Fast Food Looks for Growth

From time to time, we like to check back in with our senior restaurant industry analyst, Ann Northrop, CFA, to find out where the strengths and weaknesses within this market are likely to be found in the near term.

What’s new in the “fast-food,” or quick-service restaurants [QSRs], under your coverage?

Well, this may not be very new, but it’s still substantial: after two failed attempts, Nelson Peltz, Chairman of Triarc (TRY), the franchisor of Arby’s restaurant chain, was able to strike a buyout deal with Wendy’s (WEN). Under the agreement announced April 24th, Wendy’s shareholders will receive 4.25 shares of Triarc Companies for each share of Wendy’s they own. This equates to $28.18 per share at Triarc A shares' current price, an 11.8% premium to Wendy’s share price at the close the day before the announcement. On June 2nd, the Federal Trade Commission approved the deal and it is expected to close in the second half of 2008.

Are you seeing any QSRs making strides internationally, in places such as China?

Actually, yes. Shares of Yum! Brands (YUM) are a great way to gain exposure to China’s booming economy as well as other fast-growing international markets, while investing in the only stable segment of the restaurant industry, QSRs. Yum! Brands’ two overseas divisions – which represented 50% of 2007 revenue – are expanding rapidly.

China, which accounted for 20% of 2007 revenue, and Yum Restaurants International [YRI] are on track to grow operating earnings by an average compound annual growth rate of 20% and 10%, respectively, over the next five years. The U.S. operations (50% of revenue) are also showing signs of revival as same-store sales turned positive in in the first quarter of 2008. This was after suffering the effects for several quarters of Taco Bell’s 2006 E. coli incident and KFC’s New York City rat infestation in February 2007.

The company plans to introduce new products, including beverages and value menus at all three of its U.S. brands – KFC, Taco Bell, and Pizza Hut – which we expect to bear fruit, although we think improvement will be slow and gradual.

How has growth been for Yum! Brands in China and elsewhere so far?

Revenue for the China division increased 52% year over year to $520 million in the first quarter. Operating profit increased 32.9% to $101 million led by growth in Mainland China. Mainland China’s 1Q08 same-store sales increased 12%. However, company-owned restaurant margin shrank 160 basis points to 21.3% in the quarter from 22.9% in the previous-year first quarter, primarily due to high food cost inflation. In 1Q08, the company opened 88 new units in Mainland China.

Comparatively, revenue for the International division increased 2.3% year over year to $697 million in the first quarter. Operating profit grew 16.8% to $139 million. Company-owned restaurant margin shrank 10 basis points to 13% in 1Q08 from 13.1% in 1Q07. Overall, the vast majority of YRI markets generated same-store sales growth of 5% in the first quarter.

How does this compare with the U.S. division?

Revenue for the U.S. division declined 0.8% year over year to $1,191 million in 1Q08. Operating profit declined 4.8% to $157 million. Both the system and company same-store sales increased 3%. Restaurant margin declined 90 basis points to 12.4% from 13.3% year over year, primarily due to high food-cost inflation. The company expects to refranchise 200 company-owned restaurants in the second quarter and at least 500 during 2008.

Do you have any Buys for us in the space at this time?

McDonald's (MCD) focus on core brands, its re-imaging program, and innovative marketing campaigns have been successful. After doubling margins in its U.S. operations, the company is turning its focus to Europe and APMEA [Asia/Pacific, Middle East and Africa], where company-operated restaurant margins lagged the U.S. by 120-180 basis points in the first quarter.

Re-franchising continues to be another engine of growth, bolstering ROA [return on assets] by an expected 100 basis points on a less capital-intensive business and a steady growth in royalties. We also think additional margin and ROE [return on equity] expansion is possible as the company leverages its general and administrative costs through cost-control initiatives, and uses the cash generated from operations to retire debts, distribute dividends, and pursue share repurchases. We think this stock provides relative safety and moderate growth in a turbulent environment and exposure to faster-growing international markets.

McDonald's reported that global comparable sales rose 7.4% in 1Q08, whereas system-wide sales for McDonald's restaurants worldwide increased 16% for the reported quarter. By region, comparable sales for the quarter increased: U.S. +2.9%, Europe +11.1%, APMEA +9.4%, and Other Countries & Corporate1 +15.3%. System-wide sales for the quarter increased: U.S. +4%, Europe +26%, APMEA +24%, and Other Countries and Corporate +31%.

Ann Northrop, CFA is a senior analyst covering the restaurant industry for Zacks Equity Research.

Comments

[John Pseudonym]

Family feud, March 2008.

Survey of 100 people asked:

"How many times per week to you eat at McDonald's?"

Number 1 answer: ZERO

Fast food of the 90's is dead. The first one to make the change to the next step will be the winner.

What's the next step for fast food?

[KSTHANE]

"ZERO" being the number one answer tells us nothing. If 100 people were surveyed and 51 people answered "ZERO" while the other 49 people answered with a differing number of times per month then I think it would be pretty easy to make the case that MCD has a pretty strong hold on the market. Oh, and let's not forget that the survey is probably biased downwards because some people will not admit to eating at McDonald's in a survey due to the health stigma attached. Another criticism of the survey that you didn't cite is taht a 100 person survey is a tiny, tiny sample size.

It's much more productive to analyze whether fast food is dead by looking at the comps. McDonald's registered negative monthly y/y comps in the US for the first time in 5 years back in I think either December or January and weather was the blame. Comps from there on out have exceeded analyst expectations every single time. This is ignoring international comps which are growing in high single digits...and the company gets 65% of revenue from outside the US!

If investors want to keep trading this stock based on the perceived "health" of McD's products, or on U.S. comps or other anecdotal evidence then more power to them.