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Yum! Brands, Inc. (YUM - Analyst Report) and McDonald's Corp. (MCD - Analyst Report) could once again encounter the dark days of China in 2012.

Both these quick-service restaurant chains spent millions over the past two years on promotions, trying to boost sales and getting a clean chit after the 2012 food safety scandal in China.  Both Yum! and McDonald’s suppliers allegedly sold chicken fed with unapproved and excessive levels of antibiotic drugs and growth hormones during that time.

The local Chinese television media uncovered a new scandal blaming workers at Shanghai Husi Food Co – unit of U.S.-based OSI Group LLC –  reusing meat that had fallen on the factory floor as well as mixing fresh and expired meat. Before long, the food regulators came roaring back.

Notably, Shanghai Husi Food Co was a supplier for both KFC – a division of Yum! – and McDonald’s in the Shanghai region.

Damage Done?

As Chinese regulators investigate allegations of Husi selling expired beef and chicken products, both the fast-food chains reportedly apologized and announced a change in meat suppliers. The Shanghai Food and Drug Administration reportedly closed down Husi’s operations, yesterday, according to a Forbes report. However, the damage has already been done.

In fact, the scandal has spread beyond the shores of China, and McDonald's Holdings Co (Japan) admitted that it had sourced about a fifth of its Chicken McNuggets from Shanghai Husi and stopped selling the product on Monday.

According to Reuters, other fast-food chains like Burger King Worldwide, Inc. (BKW - Analyst Report) and Dicos, one of China's leading fast food chains owned by Ting Hsin International, have also promised to remove Shanghai Husi food products from their outlets.

Pizza chain Papa John's International Inc. (PZZA - Snapshot Report) has already removed products with Husi-supplied meat from its menu and cut off its ties with the latter. Starbucks Corp. (SBUX - Analyst Report) however declared that it had no direct business relationship with Shanghai Husi, but that some of its chicken acquired from another supplier had originally come from Husi. This was used in some of its products, which have already been sold. The company also declared that it has disposed of the remaining products.

Regulators Cracking the Whip

Food safety is one of the top issues for Chinese consumers. In 2008, an alarm was raised on dairy products contaminated with the industrial chemical melamine, which led to the deaths of six infants and indisposition of thousands.

Other food scandals have also hit the meat and dairy industries in recent years, like the sale of chicken injected with excessive levels of antibiotic drugs. These incidents highlight the difficulty in ensuring quality and safety along the supply chain in a country as large and populated as China.

In the most recent case, Chinese regulators have ordered regional offices to carry out spot checks on all firms which had used Shanghai Husi products, and an inspection of all of OSI sites around China to see if food safety standards are met.

The regulator's Shanghai branch has also reportedly demanded production, quality control and sales report from OSI. The regulator has also ordered McDonald's to seal around 4,500 boxes of suspected meat products and Yum's Pizza Hut to seal more than 500 boxes of beef.

Conclusion

In our view, this latest scandal will spell trouble for both McDonald’s and Yum!’s sales in China. Yum! in fact derives half of its worldwide sales from China and is looking to further expand into this profitable market. If consumers shun these fast food joints due to quality concerns, sales in the China will hit hard, especially at a time when comparable sales at U.S. are suffering due to declining consumer spending in a sluggishly recovering economy.

Although, foreign food companies enjoy a better reputation among Chinese consumers than domestic competitors, such media reports might tarnish their popularity.
 

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