Reading List - January 20, 2011

In the past week, both YUM! Brands and the Wendy's Arby's Group both announced selling off less successful restaurants in their portfolios.  Announcements by both of these companies represent just a small portion of the spin-offs by companies.

An article by NYT DealBook looks at the value and reason for corporate spin-offs.  There are a few key points in the article worth noting:

• Wall Street's recent drive to break-up companies is nothing new.
• The parent company often uses the spin-off to divest itself of problems (i.e. debt).  Although these problems are divested, spin-offs often mask the true problems that caused the business to have problems in the first place.
• Spin-offs create shareholder value, but only in the short-term.  This value is created by the anticipation of the spin-off versus the actual spin-off

Reading about YUM! Brands spin-off of Long John Silver's and A&W is interesting.  After acquiring both of the brands early in the last decade, the company tied its fortunes to U.S. marke by opening up "dual branded" restaurants.  These restaurants created their own complexities, so the company moved towards a global focus.  In particular, the company is expanding in China and Africa with its KFC brand.  The key takeaway is YUM! is betting future growth to come from emerging economies, not developed economies.  I believe this is beneficial for several reasons:

• Long John Silver's and A&W represent only a small percentage of total YUM! branded restaurants (little over 4%).
• In places like Africa and India, consumers cannot eat beef limiting the expansion of McDonald's.  By focusing on the KFC brand, YUM! can develop KFC into a McDonald's of the emerging economies.
• Expansion overseas should lead to higher earnings growth, thus increase shareholder returns through either higher dividends or share buybacks

The most important news of the week could surround the recent wave of bank earnings.  NYT DealBook had an interesting article that highlights the new troubles banks face - top line revenue growth.  In late 2008 and 2009, banks faced the problem of write-downs.  To counter this, banks increased bad debt expense.  As less loans are going into default than expected, less than expected bad debt expense is providing a profit boost to banks, while top line revenues remain flat or lessen.  According to the article, top line revenue is down 17% from the peak in 2007.

In my opinion, this will create a buying opportunity for either traditional lenders or investment bank/money center banks with strong franchises and prudent risk controls.  Until there is an increase in interest rates and economic activity, these banks should remain at low valuations to historic levels creating the opportunity for a long-term investor.  For traditional lenders, economic expansion needs to take foot so loan portfolios can expand, and higher interest rates can cause net interest margin to increase.  For investment bank/money center banks, new revenue sources will need to found to replace profits from lost trading opportunities due to Dodd-Frank.  An interesting not is comparing earnings for Morgan Stanley compared to either Goldman Sachs or JPMorgan Chase.  Morgan Stanley experienced less of a decline than either of the other two banks from trading.  This is in lieu of Morgan Stanley trying to de-risk by focusing on more traditional investment banking and brokerage activities.