On Nov 23, Chinese media accused one of the chicken suppliers to KFC China known as the Su Hai Group of feeding toxic chemicals to chickens to accelerate their growth cycle from 100 days to a mere 45. KFC China responded that day, denying the allegations and stating that 45-day is the industry standard. At the same time, KFC China highlighted that Su Hai Group supplies less than 1% of its chicken supply.
That was obviously not good enough to stop the bleeding.
On Nov 29, just one week ahead of its December 6 Analyst Meeting, KFC China's owner, Yum! Brands (NYSE:YUM), issued a press release after the market close, guiding down China's same store sales (SSS) to -4%, from a previous projection of flat or low single-digit growth for Q4 2012. In addition, the company announced that new restaurant opening growth would decelerate from 700 in 2013 to 800 in 2012, citing a slowdown of China's economy.
The day after the announcement, YUM plunged 10%.
With some 3,700 stores in China, more than half of YUM's business now comes from KFC China, 44% revenue and 50% profits, to be specific. Although it now occupies half of the total fast-food industry in China, comparing China to the U.S., conceivably Yum! Brand is still in the very early innings of penetrating the China market. For every million people in China there are only 3.5 YUM! restaurants, compared with 58 in the U.S.
So the "China slowdown" catchall, while somewhat valid, is unlikely to tell the entire story behind KFC China's dimming prospects. With no other notable factors on the horizon, the toxic 45-day chicken hullaballoo emerges as a possible culprit.
China's Social Media Reacts…with Alarming Signs
As the "fast" chicken story unfolded, the Chinese media - including the largest TV cable network CCTV - framed the story as a food safety scandal. Meanwhile, chatter about "KFC's 45-day chicken" picked up in online forums. Three leading internet sites went so far as to survey user opinions on the safety of KFC's food. And if there is any truth in the survey results, YUM is facing a bumpy road in China.
One would argue that in a country where food safety practice and standards are as infamously lousy as they are in China, this would blow over quickly. After all, it is fried chicken, not exactly considered the paragon of health to being with. However, this betrays a Western mindset. In China, KFC is premium fast food - a dining experience that symbolizes the purity and heartiness of American life.
More a Publicity Problem than a Toxicity One
According to a study published by the Minister of Agriculture of China in 2003, there are about 100 chicken breeds in China: 95 local and 5 imported breeds. Local ones are known as yellow chickens due to the color of their feathers. Imported ones have white feathers and are, unsurprisingly, called "white chickens."
Compared with white/imported chickens, the average yellow/local chicken has a higher feed-to-meat conversion rate (3.5:1, compared with white chickens' 2:1), a longer growth cycle (100 vs 45 days) and, naturally, sell at a higher wholesale price (RMB 28 per chicken vs. RMB 20).
In addition, white chickens are generally bred and raised in a more adverse environment to prompt the development of body weight. For example, the average farming space for a white chicken is about 130 sq inch. Yellow chickens, on the other hand, are mostly pasture raised and considered to be naturally bred.
Given the above information, theChinese are inclined to associate white chicken with chemical injection, poor nutritional value, cheap meat and inferior taste, despite the fact that 45-day is the industry standard in most developed markets. Take for example this picture of a chicken with 6 wings and 4 legs posted online by a Chinese Internet user.
As it happens, the impact of the 45-day chicken sourcing isn't, as Yum! Brands might have led people to believe, limited to Su Hai. Taking a closer look at its supply chain, the top two Chinese suppliers, Dachan (3999 HK) and Shengnong (00239 SZ), farm chicken with growth cycles of 42 days and around 45 days respectively, according to the companies' prospectuses. This suggests that if the "white chicken" paranoia fails to die down, KFC China might have to change its sourcing approach.
Hypothetically, if KFC China starts to start to source yellow chickens in a bid to cater to local taste and meet customers' high expectations for food safety, its gross margins would decline sharply, from 65% today to around 57%. Although unlikely just yet, this may become one of few options left if Chinese media chatters gain further traction and KFC China sees worse-than-expected same store sales decline.
A Victim of Its Own Success
So far, KFC China's success is largely attributable to its rebranding strategy. The quintessential American fast food chain has established itself as a "luxury" fast-food among Chinese consumers, largely in foil to McDonald's (NASDAQ: MCD).
KFC foods occupy the premium market segment, meaning that it is somewhere in the range of double to triple the prices of local restaurants with similar menu offerings. For example, a chicken thigh and a chicken wing are about RMB 8.5 and RMB 4 at KFC, but only RMB 4 and RMB 3 at Country Style Cooking Restaurant Chain (NYSE: CCSC), a KFC knock-off. KFC's claim to the premium segment lies in its environment - it's clean, spacious, well-lit and, at least by Chinese restaurant standards, well appointed.
But luxury comes with a price tag. An average meal there costs about RMB 25 (~$4) per head, placing KFC in the premium fast-food segment of the industry, not in consumer staple but discretionary spending category. Given the pleasant dine-in atmosphere and nutritious and safe image it has created, locals are happy to pay for it. But all this could change especially as the economy is cooling down.
A Tough Winter Ahead
A colder-than-usual winter in many regions in China is hurting KFC as more customers now choose to dine in. Even if they order delivery online - a feature KFC has - ordering is price driven, therefore store ambiance is no longer a purchasing factor, giving KFC's local competitors a leg up.
While it is impossible to quantify the impact of the 45-day chicken scare coupled with a harsh winter in the absence of a close monitoring of the latest development, the combined trends of negative consumer sentiment and a deceleration of new stores opening could indicate YUM's China growth is facing a steeper grade than before. KFC's past China strategy succeeded in a big way. But this current fast chicken controversy may well signal the end of KFC's era of the incredible China growth, as customers seek to ignore the Colonel in search of the next big dining trend.
This article is co-authored by Yifeng Mao, the Head of Equity Research at Goldpebble Research, a China based research firm specializing in data procession and analysis. Opinions expressed are our own.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.