This Is Why KFC and Pizza Hut Are Struggling in China

Yum! Brands' KFC and Pizza Hut are Struggling in China... again. Credit: Yum! Brands.

If you thought Yum! Brands'  (NYSE: YUM  ) struggles in China were finally over, think again. Shares of the global fast food giant fell nearly 3% early Thursday after it revealed its KFC and Pizza Hut subsidiaries have "experienced a significant, negative impact to sales following adverse publicity regarding improper food handling practices" by Shanghai Husi, which formerly supplied meat to both Yum! and competitor McDonald's.

Specifically, on July 21, a local news outlet revealed an undercover reporter had witnessed workers at the Husi factory using meat that had been dropped on the floor, and even mixing expired meat with fresh products. Unsurprisingly, Yum's China division's same-store sales for the third quarter ended Aug. 31 are now expected to decline around 13% from the same year-ago period.

Damage control 101
At the same time, however, Yum! also stated it plans to "vigorously pursue legal action" against the supplier to recover damages. What's more, Yum! reminded investors, "Our brands have proven resilient over time, and we expect this to be the case with this situation as well."

To be sure, this isn't Yum! Brands' first experience with damage control in the Middle Kingdom. Around this time last year, Yum!'s KFC was finally showing signs of a recovery in the aftermath of not only a tainted chicken scandal involving a different Chinese supplier, but also misconceptions surrounding whether the food was safe to eat amid an avian flu outbreak in the region. Similar to its latest situation, Yum! promptly severed ties with the offending supplier, and even implemented new quality-assurance measures in a bid to restore brand confidence.

Sure enough, those efforts appeared to be working by the time Yum! Brands announced first-quarter results in April. China Division systems sales, for example, had jumped 17% year over year on a combination of 7% unit growth, and 11% and 8% same-store sales increases from KFC and Pizza Hut, respectively. That outperformance continued in the second quarter, as Yum!'s China system sales jumped 21% year over year, again thanks to 7% unit growth and a 21% same-store sales increase at KFC.

Why Yum! Brands is staying the course
On one hand, it's worth noting that these particular supplier issues are largely out of Yum!'s control. The Chinese government also has promised to crack down with severe penalties for offending suppliers, and Yum! is rightly setting a "no tolerance" precedent by immediately ceasing to do business with these companies. At the same time, it stands to reason that, with each subsequent quality assurance issue, it could become more difficult for Yum!'s brand to recover.

On the other hand, it's admittedly frustrating that these situations keep cropping up for Yum! Brands in China, given the region's sheer potential for growth. For example, Yum!'s China division's operating profit came in at $777 million last year -- or more than 43% of its total -- on a slim operating margin of 11.3%. By comparison, Yum!'s U.S. operating profit was $684 million last year, but on an operating margin of 23.2%.

Given Yum!'s insistence that its brands will stand the test of time, however, it should come as no surprise that it recently affirmed that it's still on track to open at least 700 new restaurants in China this year alone. Given that sustained growth over the long term, the financial rewards could be immense if Yum! can ultimately put all the pieces together.

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