This article was first published on Forbes.
After publishing the story "Too Fast Food: Behind the Scene of YUM! Brand China Slump," on 12/6/12, further research has been conducted to verify concerns raised in that article. It seems that the chicken safety issue is merely the tip of the iceberg that is KFC China's slump. Economic slow down, rising competition in fast food, an unusually harsh winter, and most importantly, a change in consumer behavior, collectively are causing a sharp decline in same store sales growth for KFC in China.
YUM! Brands Inc. (NYSE:YUM) is an American quick service restaurant chain operating 37,000 restaurants in 110 countries. Its most famous brands include KFC, Pizza Hut, and Taco Bell.
Its crown jewel is, of course, KFC China. With approximately 4,500 stores, KFC China generates 50% of YUM's operating profits. For this reason, the stock has attracted the interest of investors seeking a proxy for China's booming middle-class consumption growth.
Based on fact-finding, it is clear now that KFC China's organic growth has unfortunately come to an end. By shifting its China strategy from saturated coastal cities to much less populated inner provinces with significantly lower average disposable income levels, KFC China is signaling that its prime period is over.
A Secular Shift to Online Shopping Hurts KFC Store Traffic
With approximately 90% of its store locations in or around shopping malls and business centers, KFC China's traffic depends heavily on overall traffic at commercial centers. The growing popularity and convenience of online shopping not only competes with brick and mortar shopping, but also with the ancillary industries, such as fast food, which depend on foot traffic in commercial areas.
Today, the shopping behavior of many of the 530 million Chinese internet users is changing gradually, but clearly towards online markets. The largest B2C online shopping site, Taobao, has reached a record high gross merchandise volume (GMV) of 1,000 billion RMB year-to-date. Shopping trips and outings to KFC stores have been further deterred by an unusually cold winter and a sluggish economy.
To compensate for the declining store traffic, KFC responded with new offerings of value combos to go, free delivery services and no tipping from October to December 2012. However, as most of KFC's customers seek the dine-in American fast food experience, these new product offerings are much less attractive compared to the local restaurants with cheaper menus. This phenomenon is most noticeable in lower-tier cities.
While the world speculates that urbanization will continue to drive China to become the world's largest economy by 2020, urbanization is an outcome of economic growth rather than its cause. Until the re-balancing between domestic consumption and government-led investments improves, industrialization will decelerate as overcapacity is already prevalent in many sectors.
Therefore, it is unclear whether the hundreds of millions of rural residents are poised to benefit from the urbanization trend. A more detailed demographic profiling of the rural provinces is needed to accurately assess the consumption potential of those to be urbanized.
Despite consensus readings of the latest PMI data as signaling a revival of demand, we believe stronger-than-expected numbers are driven by capital restocking, not consumer spending. This is grim news for KFC China, given that restaurants and retailers tend to lag in overall economic recovery.
Since its first store opening in Beijing in 1987, KFC China has achieved consistent success in branding itself to appeal to the swelling ranks of middle-class Chinese consumers, playing off this group's fascination with the concept of American fast food coupled with a localized menu.
However, the "new" factor has long since faded and other international fast foods and local knock-offs offer similar products at lower price points. Therefore, the competition - mostly local vendors offering the same menu for 30% cheaper or more - has finally become a material headwind to KFC China. In fact, we have observed that Chinese consumers tend to return to local food fare after trying American fast food. Ultimately, local fast food is regaining market share.
What's more, rising rental expenses reflected in the Company's lease renewals highlight the fast food leader's diminishing appeal and thus its bargaining power with landlords. KFC was once highly desirable in shopping malls because it drove traffic. Commercial landlords offered KFC a discounted rent and 5- to 15-year rental lock-up contracts. As newer and trendier dining concepts have emerged, competition for prime casual dining locations has driven rent increase as high as 300% on renewed leases.
For KFC, rental expense is approximately 8% of revenue with 25% of leases expiring in the next 5 years. KFC China's profit margin is around 20% today. An increase in rental expense will squeeze the margin by approximately 50-100bps per year for the next 5 years.
More Food Safety Risks in the Fragmented Supply Chain
We have analyzed the recent KFC chicken safety issue exposed by China's media. KFC China manages more than 500 suppliers and approximately 30 chicken providers. Out of the 30 providers, only one is farming its own chickens while the rest contract farmers at lower costs. Furthermore, only 0.1% of the chickens sourced from contract farmers have been sampled for safety testing. Chinese farmers are increasingly aggressive in abusing toxic chemicals such as antibiotics and anti-depressants (especially in the summers to calm down tightly caged chicken) to increase the yield and maximize profits. As the new administration tightens food safety practices, especially among the mom and pop poultry farmers, KFC China will face more frequent sample tests and heightened media scrutiny.
The Inevitable: Law of Diminishing Returns
The KFC China example reflects a common midlife fatigue that many other multinationals will inevitably experience in China after the initial honeymooning period is over. As local competition catches up to the intrigue of new international products, offering similar value and experience for lower costs, other factors will come into play that threaten to squeeze the profits of international companies such as YUM! Brand.
The recent CCTV expose on KFC China can be viewed as one of these factors. Drawing attention to food safety issues of one multinational undoubtedly has a knock-on effect of promoting restaurants that exist as alternatives. One might even view the expose as "helping" local casual dining restaurants to gain back some market share.
Much like the over-expansion of government-led infrastructure projects, KFC China will experience diminishing returns if it continues to expand into areas with lower spending power. This, coupled with a decline in store traffic, heightened competition, a cooling economy, and rising food safety scrutiny, KFC China will have plenty of challenges to tackle in the coming years.
Additional disclosure: Research is contributed by Goldpebble Research, an independent researchfirm specializing in data engineering and analysis. Goldpebble is headquartered in Singapore, with R&D operations in China.