What The Recent China Meat Scare Means For Yum Brands

Aug.19.14 | About: Yum! Brands, (YUM)

Summary

Yum! Brands was again hit by a chicken scandal in China that’s hurting restaurant sales.

The company’s massive reliance on the mainland exposes it to significant concentration risk.

Yum! Brands has undertaken measures to counter the weakness emerging from the meat scare and is working to revive consumer confidence in the brand.

Yum! Brands (NYSE: YUM), one of the leading American fast food companies and owner of KFC, Pizza Hut, and Taco Bell brands, entered China in 1987. Since then, the Mainland has become the company's No. 1 market. Out of the 14,000 KFCs worldwide, more than 4,500 are in China together with 1,200 Pizza Hut outlets and approximately 400 stores of China-exclusive brands like Little Sheep and East Dawning.

In the last couple of years, the company has faced a series of untoward episodes in China that led to disappointment among stakeholders. But the quick service restaurant (NYSE:QSR) behemoth handled the crises well to inch back to normalcy -- in the second-quarter results reported on July 16, Yum! Brands saw better-than-expected improvement in its China operations. Sadly, soon after, it got hit by yet another crisis. Though it's too early to say how deep the ill effects will be, here's a lowdown on what's happened and its implications. Also, a look at the measures taken to counter the previous crises will help us gauge its ability to fight the latest challenge.

Why is China So Important?
The Mainland offers tremendous growth opportunity to the QSR companies. According to researcher Market Realist, there are only two restaurants per million people in emerging markets in comparison to 58 food outlets per million in the U.S. With rising disposable income and climbing discretionary spending, the market holds immense prospects.

China is the engine of growth for Yum! Brands as it is the company's biggest and most lucrative market. In the second quarter, the company earned more than 90% of the total KFC profit from its international operations with China being the main pillar of support. Restaurant margins showed marked improvement of 6.2 percentage points to 16.8%, while operating profits climbed by a staggering 188% to $194 million. The company opened 104 outlets during the period that aided top line growth. In 2014, the company plans to open 700 new units in the country and targets a three-year cash back period to recover the investment. CEO David C. Novak said he was reasonably satisfied with the progress the company was making with KFC outlets.

The Chronic Problem
In the second half of July, the Louisiana-based company found out that one of its Chinese suppliers Shanghai Husi Food -- a unit of Chicago-based OSI Group -- supplied meat that had crossed the expiry date. Since then, sales at KFC and Pizza Hut have declined sharply. Sadly, this is not the first time Yum! Brands' got entangled in a food safety scandal. In 2012, it was the chicken scare, and in early 2013, the avian flu outbreak. The two together had hit Yum! Brands' comparable store sales in China by 20% in the first quarter of 2013. And now that sales were stabilizing with China comps going up by 15% in the second quarter, the incident has stopped the company in its tracks.

If the recent meat incident has a prolonged bearing, it might materially damage the company's full year earnings outlook. Company VP finance David E. Russell said that events such as these draw "extensive news coverage in China", shaking consumer confidence and marring brand image.

Countering Measures
Yum! Brands has always been very quick in responding to any quality issues. In 2012, after the chicken scandal, it took instant action and severed ties with suppliers guilty of malpractices. The fast food major worked toward enhancing the Chinese customers' satisfaction by taking various measures. It's been focusing on value meals with greater stress on making superior quality offerings. At KFC, the company is upgrading its menu, redesigning the packages, refreshing its look with new uniforms for its staff, and giving free Wifi access to its customers. All these steps bore fruit as seen in the second quarter when China division's sales jumped 21% compared to the year-ago period.

This time too, Yum! Brands has dissolved its relation with local vendors and Shanghai Husi Food. It will also apply the tried and tested strategy of providing any one particular meal at 50% discount each day to drive sales. It was toying with the idea of starting a mobile application so that customers have the choice of pre-ordering using the app for payment, and could soon bring this online.

But, considering the frequency with which food related incidents are occurring, it would be great if the fast food giant can build its autonomous inspection unit to monitor quality and keep a check on supply chain. As a measure, the company may also alter its source of chicken, similar to what McDonald's (NYSE:MCD) proposed for its Japanese outlets. The Big Mac maker has recently shifted to Thai vendors for chicken supply for its Japan restaurants.

Concluding Word
Recurring food safety scandals in China have been a drag on the American fast food giant's financials as it vastly relies on this emerging market for its development. The company's done well to arise out the lows by taking immediate action and devising strategy to win back the trust of customers. In the short run, the state of affairs might look topsy-turvy for the company, but with strategic planning and corrective measures, Yum! Brands could find a way to handle the situation.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.