Yum Brands, China And Buybacks Shouldn't Cover Up The Real Issue

| About: Yum! Brands, (YUM)

Summary

YUM is finally set to jettison its Chinese business.

That should help make the company a lot more predictable.

But don’t kid yourself YUM is embarking on a new path.

Yum Brands (NYSE:YUM) owns Taco Bell, Pizza Hut, and KFC. That's an enviable collection of restaurant brands to say the least, since each is a giant in the fast food space. However, for many years, the big story at Yum wasn't the restaurants as much as it was the company's expansion in China. Things are about to change for the company in a big way.

The spin

China was a huge plus for Yum until a couple of food scares made Chinese consumers think twice about eating in foreign branded restaurants. While those food scares were going on, Yum's business in China took a big hit. It's not that Yum, or any other foreign company, did anything wrong, per se, but that Chinese consumers shifted to other, often local, brands. And those customers didn't shift back as quickly as expected.

Needless to say investors weren't pleased with the falling sales in what had become Yum's biggest market. The company's significant exposure to China went from a feather in Yum's cap to a liability pretty quickly. And, it became clear that China could be a source of significant volatility because of the business's size and the fact that events in China weren't always positive.

That's when an activist investor came in and suggested it was time to spin Yum's Chinese business off. Not a bad idea in some ways, but no slam dunk either. In fact, it took a little while to find an agreeable way to make it happen. But finally a consortium has agreed to effectively take on Yum's Chinese business. Here's the question now: If the big story at Yum was Chinese growth, what's the company going to be without China?

A whole new story

Companies usually invest where they expect to get the most bang for their buck. That's not China anymore for Yum. So it's back to the drawing board in many ways. And for investors that means potentially big changes that you need to pay close attention to.

For example, the company is going to work to reduce its direct ownership of restaurants so that there are more franchised locations. That should help smooth out revenues, since fees and such will become a larger piece of the top line. Getting out of China will play a big part in that, moving the company from 77% franchised to 93% in one move. But the goal is to get to 98%.

That's a perfectly fine number, but there's a lot of work to be done to get there. Selling restaurants to franchisees takes time, including finding the right people to sell to. Rush this process and Yum could end up with sub-par business partners on its hands. You'll want to watch the progress here.

Yum is also stressing the opportunities it will have to trim down. For example, as it reduces its direct ownership of restaurants, it won't need as many folks in the home office. And without its Chinese business, it won't have to pony up the costs to grow in the giant nation. That said, by 2019, it hopes to trim capital expenditures to just 20% of what they were in 2015. That's a massive drop that's backstopped by shifting costs onto franchisees. Sounds good in theory, but practice could be another thing altogether.

And while Yum is talking about trimming down, it's also talking up the growth opportunities with its core brands. For example, it suggested it could more than triple its global store count in the KFC business alone. That would be impressive, though it seems like most developed markets are, at this point, pretty well saturated on the fast food front. And while emerging markets may offer better prospects for expansion, can they actually support the kind of growth Yum is suggesting? You need to pay close attention to how well the company executes on this front, too.

There's also a couple of things on the growth front to pay closer attention to, in my mind. First, Taco Bell is only in around 22 countries outside the United States today. The company hopes to get that up to 40 while more than tripling the foreign store count. If Taco Bell doesn't play well overseas, that may not be feasible. The fact that Yum hasn't made this hard a push yet makes me wonder if the brand could have more problems expanding internationally than management is letting on.

The pace of store openings is another expansion issue you'll want to watch. For example, the company reportedly opens two Pizza Huts a day right now. It wants to get that up to three a day by 2020. I'm not suggesting that's impossible, but restaurants have historically gotten themselves in trouble when they expand too aggressively. It leads them to second-rate locations with second-rate franchisees as they try to hit a number that may not be sustainable let alone in the best interest of shareholders.

Then there's debt. Yum has a lot of it and no plans to trim that down. At the end of the most recent quarter, the company had over $9 billion in debt and negative shareholder equity. It's not that it can't keep going along in this direction, but another big risk factor for restaurants in expansion mode is too much debt. Interest expense isn't that big a deal in the current low-rate environment, but at some point, those loans will have to be paid back. If operating performance doesn't go as well as planned, it could be harder than expected for Yum to roll over that debt.

The cover story

But Yum is looking to make investors happy, too, despite what is a lot of uncertainty. And on that score it announced a massive return of capital to shareholders via dividends and stock buybacks. How big you ask? How about $13.5 billion big! It hasn't really given a good idea of how that will break down between buybacks and dividends, so income investors probably shouldn't get too excited here.

And then there's the very real risk that this piece of the story is more about trying to cover up the risks the company faces as it tries to revamp after jettisoning nearly half of its business. In other words, returning value to shareholders is nice to hear, but what's going to make the difference at Yum is executing a new business model. That's the piece you need to focus on from here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.