China's Biggest Restaurant Company Is Selling a 20% Stake. Who Will Buy It?

We mean Yum China, owner of KFC, Pizza Hut and other brands. A business with more than 7,000 stores and 2 billion customer visits a year is rare even in China.

Every year more than 2 billion customers walk into its 7,176 stores and spend more than 30 yuan per order on average. Its two apps rank first and second among their peers by activated users, with 3.759 million and 513,000. Online and offline are connected, giving customers a new O2O experience and pushing average daily sales to $18.6 million and annual operating profit past $700 million.

That is not an internet company. It is Yum China, a restaurant operator. KFC, Pizza Hut, Pizza Hut Home Service, East Dawning and Little Sheep all belong to it. By scale or by profit, it is China's biggest restaurant company today.

Now it faces a choice about its own future. Except the choice isn't its to make.

A week ago Yum! Brands, headquartered in the United States, said it would sell 19.9% of its China business. Nearly a fifth of the equity is changing hands — and remember, a shift in control at Vanke, China's biggest property developer, was enough to set off the sensational "Baoneng-Vanke battle."

Analysts put Yum China's valuation at about a third of Yum! Brands' total market capitalization, or $10 billion, since the China business supplies roughly 30% of group operating profit (Yum! Brands is worth about $32 billion in all). On that math, 20% of the China business is worth $2 billion.

The sale fits a plan already in motion: Yum! Brands intended to finish carving out its China business by the end of this year, splitting it off as a new, separately listed company.

Why the rush to sell a stake in a company that hasn't finished separating? One reason is that China matters enormously to the group — it has supplied more than half of group sales for years running — while Yum's markets elsewhere, North America above all, keep weakening. Splitting off China and selling part of it lets the company move resources to where they are needed most, so the two halves stop dragging on each other. The second reason is money. Yum has its eye on China's third-, fourth- and fifth-tier cities, and even on Southeast Asia next door, and expansion costs more than it has.

What does Yum need to fix?

Its most valuable brand in China is KFC: of Yum's 7,000-plus stores in the country, more than 5,000 are KFCs. KFC's problems are, in large part, the problems Yum has to solve in China. So look at what KFC is up against.

Counting from its first store in Beijing, KFC has been in China 29 years. Ten years ago it had about 2,000 stores. Take Yum's own line that "store leases run mainly 10 to 15 years," and at the most conservative estimate at least 1,000 KFC outlets are more than a decade old.

To pull young people back, it has to shed the dated look and feel fresh again.

Yum China knows its stores are aging. At an investor and analyst meeting last December, newly appointed CEO Micky Pant said the company would remodel more than 1,000 KFC stores in 2016. That, yes, will cost a great deal.

But it may not be the most urgent thing Yum has to fix in China.

The sorry fact is that from 2012 to 2014, KFC ran into a major public health or food safety scandal every single year, and each one hurt. The 2013 bird flu scare cut KFC's same-store sales by 15%, and operating profit for the whole China region fell 26% year on year. The Husi Food scandal sent KFC China's sales down by double-digit percentages for four straight quarters beginning in the second half of fiscal 2014; Pizza Hut's decline ran for six.

It climbed out of the hole every time, but the time and the marketing money needed to recover keep rising. None of this is what investors want to see. Yum needs to make another such shock to its share price less likely, and to stop analysts and investors from turning cautious or skeptical about what the company is worth.

Which brings it back to product quality and a tighter supply chain. Which, again, takes money.

Worse, the years KFC spent mired in food safety crises were exactly the years the restaurant business was being rearranged: food delivery began moving into our lives. It matched fast food on convenience and speed, and offered more choice besides. That is why KFC and Pizza Hut both built apps, talked up O2O and plugged into delivery platforms. This "plus internet" logic goes down well in capital markets.

Here, what Yum needs is a partner with internet in its blood.

What is Yum China worth to an investor?

Back in 2003, a Yum executive told The Wall Street Journal that China was "an absolute gold mine." The golden age may be over, but the assets, hard and soft, are still there.

By fiscal 2015, Yum had more than 7,100 stores in China (KFC, Pizza Hut, Little Sheep and East Dawning combined), a scale nobody else comes near; the closest rival, McDonald's, has a third as many. At a conservative 350 square meters per store (a KFC restaurant usually runs 350 to 500 square meters), Yum occupies roughly 2.5 million square meters of Chinese real estate, about the floor area of all the owner-occupied commercial housing built in Beijing in 2013.

Yum does not own that property. It leases it on 10- to 15-year terms. But land is scarce, especially in first- and second-tier cities, where sites are harder to get and rents keep climbing. For an investor, buying into Yum China means buying indirectly into scarce land. And don't assume the space Yum China holds can only sell fried chicken and pizza: if the company is willing — more precisely, if its shareholders are willing — that floor space can do plenty of other things and earn investors extra income.

Yum China also had more than 400,000 employees at the end of 2015. For comparison, take the internet companies built on enormous labor costs: BAT plus the merged Meituan-Dianping employ about a quarter as many people between them.

Pizza Hut may not sound as fashionable as it once did, and KFC's reputation takes a hit with every food safety incident, but brand recognition cannot be built in a hurry, and that too is a competitive asset.

Besides, eating is not an optional purchase. In the fairly crowded territory of food, clothing, housing and transport, a company this well known rarely opens itself up to investors. China's middle-class consumers are also projected to reach 600 million, and many investors read that as a huge opportunity for Yum. Whether it can seize it is another matter.

More important, of course, are the numbers: annual sales above $6 billion and operating profit above $700 million. Even in a bad year, its margin beats the restaurant industry average.

Yum's plan is for the spun-off Yum China to list on the New York Stock Exchange first.

In the United States, fast food holds up relatively well within the food and restaurant industry. Around the 2008 financial crisis, fast food companies' P/E valuations moved by about 2.6, against 4 for full-service restaurants and more than 20 for casual dining and beverage companies.

What does KKR, said to be the likeliest private equity buyer, see in Yum?

From what has been disclosed so far, the 20% of Yum China will most likely end up with a private equity firm.

"Private equity firms are relatively neutral," Zhu Yi, deputy director of financial advisory at Deloitte China, told QDaily. That, he said, is the main reason Yum approached fund firms in the first round.

Even after carving out the China business, he believes, Yum! Brands still wants to keep the franchise rights to KFC, Pizza Hut and its other brands in China and to control how they are run. Hony Capital, Lenovo's private equity arm, reportedly made an offer too and was politely turned down: it bought the British restaurant brand PizzaExpress in 2014, which was read as putting it in competition with Pizza Hut.

What KKR wants from Yum China is plain: to pull together its own holdings in Chinese food and restaurants.

In 2014 KKR spent 2.46 billion yuan to buy into Fujian Sunner Development, becoming its second-largest shareholder; Sunner raises and processes broiler chickens. Before that KKR had taken stakes in livestock companies including China Modern Dairy, COFCO Meat and Asia Dairy. It usually holds an investment for five to seven years.

KKR global partner Liu Haifeng told Tencent Finance that the bets on COFCO Meat and Sunner Development reflect faith in their control of the whole production chain. Then again, Sunner's "chain" is mostly feed processing, chicken raising and slaughtering. It still has to find buyers downstream, and the buyer is a company like KFC.

Sunner was already an important KFC supplier before KKR got involved. But KFC has more than a hundred suppliers in China, and if KKR takes the stake it will probably raise how much Sunner ships to KFC.

For KKR, the investment completes its position along the chain. The timing says something too: the Sunner stake and the Yum deal, if it closes, come close together, another sign KKR is moving faster into chicken.

"The usual way a private equity fund works is to buy a company, issue debt, load it up with a heavy debt burden, force it to cut organizational fat and costs, improve efficiency, then sell it," Zhu Yi said. If KKR proposes something like that, it will help Yum China run leaner.

Hmm, why couldn't the buyer be one of them?

We have been describing this deal in a string of "internet language" from the start, which itself hints at what is buried in this company.

A $2 billion price tag means few companies can play. And the ones with the money — you have already guessed — so why haven't the internet giants moved?

Look at what Yum China might be worth to them.

1) Offline

Every internet company keeps telling you about O2O. What they lack is the offline "O." Beyond the billboard effect, a store's real value is closing the distance to users and building stronger trust.

In 2014, for instance, Taobao opened its first Taobao Experience Hall, in Guangzhou; that same year Alibaba put HK$5.37 billion into Intime Retail. Online plus offline makes the O2O story easier to tell.

2) Footprint

Building 7,000 stores is hard, and stores this big are harder. In theory, with KFC and Pizza Hut already spread from first-tier cities to fifth-tier ones, you could do almost anything with them. Ele.me covers more than 260 cities, but Ele.me has burned cash the whole way: judging by the money it has raised, it has spent at least $1.2 billion in five years. Yum's coverage is already built.

3) Supply chain

KFC alone has more than 300 ingredient suppliers in China — the kind of resource delivery companies have been desperate to consolidate.

Meituan Waimai launched its "Kuailv Jinhuo" wholesale service this year, selling merchants rice, flour, grain, cooking oil and the like, while Ele.me's "Youcai" aims squarely at the restaurant supply chain, supplying merchants with ingredients.

4) Consumers

It is like Evergrande: the football club costs a fortune, but "I have consumers, so I can sell them water."

Yum has spent 30 years in China, and its customers probably run from their teens to their forties. Together they visit Yum 2 billion times a year.

And despite the food safety problems, KFC is on the whole still trustworthy. When you don't know what to eat, or don't know whether the other restaurant has food safety problems of its own, it is one of the safest bets.

All right, and if we are willing to be a little shameless about it, a consumer base this large could probably be squeezed for some big data too.

5) An internet mogul with ambitions, if all he wants is to sell good food

Then obviously, with more than 7,000 stores and a home delivery service already running, he can get started.

6) Whatever else you can think of

Hmm, media, say. Huang Taiji put a TV in its stores and started calling itself a channel and a media outlet; why not Yum, with more than 7,000 terminals?

And come to think of it, why not Huang Taiji itself, or Focus Media? Looks like they need a Chinese-style mentor.

Cover image from Flickr user Natalie jill Lim, eater.com and wpaperhd