Yum! Brands, Inc. (YUM): Activists, Spinoffs And China Troubles

Yum! Brands, Inc. (YUM): Activists, Spinoffs And China Troubles
By Yum! Brands, Inc. [Public domain], via Wikimedia Commons

Is Yum! Brands a harbinger for a difficult third quarter earnings reporting season? Analysts are forecasting the first decline for the S&P 500 since the third quarter of 2009, and for a moment, it looked like they might be wrong. But as is always the case with earnings, the tides can change quickly, and Pepsi’s strong earnings report on Tuesday morning was followed by an extremely disappointing report Tuesday evening from Yum.

This morning management answered to investors and analysts for that week report on the company’s earnings call. Meanwhile shares of Yum plummeted, falling as much as 18.51% to $67.34 per share in early trading.

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Dire warnings about China

China’s economy has cast doubt on whether U.S.-based companies can continue to perform there, and Apple has thus far managed to dodge the worst of the trouble. However, Yum! Brands took a big hit from China and warned that the future for its business in the country looks like a quagmire. If you’re feeling déjà vu from Yum’s July earnings report, you’re not alone.

Yum’s adjusted earnings were $1 per share, coming up short of the consensus estimate of $1.06 per share. But Wall Street was more worried about China than about that wide earnings miss. Same store sales in the China Division only edged upward 2% even though the fast food chain operator had a very easy comparison as last year’s third quarter marked a 14% decline in sales and 2013’s third quarter saw a 25% decline in same store sales.

Yum Brands management cuts guidance

Breaking down Yum’s China results, the company said KFC comparable sales increased 3% compared to last year’s 14% decline, and KFC Pizza Hut fell 1% compared to last year’s 11% decline. Bank of America Merrill Lynch analyst Joseph Buckley had been expecting an increase in the double digits for Yum China.

Management lowered their full year guidance for same store sales in China to the low-single digits and guided for fourth quarter comparable sales to increase in the mid-single digits. They also cut their full year earnings per share guidance to growth in the low-single digit percentage from the previous estimate of at least 10% growth.

Buckley said he isn’t worried that Yum Brands’ problems in China will spill over to other markets. They note that at its peak, China contributed 40% of Yum’s sales, compared to 5% for Starbucks and in the low-single digit percentages for McDonalds. This means Yum has a disproportionate exposure to the country, which is currently in deep economic turmoil.

Suggestions for Yum! Brands

Unsurprisingly, last night’s earnings report triggered some price target cuts for Yum. Nomura analyst Mark Kalinowski and Ryan Kidd slashed their price target from $106 to $82 per share but maintained his Buy rating on the stock. The reason for that is because they think the earnings report should spur management to make some big changes and restructure the company. And if management doesn’t make changes, they expect the two activist investors who already own shares to step in and push for change and possibly even more activists to wade into the fray. The Nomura team offers three suggestions for management to increase value for shareholders as well.

The first suggestion is for Yum Brands to spin off Taco Bell, which returned solid results for the third quarter. The chain saw a 4% increase in same store sales, meeting estimates. They note that since the company sees such a large percentage of its sales in China, it’s largely a China stock at this point, although Taco Bell doesn’t appear to have any stores there. As a result, investors don’t really care that Taco Bell did well, and they think investors should be able to buy shares in a separate Taco Bell without being exposed to the risks involved in doing business in China.

Morgan Stanley’s John Glass and his team disagree with Nomura on the topic of a spinoff. They suggest that a spinoff is still logical but question whether the time is right. They also note, however, that a spinoff does not require such specific timing as a sale would, and they think all the problems in China might keep management from conducting any kind of spinoff.

Divestures and expense control

The Nomura team also suggests that Yum divest some of its other smaller brands, noting that other companies with multiple brands have found success in doing this. For example, Brinker is now a two-brand company that’s performing better than it did with eight brands 15 years ago. They believe Yum should divest all of its brands except KFC and Pizza Hut. This would result in the divesture of Little Sheep, which is based in China, Texas-focused Banh Shop, and Shanghai-focused Atto Primo.

And third, Kalinowski wants to see “meaningful” reductions in expenses. They note that Yum! Brands was one of the restaurant industry’s “very best success stories” between the late 1990s and 2012, partially due to success in China. However, they think those successes “may have masked some cost/ bureaucracy bloat that built over time” and that hasn’t been addressed yet.

Other price target cuts for Yum

Wells Fargo Securities analyst Jeff Farmer and his team also slashed their valuation range for Yum! Brands from between $82 and $86 per share to between $74 and $76 per share based on last night’s earnings report. Like Nomura analysts, they believe some “aggressive” and “significant” actions will be taken by management to turn things around.

Stifel analysts Paul Westra and William Smith also cut their price target for Yum from $110 to $100 per share but maintained their Buy rating on the stock. They actually think Wall Street has overreacted to last night’s earnings report. Also they agree with Nomura in that Yum could be ripe for the picking by activists, and they’re leaning toward restructuring as being the goal to spur a return to growth. Currently Dan Loeb’s Third Point and Corvex Management own shares.

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