KFC's Chinese Nightmare Could Finally Be Coming to an End

Yum! Brands has had a very difficult 2013 in its largest market, China--but after months of declining sales and scandals, KFC's Chinese nightmare could finally be coming to an end.

Jan 4, 2014 at 7:00AM

It would be an understatement to say that Yum! Brands' (NYSE:YUM) KFC chain has had a rough year in China.

It all began on Dec. 18, 2012 when an investigation into KFC's supply chain was prompted by a report broadcast on China's national television, or CCTV. The report showed that some of the poultry farmers which supplied KFC were using excessive levels of antibiotics in their chicken, a violation of Chinese law. In response, the Shanghai FDA, or SFDA, took up an investigation into KFC's poultry-supply management. 

On Jan. 25, 2013 the SFDA concluded their investigation and brought no charges against Yum! Brands. However, the damage had already been done. The massive media coverage of the investigation caused KFC's same-store sales in China to plummet 8% in the fourth quarter of 2012. 

KFC was already looking at a bad 2013 in China when disaster struck in late March. H7N9 bird flu infected 140 people and killed 45. The disease was traced back to chickens, and the resulting media coverage turned public opinion sharply against KFC. 

Even though health officials in the country believed that the flu was being passed on by live poultry and not cooked poultry, the prevailing opinion dictated avoiding chicken at all costs. KFC, whose entire menu is based on chicken as the main ingredient in its meals, experienced significant backlash.

In the first quarter of 2013, same-store sales for KFC China declined a stunning 24%. In the second quarter the decline accelerated, with same-store sales falling 26%. Even months after the main strain of the flu had subsided in the third quarter of 2013, KFC China's same-store sales fell 14%. 

McDonald's (NYSE:MCD), which also offers chicken-based products in China, has also been affected by the bird flu. In January 2013, McDonald's reported a 9.5% decline in same-store sales in its Asia/Pacific, Middle East, and Africa, or APMEA, segment and cited "the residual effects of consumer sensitivity around the recent supply chain issue in the chicken industry." 

Since then, the decline has mellowed. In November, the company only reported a 2.3% decline in same-store sales in its APMEA segment. 

Does one chain in one country really even matter?
To Yum! Brands, KFC China is a big deal. In 2012, 50.5% of the company's $13.63 billion in revenue came from China. Within China, 74% of the company's 5,726 locations were KFC restaurants in 2012. 

Based on these numbers, KFC China accounted for 37.4% of the overall company's revenue in 2012. Therefore, when sales at this one chain in this one country are falling in the double-digits, investors start paying attention. 

In comparison, only 4.9% of McDonald's 34,492 restaurants were located in China in 2012. 

The nightmare could finally be coming to an end
Even now, reports are still being released in regard to new strains of the bird flu in China. On Dec. 26, the Chinese government confirmed that an 80-year-old man infected with the H7N9 bird virus died in Hong Kong. 

Nevertheless, the buzz around the subject has died down significantly. In November Yum! was even able to report that same-store sales for KFC China were unchanged thanks to a "Half Priced" bucket promotion. Still, negative fourth-quarter same-store sales are expected for KFC China as this promotion will not be repeated in December.  

In an investors' note Yum! released on Dec. 2, it noted that the company expects "a strong bounce back year in 2014" and that "In China, we have an aggressive plan to reignite sales at KFC." Yum! Brands even wants to start expanding again in 2014 with at least 700 new units in China, with the majority of them being KFCs. 

The Foolish conclusion
KFC China has been put through the wringer, but after over a year of crushing media coverage and plummeting sales, things are finally looking up for the company. Bird flu media coverage is mellowing in China, as is the degree of decline in same-store sales for Yum!. By 2014, Yum! plans to be back to expanding its store count in China.

As an overall investment, Yum! Brands is a solid company. Disregarding 2013, Yum! is expected to maintain double-digit revenue and earnings growth for at least a couple of years into the future. The company pays out a 2% dividend and sports a P/E ratio just north of 30, which is artificially inflated due to KFC China issues.

The key to Yum!'s future success will be how effectively the company is able to regain customers and reestablish trust in China. Back in 2003, KFC China's sales dipped 30% due to a SARS outbreak before recovering, and there is no reason why KFC China should not be able to fully recover again. 

We will get an indication of how this recovery is going on Jan. 13, when Yum! will release December same-store sales. 

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Ryan Guenette has no position in any stocks mentioned. The Motley Fool recommends McDonald's. The Motley Fool owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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