Yum! Brands (YUM) did its best to soothe investor concerns by announcing a split of its China business, but some serious risks linger.
First of all, the company clearly rushed the decision out to appease new activist investor Keith Meister. In fact, I would say the executive ranks at the company are in a bit of disarray at the moment. Consider the news flow from the company in the past few weeks:
1. Bad third-quarter earnings report due to horrible China performance. Guidance is reduced.
2. A couple of days later, Yum! announces Meister as a board member. Guidance is lowered, again. When I talked to Yum! after this announcement, the company offered no clarity on when it would announce a decision on its strategic review. I reasoned, once I got off the phone, that a decision would come before a Dec. 10 analyst day -- and that any release would be light on details.
3. A few days after that release the company announces, arguably, its biggest decision as a public company, to separate its nearly 7,000-unit China business from the parent company. No projection on the value of the spinoff was shared, likely as the market value for Yum!'s China assets are at a low point following weak results and execs talking down the performance to investors. No signal was shared on how the spin proceeds would be used. Special dividend? Share repurchases? Beats me -- the disclosures yesterday were embarrassing in light of the gravity of the fundamental transformation now under way at the company.
All of that aside, let's say Yum! Brands successfully spins off China by the end of 2016 and nets about $500 million to $1 billion to be returned to shareholders. What is left? While the company certainly has attractive assets in KFC, Taco Bell and Pizza Hut operating in the U.S. and non-China markets, the reality is it's a fast-food business under siege not unlike McDonald's (MCD).
I think there is significant risk to what will become the legacy Yum! Brands looking out over the next five years.
Here are some cold hard truths related to each remaining business segment:
Taco Bell: The numbers at Taco Bell have been just fine, benefiting in large part from McDonald's struggles during the lunch and dinner hours. However, I think investors are underestimating the impact of Chipotle's (CMG) aggressive expansion nationwide. The better burrito chain will open up well over 200 new locations in 2016, on top of 200 plus new sites in 2015. While Taco Bell will always be the destination for something cheap in Mexican, Chipotle's growing number of restaurants over time will likely grab some of Taco Bell's customer base that could afford to trade up but as of today, do not have access to Chipotle.
Chipotle is also showing a little bit of a willingness to give food away for free to drive trial runs -- it will likely to continue doing that. Also, as it opens more locations and gains greater scale, I suspect Chipotle will offer some form of value platform to drive volume. I also see several competitors such as Moe's and Del Taco (TACO) making inroads in the Mexican value segment.
KFC: Similar to Taco Bell, KFC's sales in the U.S. have been pretty solid. Full credit should go to reinvigorated marketing featuring Colonel Sanders and new $5 fill-up bowls. But, also similar to Taco Bell, KFC is likely to confront a more competitive environment in the years ahead. Popeye's (PLKI) continues to expand into KFC's markets with, in my view, much higher food quality for not much of a higher price.
For those folks able to trade up, Wingstop (WING) offers a superior food experience to anything on the KFC menu -- and the chain is well on its way to more than tripling its store count in coming years. I also think consumers are finding better value buying rotisserie chicken in supermarkets instead of fried chicken buckets from KFC. That trend is unlikely to abate as Wal-Mart (WMT) opens up smaller-format stores that emphasize takeout food.
Pizza Hut: I see the most significant risks to Yum! Brands from a deterioration in the value of Pizza Hut. For starters, Domino's (DPZ) and Papa John's (PZZA) continue to do a fine job emphasizing their ingredient quality and online ordering. Both elements have weighed on Pizza Hut's results for a year or so.
But outside of the well-known fast food pizza players, there is a new crop of fast casual restaurants bursting onto the scene. Blaze Pizza is growing significantly, promoting healthier pizzas and benefiting from cooler-looking restaurants. The chain, in many respects, is cultivating the next generation of pizza eaters. The company is a threat to all players in the pizza business. In addition, I suspect Chipotle over the next 10 years will have hundreds of Pizzeria Locale spots opened in key markets -- the business model is very similar to Blaze Pizza.