Trouble in China for Yum! Brands

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Yum! Brands' (NYSE: YUM) Chinese empire is falling apart. It runs around 4,400 KFCs in the country and some 1,000 Pizza Huts. It also owns two small Asian chains by the name of East Dawning and Little Sheep.

China is the company’s single largest market and accounted for over half the group’s revenue last year. But recently Yum! has been struggling with a series of setbacks. This is worrisome for investors.

The story so far

Trouble started in China late last year when two of the company’s wholesellers were found to be supplying chicken meat with high antibiotic and hormone levels. People stopped going to KFCs and even abandoned Pizza Huts.

The negative trends continued through the first quarter and resulted in a 20% drop in comparable store sales in China. The drop at KFC was 24% and at Pizza Hut it was 2%. The company launched its “Operation Thunder,” whereby it severed ties with 1000 odd suppliers and started promoting the safety of its food through television ads and social media.

Just when sales were improving in March, Yum! faced the second setback in the form of an avian flu scare. Despite the company insisting over and over again that its products are perfectly safe, people at large have chosen to remain reluctant. This significantly washed off sales in April.

Same store sales in China in April were down 29%, roughly in line with the 30% drop predicted by the company and slightly worse than the negative 27% estimated by analysts.

Digging deeper

Yum! expects to get the situation under control over the next two quarters and to return to positive comparative store sales in the fourth quarter. But gaining back lost ground will be difficult.

KFC is one of China’s most loved brands. According to Euromonitor, Yum! held a 39% share in China’s fast food market in 2011, way ahead of McDonald’s (NYSE: MCD), which had 15.6%. But as a result of its recent setbacks the group is losing valuable market share to both Western and local chains.

Aside from McDonald’s, which is planning to open another 300 restaurants this year, there are many local Chinese chains that are growing rapidly. Euromonitor predicts that in 2013, the combined number of Asian and Western-style fast-food chain outlets will increase by 10% in China, and this will be on the back of a 13% rise last year. Yum! will face severe competition.

In addition, the Little Sheep chain was rumored to be connected to a fake mutton scandal that had broke out recently. While Yum!’s name has been cleared completely, the rumor leaves doubt in people’s minds. This is especially worrisome in a country like China where word of mouth can make or break the fate of any service provider.

The company is also suffering from a weak eating out environment in the US, its second largest market. Both KFC’s and Pizza Hut’s same store sales growth were negative in the first quarter. Only the strong 6% growth at Taco Bell offset the impact of the 1% decline from the two other chains and led to a 2% overall comparable stores growth for the group in the US.

McDonald’s is feeling ripples

Yum!’s chicken scandal was so potent that it not only affected its own chains but it also created a feeling of distrust for McDonald’s. And the avian flu scare has increased the pressure quite a bit.

There was little surprise when Big Mac’s China same store sales were down by 4.6% in the first quarter. The weakness continued in April and resulted in a 2.9% drop for the Asia Pacific, Middle East and Africa segment.

McDonald’s is trying to combat the challenges by slashing down prices of its chicken nuggets and emphasizing its other meat options. It is also heavily promoting fish items and its breakfast concept. But any immediate pickup in sales is unlikely.

However, McDonald’s is better placed than KFC in terms of the avian flu scare because the latter’s name itself over emphasizes its chicken menu. People often tend to forget that other protein options are also available at the chain.

Starbucks is safe

Yum!, McDonald’s, and Starbucks (NASDAQ: SBUX) are the three biggest western restaurant chains in China. Of the three only Starbucks is unaffected by the food-related controversies and bird flu impact. This is because the chain is still better known for its coffee than for its food offerings.

The company’s performance in the China and Asia-Pacific region remains solid. In the second quarter, revenue surged 22.3% to $213.6 million. Starbucks also posted its best comparative sales growth here. The comps surged 8%, compared to 6% in the US and a decline of 2% in Europe, the Middle East and Africa.

The chain is trying to boost its current presence in China from 800 outlets in 58 cities to about 1,500 outlets in 70 cities by 2015. The company intends to make China its second largest market after the US by 2014. It already has 61% market share in the coffee shop segment, according to Euromonitor.

So what happens to Yum!?

Yum! has already issued guidance for a mid-single digit decline in its 2013 earnings per share, but factoring in a recovery in the fourth quarter. Keep an eye on how the company’s recovery is progressing through the year. Market share will continue to be of critical importance. Given that around half of the group’s entire profits come from this region, the impact of declining sales in this market cannot be emphasized enough.

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Eshna De has no position in any stocks mentioned. The Motley Fool recommends McDonald's and Starbucks. The Motley Fool owns shares of McDonald's and Starbucks. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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