Why Food And Coffee Vendors Offer No Shelter In A New Recession

by: The Value Investor

Shares in the wider outdoor food and beverage sector have performed really well in recent years with returns outpacing those of the actual food producers. Many of the nation's largest franchise chains have seen shares booming over the last five years.

What happened in the last years?

Large food franchise operators have combined the best of both worlds. Besides their economies of scale and national or global identity, they have also successfully adapted some of their product offerings to tailor specific markets and have included healthy offerings on their menus. Their biggest reason for their success was sadly enough the recession of 2008 which indicates that many "poor" consumers rely on cheap fast food for their daily meals. At the same time many consumers, especially the middle class, have scaled up on their coffee habits. Rather than drinking regular black coffee, people have adopted fancy lattes, cappuccino's, ice coffees and personalized cups for their consumption at home. These coffees typically sell at premium prices, generating premium margins for the vendors.

It is not just increased demand for fast food and coffee & bakery products which drove up the stock prices of these companies. As companies in the industry have increased their revenues and profit margins, investors have assigned higher valuation multiples to their shares. While this has been beneficial on the way up, it leaves investors vulnerable for a "double whammy" in case margins decline or revenues stabilize. In such a scenario where profits are no longer increasing or even falling investors must brace themselves for a decline in valuation multiples, as the investment community will lower the growth prospects for the industry. This analysis assumes that shares have more room to the downside than the upside.

Fast Food

Shares of McDonalds (NYSE:MCD) have returned some 70% over the last five years as the hamburger giant included new healthy offerings on its menus and it revamped a lot of its stores. Shares in Yum! Brands (NYSE:YUM) returned 90% in the same time span as the operator of KFC, Pizza Hut and Taco Bell also set for an aggressive expansion in Asia. Pizza chain Domino's Pizza (NYSE:DPZ) returned some 47% but the absolute winner was Chipotle Mexican Grill (NYSE:CMG) returning over 350% over the five year period. The two giants of the fast food industry, McDonalds and Yum! also benefited from the limited scale of smaller competitors such as Jack in the Box (NASDAQ:JACK) and Wendy's (NASDAQ:WEN) which lack resources to compete.

Coffee & Bakery

Who ever thought that US consumers would pick up taste for coffee and switch over from traditional black to fancy lattes and ice coffees? The trend has been great for Starbucks (NASDAQ:SBUX) which returned 89% over the last five years and Green Mountain Coffee Roasters returning 342%. Donut seller Dunkin Brands (NASDAQ:DNKN) returned 12% since it went public last year, while bakery franchise Panera Bread (NASDAQ:PNRA) returned 150% during half a decade.

Recent correction

Shares in fast food restaurants and coffee & bakery chains have seen a correction in line with the wider markets in recent weeks. Investors fear that lower job growth and a slowing US economy could put pressure on "discretionary" coffee spending at high end coffee shops and bakeries. Shares of Panera Bread lost 15% from their highs, Starbucks lost 17%. Shares of the lower cost chain Dunkin Brands fell merely 7% as investors might anticipate a shift from high-end coffee places towards lower-end places like Dunkin in a recession.

In the fast food area shares of Yum! and Pizza Hut have fallen 13% and 30% respectively, amidst fears of a slowdown in China and the wider Asian region. Asian operations are an important source of profits for the companies and meals at the restaurants are considered "upscale" in those countries vs. "downscale" in the US. McDonalds lost 13% as investors fear about the effects of food inflation in recent months and slowing same store sales growth in Europe and other areas of the world affected by the economic slowdown. Shares in Chipotle Mexican Grill lost merely 10% after the company already successfully raised its prices late 2011 in order to combat raw food price inflation.

What's to learn?

In recent years shares of food and drink vendors have outperformed those shares of the actual producers like Procter & Gamble (NYSE:PG), Coca Cola (NYSE:KO) and PepsiCo (NYSE:PEP) as consumers scaled up on their coffee demands and fast food proved to be recession proof. It has become apparent in recent weeks that shares of these vendors are not recession proof and are impacted by general economic circumstances. After significant share price increases in recent years which led to "inflated" valuation multiples, investors should be aware that these shares do not offer a great shelter in case a new recession might develop, as they thought it might be.

Disclosure: I am short CMG.