So Who Actually Bought China's Biggest Restaurant Company?

Yum China, owner of KFC, Pizza Hut and other brands, is a business of more than 7,000 stores valued at over $10 billion. A private equity fund and an internet finance group have just put down a $460 million deposit on it.

Its 7,176 stores draw more than 2 billion visits a year, at an average spend of over 30 yuan per customer;

Its two apps rank first and second in their category by activated users — 3.759 million and 513,000;

Linking online and offline gives customers a new O2O experience, pushing average daily sales to $18.6 million and annual operating profit past $700 million.

None of this describes an internet company. It describes Yum China, a restaurant business. KFC, Pizza Hut, Pizza Hut Home Service's China operations, East Dawning and Little Sheep all belong to it. By scale or by profit, it is China's biggest restaurant company today.

On the evening of September 2, a story began circulating under the headline "KFC Joins the Alibaba Camp: Ant Group Buys Yum China's Business for $460 Million." Add the "KFC Official Flagship Store" that had gone live on Tmall that morning, and it looked very much as if Jack Ma had driven another big investment.

Then more of the story came out. Of the $460 million, $410 million came from a private equity fund, Primavera Capital. Ant Group put up only $50 million.

Fred Hu, Primavera's founder and former chairman of Goldman Sachs Greater China, will become Yum China's "non-executive chairman." He manages close to $3 billion today, but since this is his first public investment in the restaurant industry, the word "non-executive" sounds more like insurance.

The spin-off of the China business that Yum has been discussing for a long time will also begin once this investment closes:

From November 1, Yum China's shares will list separately on the New York Stock Exchange under the ticker "YUMC," with a future move to the Hong Kong Stock Exchange not ruled out. After the listing, Primavera Capital and Ant Group will jointly hold two rounds of subscription rights, letting them buy roughly 2% of Yum China's common shares in each round, at equity valuations of $12 billion and $15 billion.

That is close to what the market had already estimated:

The China division contributes 30% of Yum Brands' operating profit each year. Against the group's current market cap of $35.6 billion, the share attributable to Yum China works out to about $10.7 billion.

Only about 20% of that — $2.136 billion — will go to new investors such as Primavera and Ant Group; the rest stays with Yum's existing shareholders. The gap between $2.136 billion and $460 million means bigger investors may yet appear.

Micky Pant, who has been CEO of Yum China for less than a year, has new bosses. He said: "Rapid urbanization and digital transformation are two of the major forces driving China's economic development. Primavera Capital and Ant Group understand this deeply, so we are very pleased to have their investment in Yum China."

So how far can Fred Hu's money and Alipay's reach into the Chinese market take them?

Who Is Fred Hu?

Before he was an investor, the title that fit Fred Hu better was "economist":

His career began with macroeconomic research at the IMF (International Monetary Fund), the World Economic Forum and Tsinghua University's China Center for Economic Research. In his early years at Goldman Sachs China, a run of reports written during the Asian financial crisis built his influence and his contacts in the industry.

But Goldman's insistence on team credit over individual credit made it hard for outsiders to tell who really led its big IPOs — PetroChina, Sinopec, ICBC. Was it Hu, by then a partner, or Fang Fenglei, the legendary banker who had co-founded CICC? Hu's later title, "chairman of Greater China," was widely read as a promotion in name and a demotion in fact.

Hu left Goldman Sachs in 2008. With several former Goldman colleagues, he quickly put together his own fund, Primavera Capital, which now manages close to $3 billion.

Its early investment style drew plenty of argument, but the firm soon settled on an easier and safer line: chase internet companies that already had a big backer but still had room to grow. After turning a modest profit on Alibaba's IPO, Primavera quickly added Alibaba-affiliated companies to its portfolio — Didi, Ant Group, Cainiao.

Before the Yum China deal was confirmed, though, few outsiders considered Primavera a strong contender. Hu still liked to talk in macro terms, but the firm had little real investment experience in specific sectors such as restaurants or agriculture, and trailed far behind players with deeper industry positions, like KKR and Hony Capital.

Zhu Yi, deputy director of financial advisory at Deloitte China, once told QDaily that in this kind of deal private equity firms are fairly neutral, and that if they do hold positions across the supply chain, they can genuinely help the company they invest in transform faster: "The usual way a private equity fund works is to buy a company, issue debt, load that company with a heavy debt burden, force it to cut departments and costs, improve operating efficiency, and then sell it."

So Primavera's arrival may be a plainer piece of business: ride the window opened by Yum China's spin-off listing and take a premium.

So Is Yum China Actually Worth Investing In?

Confirming the investment, Fred Hu said: "China's large cities and small towns are still investing in and building new transportation hubs, shopping centers and physical and digital infrastructure of all kinds. This will keep pulling consumption along and drive strong growth and expansion in retail and restaurants."

As of fiscal 2015, Yum had more than 7,100 stores in China (KFC, Pizza Hut, Little Sheep and East Dawning). No one else comes close; its nearest rival, McDonald's, has a third as many. Take a conservative 350 square meters per store (a KFC's operating area usually runs 350 to 500 square meters) and Yum's total real estate footprint in China comes to about 2.5 million square meters, roughly the floor area of all the owner-occupier commercial housing built in Beijing in 2013.

Yum does not own that real estate. It leases it on 10- to 15-year terms. But land is scarce, and in first- and second-tier cities it is getting harder to secure sites while rents keep rising. For investors, buying into Yum China is an indirect way of buying scarce land. And don't assume the space Yum China holds can only be used to sell fried chicken and pizza. If the company is willing — more precisely, if its shareholders are willing — that space can be put to many other uses, and bring investors extra income.

At the end of 2015, Yum China also had more than 400,000 employees. For comparison, BAT plus the merged Meituan-Dianping — internet companies built on huge labor costs — together employ about a quarter as many.

Pizza Hut no longer sounds as fashionable as it once did, and KFC's brand reputation has been battered by one food safety scandal after another. But name recognition cannot be built in a hurry, and that too is a form of competitiveness.

Eating, in the end, is a need that doesn't go away. In the fairly saturated business of food, clothing, housing and transport, a company this well known rarely opens itself to outside investors. Meanwhile China's middle-class consumer base is projected to reach 600 million, and many investors see that as an enormous opportunity for Yum — whether it can seize it is another matter.

What matters more, of course, is the financials: annual sales above $6 billion and operating profit above $700 million. Even in its weaker years, its margin still beats the restaurant industry average.

In the United States, fast food weathers shocks better than most of 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 dining and more than 20 for leisure-beverage chains.

And Why Did Ant Group Invest?

For $50 million, Ant Group bought itself a place in a possible upgrade of the restaurant industry. Seen that way, it got a bargain.

You may remember that from late June 2015, KFC outlets across China gradually began accepting Alipay. Before that they had always favored cash and bank cards, but scanning a QR code is quicker and easier than waiting for change or signing a POS slip.

Accepting mobile payments is only the most routine step in remaking a traditional retailer. Judged by what it takes to rebuild internal processes and raise store efficiency, a better management system would be worth far more.

Koubei, Ant Group's local-services arm, has long wanted to do exactly that, but it lacks the resources. China has a vast number of restaurants and very few dominant brands. After Meituan and Dianping, the first to push into this market, merged, little room was left for Koubei.

A fast-food chain with an enormous number of stores and an already high degree of integration is exactly the right subject for that experiment. As we noted earlier, to an internet company a business like Yum China is worth working with on several fronts:

1) Offline presence:

Every internet company wants to talk to you about O2O, and what they lack is the offline "O." Beyond the billboard effect, a store's real value is that it shortens the distance to users and builds trust. Online plus offline makes the O2O story much easier to tell.

2) Coverage:

Opening 7,000 stores is not easy, especially stores this large. In theory, with KFC and Pizza Hut already spread from first-tier to fifth-tier cities, you could do almost anything with them.

Ele.me, which Alibaba has also invested in, covers more than 260 cities, but it has been burning money the whole way: judged by what it has raised, it has spent at least $1.2 billion in its five years. Yum's coverage is already built.

3) Supply chain:

KFC alone has more than 300 raw-material suppliers in China — precisely the resource food-delivery companies have been desperate to pull together.

4) Consumers:

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

Yum has been in China for 30 years, and its customers likely run from early teens to people in their 40s. Together they visit its stores 2 billion times a year.

Food safety problems and all, KFC on the whole is still trustworthy — at least when you can't decide what to eat, or can't tell whether some other restaurant has food safety problems of its own, it remains one of the best options.

And to put it more crassly, a consumer base this large can probably be squeezed for some big data too.

And What Can Yum Solve With This?

Its most valuable brand in China is KFC: of Yum's 7,000-plus stores in China, 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 faces now.

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

To pull young people back, it will at minimum have to shed that dated look and feel new and fashionable again.

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

But that may not be the most urgent problem Yum has in China.

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

It has climbed out of the pit every time, but the time and the marketing money each recovery takes keep rising. None of this is what investors want to see. Yum needs to reduce the risk that such an event again swings its share price hard, and to keep analysts and investors from turning cautious or skeptical about where its market value can go.

Which brings it back to product quality and a stricter supply chain. That, too, takes money.

Worse, the years dogged by food safety crises were also the years the restaurant business itself shifted: food delivery started taking over our lives. It didn't just deliver convenience and speed, fast food's traditional advantages; it also offered more choice. That is exactly why KFC and Pizza Hut both built apps, talked up O2O and plugged into delivery platforms. Capital markets love that "plus internet" logic.

So what Yum needs is a partner that is strongly internet-native and has money. Primavera Capital plus Ant Group fits well.