McDonald’s Faces Declining Sales In Asia After China Food Scandal

McDonald’s Corporation (NYSE:MCD) continues to appear in the news for all the wrong reasons. After facing a food safety scare in China, the Golden Arches has been facing temporary shutdowns in Russia. These added headwinds come at a time when the company has been struggling with rising commodity prices, changing consumer preferences, tough competition in the breakfast and the fast-casual segment. The company has witnessed sluggish growth over the last three quarters, with relatively flat global comparable store sales and 1% increase in consolidated revenues in Q2 2014. In the U.S., comparable store sales decreased 1.5%, while operating income rose mere 1%. ^[1]

In August, Russia’s food safety watchdog ordered the temporary closure of five McDonald’s restaurants in Moscow and Southern Stavropol region, on claims of alleged sanitary violations. ^[2] However, experts believe that the decision comes as a result of tense U.S. – Russian political ties over Ukraine. (see Temporary Shutdown Of Outlets & Agricultural Ban In Russia To Worsen McDonald’s Sluggish Growth)

China Meat Scandal

In July 2014, a local reporter in Shanghai secretly captured footage of contaminated meat being processed inside a factory – Shanghai Husi Food – a subsidiary of American-based OSI group. Apart from bad meat being processed, the video also captures workers using expired meat products. ^[3] The video went viral in the country, forcing the Shanghai Municipal Food and Drug Administration (FDA) to investigate the processing unit. Upon investigation, the officials found that expired meat products (chicken and beef) were repackaged and processed with new expiration dates, with around 3,000 cases of contaminated beef cases already sold.

Shanghai Husi Food had been supplying meat products to various fast food chains such as McDonald’s, Starbucks (NASDAQ: SBUX), Papa John’s, Yum Brands and Burger King (NYSE: BKW) in several cities of China. Unlike Yum Brands, which has discontinued its operation with the supplier, McDonald’s decided to continue its 50-year long business with the food processing group by using a different OSI plant. ^[4] McDonald’s believes that the quality of meat is still better than the local alternatives and mentions that the company will ensure high quality of meat in future. The company is switching its Shanghai Husi plant to an OSI-owned plant in Henan province and will rely on an additional third undisclosed Husi plant for its meat supplies.

We have a $103 price estimate for McDonald’s, which is about 12% above its market price.

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McDonald’s reported net revenues of $28 billion in 2013, with the Asia-Pacific, the Middle East and Africa (APMEA) segment contributing 23% of the net revenues. ^[5] For the past nine months, the burger giant has been struggling with the comparable store sales growth, which remained relatively flat according to the latest Q2 report. Factors such as fewer guest count, severe weather conditions, and tough competition from other major fast food restaurants have been the reasons behind McDonald’s sluggish growth. The meat scandal in China and shut downs in Russia might worsen the situation and might negatively affect the company’s third quarter results.

McDonald’s Faces Sales Decline In Asia

Soon after the issue came to light, China’s government issued a ban on import and sales of products processed by Husi Food Group. ^[6] As a result of the ban, sales of McDonald’s popular chicken nuggets and chicken fillets were suspended in many Shanghai branches. Moreover, this scandal also affected McDonald’s Japanese unit, as 20% of the meat for chicken items in McDonald’s Japan were supplied by the Husi Food Plant. The country’s McDonald’s stores have suspended its imports from China and are using substitutes such as Tofu and fish for their nuggets. ^[7] Before this scandal, the company was already facing a hard time in Japan with McDonald’s Japan reporting a significant 60% year-over-year  (y-o-y) decline in the net income and 4% decline in sales for six-months ended June 2014 period, due to store closures. ^[8]

The company mentioned in its 2013 annual report that China, Australia and Japan, collectively accounted for 54% of APMEA’s revenues. Assuming same annual revenue per store across all the stores worldwide and proportionately distributing the net revenues according to the number of restaurants, China and Japan together accounted for 10.5% of the company’s net revenues in 2013. ^[9]

• Declining Sales In China

The company hopes to bring chicken products back to its outlets in China soon, but it might take longer time to recover the damage done to its reputation. The impact of the recent incident is visible in the company’s monthly sales report. In August, McDonald’s reported that its global sales for the month of July dropped 2.5%, with 7.3% drop in the APMEA segment, driven by China’s food scandal. ^[10] The company operates over 2,000 restaurants in China, of which most stores in Northern and Central China witnessed plummeting sales due to the unavailability of beef and chicken products, whereas restaurants in Southern China were unaffected. The scandal has built a negative reputation among the Chinese customers, leading to a drastic decline in customer count.

McDonald’s recently released its sales report for the month of August, reporting 3.7% decrease in global comparable sales, with 14.5% decline in the APMEA segment, largely due to food scare in China. ^[11] Looking at the past 3 months’ performance, the company estimates $0.15-$0.20 decrease in earnings per share y-o-y for the third quarter.

• McDonald’s Pulls Back Guidance In Japan

As already mentioned, McDonald’s Japan has suspended its imports of chicken products from China and will import its chicken products from Thailand’s McKey Food Services. In 2013, Thailand accounted for 62% of McDonald’s Japan chicken imports, with China accounting for the remaining 38%. ^[12] Shortage of beef and chicken items, as well as dented image of the company has resulted in decreasing customer traffic in the last two months.

Earlier, the company forecast operating profit of $115 million for the fiscal 2014, up 1.5% y-o-y, and net profit of $59 million, up 17% y-o-y. However, for the six months ended June 30, the company reported a 50% decline in operating profit to $34.4 million and a 59% decrease in net profit. As a result, McDonald’s Japan lowered its annual guidance at the end of July, on account of declining consumer confidence in Japan. ^[13]

Considering that Japan and China together account for 10.5% of the company’s net revenues, we might witness a significant drop in company’s revenue growth in the third quarter, as well as for the whole fiscal year.

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1. McDonald’s Q2 2014: Earnings call transcript [↩]
2. Russia is closing McDonald’s restaurants over health concerns [↩]
3. China’s tainted meat scandal explained [↩]
4. McDonald’s China will continue to use scandal-ridden meat supplier OSI Group [↩]
5. McDonald’s annual report, 10-K SEC filing, 2013 [↩]
6. McDonald’s misled Hong Kong food safety authority about rotten meat [↩]
7. Ref: 3 [↩]
8. Meat Scandal takes a bite out of McDonald’s sales in Japan [↩]
9. List of countries with McDonald’s restaurants [↩]
10. McDonald’s global sales drop amid China food scandal [↩]
11. McDonald’s reports global comparable sales for August [↩]
12. McDonald’s Japan switches to Thai chicken [↩]
13. McDonald’s Japan withdraws profit guidance after China food scare [↩]