RETAIL: New China Stories For KFC In Spin-Off, McDonald’s In Franchising

Bottom line: A potential future spin-off of Yum’s China operations looks like a good move that would give the new company more focus, while McDonald’s China franchising drive also looks good if it can find the right partners.

Investors eye spin-off for Yum’s China unit

China was once the hot story for fast food companies like KFC and McDonald’s (NYSE: MCD), as Chinese consumers flocked to the concept of reasonably priced food that was served quickly in attractive restaurants with friendly workers. But that story has become quite stale in recent years, leading this pair of global heavyweights to look for new China stories to pump up their local business and excite investors.

KFC has been trying to achieve that goal through a major overhaul of its China restaurants over the past year, and now is back in the headlines as some investors call for its parent, Yum Brands (NYSE: YUM), to split off its China operations into a separate company. Meantime, McDonald’s is trying to bring some excitement back to its China story by rapidly accelerating the expansion of its traditional franchised store model in the market.

Let’s start with Yum and KFC, which is the newer of the stories as the idea of splitting off its China operations gets floated for the first time. Yum is certainly no stranger to spin-offs, as it was originally the restaurant division of beverage giant PepsiCo (NYSE: PEP) that was spun off as a separate company in 1997. Now some investors are saying that Yum might consider doing the same thing for its China operations, which include not only KFC but also Pizza Hut and several of its local brands.

According to the latest reports, billionaire hedge fund investor Daniel Loeb has said that he sees a possibility for Yum to split off its China operations into a separate company, but won’t be actively lobbying for such an action. (English article). His comments came just a week after he disclosed that his Third Point hedge fund recently took a $1 billion stake in Yum. He made the remarks after another major hedge fund manager, Keith Meister, disclosed that his Corvex Management had taken a major stake in Yum and wanted the company to consider splitting off its China operations.

This kind of spin-off is usually done when a division is big and different enough from its parent company’s core operations to justify becoming independent. In this case Yum’s China unit was once growing much faster than its other operations, though lately the opposite is the case. Still, China is a big and unique enough market that this kind of spin-off could actually be a good idea, as it would allow top management to focus exclusively on the market without having to rely on decision making from a US-based parent with little or no knowledge of China.

Next let’s look at McDonald’s, which has actually been talking for a while now about quickening its franchising drive in China. The company traditionally used the franchising model in the US and many developed overseas markets, which is cheaper and more flexible than a more conventional model of self-owned and -operated stores. But in China both KFC and McDonald’s traditionally owned most of their stores, often through joint ventures, in a bid to control quality in a market that was unfamiliar with the franchising concept.

Only about 15 percent of the more than 2,000 McDonald’s China stores were franchised outlets at the end of last year, far lower than its global average of 80 percent. A company official said it is aiming to raise that figure to 20-25 percent of its China store count by the end of this year. (Chinese article)

Those figures are actually consistent with plans McDonald’s gave about a year ago (previous post), indicating the campaign is moving ahead on schedule. The idea looks good to me, as it will move responsibility for individual store growth to more entrepreneurial local owners and allow McDonald’s to focus on the bigger China picture. But McDonald’s will also need to be careful to find reliable partners, which isn’t always easy in China, or risk ending up with headaches when conflicts occur.

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