Nationwide Reaction of Chinese KFC Consumers to Shanghai Husi Food Scandal

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1 Nationwide Reaction of Chinese KFC Consumers to Shanghai Husi Food Scandal Aug 5, 2014 Analysts: Junheng Li Background: Earlier this year, an undercover journalist snuck into Shanghai Husi Food Co. with a hidden camera. The recording shows 18 tons of expired chicken meat long past its shelf life, based on the expiration date on the package -- being used to make Chicken McNuggets on the production line. On July 20, Shanghai Dragon TV used this video footage in a televised segment, which reported that Shanghai Husi Food Co. supplied food products using expired meat to KFC and McDonald s. On Aug 4, 2014, we conducted an online survey of more than 400 Chinese KFC consumers, of whom 20% were residents of tier-two (T2) cities, 40% were from T3 cities, 20% were from T4 cities, and 20% were from T5 cities. In our analysis, we combine T2 with T3 residents, and T4 with T5 residents, labeling the two groups as large city residents and small city residents, respectively. The purpose of the survey was to understand the impact of the latest meat scandal outside of the greater Shanghai area on a national scale. Survey Design: At the beginning of the survey, we asked participants to indicate the types of restaurants they have dined in in the last two months, and then to select the names of the QSR visited if and only if they have selected Western-style QSR in the previous question. This screening process ensures that only those consumers who have dined at a KFC restaurant at least once in the past two months were admitted into the survey. Overall, the survey results show consumer reactions to the food scandal were similar among large city residents (T2/3 residents) and small city residents (T4/5 residents). The meat scandal has had negative impacts on consumers in both large and small cities, and more than half respondents indicated they are not satisfied with the responses of KFC and McDonald s. The following chart illustrates consumer preferences for various Western-style QSRs. Given the screening process, only those who have visited a KFC at least once in past two months were selected for the survey.

2 Western-style QSRs visited in the past two months KFC 100.0% 100.0% McDonald's 60.0% 79.4% Pizza Hut 35.0% 65.0% Dicos 45.9% 46.3% Other 3.8% 10.0% T2/3 City T4/5 City Details: All survey participants indicated that they had heard of the food scandal. More than half of the participants in both large and small city said they were not satisfied with KFC and McDonald s responses to the food scandal. Are you satisfied with responses by KFC and McDonald s? T2/3 T4/5 Satisfied 21.3% 13.8% Not satisfied 58.4% 57.5% Lost confidence & will not go back again 17.5% 20.0% Have not seen their responses 2.8% 8.8% More than 70% of survey participants in both large and small cities stated they will not consumed any foreign fast food in the near future.

3 What do you think of the repeated food safety issues at KFC and McDonald s in the past two years? T2/3 T4/5 Won't have any foreign fast food in the near future This is normal in China and played up by the media. Their business will recover soon I don't care. I've been eating them and didn't get sick 70.6% 71.3% 22.5% 20.0% 6.9% 8.8% Among residents of small and large cities combined, 49.5% of survey participants reported that they would not visit KFC in the near future due to the meat scandal. After this meat scandal, will you visit KFC again? 8.0% 42.5% 49.5% Not in the near future Will reduce visits will not reduce visits About 1/3 of both small and large city residents said they felt comfortable with the food items that are still available. Large city dwellers said they would be more cautious about food items with meat if they were to visit KFC at the moment.

4 If you were to visit KFC now, what would you order? T2/3 T4/5 Anything that's still available 27.5% 30.0% Won't order anything with meat 11.3% 1.3% Only beverages, coffee, or ice cream 34.4% 38.8% Won't visit KFC in the near future 26.9% 30.0% Surprisingly, small city dwellers appeared to be more disappointed about the meat scandal: 25% said they would not return to KFC or McDonald s for the next six months, compared with 18.8% in large cities. On the other hand, 1/5 of residents in both small and large cities said they would not change their dining habits because of the meat scandal. When will you start dining at KFC and McDonald s again? T2/3 T4/5 Will not change dining habits 20.9% 21.3% After 1 to 3 months 26.6% 27.5% After 3 to 6 months 20.6% 13.8% After 6 months 18.8% 25.0% Won't go until the media stops reporting 8.4% 7.5% Won't go there anymore 4.7% 5.0% The following table is a comparison of consumer reactions to KFC and McDonald s. Small city dwellers had a more positive perception of KFC, since KFC had fewer menu items with expired meat. Which brand do you think was impacted more by the scandal, KFC or McDonald s? T2/3 T4/5 They both used bad meat, so they are the same to me KFC had fewer food items with bad meat, which makes KFC safer 75.3% 70.0% 24.7% 30.0%

5 Summary: The results suggest that the meat scandal and the subsequent negative media exposure have had a negative material impact on KFC s business in China. We now estimate that nationwide KFC sales will likely be down ~15% from the 2012 level in Q Moreover, repeated food safety issues over the past two years will likely mean that KFC China suffers from brand erosion. This means that it now will take longer for consumers to regain their confidence in the brand compared with scandals in earlier years. We now expect that the company s goal to normalize its sales back to 2012 level this year will not be realized. During the recovery, KFC China will incur additional legal fees, as well as the cost of a new marketing campaign to reestablish itself as a reliable American fast food leader. Therefore, in H2 we expect the company s profit margins to fall as a result of declining sales and additional recovery costs.