What's China Really Worth To A YUM-Of-The-Parts Model?

• Shares of Yum! Brands, Inc. YUM have lost more than 16 percent over the past three months have but have rebounded from its 52-week lows of $66.35.


• The company recently announced it will spin off its China operations into a separate, public company.


• Karen Short of Deutsche Bank estimated the entire company is valued at $74 based on a sum-of-the-parts valuation.

Shares of Yum Brands have lost more than 16 percent over the past three months, mostly due to ongoing China concerns. The company announced earlier this week that it will split itself into two companies: Yum! China and Yum! Brands.

In a report published Tuesday, Karen Short of Deutsche Bank crunched the numbers and valued Yum China and Yum Brands at a combined valuation of $74 per share.

Yum China Volatile

Short assumed the following: 1) no debt assigned to Yum! China, 2) an incremental $9 billion in debt was assigned to Yum Brands to lever the division to 6x, 3) the company buys back 112 million shares with the incremental debt, and 4) a 12x multiple for each division was used.

Karen noted that she "hesitated" on assigning a higher multiple to the China division as sales trends have proven to be "exceptionally volatile" over the past few years and "even more so" in the past few weeks. In addition, Pizza Hut China (one third of the division) has shown "even greater" revenue volatility than KFC China and may now be "structurally challenged."

Karen continued that the competitive landscape in China continues to intensify, especially in malls where the company has a "limited" presence. She also noted "it isn't clear to us that a spin-out is even feasible given how undeveloped the (Shanghai) market is."

Yum Brands Also Faces Risks

Switching over to Yum Brands, the analyst argued that the ex-China company should also be valued at 12x given the high leverage and associated risks.

The analyst cited: 1) Pizza Hut is facing structural and strategic challenged and should be valued at a discount to Taco Bell and KFC, 2) the remaining business should be 6x levered, 3) free cash flow should increase "significantly" given the fact that China accounted for approximately 80 percent of the company's consolidated capital expenditure, and 4) Yum Brands should use $9 billion in incremental debt to buy back stock.

Finally, Karen argued that investors who are positive on the company will argue that a 12x multiple is too conservative while skeptics will assign an even lower multiple to the two divisions. Meanwhile, the analyst stated that her assumptions "sit somewhere in between."

Karen maintained a Hold rating with an unchanged $76 price target.