulted from stale styles. Sales didn’t rise for the better part of two years, including a three-quarter stretch of negative sales growth in its hottest region. Nike revamped its styles, and now the Greater China market is back to posting the top growth among its biggest regions.
The difference between Nike and Yum, and the reason Yum’s announced spinoff is less a trend than company-specific, is that fast food is at its heart a franchise business. Instead of sinking capital into tens of thousands of stores, McDonalds, KFC, Taco Bell and others charge franchise royalties in the U.S. The same concept is behind the spinoff: The entire Yum China business will still function as a kind of massive franchise, sending an as-yet-unannounced royalty back to Yum.
After a spinoff, Yum stockholders may not experience the risks of China’s market, but they’re also less leveraged to the China business’s comeback, should it happen. KFC has spent more than a year improving its restaurants in China, which are still considered nice places to eat, if not as exciting as they were in the 1990s, by middle-class Chinese.
That’s one reason Western companies are unlikely to follow Yum’s decision. Another is that Volkswagen, General Motors, and Apple, which receive a large portion of their revenues from China operations, don’t have China operations that can function as separate companies like Yum’s can.
For more about U.S. companies doing business in China, see this Fortune video:
Update: This article has been corrected to reflect that OSI’s case is still pending in Chinese courts.