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Summary

  • North America QSR earnings are well underway, in which we see high-income focused names to outperform those focused on the low-income earners.
  • High underemployment and stagnating income growth to continue to impact the low-end QSRs.
  • Stick with the high-end: SBUX, CMG and YUM. Avoid low-end PZZA, WEN and MCD.

Papa John's (NASDAQ:PZZA) and Wendy's (NASDAQ:WEN) both will report earnings next week. Consensus expects PZZA to earn $0.42 (+7.7% y/y) on $382m (+9.4% y/y) in revenue. As for WEN, consensus expects $0.10 in EPS (+25% y/y) on $518m (-20% y/y) in revenue.

Prior earnings from the large North American QSRs highlighted the trend that underemployment in the US and the high unemployment rate in Canada, coupled with stagnating wage growth are putting pressure on the QSRs that focus on the low-income earners, who are increasingly dining in. While the topline is facing downward pressure, the upward pressure from raw material and labor cost is putting a squeeze in QSRs' operating margin. In my view, QSRs that cater to the high-income earners, focus on continuous menu innovation and spot a global growth profile are likely to withstand the industry headwinds.

Earnings from Yum Brands (NYSE:YUM), Chipotle (NYSE:CMG) and Starbucks (NASDAQ:SBUX) support my thesis, as SBUX and CMG saw solid comp sales as they benefited from new menu times and successfully passing down the cost to the consumers. Yum, on the other hand, saw a solid rebound in China, which accounts for half of its revenue, and that offset the weakness in its North America comps. McDonald's (NYSE:MCD), however, was not so lucky with its $0.04 EPS and $100m revenue miss in Q2, due to its exposure to the low-income earners. Despite MCD's global footprint, one area of concern is that it does not innovate its menu around the local tastes (contrary to YUM, which offers congee and fried dough in China). I expect the trend to flow through next week's earnings involving PZZA and WEN.

For PZZA, North America comps is likely to remain weak as the company focuses on the low-income earners and lack the pricing power to pass down the rising raw material costs to the customers. International could be better, and PZZA has done a solid job in trying to reinvent itself overseas by capitalizing on the rising diary consumption within emerging markets. However, I expect PZZA's international growth to be negatively impacted after the recent food scandal in which PZZA was found using expired ingredients in its China stores, so investors can expect guidance to be somewhat weak this quarter. I will be a seller of the name heading into the quarter.

WEN's story is similar to that of MCD, due to its leverage towards the low-income group and its geographic concentration in the US. Despite a solid beat last quarter, expect margins to decline to the 16.3-16.8% range, compared with the prior guidance of the 16.8-17% range, indicating that rising raw material costs are having a heavier impact on margins than previously expected. At 36x earnings, the stock is expensive, after a solid run in 2013. The market is concerned about margin contraction as well as industry headwinds, and the recent pullback supports that view.

In conclusion, investors are better off buying names that have a growing global footprint, focus on menu innovation either organically or via M&A and cater to the high-income earners so that the rising raw material cost can be easily passed down to the consumers, thereby protecting margins. I reiterate my bullish view on CMG, SBUX and YUM and my bearish view on PZZA, WEN and MCD.

Source: Hindsight And Insight: North America QSR; Wendy's And Papa John's Earnings Preview