Fast food is a massive industry accounting for more than $1 trillion of annual global sales. The associated companies are Wall Street favorites for good reasons, especially the huge, steadily growing profits generated by the market leaders. In addition, a significant portion of those earnings is up for grabs each year as upstart rivals with innovative menus and selling strategies jostle for market share against established giants like McDonald's (NYSE: MCD).
Below, we'll take a comprehensive look at how those battles are shaping the industry and the ways investors can profit from owning stocks in this attractive restaurant niche.
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The fast-food industry
Fast food involves quick-service dining that stands apart from full-service eateries such as restaurants and certain bars, which often include elements of both food and entertainment. The fast-food segment is defined by its focus on speed, convenience, and value and includes everything from food trucks to select casual-dining restaurants. The global industry generated about $1.3 trillion in sales in 2017, up from $1.2 trillion a year earlier.
In recent years, the fast-food portion of the broader restaurant industry has grown while full-service restaurants have lost ground. Fast-food visits and average spending are on pace to expand in 2019 but at a slower pace than in the prior year.
Investors like the fast-food industry for a few reasons. First, it straddles the line between consumer discretionary and consumer staples stocks, meaning it is a priority in many shoppers' monthly budgets. That positioning means the industry can show strong growth during periods of economic expansion but won't collapse during a downturn. Consumers tend to pull back only slightly on their eating-out budgets in recessions, and most of that cutting occurs at the full-service side of the industry.
Fast-food companies can generate robust profits from the sale of value-priced food thanks to the fact that labor, preparation, and ingredient costs are low as compared to full-service competitors. Most industry participants limit their risk exposure and maximize profit margins, too, by using a franchise model under which the company licenses out its brand and operating expertise to individual entrepreneurs who run the day-to-day business. The parent company earns money by charging these franchisees license and royalty fees.
The upshot of all of this is that a successful fast-food business can generate high, sustainable profits through a wide range of economic conditions. Staple brands like McDonald's, Sonic, and Domino's Pizza (NYSE: DPZ) help show that this formula can endure for decades against even the most intense competition.
Fast food's biggest stocks
McDonald's is the industry's biggest player, with 32,000 locations that account for about 7% of worldwide sales. Other large operators include Yum! Brands (NYSE: YUM), the owner of Taco Bell, KFC, and Pizza Hut; Restaurant Brands International (NYSE: QSR), which operates Burger King and Tim Horton's; and Domino's Pizza. Starbucks (NASDAQ: SBUX) focuses mainly on beverage sales, but it is increasingly moving into the breakfast and lunch space along with rival Dunkin' Brands (NASDAQ: DNKN). There are internationally focused companies as well, such as Yum Brands China Holdings (NYSE: YUMC), the largest restaurant operator in China.
Smaller brands that have carved out significant market share positions include Shake Shack (NYSE: SHAK), Wendy's (NASDAQ: WEN), and Jack in the Box (NASDAQ: JACK). Many other companies you might have heard of are not available on the public market and therefore have no stocks associated with them. These private fast-food businesses include national giants like Subway, Arby's, and Chick-fil-A. In other cases, companies used to be public but are now privately held. That list includes casual-dining specialist Panera Bread and the drive-thru giant Sonic.
Fast-food stock terms to know
Before investing in fast food stocks, it's important to understand the key operating and financial metrics used by most players. They are as follows:
Comparable-store sales: This metric is sometimes referred to as "same-store" sales or "comp" sales but always describes the change in average sales at an existing location from one year to the next. Tracking sales this way gives management an apples-to-apples comparison that strips out the impact of new store openings and volatile swings in foreign currency exchange rates. What's left is pure growth achieved through higher sales. Fast-food companies aim to achieve comps that are higher than the broader industry, which is a good indicator that they are making market share gains.
Rising comps come from two main areas, each of which is important for an investor to follow. The first is improving customer traffic (also called guest count). Fast-food businesses work hard to win new customers and to convince existing fans to visit more often through promotions and limited-time offers.
At the same time, a fast-food company aims to increase average spending per customer through a mix of increased menu prices and popular higher-margin offerings like premium food and beverage options. Ideally, investors are looking for comps that consistently outpace those of rivals thanks to a balance between customer traffic growth and higher spending per visit.
Unit growth: The broad appeal of their product means that many fast-food restaurants have an almost unlimited opportunity to expand their restaurants into new locations and geographies. Investors track success on this score by following a company's unit growth, or the rate of new restaurant openings in a given year.
Store growth is usually expressed as a net number, and it's a good sign for the business if it can consistently open far more restaurants than it closes. That fact suggests that most franchisees are generating significant profits and that the company's management team is finding plenty of space to expand into new territories. By combining unit growth with comparable-store sales gains, a fast-food company can achieve robust gains in overall annual revenue.
Profitability: A fast-food stock's profitability is a function of many factors, including the size of its sales base and the appeal of its brand to franchisees. The best businesses routinely put up market-leading margins by running an efficient operation that supports attractive returns both for restaurant owners and for the wider business.
Restaurant-level operating margin captures profitability at the level of individual stores, and operating margin, in general, describes the earnings power of the broader company. Investors like to see both figures in solidly positive territory and, ideally, rising. Comparing operating margins between fast-food stocks is one of the best ways to judge their relative performances.
Capital outflows: Good companies generate plenty of cash, but great companies allocate that capital in ways that consistently maximize shareholder value. Fast-food giants have no shortage of investing requirements for the business, including upgrading and modernizing restaurants, adding new functionality like digital ordering, or fitting kitchens with better equipment.
Investors judge a fast-food stock's cash efficiency by watching metrics like return on invested capital and free cash flow. Consistently high results here indicate that management is making prudent choices when it comes to investing in the business to support long-term earnings growth.
Fast-food stock risks to understand
The restaurant business is famously risky, mainly because barriers to entry are so small and consumer tastes frequently shift. These dynamics mean that fast-food companies must continually improve their dining experience if they want to maintain or expand their market share.
Among the other main risks to investing in this industry is the fact that it is sensitive to wider swings in the economy. While not as leveraged to recession moves as, say, a full-service restaurant or a car dealership, a fast-food restaurant still depends on a healthy economy to support robust growth.
Image source: Getty Images.
Fast-food stocks have a few specific risks that are worth understanding, too. The biggest is food safety. After all, these businesses prepare meals that are consumed by thousands of people each day. That means the risk of contamination is always present when dealing with fresh ingredients. Even one outbreak of sickness traced to preparation methods at a given location can seriously harm a fast-food company's brand and growth prospects. It might have been the company's supplier that was at fault, too, but consumers typically will blame the restaurant chain and choose to dine out elsewhere.
Fast-food giants also make heavy use of franchising, which lessens financial risks and allows for quick growth. However, this operating setup puts day-to-day control of the brand into the hands of private managers, who might hurt the wider enterprise -- for example, by using unsanitary business practices.
Fast-food companies typically use debt to fund at least part of their expansion strategy, which adds financial risk. This issue usually isn't obvious during boom times but rather comes to the forefront during an unexpected downturn. Thus, investors should keep an eye on debt levels and on interest expenses to ensure that they don't threaten to create a liquidity crisis when the next recession hits.
Finally, these businesses are among the biggest employers in the country. As such, their earnings can be squeezed during times when demand for increased wages and benefits is heightened by tight labor markets and political pressures.
Fast-food stock trends to watch
It can seem as though fast food is an unusually stable industry, given that consumers' tastes for burgers, sandwiches, and pizza don't change much. In 2019, McDonald's celebrated the 50-year anniversary of its Big Mac sandwich, after all. However, major trends frequently sweep the industry, and it's up to the companies to respond to shifting desires or risk falling behind.
A notable trend in recent years has been the shift toward preferring higher-quality ingredients and preparation methods while abandoning products that were seen as too highly processed or filled with unnatural ingredients. Fast-casual specialists like Chipotle Mexican Grill (NYSE: CMG) capitalized on this move early on, and the shift forced industry leader McDonald's to make major changes to its menu, including adding more fresh beef options and moving to cage-free egg supplies.
Lately, consumers are increasingly choosing to order food online and either skip the fast-food line or opt for home delivery. This trend poses major challenges for established fast-food companies that have built up national networks of stores. It also represents a potential new growth opportunity. In either case, fast-food demand is moving toward more convenience, and that helps explain why every leading industry player is aggressively investing in its e-commerce and delivery capabilities. This comes in the form of building a chain's own delivery service or partnering with third-party delivery aggregators like Uber (NYSE: UBER) Eats and Grubhub (NYSE: GRUB).
Finally, while a few competitors like Chipotle choose to run all of their restaurants, the general shift in the industry has been toward a nearly 100% franchised setup. McDonald's controlled 15% of its restaurant base in 2015, but by early 2019, that rate had fallen below 5%. Smaller fast-food peers have moved in the same direction, in part due to the increased profitability that such a shift promises.
Which fast-food stocks to buy
Investors have a full range of choices when it comes to buying fast-food stocks. They can choose to purchase established global giants like Yum! Brands and Starbucks or pick companies with smaller sales bases and more potential unit growth ahead, like Dunkin' Brands.
The industry leader: McDonald's
If you prize stability and high profits, it's hard to ignore McDonald's. The industry leader enjoys market-thumping operating margins and attractive growth prospects around home delivery given its established footprint. It has proven itself agile enough to adjust to huge shifts in consumer tastes over the decades, too, even if those adjustments have sometimes taken longer than investors would have liked. Its successes ultimately have kept it one of the most efficient businesses in the industry, if not the entire stock market. Still, as the top stock in the industry, McDonald's has the most to lose in any prolonged market share battle.
Good at growth: Domino's
For a more growth-oriented pick, consider Domino's. The pizza delivery specialist has a knack for gaining market share each year, in part thanks to its many innovations around digital ordering. The fast-food giant's tiny store footprint and flexible menu, meanwhile, give it lots of agility as it seeks to deepen its presence in established markets like the U.S. as well as internationally. Domino's management team makes aggressive use of debt, and that's something worth watching. The chain also struggles at times to achieve the level of international growth that executives have targeted. What it has going for it is that Domino's is uniquely well positioned to prosper as more fast-food ordering moves online.
Risk coupled with opportunity: Shake Shack
Finally, aggressive investors might want to consider Shake Shack, a risky company with a wider growth opportunity than others already listed. The "better burger" chain has struggled to boost comps in the early years of its expansion from its New York roots. However, Shake Shack's unit-level finances describe a strong business that's proving able to attract customers in competitive markets. That success bodes well for shareholders who believe in management's aggressive store base expansion goals. Going forward, watch for profit margins to stabilize as more of its store footprint moves to lower-volume areas outside of New York City. That success plus steady customer traffic growth would be the best indicators that Shake Shack can continue adding new locations at a robust clip before reaching a limit to its market opportunity.
Other ways to play fast-food stocks
Investors seeking exposure to the fast-food industry can also look outside the list of public companies in that niche. McDonald's and Starbucks feature prominently in index funds that cover consumer discretionary stocks, for example. Buying such an exchange-traded fund would immediately deliver portfolio diversity by including other consumer growth sectors like retailing and apparel. The Vanguard Consumer Discretionary ETF (NYSEMKT: VCR) is one of the most popular of these funds for good reason: It boasts high liquidity, wide industry coverage, and low annual expenses. Restaurant-specific real estate investment trusts, or REITs, represent another way to gain exposure to the industry. Four Corners Property Trust (NYSE: FCPT), for example, collects rent and restaurant sales from more than 600 properties spanning 20-plus brands such as McDonald's, Chick-fil-A, Red Lobster, and Burger King.
You can also invest in ancillary sectors that benefit from growth in the fast-food industry. Food delivery aggregators like Grubhub are increasingly winning the business of national chains because they represent a ready-made platform for digital ordering and fulfillment. Moving further up the risk chain, an investor can choose to bet on companies that seek to supply major fast-food companies with proprietary food or ingredients. Such potential future winners today include Beyond Meat (NASDAQ: BYND), along with cannabis specialists like Canopy Growth (NYSE: CGC). You might consider buying a major food supplier, too.
Fast-food stocks' future
However you choose to invest in the fast-food industry, you'll likely find it will be a key driver of economic growth in the years to come. That's because the focus on value and convenience insulates the niche from the harshest downdrafts of a recession.
At the same time, the potential for more premium food and delivery options opens the door to rising profit margins and booming e-commerce sales gains. In short, fast food is a bedrock consumer-focused industry that's likely to continue growing faster than the wider economy in the future, just as it has over the last few decades. That type of situation is usually fertile ground for solid long-term investor returns.
Demitrios Kalogeropoulos owns shares of Chipotle Mexican Grill, McDonald's, and Starbucks. The Motley Fool owns shares of and recommends Chipotle Mexican Grill and Starbucks. The Motley Fool recommends Dunkin' Brands Group, Grubhub, and Uber Technologies. The Motley Fool has a disclosure policy.
This article was originally published on Fool.com