Colonel Sanders Devouring Little Sheep Means 69% Gain: Real M&A

Anti-monopoly regulators are turning Yum! Brands Inc.’s acquisition of a chain of Mongolian hot-pot restaurants into the most profitable bet in China.

Little Sheep Group Ltd. (968) has tumbled after saying last week that China’s Ministry of Commerce extended a review of Yum’s HK$4.4 billion ($573 million) takeover by two months. Little Sheep, which rose to within 25 cents of Louisville, Kentucky- based Yum’s HK$6.50-a-share bid, last week slumped 18 percent below that price, according to data compiled by Bloomberg.

Yum, the owner of the KFC fried chicken chain founded by Colonel Harland Sanders, is facing increased scrutiny from regulators as it attempts its biggest acquisition. While Little Sheep would extend Yum’s lead among restaurant chains in China, independently owned eateries would still control more than 90 percent of sales. That means the Ministry of Commerce, which has blocked only one of the more than 250 takeovers it has reviewed since China’s anti-monopoly law began three years ago, is unlikely to reject Yum’s bid, DBS Vickers Hong Kong Ltd. said.

“People are just too nervous,” Alick Wong, an analyst at Louis Capital Markets in Hong Kong, said in a telephone interview. “If an American company wants to buy in China, it makes investors cautious. Any bad news will move the stock.”

Wong expects the deal to close by March, which implies an annualized 69 percent return based on last week’s closing price of HK$5.30 a share, data compiled by Bloomberg show.

Jonathan Blum, a spokesman at Yum, didn’t immediately respond to telephone or e-mail messages requesting comment on whether it expects the transaction to gain approval.

Mongolian Hot Pot

Zhang Zhanhai, chief operating officer at Baotou, Inner Mongolia-based Little Sheep, declined to comment. The Ministry of Commerce, known as Mofcom, didn’t respond to a faxed request for comment on Yum’s bid for Little Sheep.

Today, Little Sheep declined 4.7 percent to HK$5.05 in Hong Kong. Yum fell 1.1 percent to $53.57 in New York.

Founded in 1999, Little Sheep has more than 400 Mongolian hot-pot restaurants, where diners cook a variety of thinly sliced meats such as pork, mutton and beef in a simmering broth. The restaurant operator, whose Chinese name translates to Little Fat Sheep, agreed in May to an all-cash deal that would give Yum 93 percent of the company, data compiled by Bloomberg show.

The acquisition would strengthen Yum’s presence in China, where it generates more sales than in the U.S., by enabling the fast-food chain operator to offer a local specialty in the world’s most populous nation.

Little Sheep has posted annual sales growth of more than 20 percent since 2006 and analysts project the company will extend that streak through at least 2013, according to data compiled by Bloomberg. Yum’s sales haven’t increased by more than 10 percent since 2002, the data show.

Local Specialty

“They want to be a leading brand in all the major markets,” Sara Senatore, an analyst at Sanford C. Bernstein & Co. in New York, said in a telephone interview. “Little Sheep is how they’re going to do that.”

Right now, Yum doesn’t “have an Asian or Chinese full- service, and Chinese food is still many, many times bigger as a market than the market for Western food,” she said.

Little Sheep, which had climbed as high as HK$6.26 after the announcement, plunged by the most in three years on Oct. 26 after Yum notified the hot-pot chain of the 60-day extension by the Ministry of Commerce. The decision came four months after it first acknowledged the application. The regulator now has until December to decide on Yum’s acquisition.

With the gap to the deal offer widening to HK$1.20 based on last week’s price, buying shares of Little Sheep would translate into a 23 percent gain if the deal closes -- without accounting for how long it will take to complete the transaction, data compiled by Bloomberg show.

Spooked

That’s a bigger potential windfall than any other takeover target based in China, data compiled by Bloomberg show.

While investors dumped shares of Little Sheep because of the possibility the deal will be blocked by antitrust regulators, the concern is unwarranted because China is dominated by independently owned eateries, said Titus Wu, a Hong Kong-based analyst at DBS Vickers.

Under China’s anti-monopoly law, an acquisition that allows the companies involved to reach certain market share and sales levels needs the approval of the commerce ministry.

The ministry has reviewed 267 mergers under the anti- monopoly law and rejected only one -- Coca-Cola Co. (KO)’s $2.3 billion bid for China Huiyuan Juice Group Ltd. (1886) in 2009, said Marc Waha, Hong Kong-based partner at law firm Norton Rose LLP.

The deal would have combined China’s largest and third- largest juicemakers and given Coca-Cola a 17.5 percent share of the market that year, according to Euromonitor International.

‘Finger Lickin’ Good’

In China’s restaurant industry, independent operators garnered 92 percent of sales last year, while restaurant chains including Yum controlled just 8 percent, Euromonitor said.

Yum, which opened its first KFC outlet in China in 1987 and has more than 3,300 fried chicken outlets across the country, still accounted for less than a fifth of the sales within the smaller chain market. Little Sheep had a 2.1 percent share.

“This case is more likely to be approved because it’s hard to standardize Chinese food,” said Mei Xinyu, a researcher at the Ministry of Commerce’s Chinese Academy of International Trade and Economic Cooperation. “There are many local restaurants which have the capability to compete.”

Nevertheless, political objections to non-Chinese companies acquiring local businesses can’t be ruled out, according to James McGregor, senior counselor in China for APCO Worldwide, a public-affairs consulting firm.

Overreacting

“On a pure business level, there’s no reason to reject it,” said McGregor, who wrote the book ‘One Billion Customers: Lessons from the Front Lines of Doing Business in China.’ Still, “the government is worried about getting criticized for allowing foreigners to buy into Chinese brands. We never know what the politics are behind this.”

Traders may still have more to gain from buying shares of Little Sheep now -- even if the deal ultimately unravels, according to DBS Vickers’ Wu.

Before Yum made its takeover announcement in May, analysts covering Little Sheep had an average share-price estimate of HK$6.09, according to data compiled by Bloomberg. That’s 15 percent higher than its closing price last week.

“The market may have overreacted,” said Christina Lie, an analyst at First Shanghai Securities in Hong Kong.

To contact the editors responsible for this story: Daniel Hauck at dhauck1@bloomberg.net; Katherine Snyder at ksnyder@bloomberg.net; Stephanie Wong at swong139@bloomberg.net.

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