Introduction
Make no mistake; it is a bold move to take bets against hedge fund titans of the world like Keith Meister and Dan Loeb, both of whom I have enormous respect for. It is not a bet I take lightly. But as with all investment theses, if the underlying premise of the thesis is flawed, the outcome will deviate significantly from expectation. When Corvex announced the stake in Yum Brands (NYSE: NYSE:YUM) and pushed for a spin-off of a China Co., its implicit belief is Yum's China business will make a full recovery from the food scandal and fetch a premium valuation making the sum-of-parts investment return look compelling. However, it's my strongest belief that Corvex's analysis may have lacked the fundamental underpinning of the economic reality in China today and the upcoming deflationary environment the country may enter. To make matters worse, Greg Creed's less-than-prudent capital allocation strategy in store expansion likely makes matters worse and will only cause more pain should my view of the Chinese economy materialize.
It Wasn't a Good Quarter But a Strong Outlook?
The YUM story today is pretty much entirely a China story. Activists need the China operation to improve, so it could be spun off and get the upside from their sum-of-parts analysis. The second quarter SSS decline in KFC China was -10%, quite a bit worse than expected. The only reason stock held up from further collapse was likely because the rosy guidance CEO Greg Creed gave in both press release and the subsequent conference call, but there are plenty of reasons to doubt his rosy outlook and I am of the firm belief that when the next quarter number comes in, KFC China will not be making a strong recovery as predicted by Greg and guidance will have to be cut. In fact, with management under the gun of big activists, they seem to be pressing a losing bet instead of taking a more prudent approach in evaluating their capital allocation strategy similar to what rival McDonald's (MCD) is doing.
I listened to Yum's conference call carefully and all analysts were overwhelmingly interested in Chinese macro. Yum's quarter ended on June 13th, right around the time when the Chinese stock market with 90 million individual accounts peaked and its SSS missed expectation. Analysts on the conference call repeatedly questioned management whether the stock market crash would have an impact on Yum's performance in China, and management repeatedly stated there's no impact.
"John Glass - Morgan Stanley
Thanks. Good morning. First on China comps, yes so the recent decline in the Chinese stock market had any impact on sales. Do you notice a correlation there at all?
Pat Grismer - Chief Financial Officer
We don't. John, this is Pat. John we don't see a correlation. We think actually a very small percentage of customers have been impacted by that as to whether or not it is impacted broader consumer confidence, we have no reason to believe it at this stage if that is the case."
CFO dismissed any impact right away in that exchange. Then investors should look towards the end of the conference call.
"Paul Westra - Stifel
Great. And then when you mentioned your transaction trends on a DC line basis continue to sequentially improve, you are seeing sequential, again month-to-month traffic recovery versus…
Pat Grismer - Chief Financial Officer
Paul I wouldn't say month-to-month, certainly quarter-to-quarter. We never said that the recovery was going to be linier and so there is natural choppiness from month-to-month, but as we step back and look at how traffic has rebuilt since the incident last summer, we are seeing a nice steady improvement in that curve."
It might be a stretched psychological assessment of the CFO, but consider the response time required and the way information is accessed in all human, the most likely reason for Pat's response is July's recovery might have been experiencing some natural choppiness. This is one of the reasons that leads me to question the reliability of Yum's guidance on a strong second half recovery.
Yum's Upping the Ante While McDonald's is Taking Chips Off the Table
Yum's CEO was repeatedly questioned whether he thinks the restaurant market in China is slowing. The response was quite bullish.
"In conclusion, we are making continued progress in China and remain bullish on our long term prospects there. With cash paybacks of about 3 years, we are confidently investing in new unit expansion. We have leading brands and an enviable competitive position in the world's fastest growing economy. We expect to open 700 new units in China this year, and believe we can substantially expand our footprint over time."
Meanwhile, investors should take a closer look at how rival McDonald's is behaving in the Chinese market. In sharp contrast to Yum, McDonald's has been adopting a quite different strategy in China. According to local press reports, McDonald's is closing down 80 stores in China this year citing reasons such as wage and rent inflation. In addition, it is adopting a franchising strategy in China in order to reduce its operating leverage. When two identical companies behave in virtually opposite manner, investors should be extra cautious in assessing the merit of the riskier strategy. There is little doubt Yum's management is pressing its bets in China while McDonald's is taking chips off the table. Who is right?
Price Discount Makes Rosy Outlook Questionable
A little-noticed article in an obscure Chinese website stated KFC is discounting 30%, residents of Kunming can download discount coupons from JD.com. The article went further stating that beginning 4th of July, KFC is dropping prices in Shanghai, Guangzhou and 49 other cities and many of those discounts are offered through e-commerce websites in China. It strikes me as highly inconsistent with Yum's management's strong second half recovery outlook and really makes me wonder just how exactly is second half SSS (same store sales) in China could possibly make a strong recovery.
A Bigger Economic Conversation
The question on Yum comes back to whether the economic outlook in China warrants greater consideration in its decision to allocate capital. Without a strong view on the Chinese economy, I would not have believed Yum's bet pressing strategy sets up the stock for a perfect shorting opportunity. The Chinese economy is going through an incredibly difficult phase and further slowdown appears not only likely but also inevitable. Government's attempt to boost the stock market simply is not a proper way to reform the economy. As a matter of fact, it will be making matters worse. Here's why:
- Capital Allocation in Chinese Stock Market
Wall Street continues to miss a big problem in understanding the Chinese stock market issue. It's not as simple as wealth effect translating to consumer confidence. The bigger game at play here is a flawed capital allocation process in the China's nascent stock market.
For proper capital markets to function, you need at least two elements on two nodes. 1. Institutional investors/long-term investors who do not invest for the stock price movement, rather the underlying business performances. 2. Listed companies take good care of investors' capital as fiduciary and allocate capital optimally to grow the business. The two elements are complementary and neither one can be amiss. Issue with Chinese stock market, unfortunately, is neither one of these element presents. Market is dominated by retail investors who only care about stock price performances without understanding the underlying business performances. Companies, on the other hand, do not have an ingrained philosophy that shareholders' capital is sacrosanct.
This point can be demonstrated in two examples. 1. Consider the wave of reverse merger frauds happened in 2010-2011 where many raised capital from US investors. It's staggering that every single one of them turned out to be a scam. Why? How could there be so many scam artists in China? I think it's simply wrong to dismiss the issue as all Chinese people are scam artists. In fact, most of them do transact with you honestly in most business situations. It is a philosophical view that shareholders' capital once raised becomes my money. Few actually deploy the capital. 2. Consider the Shanghai Composite Index. Despite record economic growth over the past 10 years, the index level has remained largely the same. How could it be possible if any shareholders' capital is put to proper use? Those are the issues at play that causes Chinese stock market to lack basic accountability for the capital that flows into it. On the other hand, the Chinese stock market is no longer a nonfactor given the size it has grown into. Daily turnover at height was 2.5 trillion RMB on June 25th, given the T+1 system; the total amount of actual capital poured into the Chinese stock market is likely a substantial percentage of Chinese M1 which stands at 34 trillion RMB. If it is indeed a poor mechanism for capital transmission, you end up having a massive clogging effect which will impact spending/non stock market investing and lending. That's the bigger issue I see and it could acutely affect the Chinese economy should the government continue to encourage stock market speculation.
During the stock market boom, while the vast majority of capital flew into the market likely did not get put to good use; it did provide the benefit of confidence and altered behaviors of many small business entrepreneurs and VCs. It encouraged investments in small business, ideas and startups, which is really what the government had hoped for to serve a new engine of growth. Unfortunately, recent stabilizing policies such as the ban on selling for large shareholders and IPOs will most likely cause the trickle of capital flowing into the real productive side of the economy to slow, as VCs respond to the likely difficulty in their ability to exit investments through secondary sell-down and IPOs. Chinese people respond to incentives too.
Why is the stock market speculation causing a more acute problem for the economy than property bubble and credit expansion the government had encouraged for decades? The answer lies in accountability. In a property speculation, a developer cannot take the money and not build a home. He would have a problem. Therefore, in the property speculation, while excessive, many jobs were created, cities were built and real economic growth was happening. Credit lending operates much the same way because there is a time limit on the return of that credit, you have to pay it back. You can't just keep on telling a story or you default and the bank takes your assets away from you. Stock market speculation is different, however, without long-term investors investing for real business performances as a binding mechanism, companies are raising capital telling stories and not doing real businesses. To change the infrastructure will take decades of efforts and a true capitalist mentality to be ingrained in the society. It won't happen simply by encouraging people to pump massive amount of money into the stock market or running slogan such as "revive A shares, benefit the people." It only worsens the problem.
- Data Point and Deflationary Environment
It is no secret to many that Chinese government data are not reliable. The GDP print and retail sales print should both be viewed with caution. The data become increasingly meaningless when its economy is truly slumping. Confidence is everything.
Meanwhile, Chinese economy may very well be on the cusp of deflation.
1. 1st quarter GDP deflator was -1.1%, suggesting China is in deflation; economists largely questioned the reliability of the GDP data without thinking the possibility that China may actually be in deflation.
2. Chinese CPI has been persistently low around a bit over 1%.
3. Google "price decline" or "price war" in Chinese and you will find a shocking number of results. Of 12 page of search results I read, prices of items such as glasses, milk, watermelon, wheat, edible oil, iron ore, steel, construction materials, liquefied petro gas, corn, shrimp, cosmetics, household appliances, bananas and baby formula are all dropping. Services such as education classes from New Oriental, durables like cars and consumer goods like smartphones are all dropping. Against an economic backdrop like this, KFC faces an uphill battle competing against local fast food restaurants selling meals for half or 1/3 the price.
Conclusion
I believe in search for returns in an increasingly lofty valuation environment, activists may have moved into areas where margin of safety has declined. With Chinese economy in an incredibly difficult transition phase and likely significant price competition from local competitors in all products and services (see Mead Johnson's PR), Yum's outlook was simply too rosy and is unlikely to be met.
