One Year Later, Yum China Thrives After Its Spin-off

Markets Motley Fool

It's been nearly a year since Yum! Brands (NYSE: YUM) completed its spin-off of Yum China Holdings (NYSE: YUMC). Since then, the latter has largely enjoyed life on its own with the stock up over 70% from its spin-off to date. Join our Motley Fool Industry Focus podcast hosts as they discuss Yum China's recent quarter, the factors behind the split, and risks and opportunities going forward.

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A full transcript follows the video.

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This video was recorded on Oct. 10, 2017.

Vincent Shen: For our second piece of earnings coverage, a company I don't think we've discussed too often on prior episodes of Industry Focus, we have Yum China, ticker YUMC. Yum! Brands spun off its China business this time last year. Yum China licenses now the KFC, Pizza Hut, Taco Bell and other smaller brands from its former parent company. What amazes me about this company is, it's the largest restaurant player in China with over 7,500 stores. KFC and Pizza Hut make up the large majority of those locations, though they are testing with some smaller concepts. But that kind of leadership position definitely has its benefits.

During the most recent quarter, same-store sales were up 6% across the company. Most of that strength was delivered by KFC. Total revenue was up 8% as well, topping $2 billion. One year into the spin-off, it appears that we have a very smart deal. Yum originally spoke to the idea that an independent China business would allow that entity to focus more on the conditions that are unique to the Chinese market. Asit, that seems to be proving out here. What is it about the Chinese market that made this such an effective split? What were some of the considerations that they had to make?

Asit Sharma: Yum! Brands, when it owned the total business, had a few stumbles. Consumers may remember that if you saw headlines in 2012, 2014, and 2015. These were primarily supplier problems. Yum! Brands had a really fast-growing business in China, but it hit a wall with trying to manage the business from afar. Management finally realized that the strength that it had been posing to investors for years as this save all for the company was actually both a strength and a huge weakness, and that the unit which exists on the mainland would be better-managed by its own self. And given the chance to expand and focus locally, it would prosper, versus Yum! Brands trying to control it and simultaneously make that huge North American business continue to grow. We talk about this a lot on the show -- comparable store sales, that's always the market that you have to meet every quarter. The company decided, let's spin-off Yum China, which, as you said Vince, the symbol is YUMC, and let that take its innovations into the market without us having to prove it from the United States. And that's worked out very well.

I want to talk a little bit about some other considerations that come into a decision like this that are particular to China. China is a really hard market to crack, as you've probably heard if you invest in any companies that are over there. No. 1, the Chinese government has a love-hate relationship with foreign brands. It wants those brands to come in, because China is gearing its economy from manufacturing toward consumption, it wants people to consume, so look more like the U.S., which is less of a manufacturer now and more of the consumption-based economy. But it's a tightly controlling governmental apparatus, and there's a lot of red tape. Companies find themselves very often -- McDonald's has had this problem, Starbucks even has had problems with the Chinese government -- that they can very arbitrarily come in and put pressure on a certain city's restaurants so that that company then has to lose comparable store sales and regroup to whatever the government is asking it to comply with.

No. 2, the consumer in China loves foreign brands as well but has a deep-seated loyalty toward the Chinese economy. So once a Chinese consumer becomes bored of a KFC, which is owned by Yum China, that consumer will start looking for what local brands are around, and out of a sense of, whether it's nationalism or patriotism, this is something you have to grapple with when you do business in China. You have the customer's loyalty only so long. You're only as good as your next innovation.

Third is the supply chain problems that I referenced. You have to have a very tight control over your suppliers. In China, what we've seen over the years is, suppliers don't have the same standards that are already in place maybe in the U.S. or in Europe. And that's not saying anything bad about the supply in China or how their rules operate, it's just a younger economy. It's not had the decades of regulation that you would see here in the U.S. So you're going to have people who cheat sometimes. Again, this also happened to McDonald's. A bad supplier, especially with chicken, seems to be endemic to these companies. If you're doing business in China, watch your chicken supplier. I think that's the message. But this is something that is very difficult to keep an eye on through third parties, or manage from a remote location like the U.S. So all of these problems were solved a bit when Yum China became its own company and could manage things locally in China.

Shen: Thanks, Asit. I think that's a good rundown on some of the risks that you face, even though you have a company that appears to have such strong tailwinds behind it, shares are up over 60% just in 2017. Management says the company is on target to hit expansion of 550 to 600 restaurants this year. They just initiated a dividend at $0.10 per share. Management continues to repurchase shares. But overall, I think they definitely have a very positive environment to work in this as well, that they've been growing their store base for several years at a compound annual rate of 11% thanks to this market's growing middle class. They're not running into the kind of saturation issues that U.S. chains have encountered with the so-called restaurant recession. We have our last minute or so here, any last thoughts from you from this earnings report or for the company before we close out?

Sharma: I love that Yum China is pursuing a lot of innovation. This is what investors may want to keep an eye on. There's a new store in the city of Hangzhou, China, which is KFC Pro. In this store, you smile to pay. You walk up to a machine, and in partnership with Alibaba's Ant Financial, KFC China will take a picture at the kiosk, you enter your phone number, you have to smile so it sees that you're not a static photo, and that's the way that you pay for your meal. They offer roast chicken, a brand-new menu. They're constantly innovating, testing prototype stores for this younger generation of Chinese consumers. Just one batch of these is a couple of hundred million people. So you have to like that if you're a long-term investor of Yum China. Free from their parent company, they're pursuing innovation in a pretty aggressive way. That's something else that will show up in future earnings reports, in my opinion.

Asit Sharma has no position in any of the stocks mentioned. Vincent Shen has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Starbucks. The Motley Fool has a disclosure policy.