Why Does the Market Hate Fast-Food Stocks?

by James Brumley | October 4, 2012 8:49 am

If you’re an owner of a fast-food stock like McDonald’s (NYSE:MCD[1]), Wendy’s (NASDAQ:WEN[2]), Yum! Brands (NYSE:YUM[3]), and Burger King Worldwide (NYSE:BKW[4]), then 2012 hasn’t been a very fun year for you.

While the market is up 15% year-to-date, stocks for those burger joints are in the red … and in some cases, in the red by a lot. McDonald’s stock is off 10% since the end of last December, Burger King is trading below its June IPO price, and Wendy’s shares are in the hole by 21%. YUM shares are the only ones up for the year, but even they’re still off by 9% since their March peak.

What gives?

The Good News Is …

To fully appreciate the answer of what’s going wrong for the likes of Burger King and McDonald’s, investors also need to understand what’s going right. Fast-food chains are …

• Increasing earnings: They’re not leaps and bounds better, but revenue and profit growth in the highly competitive quick-service industry never are. For perspective, McDonald’s earned $5.27 per share last year, is on pace to earn $5.42 this year, and is plausibly expected to earn $5.96 in 2013. Sales are growing accordingly. The same broadly goes for Wendy’s, and to the extent we can see it, also for Burger King. Nothing speaks louder than current success.
• Getting relevant again: Somewhat related to growing earnings (and somewhat not), fast-food chains are finally realizing they’re not recession-proof, nor does a more-empowered consumer inherently have to “go upscale.” Taco Bell unveiled its Cantina Bell menu[5] to compete with Chipotle Mexican Grill (NYSE:CMG[6]), and — surprise — it’s working … a little. Wendy’s is spending $700,000 a piece to remodel 50 of its restaurants, which will include a new (free) Wi-Fi service once completed. While small on the surface, they’re actually game-changers for restaurants’ bottom lines.

So what, pray tell, is driving these stocks downward? More than anything, fear about the future is crimping fast-food stocks.

Uh-Oh

As is typically the case, some fears are overblown, while other potential pitfalls are being recklessly overlooked. Either way, there are three key worries bouncing around inside investors’ heads right now.

• China: Two years ago, expanding your American-brand fast food into China was all the rage. Now, it’s becoming a headache again … and an expensive one at that. As China’s culture becomes more consumeristic, its workers are demanding more pay[7]. They’re getting it, too. At the same time, once-hot Western restaurants just aren’t the same draw they were in 2010. Take Yum! Brands, for instance. Its KFC and Pizza Hut chain were slated to grow by 700 new stores in China this year. Operating costs as well as margins fell 4% last quarter on higher commodity and labor costs. The company opined the obligatory “this is only temporary” cliché, but one has to wonder.
• Labor costs: Earlier in the year, it looked like the Affordable Care Act might be undone — if not by a Supreme Court ruling, then by President Obama being ousted by a Republican president vowing to repeal the measure. But the Supreme Court (mostly) upheld the new health care laws[8] required by the plan, and unless the polls change, Barack Obama is going to be re-elected, and his health care plan will continue to unfurl as planned. It’s a worry for fast-food restaurateurs who rely on lots of cheap labor to man their stores, as “Obamacare” essentially requires businesses to provide health care coverage for all of their employees. While there are some ways to stave off the worst-case scenario (hire and use part-timers or temporary workers, and limit the number of full-timers), there’s no way to avoid this cost increase for a company that is labor-intensive and operates on paper-thin margins.
• Food costs: Even without soaring corn prices following the United States’ drought[9] this year, higher food commodity prices were starting to be a drag on earnings — the corn rally simply pushed input prices into the “miserable” category. Corn has settled down a bit since then, but overall, food costs are still frustratingly high for these quick-service chains. For perspective, 2011’s wholesale food prices were up 8%, while the average price increases on fast-food menus were less than 4%. This year’s wholesale/menu price changes are about the same — a disparity that can’t last indefinitely.

Bottom Line

So which is it? Is the market right about fast food’s looming pitfalls, or are the quick-service restaurants on the right growth path?

As always, the truth is somewhere in the middle. In terms of value, though, investors seem to have errantly priced in a worst-case scenario that likely won’t play out. Traders might want to take advantage of the dip rather than fear it — there’s not much fast-food businesses are dealing with now that they haven’t survived before.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

Source URL: https://investorplace.com/2012/10/why-does-the-market-hate-fast-food-stocks-mcd-bkw-wen-yum/

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