Taco Bell has performed better than expected for Yum! Brands, but it doesn't fit into the larger narrative the restaurant operator is developing.
Following Yum! Brands' (NYSE: YUM) third straight quarter of disappointing results in China and its stock losing almost a fifth of its value in the aftermath, calls to break up the restaurant operator are getting louder.
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While the loudest call has been to spin off the China division, because that is where the weakness and greatest risks lie, could Taco Bell be the actual business Yum! Brands needs to shed?
One of these things is not like the othersBetween Taco Bell, KFC, and Pizza Hut, only the Mexican food chain has virtually no presence at all on the Chinese mainland. Yum! Brands operates 6,867 restaurants in China, comprised of almost 4,900 KFCs and over 1,700 Pizza Huts. Taco Bell, on the other hand, has 6,200 restaurants spread across 21 countries, none of which is China.
Considering that China represents more than half of Yum! Brands revenue and profits, when you're investing in the company, you're placing a proxy bet on China. As a result, it's Taco Bell that's the square peg trying to be forced into the round hole. Spinning off the Mexican food restaurant might make it and Yum! Brands even stronger companies since Taco Bell wouldn't be competing for resources that its parent could then apply to revive the chicken and pizza chains.
Spicy resultsOver the first nine months of 2015, Taco Bell represented 15% of Yum! Brands revenue and 26% of its operating profits, an increase over the same period last year when they accounted for 14% and 25%, respectively. Yet despite the chain's broad geographic footprint, virtually all of Taco Bell's operating profits -- more than 95% -- come from the U.S.
Separating Taco Bell makes sense on another level as well: Around 90% of the restaurants are owned by franchisees, a figure that holds true across the entire companyoutside of China and India (it owns only 9% of its restaurants). Yum! Brands is committed to reach 95% very soon.
Two food scandals in two years is two too many for Yum! Brands, which is finding it more difficult than expected to woo customers back this time around.
McDonald's, which also felt the effects of the food scandal that roiled its fast food rival (though more so in Japan than in China), has franchised about a fifth of the 2,000 restaurants it operates in China as of the end of last year.
The burger joint reports its third quarter earnings next week, and Yum! Brands results could be a warning. Like its rival, McDonald's also expected its Asian business to return to normal levels in the back half of the year, an outcome that is no longer assured.
Do one thing, but do it wellSpinning off Taco Bell would give Yum! Brands' franchisees greater access to financing and support from management, which wouldn't have to balance the needs of the other chains or regions of operation.
Similarly, because CEO Greg Creed admitted on the most recent third quarter conference call with analysts that "the key for us is to turn this business around with particular focus on China", Yum! Brands' management team could keep its attention fixed on the operations it obviously prefers.
Even so, he also seems resistant to calving off any of its businesses, maintaining that Yum! Brands' "value is really in the value of the three brands".
The outsized contribution of China to the restaurant operator's financial health, however, means the division's slow recovery after suffering its second food scandal in as many years is a particularly heavy anchor to be dragging.
Slow boat to ChinaAlthough same-store sales in China finally turned positive, rising 2% over the year-ago period, it was so far below even management's target that Yum! Brands had to concede it wouldn't hit its earnings growth target of 10%, but rather revised it to say earnings per share would likely only grow in the low single digits.
It's why a number of analysts say Yum! Brands would be better off getting rid of the China business and is the rationale of at least one of the two hedge funds that established large positions in the restaurant operator earlier this year. Corvex Management said a spinoff could create an additional $16 per share of value for investors, and the separate entity could trade between $40 and $70 per share on its own.
Third Point Capital hasn't endorsed that view but believes China is the future, with the stage set "for a dramatic profit recovery over the next 12 to 24 months, and change the public market narrative around long-term shareholder value-creation for the company".
Betting on China is probably not a bad strategy considering the demographics at play, but it does suggest separating Taco Bell may be the way to go.
Yet if nothing else, Yum! Brands has proven it remains committed to building out the Mexican food chain, and so far in 2015 has opened 111 net new restaurants, double the number it did a year ago. That money, though, might be better spent elsewhere, and as the restaurant operator's performance flags, the calls to "do something" will grow louder.
The article Should Yum! Brands Inc. Spin Off Its Taco Bell Business? originally appeared on Fool.com.
Rich Duprey has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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