We knew the tainted-meat scandal in China was going to be bad for the global food giants that do a significant amount business in the country, but Yum! Brands (NYSE:YUM) just reported on Wednesday that the fallout at its KFC and Pizza Hut chains has been particularly severe, bringing into question just how many times these companies can go to the well of consumer goodwill before it runs dry.
As is well known by now, Chinese media revealed in July that Shanghai Husi Food, a division of U.S.-based OSI Group, and a major supplier to U.S. fast-food restaurants in Asia, was found mixing fresh meat with meat that was long past its expiration date, picking up meat that had been lying on the floor of the meat-processing factory and using it, and falsifying food production dates.
The reaction was swift and immediate. Husi customer McDonald's (NYSE:MCD) -- which had at the time just reported a near-9% jump in comps for the region in the second quarter, saw margins expanding, was taking market share from competitors, and had an otherwise heady outlook for the country where it said it was growing "solidly," -- suddenly saw the wheels come off its forecast.
Just two weeks after the quarterly report was issued, the burger chain said sales plummeted 7% in July and that its forecast for comparable sales in its global division was now at risk.
That was similar to the update Yum! gave investors when it said that in the 10 days after the scandal broke, it suffered "a significant, negative impact to same-store sales at both KFC and Pizza Hut."
Now the company has quantified just how severe the negative impact was: July saw same-store sales tumble 13% year over year.
Mind you, that decline came against a particularly weak comparison from 2013, when the quarter's comps were damaged from the previous tainted-meat scandal it was attempting to recover from. Last year, third-quarter same-store sales in China were down 11%, meaning that this year's drop, which included presumably higher comps for June and the first three weeks of July before the scandal broke, was even more severe than the reported number indicates.
Yum! might want to say that its sales are already rebounding and that it expects its brands to bounce back as they have before, but can it really hope Chinese consumers are ready to trust them again so soon?
Part of the tremendous growth U.S. companies have enjoyed in China stems from the distrust consumers have over local producers.
McDonald's counts China as its third largest market, with over 2,000 stores located there, and derives about 10% of its revenues from it. It's even more important for Yum! Brands. The KFC and Pizza Hut operator counts on China for more than half its revenues and 40% of its operating profits.
Other companies that have a significant presence in the country and were also supplied by Shanghai Husi Food include Burger King Worldwide (UNKNOWN:BKW.DL), Starbucks (NASDAQ:SBUX), and Papa John's Pizza (NASDAQ:PZZA). Because their exposure to China is lower than either Yum! or McDonald's -- BK has just 190 stores in China, or about 1% of its worldwide total, and derives about 5% of its revenues from the entire Asia-Pacific region; the other two get about 7% of their revenues from China -- they haven't updated what the impact is on their business.
To deal with the current allegations of misconduct, many have severed their ties to Husi, which is the Chinese division of U.S.-based OSI Group, and Yum! is already promising legal action against it. McDonald's is promising to strengthen inspections of suppliers, halt all chicken imports from Husi in China, and switch to sources in Thailand.
No doubt such actions will help restore confidence, but it's likely only to be limited. The old saying "fool me once, shame on you; fool me twice, shame on me" would seem to be at play here.
Consumers were just starting to forgive KFC for its previous transgression of having fooled them once. Now they've been fooled again. It may be a long time coming before they're willing to allow Yum! Brands, McDonald's, and the others the chance to fool them a third time.
Rich Duprey owns shares of Nike. The Motley Fool recommends BMW, Burger King Worldwide, McDonald's, Nike, and Starbucks and owns shares of Nike, Papa John's International, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.