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Back in December, I noted that Yum Brands (NYSE: YUM) was one of a handful of restaurant stocks in need of an activist intervention. Well, not just one activist has intervened, but two: Dan Loeb’s Third Point Management and Keith Meister’s Corvex Management.
Third Point detailed its thesis on being long Yum Brands in its first-quarter investor letter last week. In the letter, Loeb notes that Yum has a lot of opportunities to reposition itself as a dominant force in China as it recovers from last year’s public relations backlash, when one of its suppliers intentionally sold meat past its expiration date. Loeb also noted that the company has the opportunity to focus on franchising in other countries across the world.
In terms of the room for a rebound in China, think about this: Yum’s KFC China is generating just $1.3 million per unit in revenue a year with a 15% operating margin. Back in 2012, before a separate food safety scandal, it was generating $1.7 million with 20% margins.
Now, recall in December I noted, “What an activist could do is look to separate Yum’s U.S. and international businesses.” Corvex’s thesis includes just that. As the hedge fund laid out on Monday at the Sohn Investment Conference, there could be upside to $130 a share if Yum spun out its Chinese operations.
The core reasoning for the spinoff would be that Yum is trying to run two very different businesses under one roof. What’s more is that the current business model shuns a number of investors that might be willing to own a stable U.S. franchise focused business, but not a riskier China focused one.
Recall that there’s more to the differences than just location and customer base for Yum businesses. In China, Yum owns over 80% of its stores, while over 90% of its stores outside of China are franchised.
Back to Loeb for a minute. His letter highlights some interesting aspects of the Yum business that are lagging major peers. For starters, the U.S. business could use some love and care without the hassle of navigating regulation and safety issues in China.
As Loeb detailed, Yum’s Pizza Hut and KFC businesses are lagging in the U.S. compared to major peers. Pizza Hut is generating just $800,000 per unit with 8% restaurant-level margins. Meanwhile, its top competitor, Dominos (NYSE: DPZ), is generating similar revenues with much smaller stores and has 23% margins.
Dominos is dominating Pizza Hut in the delivery market, while Pizza Hut is still trying to operate larger stores and cater to dine-in and delivery customers. The fix is to open more smaller-format stores and focus on the growing delivery market.
KFC is a laggard in the U.S as well. It pulls down just $1.2 million per unit with a 13% restaurant-level operating margin. Top competitor Popeyes Louisiana Kitchen (NASDAQ: PLKI) generates $1.6 million a unit at 19% margins, and Bojangles does $1.8 million at 18% margins. For KFC, the fix includes getting away from fried chicken buckets and offering more sandwiches, in addition to breaking into the late night market.
If Yum does break up it would allow the company to cater to two potentially more receptive investor bases: one that wants to be levered to China’s fast-growing middle class, and another that is happy owning an asset-light turnaround play that’s focused on U.S. fast food.
Now granted, shares of Yum Brands are up 16% since December, yet Third Point’s and Corvex’s bullish stances suggest there’s plenty more upside to be had. And it’s hard to find a restaurant stock trading at 22 times forward earnings estimates, while generating a near 25% return on invested capital. McDonald’s (NYSE: MCD) pales in comparison, as does Wendy’s (NYSE: WEN), Jack in the Box (NASDAQ: JACK) and even Chipotle (NYSE: CMG).
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