Finding Supersized Profits in Fast Food
Christopher is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Now that most of the major restaurants in the fast food industry have reported their second-quarter earnings, investors are attempting to decipher the widely disparate results in order to create an accurate macro-level picture of the sector as companies attempt to navigate the shaky economy and convince weary consumers to part with their increasingly scarce income.
The news was dominated by McDonald's (NYSE: MCD), which is by far the largest fast food restaurant in the country in terms of revenue, when they surprised investors three weeks ago by reporting that year-over-year net income fell by more than 4 percent during the quarter, which missed the consensus estimate of analysts by five cents per share. Things only got worse last week when they reported that same-stores sales, one of the most closely scrutinized numbers in the restaurant industry, actually fell in July, missing both analysts' expectations and their own previous guidance.
McDonald's cited weakness in international markets, which account for nearly 70 percent of its revenues, for these unexpectedly poor results, a fact that was not lost on investors of other restaurants that have been focused on expanding into foreign countries. For instance, Yum! Brands (NYSE: YUM), whose KFC and Pizza Hut restaurants have been operating in China for more than 20 years, saw profits drop in that rapidly growing country during the quarter, a bad omen for a company that derives more than 72 percent of its revenue from overseas – including half from China alone.
Although the company expects conditions to improve in China – a somewhat dubious proposition given slowing output and retail sales – they had to rely on the domestic profits of Taco Bell to buoy earnings by 5 percent during the current quarter. Taco Bell has benefited from a bifurcated strategy in which it has simultaneously targeted both the low end of the fast food market with its traditional cheap fare, including the very popular Doritos Locos taco, and the higher end of the market with its recently introduced Cantina Bell menu.
This latter initiative has been embraced by several leading fast food restaurants, which have been searching for ways to produce growth in the very saturated American market. Wendy's has been one company that has had success in implementing such a strategy by introducing premium food items and renovating its traditionally dull retail locations. Meanwhile, Burger King (NYSE: BKW) saw its profits jump 60 percent as the company benefited from its own renovation strategy that includes an updated menu of coffees, smoothies and salads.
Companies like Yum! Brands, Wendy's and Burger King are attempting to piggyback off the success of so-called “casual fast food” restaurants like Chipotle Mexican Grill (NYSE: CMG) and Panera Bread (NASDAQ: PNRA). However, even these companies have demonstrated the schizophrenic nature of the current fast food environment. Chipotle recently saw its shares drop by more than 20 percent after it missed analysts' earnings expectations. Investors who had bid up the richly valued company to nearly 60-times earnings were unimpressed by 56 percent earnings growth; instead, they focused on the 8 percent growth in same-store sales, which, although impressive, was their weakest number in the last eight quarters.
Chipotle's second-quarter results put downward pressure on Panera, another company that had significant growth expectations already priced into its stock, as investors feared that similar problems would befall the popular bakery-cafe, but those fears turned out to be completely unfounded. Panera managed to beat expectations for both earnings and same-store sales, which helped the stock recover all of its recent losses from the Chipotle earnings release.
When taken together, it is difficult to deduce any clear patterns throughout the entire industry. Although many restaurants are implementing upscale renovations and international expansions, the success of those initiatives have been decidedly mixed. Wendy's and Burger King have had some success with premium food offerings, but Chipotle's rapid growth – attributable in large part to its high-quality ingredients – may be starting to stall. At the same time, weakening international growth has hurt McDonald's and Yum! Brands, but Burger King has bet big with expansion plans into China, Russia and much of the rest of the world.
In short, the fast food industry has become something of a stock picker's market. Of course, all the companies in the industry are facing pressure from the weak economy, and these challenges could become more difficult if the price of corn – a key input for fast food restaurants – continues its rapid accent. Indeed, the NPD Group, a consumer market research company, has estimated that growth in the industry will be nonexistent over the next two years.
However, it is the idiosyncrasies of fast food restaurants' specific growth strategies that seem to be the driving force in current investment returns, and those companies that can efficaciously combine an upscale domestic offering with well-managed international growth could provide excellent above-markets returns even if the economy fails to improve.
cjcoyle has no positions in the stocks mentioned above. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Panera Bread. Motley Fool newsletter services recommend Burger King Worldwide, Chipotle Mexican Grill, McDonald's, Panera Bread, and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.