We are adding YUM to the Hedgeye Best Ideas list as a long.
Vulnerable to Activism
Both Wall Street and the media have been focused on McDonald’s as the next target of activism in the restaurant space. While it certainly could be, we believe the often overlooked Yum! Brands is the more sensible target. Unlike McDonald’s, YUM’s multiple brands and new operating structure can, and should, be altered in a way to create significant shareholder value.
For the better part of the past two years, management has been asked about a potential spinoff of the China business. Spinning out this business would be the first step in a series of potential transactions that would simplify the structure and improve the operating performance of the company. In fact, we find it likely that a group of influential shareholders begin to push the board in that direction.
We’ve been saying for years that multi-concept restaurant companies are structurally flawed, putting them at a distinct disadvantage to their nimble counterparts. If you recall, YUM initially got off to a rocky start as a public company, but has benefitted greatly over the last decade as growth in the China business has largely overshadowed inefficiencies and other underperforming brands. For this reason, YUM has never been lumped into the category of inefficient multi-branded restaurant companies.
Times are a changing for YUM. The company’s growth driver, China, has been under pressure and the overall performance of the enterprise has suffered, while the stock has underperformed the S&P 500 for the past three years. Underperformance is the kiss of death and typically the starting point for most activist white papers.
But mere underperformance is only the tip of the iceberg. There have been a series of transactions in the restaurant space that highlight how vulnerable YUM is to more progressive thinking. The balance sheet is underleveraged and there is ample liquidity in the marketplace to fund the type of restructuring we believe would benefit all constituents.
Activist investors have been an ambitious bunch lately, amassing war chests to support their cause. In the last two years, we’ve seen the community shift from buying up 5-10% stakes in smaller companies to buying smaller stakes in larger targets and working together to effect change. Recent examples of this include Icahn’s Apple campaign, ValueAct Capital Management’s sub-1% stake in Microsoft, Elliott Management Corp’s $1 billion investment in EMC and Jana Partners’ $1 billion investment in Apache Corp, which is approximately the same market cap as YUM.
In this day and age, YUM’s $31 billion in equity value is now in the sweet spot of the activist pool.
We’re not going to wait for an activist to come knocking; rather we’re going to lay out the activist thesis for you in an upcoming presentation. It will focus on the following key points:
- The new global reporting structure of the company allows for a clean split of the business units into multiple asset-lite business models.
- Creating a Pan-Asian KFC business listed on the Hong Kong exchange and headed by a Chinese national would limit the pressure being placed on the business by the Chinese government. A Hong Kong-listed company would go a long way in restoring consumer faith in the KFC brand in China.
- The BKW/THI deal highlight’s YUM’s underleveraged balance sheet.
- More shareholder friendly thinking would lead the board to take advantage of the liquidity in the marketplace and increase the leverage of the company to pay a special dividend or repurchase stock.
- There is significant liquidity in the franchisee community to refranchise more stores and structure the company as an asset-lite business.
- Cut excess G&A spend.
- Global asset-lite restaurant companies are trading at a 30% premium to YUM on an EV/EBITDA basis.
Importantly, YUM is already amidst a significant transition. David Novak, the charismatic CEO the company, is stepping down at the end of the year. Mr. Novak has been an incredible CEO and is the backbone of this company. With that being said, it will be extremely difficult to replace him.
The company announced last May that Greg Creed, the CEO of Taco Bell, will take on this daunting challenge as the next CEO of Yum! Brands. At the time, we believed the selection of Mr. Creed as CEO was a strange, although not illogical choice. It’s not that we don’t think Mr. Creed will make a good CEO, but rather that we expected Sam Su, the CEO of YUM China, to replace Mr. Novak. That would've, however, required Mr. Su move to the U.S., which is something we believe he didn’t want to do. Potentially for good reason; he is needed in China more now than ever before.
This leads us to believe that the leadership team, under a new operating structure, is already in place. YUM currently has several viable, and competent, CEO’s within the organization. When considering a potential split of the company, the two most important divisions (Yum! Brands China, Taco Bell) have management team’s that would ensure a smooth transition.
- Sam Su as CEO of the Pan-Asian KFC business
- Greg Creed as CEO of Taco Bell
We will work around these assumptions in our forthcoming black book on the company. With such strong assets, an opportunity for value creation is readily apparent to most investors. As a standalone business, we believe each of YUM’s brands would trade at a premium to where the conglomerate is trading today.
Under the scenario we will layout in our upcoming presentation, we believe the stock could trade between $95-110, representing approximately 32-53% upside from current levels.