A Leader, a Comeback Kid and Two Hungry Challengers in the Fast Food Sector

Leo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When many investors think of an all-weather, recession-proof sector, they often think of the fast food industry. In the United States, the average American eats fast food four to five times a week - a frequency that is unlikely to fluctuate greatly in times of economic prosperity or prolonged recessions. However, that generalization is broad and is better suited for assuring newer investors that big blue chip stocks with simple business models tend to outperform the market in the long run.

Although many fast food companies, such as McDonald’s (NYSE: MCD) and Yum! Brands, have held up well throughout economic downturns, others haven’t been as lucky. Burger King nearly went bankrupt in 2010 before being taken private and restructured by 3G Capital. Wendy’s (NASDAQ: WEN) had to sell Arby’s in 2011 to get its growth back on track.

In addition, rising commodity prices can crimp margins and high exposure to struggling international markets can dent revenue growth. Therefore, should investors consider fast food restaurants good or bad long-term investments? Let’s take a look at several key trends moving the industry today.

McDonald’s is not a bellwether

For too long, McDonald’s, the largest hamburger chain in the world, has been considered a bellwether stock of the fast food industry. However, investors shouldn’t use McDonald’s earnings as a yardstick to compare all other restaurants to, due to its high exposure to Europe and other troubled markets.

During the second quarter, McDonald’s adjusted earnings came in at $1.38 per share, up from the $1.32 it reported in the prior year quarter. Revenue rose 2.3% to $7.08 billion. McDonald’s earnings and revenue missed consensus estimates, which called for the company to earn $1.40 per share on $7.10 billion in revenue.

Although U.S. and total global same-store sales both rose by 1%, those gains were offset by flat performance across Europe and the Asia/Pacific, Middle East, and Africa (APMEA) region. Europe generated 39% of McDonald’s top-line in 2012, the U.S. comprised 32%, while APMEA accounted for 23%.

Same-store sales fell 0.1% in Europe due to weaker demand in Germany and France, and dropped 0.3% in the APMEA region on account of weak sales in Australia, Japan and China. However, sales in the U.K. and Russia remained robust.

Over the past year, McDonald’s high exposure to Europe and Asia have become liabilities rather than assets, throttling its growth in comparison to its rivals, which have more exposure to the U.S. market. Therefore, it would be unwise to consider McDonald’s to be a bellwether stock.

The Bistro Effect

Rather than pay attention to McDonald’s earnings, fast food investors should be aware of the “bistro effect” that is rippling throughout the industry. This idea, which started with Chipotle Mexican Grill (NYSE: CMG) and Panera Bread (NASDAQ: PNRA), emphasizes higher quality, healthier food in a more upscale, bistro-like environment in comparison to low-end fast food restaurants.

That idea has paid off handsomely. Over the past five years, Chipotle and Panera’s revenue have surged 131% and 77%, respectively. By comparison, McDonald’s revenue only rose 16.5% during the same period. Chipotle sells Mexican food made from local, mostly organic ingredients, which is regarded as a healthier alternative to Mexican fast food from Yum! Brands’ Taco Bell. Taco Bell responded to Chipotle’s popularity with its gourmet Cantina Bell menu, which boosted sales considerably last quarter.

Panera Bread popularized soup, salads, sandwiches and coffee in an urban bistro environment at lower prices than Starbucks. Starbucks fired back by acquiring La Boulange, a popular Bay Area bakery, to increase the quality of its baked goods.

Both Chipotle and Panera have stolen market share from cheaper fast food restaurants, which have been forced to renovate their stores and add healthier alternatives to their menus, as well as full-service restaurants, which suffer by comparison due to higher menu prices and tips.

Wendy’s gussies up, earnings surge

After Wendy’s sold Arby’s, it struggled to reinvent itself to compete effectively against McDonald’s and Burger King. Last year, Wendy’s unveiled a sweeping renovation plan to upgrade stores with more upscale, bistro-like features to mirror Panera Bread. It also changed its menu substantially, offering more premium burgers and sandwiches to distance itself from the Big Mac and the Whopper.

Wendy’s recently announced that it was reducing the company ownership of its stores from 22% to 15%. By selling 400 stores to franchisees, Wendy’s reduces its overhead risk considerably, and as a result expects long-term adjusted EPS growth to start rising by the “mid-teens” starting next year, higher than its vague prior forecast for "single to double-digit" growth. At 15% company ownership, Wendy’s will own fewer restaurants than McDonald’s, which owns 19%. Having a higher number of franchised restaurants generates a more stable income stream that relies on royalty fees and rent, rather than sales at individual locations.

Wendy’s also reported strong second quarter earnings on July 23, earning $0.03 per share, or $12.2 million - a significant improvement from the loss of $0.01 per share, or $5.5 million, it reported in the prior year quarter. Adjusted to exclude one-time items, earnings came in at $0.08 per share, topping the consensus estimate by two cents.

Revenue climbed 1.8% to $650 million, falling short of the consensus estimate of $659.95 million - which can be attributed to weak same-store sales growth of 0.4% and 0.3% at company-owned and franchised locations, respectively. However, Wendy’s expects same-store sales to climb 2% to 3% for the full fiscal year, based on high hopes for its innovative Pretzel Bacon Cheeseburger. Wendy’s topped off those solid numbers was a 25% dividend hike to $0.05 per share.

What’s remarkable about Wendy’s is its ability to renovate its stores without increasing its expenses, which declined during the quarter. Company-operated restaurant margin rose year-on-year from 14.1% to 16.7%. Wendy's ability to balance out costs by selling off its stores to franchisees, along with its return to profitability, are very positive growth signs. Investors appear to have taken notice as well, sending shares up 8% to an all-time high following its earnings announcement.

The Foolish Bottom Line

In these four companies, we see a slow and steady market leader, two younger and hungrier challengers, and a comeback kid.

Over the past twelve months, Wendy’s has easily outperformed its industry peers, while McDonald’s has woefully underperformed its competitors as well as the market. Therefore, investors should focus on fast food restaurants with higher domestic exposure, healthier menus, and more upscale dining environments. These factors are changing how Americans perceive fast food, and older players like McDonald’s, Burger King and Yum! Brands might need to roll with the punches to stay relevant.

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Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, McDonald's, and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Panera Bread. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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