Why Yum China May Be the Next Major Restaurant Buyout

The latest reports indicate that a group of major investors are preparing to make an offer to Yum China (NYSE: YUMC), taking the company private once again after just a short stint as a public company. The sole licensee of KFC, Pizza Hut, and Taco Bell in the world's most populous country has done well since splitting from its former parent Yum! Brands back in 2016.

In this segment from Industry Focus: Consumer Goods, Vincent Shen and Nicholas Rossolillo talk who's interested in buying before considering the chain's prospects and challenges in the fast-growing Chinese market.

A transcript follows the video.

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This video was recorded on Aug. 21, 2018.

Vincent Shen: This one is still running in the rumor mill. It's in the early discussion stages. The target is Yum China. Asit Sharma and I touched on the strong results that Yum China has been delivering since it was spun off from Yum! Brands in late 2016. This is the largest restaurant company in China, with about 8,200 stores split between its KFC and Pizza Hut banners, as well as some small restaurant concepts.

Yum China would make for a much larger deal. Its current market cap is around $13.5 billion. That explains why the rumored buyers at this point include a full posse of companies or firms. They include China Investment Corp, which is a sovereign wealth fund; Hillhouse Capital, which is a private investment firm, pretty notable as an early backer of Tencent and JD.com; Primavera Capital, which already has a minority stake in Yum China; and then some additional private equity players.

This is another company, Nick, that you've been following since inception. On one hand, you have KFC, which enjoys leading market share among chain restaurants and a management team that ultimately envisions 20,000 locations as their end goal for the Chinese market. On the other hand, Pizza Hut continues to struggle -- weak comps, declining profits. Even KFC is losing some of its allure among certain demographics in China. What do you think are the most pressing issues, and also the big opportunities for Yum China right now?

Nicholas Rossolillo: Yeah, pressing issues. China's a different animal from the U.S. market. Obviously, China's middle class is still growing and developing. Ultimately, this is not so much a story of declining same-store sales like Zoe's is, but more of, how many locations the company can actually grow. You mentioned KFC, doing well; Pizza Hut, not so much. The company also has access to the Taco Bell brand. It only has three so far, all of which are in Shanghai. There's a lot of different routes they can go to get to that 20,000 total stores in China that they ultimately foresee having. That's really the issue with Yum China.

Of course, Pizza Hut has been a drag. That's caused some weakness in share prices as of late as it underperforms.

Shen: It's a higher-end chain there, right?

Rossolillo: It's a higher-end chain in China, yeah. It's marketed as an upscale dining experience, if you can believe that, over there. The other thing that's happening is, same as here in the U.S. -- I think actually the U.S. is maybe echoing what's already been happening in China, as far as the digital movement, also the delivery movement. Most of the world's food delivery sales actually occur in China, and it's not slowing down. It's still growing by double digits. KFC, for example, well, 13% of sales were delivery last quarter. That number is still growing by double digits every quarter. That's the other thing that's been happening. As the company's trying to work in more delivery, that's a way for them to control their profit margins as they grow this massive new store base over the coming years. But, again, weakness in some of the brands has caused some weakness in share prices, and thus the private investor interest now in the company.

Shen: I'll add that, it's an interesting aspect of the operating environment for Yum China and the competing restaurant chains in that region, in that delivery is really big, but also, the technological capabilities and the infrastructure at the restaurants -- mobile pay is extremely common there. It's far more common than it is in the U.S. Kiosk ordering, things along those lines, are not as foreign to consumers there. To them, it's a perk and it's something they expect to see in a lot of their dining experiences.

Something that blew me away, I think Asit and I talked about this last year, is the loyalty programs that these two major chains have within Yum China, KFC and Pizza Hut. They boast together at this point over 150 million members. It's just a massive base for the company to work off of as they try and improve their operations, rebuild the Pizza Hut brand and the positioning of where that goes. Taco Bell, three stores, not even really a blip on the radar at this point. But if they can manage to grow that out, definitely a big part of their growth vision and the strategy.

Last point before we sign off -- if the potential buyers that we've talked about, all these private equity firms, the sovereign fund, if they manage to come together and make a deal happen for Yum China, I'm curious what you think they bring to the table specifically that can help Yum going forward, in terms of righting the ship for certain brands, or just growing KFC, or whatever it may be. What do you think?

Rossolillo: More than anything, it's probably just access to capital. This is more than double the number of restaurants the company currently has that it wants to build out in the years ahead. That costs money. So probably quick, easy access to capital to make that happen is the biggest thing they bring to the table. Outside of that, part of the reason for Yum China spinning off from its former parent Yum! Brands back in 2016 was so that it had more flexibility to control its menu to adapt to the unique market that is China versus the market here in the U.S. All of that has already happened, and the company has shown the value in doing that. Probably just the access to the capital, is what would be the compelling reason for the company to go private.

Shen: Well, and that second point, I think that's interesting. I've seen some reporting that there is some blowback from consumers in China regarding what are generally seen as these American brands. With that in mind, having a sovereign fund, for example, like CIC, buy in, adds, potentially, an air of legitimacy, and supports what can be a very nationalistic or patriotic consumer. Asit discussed that previously in his coverage of the company, and how that can add that additional vetting for the brand, and restore its popularity with KFC or Pizza Hut, whatever the chain may be within the country, being something else that, for example, a consortium like this, can help bring to the table with a lot of these investors based in the Asia region.

Nicholas Rossolillo owns shares of Tencent Holdings and Yum China Holdings, Inc. Vincent Shen owns shares of Tencent Holdings. The Motley Fool owns shares of and recommends JD.com and Tencent Holdings. The Motley Fool has a disclosure policy.