Tiger Woman on Wall Stree

by Junheng Li

  Knowing that the chicken we consume in the United States is mostly, if not all, 45-day chicken, I wanted to understand why Chinese people were having such a strong reaction. I decided to delve into the nitty-gritty of the chicken breeding cycle. I learned way more than I ever wanted to know about poultry.

  According to a study published by China’s Ministry of Agriculture in 2003, China is home to about 100 chicken breeds: 95 native to China and 5 imported. The local breeds have yellow feathers, while imported ones have white feathers. Compared with the white chickens, the local yellow chickens require more feed to yield the same amount of meat, have a longer growth cycle, and command a higher wholesale price. In addition, white chickens are generally bred and raised in a more adverse environment to encourage them to gain weight. On average, white chickens are given only 130 square inches of farming space, not much bigger than a shoebox. Yellow chickens, on the other hand, are mostly free range and thus are considered more natural. So Chinese people have come to see yellow chicken as the premium product. In contrast, Chinese people often associate white chickens with chemical injections, poor nutritional value, cheap meat, and inferior taste.

  After domestic media reported that KFC relied on the lower-quality white chicken, Sina Weibo and other social media networks in China lit up with consumer complaints. Netizens (a popular Chinese phrase for “citizens of the Internet”) decried the added hormones, and a picture of a chicken with six wings and four legs, ostensibly the product of too many hormones, even went viral online. The chicken’s defects could have just as easily been caused by China’s polluted water, but that wasn’t what mattered most for Yum. What was most important at the end of the day was consumer perception, and that had gone ahead of reality.

  As the events unfolded, Goldpebble and I closely tracked the reaction to the story on social media sites. We realized that mainstream media and Wall Street analysts had greatly underestimated the public’s disgust and outrage. Online, chatter about “KFC’s 45-day chicken” multiplied. Three leading Internet services, Sina Weibo, Tencent, and MSN, surveyed their users on the safety of KFC’s food. On average, nearly 80 percent of respondents declared that they wouldn’t buy KFC in the foreseeable future, while 85 percent said they considered KFC food to be unsafe. Jokes began to circulate: “Next time I get sick, I’m going to KFC. I’ll get my antibiotic fix from their chicken—it’ll save me a trip to the hospital!” All the conversation was in Chinese, however. In English, the U.S. media and American analysts continued to report that concerns over KFC’s performance were overblown.

  I was rather surprised by the controversy the issue provoked. One would think that in a country where food safety practices are as infamously lousy as they are in China, the scandal would blow over quickly. With the huge number of food quality problems in China, from gutter oil to the sale of dead pigs for meat, why did the Chinese choose to care about this one?

  To answer that question, I studied the KFC menu and those of its competitors. I started to realize that there was a critical difference between KFC in China and KFC in America: in China, menu items were viewed as luxury fast food. That might be an oxymoron to Americans, but it wasn’t to the Chinese. The price of a KFC meal in China, perhaps 25 RMB, or $4 per head, was often double or triple the price at local fast-food chains with similar offerings, such as Country Style Cooking, a local KFC knock-off. KFC’s claim to the premium segment lay in its environment—by Chinese standards, clean, spacious, well lit, and well staffed. KFC in China was not just a fast food but rather a dining experience that symbolized the quality and convenience of American life. So when Chinese consumers realized that the fried chicken they were paying a premium price for was the cheaper, fast-growing chicken rather than the 100-day chicken they typically ate, they felt extra disappointed.

  Yifeng, who happened to own a takeout delivery service in Shanghai, pointed out another factor that had thus far gone unnoticed but was highly relevant to KFC China’s future success. While most Wall Street investors considered the 45-day chicken scare a one-time event, a separate long-term trend was weighing on the KFC business model. Even more so than Americans, Chinese people were spending an increasing amount of their time shopping online.

  One of China’s most notable business success stories is Taobao, a shopping site that reached a record-high gross merchandise volume of 1 trillion RMB in 2012. Shopping on Taobao has simply become the new way of life, especially for young urban professionals. Yifeng connected the dots: online shopping means fewer trips to shopping malls, where most KFC stores in China are located. As the foot traffic in commercial areas falls, so will KFC’s profits.

  KFC clearly realized that it was losing business to the takeout services that were feeding China’s growing couch-potato population. So the company responded by rolling out new value combos to go, with free delivery services. But Chinese customers weren’t converted, for the simple reason mentioned above: they had gone to KFC not for the menu but for the dine-in American fast-food experience. For takeout services, consumers were more sensitive to price and therefore opted for cheaper local competitors.

  I had started checking into the 45-day chicken scandal, but my research now led me to believe that KFC China could be facing long-term challenges that few people realized—least of all its management.

  On November 29, one week ahead of a scheduled analyst meeting on December 6, Yum issued a press release after market close that lowered the company’s estimate for its China same-store sales growth—one of the key measures that investors in the retail sector rely upon to assess a company’s performance—to –4 percent for the fourth quarter, from a previous projection of flat or low single-digit growth. In addition, the company announced that it would open only 700 new restaurants in 2013, down from 800 in 2012. The management cited China’s slowing economy as the reason.

  Blaming slowing growth on China’s macroeconomy can be a convenient catchall excuse used by many management teams for missing Street expectations, even though their problems are clearly company specific. Yum’s press release did not even mention the chicken scare, suggesting to me that the company was still wishfully hoping the problem would go away. Regardless, investors could read the writing on the wall. Yum’s shares plunged 10 percent the day after the announcement.

  Without question, KFC had a nice run in China. As the first American fast-food chain to move into China in the 1980s, it had captured a first-mover advantage. Its success was also due to its rebranding strategy, including creating a menu localized for Chinese tastes with congee, egg tarts, more chicken wings and legs than the white meat that Americans preferred, and spicier flavors. It was also partly due to KFC’s use of a decentralized supply chain, a practice that helped KFC become far more lucrative in China than McDonald’s, which generated only 3 percent of its global profit in China in 2011.

  But as profitable as this decentralized supply chain was, it was now posing a major threat to Yum’s business. As I pored over the company’s filings, I learned that Yum! China’s supply chain consisted of more than 500 suppliers of products for its restaurant and just under 30 chicken providers, only one of which farmed its own chickens. The rest subcontracted to mom-and-pop chicken farmers all over the country for much lower costs. The quality control appeared to be very low: only 0.1 percent of the chickens sourced from contract farmers had been tested for safety. These lenient practices allowed Chinese farmers to become increasingly aggressive in abusing toxic chemicals such as antibiotics and antidepressants (used especially in the summer to calm down tightly caged chickens) to increase their yields and maximize profits. Farmers were also under pressure to find ways to offset rising feed costs.

  Those who read Chinese newspapers or watch TV cannot miss the ever-more-alarming reports and exposés about dangerous food in China. Consumers are so anxious about food safety that they often stockpile foreign products: French food company Danone, for example, saw its baby food sales spike 17 percent in the first quarter of 2013, as Chinese consu
mers bought up all the infant formula they could get their hands on.

  Danone also named Chinese demand for bottled water as a main growth driver. Many Chinese decided to begin shelling out for better-quality water when more than 16,000 dead pigs showed up in the river that was the largest source of Shanghai’s drinking water. While authorities never clarified the real source of the pigs, journalists speculated that overcrowding had led to an outbreak of a deadly disease.

  Similar quality issues also certainly affect poultry. Since big suppliers pay their contract farmers based on the size of the chicken, some small companies are known to sell unhealthy chickens as small or medium ones before they mature and their disease becomes evident. Big suppliers, such as Suhai and Dacheng, have relatively good control systems in place—Dacheng is even able to track each chicken online. Their contract farmers are far less disciplined, though, and the big suppliers do not test the contractors’ products frequently enough to ensure compliance. A big KFC supplier like Suhai would provide these small farmers with fodder, medicine, and a feeding schedule and would require that after 38 days, no more medications could be administered to the chickens. My research showed, however, that one big KFC supplier tested only 3 or 4 chickens out of every 5,000.

  In late 2012, as China’s new leaders were sworn in, it seemed that the public outcry was finally forcing Beijing’s new bosses to take food security more seriously. The government set up a food safety superregulator and tightened food safety practices, especially for mom-and-pop poultry farms. KFC China looked likely to face more frequent sampling tests and greater media scrutiny.

  But all the new findings made me wonder about the company’s long-term prospects. The 45-day chicken scare was unlikely to be a one-time occurrence for a fast-food company that drew half its business from a country haunted with food scandals, where it ran a supply chain that extended into remote areas with almost no regulation. Food quality issues are sure to come back to haunt KFC. That time it was the meat, but next time it might be E. coli on raw lettuce or hormonal eggs in the mayo.

  If KFC suffers from food quality issues again, another media scandal is sure to follow. China’s state-owned media, especially the all-powerful CCTV, is endowed with the power to cripple any company’s business for whatever reason it deems fit—perhaps to “encourage” companies to spend additional ad revenues or to promote local brands over foreign businesses. Whatever the reason, recurring media ambushes are to be expected. KFC’s management would have little to no control over the timing of such an attack or the way that events unfold and are resolved.

  Wall Street analysts usually term destabilizing factors over which a company has no control as “x factors.” It’s common sense among investors that prescribing a valuation premium to a business plagued with multiple x factors is imprudent. But Yum! Brand had both a premium valuation and x factors everywhere I looked. The deeper I dug and the more data points I pieced together, the less Yum sounded like a stable business that would make good on a 20-times earnings multiple.

  * * *

  On December 6, 2012, I was in a crowded conference room on the forty-eighth floor of the Mandarin Oriental Hotel in Columbus Circle in New York. Hundreds of other investors and I were attending the Yum analyst day (the meeting referred to earlier), an annual event that the company uses to tell investors about its performance and strategy going forward. I spotted the legendary American billionaire investor Ken Langone sitting at the back of the room. A backer of Home Depot and the former director of the New York Stock Exchange, Ken was Yum’s largest direct shareholder, with nearly 660,000 shares.

  The walls of the ballroom were covered in posters and projected slide shows. Many of them featured pictures of China, shots of happy kids waving from the Great Wall, young Chinese couples giggling together over a meal at KFC, and Chinese grandparents smiling over soft drinks. It became even clearer to me that the energy in the company’s story was China, and it would be Chinese growth that would make or break the stock.

  The CEO, David Novak, took the floor, bounding around the room in the style of a motivational speaker. Thirty minutes into his flowery speech (which made no mention of the problems that 50 percent of his business was currently encountering), he had all of us standing on our feet.

  “Let’s do a Yum cheer!” he said energetically, with his hint of a southern drawl. “Give me a Y! U! M!” he chanted, moving his arms over his head to spell out the letters. The people in the crowd—all adults in suits with seemingly important job titles—waved their arms in response. “What’s that spell?” “Yum!” the crowd yelled back. He then pointed to the new slide show—a group of Chinese kids in their red scarves raising their arms to do the same Yum cheer on the Great Wall.

  I was dumbfounded. This was a $30 billion company, and the CEO was communicating with his investors and supporters as if he were running a cult.

  Following a few more rounds of cheers—American motivational skills at their best—we were given a coffee break. I went straight up to David. After witnessing how things had unfolded in China in detail, I had quite a few questions for him.

  “Excuse me, David. What are you going to do about the negative press in China regarding the safety of your chickens?” I asked politely, with a smile. Jason had always told me to try to put management at ease when approaching them with tough questions. Try to make friends not enemies, he would say—only then would they open up to you and share their views and concerns.

  Unfortunately this strategy didn’t get me the answers I needed. “What?” He seemed lost.

  “Oh, you know, Chinese customers are concerned about the chickens that are sprouting five wings and four legs.” I mentioned some of the other media reports about the scandal.

  “It will blow over.”

  “Really? How and when?” I asked.

  “It always has.” All of a sudden, he looked confident again. “Don’t you worry!”

  “So you already have a comeback strategy,” I responded. “Would you mind sharing a few points?”

  “Go talk to my China hands.” He pointed to the two Asian ladies sitting at the front row. “We are in good hands. That’s all I know.” He then brushed me off by looking behind me and taking questions from other investors waiting in line.

  I went to speak with the China hands, but they just repeated their boss’s line: “We’ll be fine. These things blow over. Don’t you worry!”

  “Unbelievable,” I told myself. This was definitely not a management that I was willing to pay a 20-times multiple for.

  Jason used to ask me to “grade” every executive that I met. That grade became a critical factor in deciding whether an investment was worthwhile, and if so, how big a position to take in our portfolio. Without question, Mr. Novak had scored an F in my book. In fact, I was almost certain that if Jason were there, he would have called his trader to short the stock the minute he turned around (in retrospect, the trade would have worked out very nicely).

  As I headed out to grab a water, I passed by Langone. I heard him say the words “A great China story. I love it” to someone next to him.

  Thirty minutes later, the presentation resumed, with Novak’s China hands taking over the show. The presenters gestured to a graph showing a steep upward line as they discussed the growth to be had from Chinese urbanization, the process of relocating China’s massive rural population to its cities. The material was an exact rehash of the Communist Party line that appears in every mainstream state media publication. The China hands assured the crowd that, going forward, the company’s growth would be led by expanding into China’s smaller cities—cities few Americans had ever heard of.

  The discussion of Chinese urbanization infused the crowd with energy. Everyone was excited about how many more cities Yum could enter, how many stores it would open in each, and how much new profit was waiting for it. The contrarian part of my brain started to whirl.

  Many companies named urbanization as their major growth driver in China, just as Europ
eans talked of “growth” bringing them out of a recession. Unfortunately, neither urbanization nor growth is a policy, but rather the outcome of sensible policies that are executed well.

  China had been urbanizing for the past 30-plus years, from the days when I was still a schoolgirl in Shanghai and witnessed waves of people flooding into the city from the countryside. Initially Shanghai was overwhelmed, as the infrastructure couldn’t accommodate so many rural migrants. The crime rate, unemployment rate, and homeless population soared. It took a while for the city to digest these problems, and that only occurred as the economy soared as a result of mass production–driven industrialization. But that brought with it rising wages—and the question of what to do next.

  Whether this process of urbanization could continue depended on how the economy industrialized—whether it could move up the value chain away from mass production driven by cheap labor and toward value-added services. As China’s economic structure stood in 2013, there was little convincing evidence that this could take place. Furthermore, researchers had not produced the kind of detailed demographic profiling of rural areas that was needed to accurately assess the potential consumption power of those waiting to be urbanized.

  China is a vastly diverse country, with much of its wealth concentrated in the big coastal cities. GDP per capita in Shanghai, for example, was roughly $13,500 in 2012, compared with $8,000 for China’s 50 largest second- and third-tier cities. As companies like Yum focused on smaller-sized markets, it suggested to me that incremental new store openings would yield diminishing returns, as a result of both lower population density and lower income levels. What this meant was that the company’s organic growth within China seemed destined to slow down or even come to a halt.

  In theory, Yum could continue to “buy” growth in China. It had done this with its acquisition of Little Sheep, a popular Chinese chain that served the bubbling concoction that locals know as “hot pot.” Yum inked a deal to buy a controlling stake in the Chinese company in 2011. But acquisitions in this vein to further localize Yum’s food offerings would also involve operational and execution risks.