Does China Food Scare Mean Big Trouble for KFC?

New food-quality concerns in China will likely hurt Yum! Brands' KFC chain more than McDonald's.

Jul 21, 2014 at 12:21PM

Yum! Brands (NYSE:YUM) stock fell 6.9% after reporting second-quarter earnings late last week. While the results disappointed investors, there were a few bright spots. But now, a new health scare may rattle Yum!, and archrival McDonald's, at the worst possible time. 

Colonel

Source: Yum! Brands.

Yum!'s second-quarter recap: Chinese growth 
Yum! is the conglomerate behind well-known restaurant brands Taco Bell, Pizza Hut, and KFC. Like most large, global conglomerates, it's hard for Yum! to have every business line firing on all cylinders. This quarter, Pizza Hut did quite poorly and the market punished Yum!'s stock as a result. Pizza Hut's systemwide sales declined 1%, same-store sales fell 3%, and operating profit plunged 22%. As scary as these Pizza Hut numbers seem, Yum!'s Chinese business more than made up for it.

For the second quarter, Yum!'s earnings per share grew 30%; Yum! reaffirmed its full-year guidance of EPS growth at 20%. China is Yum!'s most important segment, and it roared back in the second quarter. Systemwide revenues grew 21% in China, and operating profit soared 188%, which also buoyed KFC's operating profit 15%. 

In a nutshell, Pizza Hut sank, Taco Bell stood still, but KFC -- and China -- soared. It's clear to see how important Yum!'s Chinese business is to its success, but unfortunately, that success may be fleeting. 

Chinese trouble ahead?
One of the reasons Yum!'s Chinese comps look so good year over year is that Yum! had so many troubles in China last year. If you recall, food quality (and bird flu) concerns in China rocked Yum! in 2013. At the height of the scandal, negative headlines in Chinese media pushed Yum! to an earnings decline over 60%. A rebound in China is the primary reason that Yum! is expecting 20% EPS growth this year, but a breaking story may derail those plans. 

Yum! and McDonald's are in the crosshairs of the Shanghai Food and Drug Administration again. According to Reuters, "A local television channel broadcast a programme claiming an undercover reporter had seen the use of expired meat and poor hygiene practices in a factory" at a Yum! and McDonald's meat supplier. The SFDA "halted the firm's operation on Sunday over food safety concerns," Reuters said. Both McDonald's and Yum! have released statements saying they will stop using products by the supplier, Shanghai Husi, but it is unclear if this will appease regulators. 

Yum!'s Chinese dependency runs high
This news is a reminder of how much Yum! relies on China, for both growth and stability in its earnings. In 2013, Yum!'s Chinese operating profit dropped from $1.015 billion to $777 million, as a result of the concerns over food quality. Yet even with this hit, China still led Yum! in terms of revenues and operating profit. China brought in $6.9 billion in revenue and $777 million in operating profit for 2013; the U.S. segment only had $3 billion in revenue and an operating profit of $684 million.

Yum!'s 2014 plan is built around a PR push in China. Like it or not, that strategy will always require cooperation from the Chinese media. In some ways, relying on this plan to work out requires a big leap of faith from investors here in the U.S. (who are unfamiliar with Chinese culture). 

That's why I continue to believe that Yum! needs Taco Bell's breakfast menu to work. Taco Bell is Yum!'s most U.S.-focused brand, and if its breakfast menu takes off, it could help stabilize Yum!'s earnings stream. While Yum!'s management did say that breakfast is already making a profit, mediocre same-store sales growth (2%) at Taco Bell suggests it's not booming. Depending on what comes of this latest Chinese scare, that could be a problem. 

Adem Tahiri has no position in any stocks mentioned. The Motley Fool recommends BMW, McDonald's, and Nike. The Motley Fool owns shares of Nike. 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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