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Should Yum Brands spin off its China business?

Yum Brands executives are convinced that 2015 will be a better year for their all-important China business, which makes sense because not much could get worse than 2014. Or 2013, for that matter.

Consider this: In 2012, KFC in China had average unit volumes of $1.7 million. Two years and two supplier scares later, that unit volume is down to a projected $1.35 million.

That could put more pressure on Yum to do something with China, especially if sales there stubbornly remain weak.

Indeed, some analysts have already opined that the company could be pressured to spin off its China business or, at the least, refranchise the restaurants there more quickly.

Paul Westra, analyst at Stifel, called a restructuring “inevitable.” And in a note this morning, Westra said he has “strongly lobbied” for the company to explore a restructuring of the China business. He suggested a partial spinoff of Yum China on the Hong Kong or Shanghai stock exchanges. Or, he said, the company could rapidly accelerate refranchising of its restaurants there.

Likewise, Bernstein Research Analyst Sara Senatore suggested something similar, and noted that the company could face increased pressure for a partial spinoff or accelerated refranchising if sales remain weak.

Yum’s stock entered the day down 6.1 percent on the year, due almost entirely to problems in China. That could force the company to look for ways to reduce its exposure to that country’s recent sales volatility.

China is hugely important to Yum. The company has more than 6,400 restaurants in the country, representing more than half of its revenues and nearly 40 percent of its profits. Yum owns many of its restaurants in that country — it is mostly franchised everywhere else.

The past two years have been tough on Yum China. Remember, in late 2012, a scare involving a poultry supplier hammered Yum’s China sales in 2013, leading to a 9-percent decline in earnings per share that year. Then, just as sales were starting to recover this year, a supplier to numerous western brands was alleged to be repackaging expired meat back in July.

Some analysts estimate that Yum’s China sales fell as much as 30 percent in July and August. In any event, they’ve remained difficult. The company said at its analyst day this morning that China’s same-store sales were down 15 percent in November.

Investors could view a more aggressive refranchising strategy in China as one way to limit Yum’s exposure to China while still enabling the company to take advantage of the country’s rapid growth. Because Yum owns many of its restaurants in China it is directly impacted by sales declines there, but the impact would be more direct in a franchising situation.

In addition, some investors could view refranchising as a way to reduce the gap between China’s share of Yum’s profits and its share of Yum’s revenue. Franchising, after all, is generally more profitable than store operations. And outside of China, Yum is heavily franchised.

In a partial spinoff of the Yum China business, a portion of the ownership in Yum China, perhaps 25 percent, Westra said, would be offered up for sale on either a Hong Kong or Shanghai stock exchange.

Yum operates KFC, Pizza Hut and Taco Bell, each of which operates as a separate division, except in China, where all the brands operate under a single division within Yum (as does India).

Westra said in a note this morning that any strategy would likely wait until after sales in China improve, so the company could do so from “a source of strength.” But Westra also indicated that Yum’s executives seemed open to a restructuring of its China business.

In the meantime, Yum is working to get that sales number back up. “China is the No. 1 priority and No. 1 opportunity,” incoming CEO Greg Creed said. “We’re committed to turning this thing around.”

This blog post has been revised to reflect the following correction:

Correction, November 15, 2014: An earlier version of this post should have said that a China supplier to western brands was alleged to be repackaging expired meat.

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