Updated June 3 with comment from OSI Group LLC

By Yimian Wu

Hedge funds such as Third Point and Corvex Management favor Yum! Brands Inc., for one thing: China. But activist investors propose divesting Yum’s China division, which generates half Yum’s revenue, as a giant franchisee that would pay big, steady royalty fees.

According to Bloomberg, the founder of activist hedge fund Corvex Management, Keith Meister, said at a recent Sohn Investment Conference in New York that spinning off Yum’s Chinese business could create additional value of $16 per share.

Currently traded at $90.32, the Louisville-based global fast-food operator consists of five operating segments: Yum China, Yum India, KFC, Pizza Hut and Taco Bell. Yum India includes all operations in India, Bangladesh, Nepal and Sri Lanka.  T he company also owns a controlling interest in Little Sheep Group Ltd., a casual dining chain, acquired in 2012.

Based in Shanghai, Yum China has 6,846 primarily company-owned restaurants, including 4,896 KFCs and 1,369 Pizza Hut casual dining restaurants, and 270 Pizza Hut home delivery units, after adding 171 units in the first quarter.

In 2014 the China division reported revenues of approximately $6.9 billion, accounting for 52 percent of the company’s total revenue, and operating profit of $713 million, 35 percent of the company’s operating profit.

“There are certain merits to spin off Yum’s China,” said RJ Hottovy, director of equity research at Morningstar, in a phone interview. “It is a largely self-contained ecosystem where you have your own separate infrastructure and real estate as well as training.”

On the risk side, he said, “You can sacrifice some shared knowledge with the rest of the system. Also, the stand-alone business will incur extra costs.”

He added that the spinoff wouldn’t happen in the near term but possibly within the next couple of years. Hottovy thinks the stock is “fairly valued.”

John Glass, an analyst at Morgan Stanley, said in a May 18 note that the hypothetical plan to spin off China is “skeptical” as the independent KFC and Pizza Hut brands do not report to the global brand president. But “a split and conversion into a master franchisee makes more sense” because Yum China would have the right to build and operate in China but still be subject to Yum’s non-China franchisee rules.

Glass has a hold rating with a target price of $82.

John Ivankoe, an analyst at JPMorgan Chase & Co., said in a May 15 note that the spinoff of China has moved from a “possibility” to a “probability.” He wrote: “Our sense is Yum is not being defensive against activist investors’ recent points, and in fact seems to welcome ideas that can drive short and long term shareholder value.”

He also upgraded his target price to $105 from $83.

Aiming at growing franchises

According to the company’s annual report, nearly 100 percent of Pizza Hut’s China units, none of the India units and 6 percent of the units outside China and India are company-owned. Also, 77 percent of KFC’s China units, 51 percent of the India units and 9 percent of the units outside China and India are company-owned.

During the company’s fourth quarter call on February 5, Chief Financial Officer Pat Grismer said the company will pick up the pace of franchise development and refranchising, converting company-owned businesses to franchised units. Yum expects to be approximately 10 percent franchised in China and 85 percent to 90 percent franchised in India by 2017.

Hottovy said franchising is a “much more capital-effective way” of running a business because it allows the company to put more responsibility on franchisees. “The market for conventional franchising hasn’t been there until recently in this region, but that’s something will create value for shareholders,” he said.

Hit by the scandal

On July 20, 2014, an undercover report in China accused meat supplier Shanghai Husi Food Co Ltd., a unit of Aurora, Ill.-based OSI Group LLC, of using expired meat in its food processing plant. Yum was hit hard by the accusation, along with other  Western fast-food chains such as McDonald’s, Starbucks and Subway. UPDATE: OSI today (June 3) responded: “To date, this allegation has not been proven.”

In the third quarter last year, same-store sales dropped 14 percent in KFC China after the scandal. The fourth quarter experienced an even sharper decline of 16 percent.

However, KFC is slowly recovering. In the first quarter ended March 21, the company reported a narrower same-store decline of 12 percent and its stock gained 81 cents per share.

The company expects to take six to nine months to recover from the scandal. Most analysts think it will not have a long-term negative affect on the brand.

“This is probably the sixth or seventh one we have seen in the last 10 years. The scandal hit everybody last year so I don’t think it will have a lasting effect,” said Hottovy.

Yum has survived previous scares. The avian flu in China alarmed consumers in 2013. A year earlier an investigation showed some of KFC’s poultry farmers used excessive levels of antibiotics in chicken. A decade ago, KFC was found using Sudan 1, a red dye that can cause cancer, in its chicken wings.

However, a survey conducted by UBS indicated that the supplier incidents have not caused long-term brand impairment and customers aren’t blaming restaurant operators generally, according to analyst Keith Siegner’s note on April 30.

Slowly recovering

CEO Greg Creed said in the first quarter earnings release that the company aims at delivering a full-year EPS growth of at least 10 percent and is confident about a recovery in China.

Analysts have an EPS consensus of $3.46 for the full year, compared with $2.32  in 2014, and the average target price is $90.74, according to Bloomberg.

KFC’s recovery efforts included new menu offerings and discounted coffee. According to Siegner, eight new products including such healthier items as herbal tea and seafood are in the new menu. KFC also offers coffee priced at 40 percent below Starbucks and 20 percent below McCafe to boost sales.

Seeing a potential faster-than-expected recovery, Siegner rates the stock a buy with a target price of $100.

Andrew Charles, a research analyst at Cowen and Co., said in an e-mail that KFC’s launch of coffee was “a good complement” to build its breakfast business as KFC faces less competition during breakfast hours.

But even though KFC seems “poised” about its recovery in the second half of the year, Charles is concerned with increased competition and government involvement against Western companies to level the playing filed for local competitors.

He has a hold rating with a target price of $84.