Why You Should Own This Fast Food Chain
Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The recent volatility in the stock market has spooked many investors. With a scale-down of the Federal Reserve's unprecedented quantitative easing program in the works, some market participants are concerned that the economy will fall back into recession.
Luckily for long-term investors, there is a special set of businesses that continue to earn stable cash flows no matter what the economic environment looks like. One such company, McDonald's (NYSE: MCD), serves as the focus of this article.
Profits no matter what
If the goal of an enterprise is to earn a profit, McDonald's has been more successful than the vast majority of enterprises ever created. However, while companies like General Electric and Southwest Airlines earn high profits in good economic environments, they tend to earn a lot less during poor economic times.
The same is true for many of McDonald's direct competitors, including Wendy's (NASDAQ: WEN) and Jack in the Box (NASDAQ: JACK). While McDonald's continues turning each dollar of revenue into about $0.14 in cash profit each year, Wendy's and Jack in the Box often experience a drop-off during recessions.
As the world's largest and best-known fast food chain, McDonald's enjoys advantages of scale not yet available to its competitors. It scale allows it to spread out its fixed costs across a larger number of units, allowing it to earn higher margins. Its brand, meanwhile, continues to attract customers during recessions, even as customer traffic falls at Wendy's and Jack in the Box.
It is unlikely that Wendy's or Jack in the Box will ever catch up with McDonald's in terms of profitability because the latter's lead is too large. For example, Wendy's and Jack in the Box have undertaken measures to reinvigorate their brands. These measures include new marketing campaigns and fresher looks at their locations. In response, McDonald's launched a revamped campaign of its own and re-imaged its locations, complete with free WiFi and longer store hours. The net effect is a slight positive for McDonald's, which spent a lower percentage of revenues increasing its brand image, more than that gained by Wendy's and Jack in the Box.
Only hope: franchise growth
From an investment perspective, the only reason to like Wendy's or Jack in the Box more than McDonald's is for their growth prospects. All three chains have robust franchise programs that allow them to expand rapidly with little additional investment. These programs also provide the firms with stable, annuity-like cash flows that enable them to earn relatively stable margins.
However, as the free cash flow margin chart shows, Wendy's and Jack in the Box have not yet reached the stability that McDonald's has reached. Jack in the Box stores are located in just 21 states, which means the chain has a long runway for growth. Meanwhile, the company's Qdoba brand has a first-year royalty incentive that is attracting hoards of well-qualified franchisees.
Wendy's, on the other hand, has already penetrated most major markets in the United States, but has hardly even begun to expand internationally. Increased efforts in international markets may push it over the hump and allow it to earn high and stable margins like McDonald's.
McDonald's is the market leader in virtually every market in which it operates. The company continues to roll out high-margin products, like McCafe specialty coffee, that increase the gap between it and its competitors. The company will continue to earn strong cash flows, even during economic downturns, unless management makes a major mistake. As a result, investors looking for protection from another recession should give McDonald's a closer look.
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Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends McDonald's. The Motley Fool owns shares of McDonald's. 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!