By Adam Jourdan and Lisa Baertlein
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)
(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)