7 Facts That Suggest KFC’s Future in China Could Get Worse

Yum! Brands, which owns KFC and Pizza Hut, has passed its golden age of rapid growth in China. A string of food safety scandals has weakened the appeal of a company that depends heavily on the Chinese market. But the deeper problem is its failure to innovate.

KFC may never get back to its good old days in China.

On October 8, U.S. time, KFC’s parent company, Yum! Brands (YUM), released its results for the third fiscal quarter of 2014. Revenue in China fell 9.5% to US$1.84 billion, while operating profit plunged 40% to US$202 million. KFC was chiefly responsible for the poor showing. Same-store sales across Yum China fell 14% during the quarter.

KFC is Yum’s most important business in China, accounting for 78% of its 6,387 stores there. Pizza Hut, another major Yum brand with a broad following, is struggling too. Its same-store sales fell 11% in the third quarter.

Yum once claimed several firsts in China. KFC has about 5,000 stores and has ranked first among restaurant companies for years. Its chief rival, McDonald’s, may be more famous, but it had only 2,000 Chinese stores as of April this year. When KFC first arrived, it was such a symbol of what was fashionable that young couples even held wedding banquets there. Pizza Hut presented itself as an introduction to Western dining. Many people born in the 1980s and 1990s in first-tier cities celebrated birthdays there. Yet when Pizza Hut comes up today, many people still recall guides to building a “salad tower”—how to pile the biggest possible serving of self-service salad onto one plate. That popular offering was discontinued back in 2009.

KFC signs are now everywhere, from fourth- and fifth-tier cities to some towns. But the chain has lost its former shine. Why? Analysts point to a limited range of products, food quality problems and changing tastes. Those are all reasons. But when the same explanations recur year after year, something deeper is at work. None of these changes came without warning. Why has Yum failed to deal with them?

1. Why does Yum look more like a Chinese company?

When times get tough for a global company, “open up the Chinese market” can sound like the answer—a new engine for growth. Yum offers two lessons: it can work remarkably well, but counting on China as a permanent fix can leave a company worse off. Just look at Yum now.

After more than 20 years in China, Yum has grown into something like a Chinese company. Few foreign brands depend so heavily on the Chinese market. In 2004, Yum China was separated entirely from Yum! Brands International and began reporting directly to U.S. headquarters. For a long time afterward, China mattered more to Yum’s global business than its home market, the United States. In 2013, China supplied nearly half its revenue and 35% of its operating profit. Even after a sharp fall in operating profit, Yum China still accounted for 50% of the company’s US$404 million in third-quarter profit.

It has been said that investors buy Yum shares for China’s long record of rapid growth, not for its U.S. business.

At the same time, Yum has run into a problem familiar to fast-growing restaurant companies in China: losing control of product quality as they expand.

The market on which Yum has pinned so much hope has brought one problem after another over the past year or two. In 2013, following revelations in late 2012 about “fast-grown chickens” and an avian flu outbreak during the 2013 Spring Festival, Yum China’s same-store sales fell for four consecutive quarters. They dropped by as much as 20% in each of the first two quarters, then by 11% and 4% in the third and fourth.

The trouble did not end there. On July 20, 2014, news reports revealed that Shanghai Husi Food, a supplier to fast-food chains including McDonald’s and KFC, had used expired meat. Another decline in results was all but expected.

Food safety incidents in China have cost Yum more and more. In fact, it has never escaped food quality problems over the past decade.

In early 2005, Sudan Red dye was found in the seasonings for KFC’s New Orleans grilled wings and New Orleans chicken burger. It was KFC’s first food safety incident since entering China in 1987. Five products implicated in the scandal were withdrawn. According to KFC: The Chinese Evolution (《肯德基：中国式进化》), the chain’s 1,200 Chinese stores lost more than 30 million yuan in revenue over five days.

That crisis did not affect Yum’s reported results, however. Even the avian flu outbreak that spread around the world in 2004 reduced KFC China’s performance by only 1% in the following month. The fast-grown chicken scandal and the later avian flu outbreak, by contrast, weighed on Yum China’s results for a full year. Yum expects a further decline in the current quarter because of the Husi incident.

“We aren’t particularly optimistic about a rebound. It may take quite a long time for consumer confidence to recover,” Wan Hui, a senior market research analyst at Euromonitor International, told QDaily. The global research firm studies and forecasts consumer behavior and habits, with particular attention to restaurant and fast-moving consumer goods brands.

Yum recovered quickly from earlier crises largely because they coincided with rapid growth in China. That growth let it present investors with better figures. Now consumers have more choices and higher incomes, and are more alert to food safety and health. China is changing in other ways as well. Yum’s biggest problem is that it still does not seem ready to take being a Chinese company “seriously.”

2. Why does Yum ultimately sell restaurants rather than fried chicken and pizza?

China’s huge demographic dividend helped drive its economic success. It also underpinned the rapid growth of almost every company. Yum spotted the opportunity early in its first two decades: expand, open stores, grow.

Combine that demographic dividend with Yum’s strength at running chains and its success is easy to understand. Yum entered China in 1987, opening its first KFC on Beijing’s Qianmen commercial street. According to KFC: The Chinese Evolution, it took nine years to open 100 stores and another eight to add 900, reaching 1,000 in 2004. It took just over three more years to grow from 1,000 to 2,000. KFC now has more than 5,000 Chinese stores; Pizza Hut has more than 1,000.

Figures reported by The Economist in August 2004 put Yum’s worldwide restaurant count at 34,000, more than 2,000 ahead of McDonald’s. Yum China had become crucial to the group’s global lead.

From 2004 onward, Yum maintained annual store growth of 20% in China. Even in its difficult year of 2013, it opened an average of 2.19 stores a day.

Sam Su deserves much of the credit. David Novak, then chairman and CEO of Yum! Brands, once said, “Under Sam Su’s leadership, the China team built a growth machine.”

Yum’s ultimate product may be the restaurant itself, more than the fried chicken or pizza it serves. That is the value its chain model created.

But the model is running into limits. By the end of 2013, KFC China had 4,600 stores and sales of 50.2 billion yuan. Its store count had risen 15.4%, yet sales fell 3.8%. Over the same period, McDonald’s grew its store count by 16.7% and its sales by 14.4%. Pizza Hut added 25% more stores, but its same-store sales rose just 4%.

Revenue from existing stores is falling, and margins are narrowing. In 2013, Yum’s worldwide restaurant margin fell from 18.9% to 17.6%, with its China business recording the steepest decline. Yum’s gross margin had been 22.1% in 2011.

There is another limit: Yum China has little room left to expand. KFC has already reached fourth- and fifth-tier cities and even towns. Pizza Hut has so far expanded only into second-tier cities and is still doing reasonably well, but its fading appeal in first-tier cities will soon become a problem in second-tier ones. Without substantive action, it looks likely to follow KFC’s path. As Yum’s more upscale brand, Pizza Hut ought to have offered first-tier city customers an alternative to KFC. So far there is little sign that it can. Competition in pizza is already fierce.

Domino’s entered China in 1997 and Papa John’s in 2003. Local brands including Babela and Haolunge also entered as affordable Western-style casual restaurants. None approaches Pizza Hut’s store count, but all are eating into its market share. On July 12, Hony Capital, the private equity firm under Legend Holdings, spent about £900 million—roughly 9.55 billion yuan—to buy the British casual-dining brand Pizza Express outright. The deal is bound to intensify competition.

In its third-quarter 2007 report, Yum described Pizza Hut’s position as facing “No Significant Competition.” Those may have been Yum’s best days: it led in store numbers and enjoyed rising recognition.

But those years concealed a problem that may now be widespread in China: expansion cannot solve everything. As the demographic dividend runs out, what else can multinational companies do in this market?

3. Marketing, marketing, marketing: Yum keeps reaching for it, though the problem lies elsewhere

Many people came to know Yum China CEO Sam Su through a KFC advertisement last year. In the campaign, titled “I Promise,” Su appeared on camera to stress repeatedly that KFC’s chicken was safe. From the Sudan Red case to the Husi scandal, Yum’s response to crises over the past decade has varied little: run ads, then run bigger ads.

First came “KFC will do better in the future,” then the “I Promise” ad featuring Su, and now endorsements from suppliers including COFCO and Nestlé. KFC seems to have tried almost every idea it has. Consumers have become increasingly unmoved; internet users even parodied Su’s ad. “The ad caused a stir in the industry, but it didn’t actually work well,” Wan Hui said. It appeared six months after the fast-grown chicken scandal, she noted, and making such a promise at that point could make people think the earlier allegations were true.

Advertising after a crisis is a standard and defensible public relations response. It can solve part of the problem. But amid repeated food safety incidents over so many years, Yum failed to find a more fundamental answer—one that would keep consumers from abandoning the whole brand when there was a problem with chicken. As things stand, a chicken scandal can hurt even Pizza Hut, which sells pizza. (McDonald’s has done little better than KFC on this score.) Seen this way, KFC’s many non-chicken products have done little to strengthen the brand, however much fanfare accompanied their launches.

Yum plainly tries to solve problems through marketing. That may have something to do with the backgrounds of its professional managers in China. Before joining KFC in 1989, Su worked for Procter & Gamble in Germany and Taiwan. Fast-moving consumer goods companies excel at marketing and rely on advertising to draw customers. The two businesses are not identical, but their underlying logic has much in common.

The impulse to solve everything through marketing often starts with how headquarters measures performance. Despite the large profits it contributes, Yum China is chiefly an organization charged with carrying out plans. Its managers, from top to bottom, are expected first to meet sales targets. The pressure to fix the immediate problem breeds strategic shortsightedness. A focus on short-term results then spreads through the business until it becomes part of the company’s character.

4. Its chain model and focus on marketing led Yum to overlook changing consumers

The New York Times once described KFC’s first Beijing restaurant this way: “Every day at lunchtime, the Beijing KFC fried-chicken restaurant was packed, with lines several people deep. The branch near Tiananmen, at Qianmen, set KFC’s record for sales at a single store. It was the largest and most profitable chain restaurant in the world.” In a 2004 ACNielsen survey of 30 Chinese cities, KFC ranked first among the international brands customers visited most often.

KFC and Pizza Hut were once seen as “upscale” restaurants. They have since lost their pull. Perhaps the clearest sign is the question: “Who goes on a date at KFC or Pizza Hut anymore?” Never mind getting married there.

Many young working adults, especially those born in the 1980s, were once loyal customers of both chains. Now they may prefer Starbucks. If they simply want a meal, a convenience-store lunchbox may be easier—and perhaps healthier.

In one sense, KFC has watched the wrong competitors. McDonald’s launched McCafé to compete with Starbucks and repeatedly updated its restaurants’ look to keep young customers. KFC, meanwhile, failed to study the competition deeply, whether the familiar McDonald’s or Dicos, a fried-chicken chain that grew out of second-tier cities. When opening stores is the strategy, attention goes to securing the best sites and entering new markets ahead of rivals. That leaves less room to study consumers themselves.

5. Yum’s biggest problem in China looks like product quality. At its core, it is product innovation

People no longer want fried chicken—or are wary of eating it.

Even when KFC ran into product quality problems in 2004, customers may have felt there was no substitute for it. They no longer feel that way.

KFC changes about 25% of its menu each year, raising purchasing costs across its supply chain. It now relies mainly on seasonal purchasing to control those costs. An industry insider told QDaily that most of the frequently introduced items are “bit players” unlikely to stay on the menu: Golden Top-Hat Shrimp, Fried Starfish, French-Style Flatbread and the Tender Beef Wrap, for example.

New products can give sales a short-term lift, but they cannot sustain growth. “KFC’s new-product strategy was designed to bring in customers in the short term, not to keep every item on the menu forever—unless one proved especially popular,” a former employee who spent 14 years at KFC told QDaily. Such successes are rare. That also suggests how little effort KFC puts into developing them.

KFC has brought little innovation to its operations, either. Its 6-yuan breakfast, 15-yuan lunch, round-the-clock opening, better coffee, dinner offerings and dessert stands all followed moves by McDonald’s. “The only operating idea KFC introduced first was afternoon tea, and that didn’t work well,” the insider said. KFC has been unable to set the direction for restaurant operations. Under heavy pressure to meet growth targets, its focus on short-term results is understandable.

Yum has long wanted a share of the rice-dish market. The insider said he had personally seen KFC’s Shanghai research team buy every rice product they could find at FamilyMart, Lawson and 7-Eleven. Yet KFC’s ad promising to “make rice dishes with care” was mocked on Weibo as “make rice dishes with a stepmother’s care.” The food has acquired neither a distinctive identity nor a competitive edge.

KFC has lost ground even in chicken, its traditional strength. McDonald’s grilled chicken thigh burger took a substantial share of the chicken market, while its proprietary double-sided grill kept KFC from offering a similar product. KFC’s Tender Beef Wrap, for its part, does not seem to have taken much business from McDonald’s. It disappeared from the menu long ago.

(McDonald’s grilled chicken thigh burger)

The central obstacle to product innovation is that traditional fried chicken still supplies the largest share of Yum’s profits. The rest of the business is bound to it. People developing new ideas may see the problem, and decision-makers may understand where tastes are heading. But when sales are the ultimate measure, managers are unlikely to tackle the deeper challenge of future growth. Meeting this year’s performance targets is more urgent.

Yum got off to a good start in China by catering to local tastes. But that advantage drew on its existing North American business, rather than any unusual ability to adapt and innovate.

6. Chinese eating habits helped Yum beat McDonald’s, but “localization” never became a strategy

Yum’s success in China is commonly credited to localization, often seen as the one thing that let it beat McDonald’s. In the United States, McDonald’s barely regarded the fried-chicken chain as a rival. KFC could hardly have imagined how well it would suit Chinese appetites: Chinese consumers prefer chicken to beef.

We cannot establish whether this preference gave rise to Yum’s localization strategy, but it certainly offered a clue. In 2008, KFC announced a plan to “create a new kind of fast food and change for China.” That year it introduced youtiao, or fried dough sticks, and soy milk. Rice meal sets followed two years later.

Look closer, though, and much of that “localization” appears to be marketing, rather than a genuine change for China.

First, most foods labeled as Chinese arrived as part of KFC’s rotating menu—a familiar way to draw customers with new items. Few became permanent. Its early Mapo Chicken Rice is long gone, while the youtiao—whose taste we will leave unjudged—are served only at breakfast.

“KFC has a ‘concentric circles’ policy for products,” an industry insider told QDaily. “Fried chicken is at the center. Chicken wraps and burgers are in the second ring, coffee and similar products farther out. The outermost ring holds the new items that come and, for the most part, disappear. Almost no new KFC product makes it into the center. Even a bestseller like the Old Beijing Chicken Wrap is doing well to reach the second ring.” By that measure, the products introduced to show KFC was “changing for China” occupy the least important place. McDonald’s, a beef-burger chain that began selling Chicken McNuggets in China, arguably looks more committed to localization.

In 2007, Yum opened its first Chinese fast-food restaurant, East Dawning, at Metro City in Shanghai’s Xujiahui district. It was hailed as the fullest expression of Yum’s localization and even as a possible new source of growth alongside KFC and Pizza Hut. Seven years later, East Dawning has just 17 stores in China, 12 of them in Shanghai.

In all that time, East Dawning has failed to produce a standout product that could give it an edge. Its vague identity is the chief reason for its failure. In the end, its only selling point was that it was “KFC’s sibling brand”—and now KFC itself is struggling.

Little Sheep is another failed case. Yum began acquiring the hot-pot chain in 2010 to claim a bigger share of Chinese dining. But Little Sheep offers traditional hot pot: it cannot match the prices of a quick-service chain such as Xiabuxiabu or the service of a chain such as Haidilao. The explanation may be that Yum excels at opening restaurants, not inventing products.

Localization does not necessarily guarantee success in the restaurant business. Still, with Yum’s command of chain operations and its management experience, it could have made a much bigger move into Chinese fast food, even amid these difficulties. Instead, it barely tested the water.

Whether consumers question the safety of chicken because of avian flu and the fast-grown chicken scandal, or increasingly regard fried food as unhealthy, Yum has offered no long-term response. Its answers have focused on the most pressing decline in sales figures, not on what to do in the years ahead. What it lacks most now is something called “strategy.”

7. Companies inevitably age. That is more alarming when their decision-makers are far away in America

Several people who have dealt with Yum for years point to the same fact: employee turnover is low, and some positions have been held by the same people for many years.

That alone is not fatal. But it is a danger for a fast-moving consumer goods company, and more troubling for a multinational whose decision-makers are far away in America.

We do not intend to dwell on an aging workforce, but the issue deserves attention. Yum has operated in China for 27 years since 1987, and many multinationals have been there for nearly 30. The ailments once ascribed to state-owned enterprises—bureaucracy, fading momentum and rigid habits of thought—can now be found in these companies too.

Together, these problems explain the company’s decline.

From the 1990s until about 2005, Yum enjoyed a golden age in China. The country’s restaurant industry benefited from the dining spaces and ideas about service it brought with it. But something Sam Su said in 2007 still applies: “The Chinese market is always changing. We hope to grasp those changes sooner and faster than our competitors, and to innovate.” Yum now faces a much less predictable market. It needs to rethink innovation from a different angle.