Why Yum’s China Market Debut Is Getting a Tepid Reaction

November 1, 2016, 2:45 PM UTC
Yum China files to issue 10 million shares to Yum employees
Customers eat at a fastfood restaurant of KFC in Huaibei city, east China's Anhui province, 20 September 2016. Yum China Holdings Inc, which is being spun off from KFC owner Yum Brands Inc, filed with regulators on Wednesday (20 September 2016) to issue 10 million common shares to certain participants in Yum incentive plans. Yum Brands, which also owns Pizza Hut, said in October that it would spin off its China operations through a distribution of common shares to its shareholders. The 7,200-restaurant China division, which operates in over 1,100 cities, is higher risk and potentially more rewarding, while Yum Brands sans the China division is likely to be more stable with greater cash flow.
Photo by Chen jialiang—Imaginechina/AP

Shares of Yum! Brands’ Chinese spinoff posted a slim gain on the first day of trading on Tuesday, a stock debut that presents investors a rare pure play opportunity to place a bet on China’s growing middle class.

Almost exactly a year after unveiling plans for a spin off, Yum China debuts to shareholders as the largest restaurant company in China with about 7,200 restaurants and $6.9 billion in revenue. With the separation now complete, Yum China will have exclusive right to operate and sub-license Yum’s (YUM) KFC, Pizza Hut and Taco Bell brands, while also owning the China-focused East Dawning and Little Sheep concepts outright.

Shares on Tuesday climbed roughly 2% to close to $25, up from the opening price of $24.51 apiece. Yum China trades on the New York Stock Exchange under the ticker symbol YUMC. It has no debt and over $900 million in cash.

“Yum China’s listing will give U.S. investors one of their only opportunities to own a pure-play on China’s appetite for fast food, with a brand recognizable to U.S. consumers,” said Matt Kennedy, an analyst at IPO ETF manager Renaissance Capital.

Renaissance Capital doesn’t consider Yum China to be a traditional IPO, as it has no underwritten offering (it is going public as a direct distribution to shareholders). And while restaurant concepts that have gone public recently have seen strong first-day pops, Renaissance Capital notes that all are trading below their first-day close. Bojangles, the fast-food purveyor of fried chicken with a concept most similar to Yum, is down 22%.

Yum China’s sales pitch to shareholders is that it is a bet on China’s growing middle class and increasing urbanization. Yum was an early entrant into the market in 1987, so it has a lot of experience after years of expansion. It also grew rapidly—opening an average of two new locations per day over the past five years. More growth is expected: executives say they can more than triple the restaurant count in China to about 20,000 locations.

Though Yum China helped propel growth at the parent company for many years, it became a liability after food safety and PR issues dented sales. The restaurant chain was found to be selling tainted meat at Yum’s KFC locations in China, news that halted the double-digit sales gains Yum’s China operations had been posting. Though sales are still growing, the increases have slowed drastically. Another issue management will need to confront: Yum China has been losing market share to local rivals.

Interestingly, Yum! Brands was itself a spinoff nearly 20 years ago. Former parent PepsiCo (PEP) spun off the company’s restaurant business back in 1997 to separate it from the packaged goods sold under the Pepsi-Cola and Frito-Lay companies.

Now, Yum! Brands needs to figure out how to stand on its own yet again. The first goal the team flagged to the investment community: it will become a more “pure play” franchisor. The plan calls for Yum (excluding the China spinoff operations) to become 98% franchise operated by the end of 2018. Yum itself will own and operate fewer than than 1,000 company restaurants on its own by that point.

By shifting to a more franchise-focused business model, Yum! Brands will reduce capital expenditures and rely more heavily on restaurant operators to run the day-to-day operations.

Analysts were split on what concept the “new” Yum! Brands would focus on in a post spin-off world. Some argued Taco Bell should be considered the “prized jewel” among the Yum! Brands portfolio, as it is mostly a domestic business with a lot of global potential. Others said Pizza Hut needs some attention because that concept generates far less in adjusted earnings than main rivals Domino’s (DPZ) and Papa John’s (PAPA).

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