Shanghai Husi Meat Crisis Food Case Study

SHANGHAI/LOS ANGELES (Reuters) - Yum Brands Inc and McDonald’s Corp are facing a new food safety scare in China, denting the fast-food companies’ efforts to shore up reputations and businesses that were hurt by a 2012 safety scandal in one of their biggest markets.

McDonald’s and KFC parent Yum apologized to customers on Monday after Chinese regulators shut a local meat supplier following a TV report that showed workers picking up meat from a factory floor, as well as mixing meat beyond its expiration date with fresh meat.

The companies said they immediately stopped using the supplier, Shanghai Husi Food Co Ltd, a unit of Aurora, Illinois-based OSI Group, and had switched to alternatives. They added that the factory served restaurants in the Shanghai area.

The report on China’s Dragon TV brought Yum and McDonald’s back into the firing line following the sales-battering 2012 scandal that involved chicken pumped with excessive amounts of antibiotics.

“We will not tolerate any violations of government laws and regulations from our suppliers,” said Yum China, which required all of its KFC and Pizza Hut restaurants to seal up and stop using all meat materials supplied by the Husi factory.

The division, Yum’s No. 1 business unit, had just seen its KFC restaurants bounce back from the double whammy of the food safety scare and a bird flu outbreak.

“If proven, the practices outlined in the reports are completely unacceptable to McDonald’s anywhere in the world,” a China-based spokeswoman for McDonald’s told Reuters.

Husi provided McDonald’s with chicken, beef and lettuce, a McDonald’s U.S. spokeswoman said.

China is McDonald’s third-biggest market as measured in number of restaurants.

“I think this is going to be really challenging for both these firms,” said Benjamin Cavender, Shanghai-based principal at China Market Research Group. “I don’t know that this is something an apology can fix so easily, because at this point people don’t have a whole lot of trust that they have good systems in place,” he added.

Yum shares fell 4.2 percent to close at $74.13 and McDonald’s shares lost 1.5 percent to $97.55.

“Although the issue is being addressed, we would not rule out the possibility of temporary sales disruptions,” Baird analyst David Tarantino said in a research note lowering his target price on the company.

The Shanghai Municipal Food and Drug Administration shut Husi down on Sunday after the local Chinese TV broadcast aired. In addition to the meat safety violations, the program showed workers saying that if clients knew what they were doing, the firm would lose its contracts.

OSI said on its Chinese website that management was “appalled by the report.” The company said it has formed its own investigation team, is fully cooperating with government inspectors and will take all necessary actions based on results of the investigation. “Management believes this to be an isolated event, but takes full responsibility for the situation,” OSI said.

OSI, which has close to 60 manufacturing facilities worldwide and had revenue of more than $5 billion in 2012, has been supplying McDonald’s in China since 1992 and KFC and Pizza Hut parent Yum since 2008, according to its website.

SUPPLY CHAIN ISSUES

McDonald’s and Yum are the top two brands by sales in China’s $174 billion fast-food market, according to Euromonitor, but face a challenge as local firms try to tempt cost-conscious diners with healthy, home-grown fare. Both companies said they are investigating the issues highlighted in the report and said that switching suppliers will cause some temporary product shortages.

News of the scare spread quickly to diners negotiating Shanghai’s lunch-hour rush on Monday.

“For now I won’t go to eat at McDonald’s or KFC, at least until this whole thing settles down,” said Xu Xinyu, 24, a financial services worker, eating at a noodle shop near a McDonald’s outlet in downtown Shanghai.

Yet Chinese consumers may already have developed a comparatively thick skin when it comes to food scandals. “Isn’t everywhere like this?” asked student Li Xiaoye, 20, eating a beef burger in a Shanghai McDonald’s outlet. “I’ll keep going because wherever I eat, the issues are all the same.”

The incident highlights the difficulty in ensuring quality and safety along the supply chain in China. Wal-Mart Stores Inc came under the spotlight this year after a supplier’s donkey meat product was found to contain fox meat. It also came under fire for selling expired duck meat in 2011.

OSI is one of McDonald’s key meat suppliers and has a good reputation, according to an industry insider speaking on condition of anonymity. He added the incident highlights the issue firms face enforcing strict processes with local staff.

As well as Yum and McDonald’s, OSI listed Starbucks Corp, Japan’s Saizeriya Co Ltd, Papa John’s International Inc, Burger King Worldwide Inc and Doctor’s Associates Inc’s Subway brand as clients in China, according to a 2012 press release.

Burger King shares fell 1.6 percent to close at $26.13.

A Starbucks spokesman told Reuters that the company does not now have any direct business dealings with Husi Food.

Burger King, Subway, Papa John’s and Saizeriya did not immediately respond to requests for comment.

($1 = 6.2088 Chinese Yuan)

Our Standards:The Thomson Reuters Trust Principles.

Additional reporting by Engen Tham and Shanghai newsroom and by Lisa Baertlein in Los Angeles; editing by Kazunori Takada, Kenneth Maxwell, Jilian Mincer, Matthew Lewis and Peter Galloway

“It was definitely a head scratcher to me,” said Adam Aronson, chief executive of Arrowsight, which provides remote video auditing of OSI plants in the United States. “They spend a lot of money on food safety systems, more than most others.”

That OSI — which other suppliers have looked to as a model — is dealing with these issues speaks to the broader weaknesses in the Chinese food safety system. After a series of food safety scandals in recent years, regulators repeatedly have promised to tighten food safety standards only to have another problem arise.

The country is making strides. Last month, the University of California, Davis and the Northwest Agricultural and Forestry University in Shaanxi Province started laying the groundwork for establishing a joint research center for food safety in China. Roger Beachy, executive director of the U.C. Davis World Food Center, said the Chinese government had made food safety a top priority, particularly as it looked for consistent supplies to feed its rising middle class.

But China is also playing catch-up to more developed nations — and on a much grander scale. “Companies have grown so fast, but the rate of growth hasn’t been met with equally robust systems for training and educating the work force,” Mr. Beachy said.

OSI said in a statement that what had happened at the Shanghai facility was “terribly wrong” and “completely unacceptable.” The company has reassigned executives in its China operations and started an investigation into the matter. It has also promised to bolster its systems. OSI has reached out to Arrowsight to help improve its processes in China.

“We will bear the responsibility of these missteps and will make sure that they never happen again,” OSI said. The company declined to comment further.

Although the company had been in China for two decades, OSI embarked on a $400 million rapid expansion plan in 2011 that included three new poultry production and processing facilities and additional capacity at its Shanghai and Beijing plants. “The goal was to completely recreate the U.S. system — from feeding and watering regimes down to the exact rate of air flow and size and placement of windows in the poultry houses — but to make it locally relevant,” according to a 2013 Harvard Business School case study about OSI’s China business by Prof. David E. Bell.

At the three new facilities, the company used a so-called vertically integrated model, giving OSI greater control over its product, from the selection of breeding birds to packaging for shipment. “For companies that have absolute raw material control, they get top priority and have a selling point around food safety,” Dennis Zhang, general manager of Husi Foods, OSI’s Chinese operation, told The National Provisioner, a trade publication.

But it also posed a new challenge for its bottom line. McDonald’s and KFC wanted to buy only the dark meat that Chinese consumers demand, which meant OSI was saddled with finding new customers for the rest of the bird, around 80 percent of it.

OSI’s strategy in China seems to have become a standard for other foreign food companies setting up shop.

Last year, Tyson, the world’s largest meat-processing business, began adopting a similar strategy for its poultry business in China, which started in 2001. And Nestlé, which is facing a lawsuit over pet treats containing ingredients from China and sold under the Waggin’ Train and Canyon Creek Ranch brands, said this year that it was moving to a single supplier for raw materials sourced in China.

Dan Fogleman, a spokesman for Tyson, said in an email that in addition to Chinese government oversight, the company deployed “dozens” of food safety and quality assurance workers in its facilities to verify compliance with its standards and existing regulations. Those workers do not report to local management but rather directly to corporate headquarters in Arkansas.

“This independence ensures that their function is dedicated solely to food safety and quality monitoring, rather than any financial goals,” Mr. Fogleman wrote.

OSI also passed muster with the United States government. The Shanghai plant was inspected by the Agriculture Department in 2004 and 2010 — and given a clean bill of health both times. “The sanitary conditions and general operations of the establishment currently meet FSIS’s requirements and appear to be in compliance with PRC regulatory requirements,” the audit team wrote, referring to the People’s Republic of China.

Experts in food safety and plant operations say, however, that even the most rigorous protocols and standards can be undermined by culture, particularly at a fast-growing company — OSI’s revenues doubled between 2011 and 2013 — in a country where high monthly turnover of factory workers is not uncommon.

“The average Chinese factory worker comes from someplace where food has likely been scarce and picking up a piece of meat that has dropped on the floor and eating would not be unusual — it’s not unusual for us to drop food on the floor and anyway eat it,” said Andy Tsay, a professor of operations management at Santa Clara University who was one of the authors of a paper on recalls of Chinese made products in 2007.

Steve Gruler, chief executive of Global Quality Consultants, a firm that provides risk management advice to a variety of companies, recalled visiting a grain elevator in China where workers were unloading grain onto trucks. “A plume of dust comes from under the door of the elevator and rises up over the truck,” Mr. Gruler said. “Our eyes got about as big as saucers.”

Grain dust is highly combustible and such explosions have been deadly. Mr. Gruler and a colleague asked the engineer at the facility whether it had a dust collection system. “Oh, yes, he said, but it had been shut off to conserve electricity,” Mr. Gruler said. “He didn’t understand that dust could cause an explosion that would blow the place apart.”

OSI itself acknowledged such challenges in interviews with Professor Bell of Harvard. “When we began building modern broiler houses, we found that the workers often took shortcuts even though every detail was spelled out in the plans,” Stefan Chen, senior vice president and general manager for OSI’s poultry operations in China, told him. “For instance, they would change the size of a window to save material. This seems like a small thing, but it affects the ventilation, which affects the production efficiency.”

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