Food Safety Scandal In China - A Risk To Multinational Fast Food Industry Growth

by: Barry Wald


High profile food safety incident in China kicks U.S. food companies in the gut.

Underscores the need for multinationals to pro-actively identify and address food supply chain weaknesses.

China winners will be fast food companies, along with their partners, utilizing preventive food safety practices to mitigate risk, enhance brand perception, and win the confidence of Chinese consumers.

The worst nightmare for any company in the food industry is a food contamination incident. Recall costs, lost sales, potential costs of litigation, PR challenges, loss of customer and investor confidence, declining stock prices, and diminished brand equity have intensified corporate responsibility and focus on the challenge of food safety.

Nonetheless, despite increased regulatory scrutiny and heavy corporate investments in food safety programs, food safety incidents still occur on a regular basis. There are simply too many points in an increasingly globalized food supply chain where protein and produce can be contaminated as they move from production to processing to consumption.

Two weeks ago in the U.S., Sysco Corporation (NYSE:SYY), the largest food distributor in the country, was ordered to pay nearly $20 million in penalties after a news investigation revealed the company had been improperly transporting and storing perishable foods. In California, a fruit recall for potential listeria poisoning forced the removal of desserts and other fresh fruit products at Whole Foods Markets (WFM), Wegman's Grocery Stores, and a host of other food retailers.

But even bigger news broke Monday, July 22nd, when major news service agencies -- including the New York Times, Wall Street Journal, Reuters, and Financial Times -- all reported on a major food safety story out of China. The story centered on two U.S. restaurant heavyweights, Yum Brands (NYSE:YUM) and McDonald's (NYSE:MCD), the largest players in the burgeoning $174 billion Chinese consumer fast food industry.

In an undercover news investigation conducted by China's Dragon TV network, serious lapses in food handling and processing protocols were uncovered at Shanghai Husi, a major supplier of processed chicken and beef products to YUM and McDonald's in China. Both firms immediately took product off their shelves, publicly apologized to Chinese consumers, and committed to investigate the incident and put corrective action plans in place. Each company saw share price market declines on Monday, with YUM shares falling 4.2 percent to close at $74.13 and McDonald's shares losing 1.5 percent to close at $97.55.

The story continued to build during the week, as U.S. chains Starbucks (NASDAQ:SBUX), Burger King (BKW), and privately held Subway also reported they had sourced meat for some of their products from Shanghai Husi. On Friday, McDonald's announced it was switching to Thai-based chicken suppliers for its Japanese restaurants, and McDonald's Hong Kong removed chicken nuggets, chicken filet, and chicken salad items from its menus.

The incident blindsided Shanghai Husi's U.S.-based owner, privately held OSI Group of Chicago, and resulted in the loss of its business with YUM and a severe strain to its 50-year-old relationship with the Golden Arches. (When McDonald's entered China in the early 1990s, the fast food giant had recruited OSI Group to supply their Chinese expansion after finding that suitable, local supply chains did not exist. Today, OSI operates eight meat or poultry processing plants in China that serve Asian markets.)

Overseas Markets Are Fast Food's Growth Engine

It's no secret that domestic growth has slowed for the major U.S. fast food, quick serve restaurant, or "QSR" chains. Changing consumer preferences and formidable new competition from newcomers such as Chipotle Mexican Grill (NYSE:CMG) and El Pollo Loco (NASDAQ:LOCO) are simultaneously challenging the major fast food chains. In response, QSRs have launched new initiatives to increase revenues, such as expanded, healthier menus and breakfast offerings.

But the real opportunity to reinvigorate growth is through overseas expansion, and fast food leaders YUM Brands, McDonald's, and others including Burger King and Starbucks have zeroed in on China's fast-food industry. In 2013, YUM generated nearly 50% of its total revenue from China through its 6,000-plus KFC, Taco Bell, and Pizza Hut stores. McDonald's has nearly 2,000 restaurants throughout the country, which is now its third largest market. Starbucks has 1,000 stores in place and is expanding.

At a time when these U.S. fast food chains are penetrating Chinese markets, food safety has become one of the top issues for Chinese consumers, especially after a national wake-up call occurred in 2008 when the industrial chemical melamine contaminated dairy products, leading to the deaths of six infants and making many thousands sick. More recently, a series of local food safety incidents and media reports involving Chinese suppliers of U.S. food chains have impacted perceptions of U.S. food companies. YUM Brands' KFC chain was hit with an investigation 18 months ago that found excessive antibiotic use at a major poultry supplier. This past January, U.S. retailer Wal-Mart (NYSE:WMT) recalled donkey meat sold in its stores in eastern China after it discovered this product contained fox DNA.

Last month, Zhang Yong, head of China's Food and Drug Administration, testified before the Standing Committee of the National People's Congress that, while Chinese food safety was improving, recent problems showed that "the situation remains severe." He added that the existing regulatory system was not effective and penalties were light and did not deter offenders. He announced plans to revamp and strengthen food safety regulations to make sure offenders face harsh civil, administrative, and criminal penalties. Government regulators would also face stiff punishment for violations under the more stringent law, facing demotion, dismissal, or even criminal penalties.

These developments highlight the difficulty in ensuring quality and safety in international food supply chains. They also underscore the need for multinationals to identify and address potential supply chain weaknesses to avoid the damage to brand reputation from a food safety incident. In a place like China, with an immature food safety infrastructure, food companies especially need to make it their own responsibility to proactively manage and monitor their supply chains to ensure they are safe and reliable. OSI's multinational U.S. customers failed to do so and now are forced to step in to protect their interests.

End-to-End Solutions Needed

In an International Business Times article published mid-week, several experts from the food industry were interviewed regarding food safety in light of the Chinese food debacle:

  • Tony Corbo, lead lobbyist at the U.S. advocacy organization Food & Water Watch, said: "It is important for companies to take this process into their own hands. Despite China making improving food safety a national priority, the implementation has yet to catch up with the rhetoric."
  • Hank Lambert, CEO of Pure Bioscience (NASDAQ:PURE), a Californian company that has championed preventive approaches to food safety through its patented silver dihydrogen citrate, or SDC antimicrobial technology platform, emphasized the importance of food companies pro-actively implementing their own food safety processes and standards and driving these processes up into their supply chain. Mr. Lambert commented: "Their size and the size of the network of suppliers increases the complexity of the challenge to ensure that their suppliers are adhering to food safety standards."

Recent history offers some examples from other consumer markets. In 2007, a wave of safety issues concerning lead paint in toys caused consumer outrage in the U.S. market, and Mattel (NASDAQ:MAT) and other toy companies had to shift much of their toy production away from Chinese contractors and implement much stricter supplier performance standards. Elsewhere, multinationals such as Apple (NASDAQ:AAPL) and Nike (NYSE:NKE) responded to unprecedented pressures from U.S. consumers and public interest/watchdog groups to incorporate fair labor and sustainability practices into their global supply chain behavior.

In the same way that Mattel, Apple, and Nike faced challenges in their respective industries, the fast food industry needs to drive food safety standards into its supply chain. Failure to do so will expose food companies to more frequent food contamination incidents, the diminishment of brand value, and loss of customer confidence - ultimately threatening their domestic markets and growth in their critical overseas regions.

Opportunities for Investors

As U.S. food companies jockey to grab market share in the Chinese market, food safety is perhaps their most daunting challenge. However, this also creates opportunities for the companies that embrace food safety as a core capability.

Some multinationals have already become proactive. YUM has stepped up its own random testing of its supply chain in China. Wal-Mart, which is No. 9 among China's top retailers, intends to triple its food safety spending and has doubled the DNA testing it does on meat sourced in China. Nestlé (OTCPK:NSRGY) now conducts 200,000 tests a day at 25-quality assurance centers throughout China.

The increased spending by these companies is the "cover charge" to compete in China and doubles as an insurance policy against the negative financial and brand effects that come whenever food safety is compromised. It also provides a marketing advantage with an increasingly sophisticated consumer audience that wishes to know where its food originated from, how it was raised, who handled it, and how it was prepared.

In short, savvy investors should carefully consider food safety as a key investment criterion. They should examine their current or potential food industry holdings to identify:

  • Their compliance status to the U.S. Food Safety Modernization Act (FSMA) of 2011.
  • Are they a proactive organization, participating in leading food safety initiatives such as the Global Food Safety Initiative (GFSI)?
  • Are they actively measuring and reporting food safety through third party verification services and requiring the same from suppliers?
  • Do they possess "chain of custody" certifications and the capability to trace produce back through their supply chain?
  • Are they employing cloud-based IT solutions that allow them to communicate and work closely with suppliers?

Major U.S. fast food companies that embrace such end-end supply chain capabilities will maximize their potential in China and other emerging markets and provide better long-term, risk-mitigated growth opportunities.

Technology companies that help enable food industry companies to address food safety issues provide further opportunities for investors. For example, FSMA's new focus on preventive food safety will increase the demand for antimicrobial and disinfectant solutions that kill pathogens and prevent food contamination at all levels of the food supply chain.

Pure Bioscience, a microcap which I covered most recently in my SA article in May, is one such company. PURE's antimicrobial technology platform, SDC, is a broad-spectrum, non-toxic antimicrobial agent that is manufactured as a liquid and delivered in various concentrations. The company has adroitly anticipated emerging food safety trends and is abreast of the regulatory curve with a portfolio of antimicrobial food safety products, test data, and trial partnerships with leading QSRs and food processors. These activities include:

  1. At the retail level, the company is engaged in active trials with four U.S. fast food, or quick-serve restaurant chains using SDC as a general purpose antimicrobial cleaner for counters, surfaces, equipment, and floors. Closure with at least one partner for commercial business is reported to be close at hand.
  2. PURE is also working with five major upstream food processors in various stages of commercial pilot adoption. These partners enthusiastically report that SDC products have demonstrated superior antimicrobial performance versus their incumbent disinfecting and cleaning agents.
  3. PURE has developed additional SDC applications, targeted at upstream food processors, where SDC serves as a broad-spectrum, non-toxic, antimicrobial "direct contact" wash/spray for produce, meat, and poultry processing as a preventive measure to kill various foodborne pathogens. The company filed for FDA approval on this product earlier this month for poultry applications and plans to follow with applications for beef and produce in the third calendar quarter.

When used together, these applications can provide end-end, preventive food safety solutions to block pathogens in the food supply chain. Once implemented in the U.S., they can be replicated in China and other overseas markets. PURE estimates the total addressable market for sanitizers, disinfectants, and cleaners for the U.S. food industry is a $1.5-$2.0 B/year opportunity. According to CEO Lambert, the new SDC-based direct food contact applications will enable PURE to pursue an additional $1 B per year addressable U.S. market opportunity. The Chinese market alone would increase the addressable market materially over time as the multinational fast food chains grow their presence there.

As previously noted, risk tolerant investors should continue to build positions or begin accumulating PURE now. The Company is poised to break higher upon the anticipated announcement of definitive agreements with major U.S. food processors and restaurant chains, and formal regulatory approval for new direct food contact applications for poultry, beef, and produce. PURE's share price has fluctuated between $1.00 and $1.50 over the past year. With high expectations for the achievement of key milestones, it may be favorable to buy shares today at prices under $1.50 as opposed to waiting for downstream announcements and paying prices as high as $3 or $4 later in the year.

PURE Bioscience has the potential to safely and effectively solve growing safety problems from foodborne pathogens such as salmonella, e.coli, norovirus and more, at all levels of the food industry supply chain.

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. The author has no business relationship with any company whose stock is mentioned in this article.

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