The Dark Side of Yum! Brands’ China Strategy

by Will Ashworth | May 10, 2012 8:00 am

Yum! Brands (NYSE:YUM[1]) delivered strong first-quarter sales in April, with its China division leading the way as system sales increased 28%, excluding foreign-currency translation.

Helping to pay for the 168 units opened in China in the first quarter were the proceeds from Yum’s ongoing refranchising initiative in the U.S. Selling company-owned outlets to franchisees is a common occurrence in the restaurant industry. Whether that’s a good thing for Yum! Brands and its investors is another matter altogether.

To own or not to own, that is the question. I was always under the impression that the concept of franchising was a simple one: The owner of a restaurant creates a replicatable system and then passes that expertise on to franchisees in return for franchise fees and royalties. That’s why Ray Kroc was so interested in the original McDonald’s in San Bernardino, Calif. Dick and Mac McDonald had a system.

But apparently, it’s not that simple.

Starbucks (NASDAQ:SBUX[2]), with the exception of certain countries and locations, tends to favor company-owned outlets so it can better control the quality of its product and customer experience. Chipotle Mexican Grill (NYSE:CMG[3]) doesn’t franchise at all. Still others, such as DineEquity (NYSE:DIN[4]), choose to operate under the more traditional model of franchising, whereby almost all of its IHOP and Applebee’s locations are operated by franchisees. Most chains seem to fall somewhere in between.

According to The Wall Street Journal[5], Yum! Brands has sold 850 company-owned units to franchisees in the past five years, generating $511 million in the past 24 months alone. In the first quarter Yum took in $102 million refranchising 139 units, for a pretax gain of $26 million. At the end of Q1, Yum had 7,456 company-owned units, of which 52% are in China. Of the 139 that were refranchised, 126 are in the U.S.

On the surface, it looks as though Yum! Brands is benefiting tremendously from these capital allocations. By putting all of its resources into emerging markets, it stands a better chance of continuing to grow.

But what does this say to existing and potential franchisees in the U.S.?

To me it says the franchisor believes it has no hope of growth beyond what each individual unit can deliver on a same-store sales basis, and that even that is questionable given its decision to refranchise.

CEO David Novak knows with certainty that China has a much better chance of achieving 14% same-store sales growth for the next 20 quarters than its U.S. stores do of achieving even 5% same-store sales growth over the same period. That’s because Novak understands that the Chipotle’s of the world, which sell higher-quality (not to mention healthier) menu items to Americans than KFC, Taco Bell orĀ  Pizza Hut do, will gain market share as legislators finally realize that fast food is the evil twin of cigarettes.

Care to guess where cigarette sales are still growing? Just as cigarette makers stumbled over each other to market in Asia, so, too, are Yum! Brands and McDonald’s (NYSE:MCD[6]). As with cigarettes, this can only end badly.

As I mentioned earlier, Yum! Brands generated $511 million via refranchising in the last two years. Over the past five, it was more like $1.1 billion. Given its plans to reduce its company-owned stores from 13% to 8% of the total store count in the U.S. over the next few years, it will sell approximately 750 additional units to franchisees, generating somewhere between $375 million and $575 million in gross proceeds.

The problem is that it doesn’t make much from those sales. In the past five years, although it brought in $1.1 billion in gross proceeds from refranchising, it lost $93 million on a pretax basis. You can argue that the sooner it redeploys the capital in China, the faster it will make a higher return on its capital. But I’m not sure that will be any consolation to franchisees who quite rightly should feel as though its franchisor is abandoning ship.

Short term, it’s easy to see why investors are excited by the move — it’s a moneymaker. Long term, it sends a message to both investors and franchisees that Yum has no plans for growing and/or improving its U.S. stores.

That’s the true story at Yum! Brands — the refranchising income is just a distraction.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.

Endnotes:
  1. YUM: http://studio-5.financialcontent.com/investplace/quote?Symbol=YUM
  2. SBUX: http://studio-5.financialcontent.com/investplace/quote?Symbol=SBUX
  3. CMG: http://studio-5.financialcontent.com/investplace/quote?Symbol=CMG
  4. DIN: http://studio-5.financialcontent.com/investplace/quote?Symbol=DIN
  5. According to The Wall Street Journal: http://online.wsj.com/article/SB10001424052702304818404577350121138389642.html
  6. MCD: http://studio-5.financialcontent.com/investplace/quote?Symbol=MCD

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