For many people, little sachets of Heinz ketchup are just the best things they can ask for when in McDonald's (NYSE:MCD). However, the world's largest ketchup supplier will no longer supply ketchup to the world's largest quick-service restaurant. This is because Bernardo Hees, the Vice Chairman of Burger King Worldwide (BKW), has taken over as the CEO of Heinz. This ends four decades of association between the two giants. This comes in as a blow for McDonald's, but the company has more serious problems on its hands and may underperform in the future. Let's take a look at those problems.
The Clown Is Slowing Down
McDonald's third-quarter report was not very good, as the company reported comps growth of 0.9% versus 1.9% in the year-ago period. The decline was due to weaker consumer spending as a result of macro-economic headwinds. Revenue increased 2% to $7.32 billion and missed the consensus estimate.
To put it into perspective, McDonald's market share all over the world, barring Europe, has been declining rapidly. I believe this is largely due to some poor product positioning. For example, in order to compete against the likes of KFC (NYSE:YUM), McDonald's introduced chicken wings. However, the company priced the chicken wings at $1 per wing, as compared to KFC's $.80 per wing, and consequently customers didn't buy it. As a result of this goof up, McDonald's is now left with more than 10 million pounds of unsold chicken! Being a vegetarian, this news really bothered me.
Other examples of poor product positioning include the introduction of premium coffee and smoothies, wraps, salads, and apple slices. I don't think anyone visits a fast-food restaurant to eat apples and salads, so I don't know what the company's management was thinking when they added these products to the menu.
However, this mistake gave Burger King an opportunity to grow. The company rightly realized that people do not visit a fast food chain for a nutritious meal, and introduced low fat fries instead. In the present world, adding "low fat" as a prefix guarantees the success of every kind of junk food, and Burger King's fries were no exception to that. As a result, Burger King has gained popularity at the cost of McDonald's.
For the fourth quarter, McDonald's expects global comps to remain consistent with the recently reported quarter; however the company will struggle to meet this estimate. The company recently announced that it will be shutting down 74 outlets in Japan, and this could have a big negative impact on the company's margins.
Burger King's New Strategy
Burger King has an ambitious plan to take McDonald's head on while also competing with Wendy's (NYSE:WEN). The loss of Heinz could be the beginning of more trouble for McDonald's. Burger King has a more holistic approach to growth than its peer, and it is also migrating to a franchise-based business model. The franchise model is less capital intensive, involves lower risk, and provides a steady stream of cash flow all at the same time.
McDonald's and Wendy's both follow the franchise model themselves, and Burger King is now joining the fray with an eye on expansion. Burger King had transitioned to a 99% franchised model by the end of the second quarter, which is why its short-term results have taken a hit.
During the third quarter, Burger King reported system wide comparable sales, or comps, growth of 0.9%. Net revenue declined 39.6%, but this should not be surprising, as the company is transitioning. It has refranchised 519 company-owned restaurants in the last twelve months.
On the back of positive comps, Burger King's system-wide sales increased 4.9% versus a 3.6% gain in the same quarter a year earlier. Excluding the impact of refranchising and currency movements, revenue increased by 8.1% year-over-year due to net restaurant growth and positive comparable sales growth. Burger King's total restaurant count stood at 13,259 versus 12,667 in the same quarter of the previous year. Adjusted diluted earnings per share increased 31.6% to $0.23 per share.
Tapping More Markets
Going forward, Burger King is stepping into the lucrative Indian market through a joint venture with Everstone Group, which will be the master franchisee for the country. The joint venture will also allow Everstone to have Burger King's sub-franchise rights throughout the country. This will be an important growth driver going forward, because the middle-income population in India is expected to grow ten-fold by 2025.
The company has also inked a deal with Groupe Olivier Bertrand in France for expanding into France with a network of 250 restaurants. Lately, it has also taken steps to expand into key markets like Russia, China, Mexico, Central America, South Africa, the Nordic countries, Singapore, Malaysia, Korea, and Vietnam to boost its business.
Burger King operates in over 13,000 locations, serving more than 11 million guests daily. This is way behind McDonald's, which has 35,000 locations that serve 69 million visitors per day. Burger King has a lot of runway ahead of it, and it could give McDonald's a run for its money with its new business model, putting further pressure on the Golden Arches.
What about Wendy's?
Wendy's has been following a completely different path for growth. It is focusing on an "Image Activation" plan, which focuses on modernizing restaurants and enhancing the customer experience. Driven by this strategy, comps at Wendy's company-owned restaurants in North America grew 3.2% while franchised units saw a 3.1% jump in the previous quarter. The growth in comps was due to new menu offerings like the Pretzel Bacon Cheeseburger, along with brand transformation initiatives.
On the back of comps growth, Wendy's total revenue grew 0.7% year-over-year to $640.8 million, which missed the consensus estimate. Adjusted earnings per share came in at $0.06, beating the consensus estimate by 33.3%.
Wendy's expects average comps at company-operated restaurants in North America to increase 2% versus the prior guidance of 2%-3% for 2013. As a part of its brand revitalization and portfolio optimization plan, it is focused on franchising about 425 company-operated restaurants in 13 U.S. markets, and this is expected to be completed by the second quarter of 2014.
However, Wendy's isn't a good pick considering its expensive P/E ratio of 91, way above the industry-average P/E ratio of 36. In comparison, Burger King trades at a much more reasonable valuation of 37 times earnings.
Given that Burger King is transitioning to a new business model, investors could consider putting their money in this stock. In addition, it also pays out a dividend that yields 1.30%. While this might not be as attractive as McDonald's yield of 3.40%, it should be remembered that McDonald's is now a mature company and its comps growth has been slowing down. Burger King's comps could go up once it completes its transition to a franchise-based business model. That's why investors looking for growth at a reasonable price in this space should definitely consider Burger King for their portfolios.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.