Necessity Forces McDonald's to Stand by China Meat Supplier

NEW YORK (TheStreet) -- Yum! Brands (YUM) and McDonald's (MCD) have taken different approaches to this week's tainted meat scandal in China that hit this week. McDonald's is standing by the company while Yum! Brands has severed ties.

Yum! shares are down 2.3% for the year to date as of the Thursday close of $73.84 while McDonald's, which reported earnings earlier this week, is down 2.3% and closed at $95.35.

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On Monday Chinese authorities shut down OSI Group's Shanghai Husi food plant for wide ranging food safety violations. A Chinese TV report showed workers in the food plant picking up meat from the floor as well as mixing expired meat with fresh meat. The report also captured workers saying that if the their clients knew what they were doing the company would lose its contracts. OSI operates 50 manufacturing facilities around the globe and have been a supplying McDonald's since 1992. Yum! has been a client since 2008.

This is the second major food safety scandal to hit fast-food companies in China, the last one occurring in 2012 when it was reported that KFC chicken was being pumped with excessive amounts of antibiotics. That scandal hit Yum! Brands' KFC particularly hard. This second scandal is likely a large reason the company severed ties so quickly.

So why the different strategies for Yum!! and McDonald's?

Yum! is the largest fast-food operator in China with over 4,400 KFC restaurants alone. Yum! is expecting China to be the driver of its future revenue growth and can ill-afford a set-back in the growing market. China food companies do not have a good reputation in China, thus giving foreign food purveyors a foot-hold. That is quickly dissipating with increased local media coverage of issues at foreign food suppliers.

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In a press release Yum! stated, "It is difficult to believe and completely unacceptable that the management of Shanghai Husi, a division of OSI, would oversee and organize illegal and dishonest operations, "Yum! China unequivocally condemns these actions." In the same release Yum! detailed how OSI is not a major supplier of meats to the company in China, saying, "This supplier is not a major supplier of Yum! China. KFC and Pizza Hut have arranged alternative suppliers and we do not anticipate disruption to KFC restaurants."

Yum! is also severing ties with OSI in Australia and in the United States where it says a few items were supplied to it.

McDonald's, on the other hand is sticking by OSI for now, saying. "We have been in direct contact with OSI's global leaders; as an added assurance of uncompromised safety, they are sending their top food safety experts to China to provide expertise on operations."

During its earnings conference call, McDonald's Chief Executive Officer Donald Thompson said "We do have audits of our suppliers. In this case, we do feel that we were a bit deceived relative to one of these plants, so we're clearly looking at that."

McDonald's is viewing this event as a breakdown in its own safety auditing and is looking to learn from the experience and as well strengthen its controls. The company is taking the approach that consumers in China will accept its apology. There is more to the story, however.

OSI is based 25 miles from the Chicago headquarters of McDonald's. OSI has been and continues to be a major food provider to McDonald's globally. So severing ties, no matter how bad the PR is at the moment, is not feasible. McDonald's is close to opening its own state-of-the-art food facility in the province of Henan so until that occurs it is forced to use other Husi Food plants around China.

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Necessity, not bad press, is the reason for the differing approaches to the scandal. McDonald's needs OSI, Yum! does not. Time will tell which approach pays off.

At the time of publication the author had no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

TheStreet Ratings team rates MCDONALD'S CORP as a Buy with a ratings score of B-. TheStreet Ratings Team has this to say about their recommendation:

"We rate MCDONALD'S CORP (MCD) a BUY. This is driven by some important positives, which we believe should have a greater impact than any weaknesses, and should give investors a better performance opportunity than most stocks we cover. The company's strengths can be seen in multiple areas, such as its revenue growth, growth in earnings per share and expanding profit margins. We feel these strengths outweigh the fact that the company has had lackluster performance in the stock itself."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • MCD's revenue growth has slightly outpaced the industry average of 6.8%. Since the same quarter one year prior, revenues slightly increased by 1.4%. This growth in revenue appears to have trickled down to the company's bottom line, improving the earnings per share.
  • MCDONALD'S CORP's earnings per share improvement from the most recent quarter was slightly positive. The company has demonstrated a pattern of positive earnings per share growth over the past two years. We feel that this trend should continue. During the past fiscal year, MCDONALD'S CORP increased its bottom line by earning $5.56 versus $5.36 in the prior year. This year, the market expects an improvement in earnings ($5.74 versus $5.56).
  • 38.77% is the gross profit margin for MCDONALD'S CORP which we consider to be strong. Regardless of MCD's high profit margin, it has managed to decrease from the same period last year. Despite the mixed results of the gross profit margin, MCD's net profit margin of 19.31% compares favorably to the industry average.
  • The change in net income from the same quarter one year ago has exceeded that of the Hotels, Restaurants & Leisure industry average, but is less than that of the S&P 500. The net income has decreased by 0.7% when compared to the same quarter one year ago, dropping from $1,396.50 million to $1,387.10 million.
  • In its most recent trading session, MCD has closed at a price level that was not very different from its closing price of one year earlier. This is probably due to its weak earnings growth as well as other mixed factors. Looking ahead, although the push and pull of the overall market trend could certainly make a critical difference, we do not see any strong reason stemming from the company's fundamentals that would cause a continuation of last year's decline. In fact, the stock is now selling for less than others in its industry in relation to its current earnings.

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