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Matthew Indyke and Brian Zen
Matthew Indyke and Brian Zen
Articles (23)  | Author's Website |

Headwinds Ahead for Fast Food Stocks

August 10, 2012 | About:

Fast food once revolutionized the everyday lives of consumers by giving them something they could grab on-the-go and be served quickly. It was cheap. It was efficient. It drew lots of customers. And it would go on to define food in America following its introduction during the early to mid-20th century. But the fast food industry has come under fire in the last decade as a result of a changing economic and political environment that is challenging its long-term well-being. Recent wave of negative reports about fast food could be enough to cool down the industry as a whole and change the mindset of consumers and investors alike.

Consumers and investors wonder: Is the fast food industry’s future being threatened by this external pressure? As consumers, we face the possibility of seeing an iconic American staple revamp its business entirely or disappear from society altogether. As investors, we are questioning whether a fast food company is the right place to invest our money in, a place that looks safe and rewarding.

The following economic and political factors are putting a dent in the future of fast food:

1) Rising commodity costs are making food production more expensive, which is cutting into company profits and causing fast food companies to raise their selling prices in what has always been advertised as an affordable and low-cost eatery.

2) Negative advertising about healthy eating from major media sources are giving the fast food industry bad press, encouraging more customers to stay away from fast food and pursue healthier options.

3) An emerging and upcoming industry of fast-casual restaurants is taking away market share from fast food, providing amenities and assets that are more in line with modern-day society’s desires.

Fast Food Losing its Low-Cost Identity

Tip-toeing around commodity-cost increases while still offering low prices is something most major chains are facing on a regular basis. Rising commodity prices have significantly tightened fast food franchises. With food and beverage inputs making up approximately 33% of costs, higher prices for commodities like livestock, corn, and wheat have shrunk the average profit margin to below 10%, while fast food companies are being forced to raise their prices to cover the rising costs. And the economic recession has hurt overall spending, with consumers purchasing less during each trip to a fast food restaurant.

In such a fiercely competitive environment, it is hard to force a price increase on customers. Business executives are left to figure out how to best introduce these higher prices. It’s how companies introduce the hikes that determine how customers will ultimately react. Cliff Courtney, executive vice president and chief strategy officer of Zimmerman Advertising in Miami, recognizes that customers understand price hikes are a fact of life. “It’s only when a price hike is very steep or sudden that it causes consumers to step back, and that impacts sales and loyalty.” Companies that do bump their prices shouldn’t expect a direct correlation between the price hike and increased revenues, says Jon Jameson, cofounder of Bellwether Food Group. “If you push your menu prices up 2 percent, you’ll see your revenues go up about 1–1.5 percent,” he says.

McDonald’s (NYSE:MCD) has wrestled with its signature Dollar Menu as economic conditions have changed. The company most recently overhauled its Dollar Menu offerings in March in an attempt to drive more business with higher-priced offerings. Menu redesigns or tweaks can help alleviate a price hike, says Lori Karpman, a restaurant marketing consultant based in Toronto. “A different font, a different arrangement to the menu, these can communicate to the regular customer that the menu has slightly changed,” she says. “If they’re really focused on prices, they may notice that the price of their favorite item is up, but for your best customers, are they at your restaurant because of your prices or your food?” That depends on who your customers are. Your more loyal customers will be those who have been coming for a long time and developed a meaningful relationship with the business, regardless of price increases.

But as a general rule, the steeper the price increase, the more price-sensitive your customers will be.

Cheap Fast Food Could Be Expensive for Your Health

Until now, not a lot of serious research have been done on potential links between fast food and health risks. That may change soon. United States is where fast food made its name. Movies like Super Size Me and Fast Food Nation have raised awareness of long-term health issues associated with consuming fast food on a regular basis. Super Size Me depicts the effects of going on a McDonald’s diet for 30 days. Fast Food Nation gives us scary insight into the manufacturing process of fast food and its slimy working environment. These movies give us a new perspective of what consuming fast food can do to you.

Researchers at Ohio University studied 24 men and women who moved to the U.S. from countries all over the world. They discovered that, after 10 weeks, the new residents had already gained two pounds each. After 20 weeks, they had put on another pound. But this was only the average weight gain. And why had this occurred? The culprit was fast food. Since other countries also have fast-food outlets, it wasn't simply the convenience of fast food that set the stage for obesity. It was cheap fast food, a fact of America.

People are slowly becoming overweight and finally so obese that they can no longer see their feet. There is more to ill health than obesity. This single problem leads to diabetes, which, in turn, leads to hypertension, blindness, kidney failure, amputation of legs, or coronary death.

People who consumed fast food even as little as once a week, increased their risk of developing coronary heart disease by 20 percent compared to those who never touched it. The rate jumped to 50 percent for those who indulged two to three times per week and to 80 percent for those who went beyond that. It is undeniable that the growing popularity of Western eating styles is coinciding with a dramatic increase in obesity and related illnesses in the United States and also in many parts of the world.

Fast Casual Overtaking Fast Food?

Fast casual chains are relative newcomers in the restaurant business. Fast food restaurants like Wendy’s (NASDAQ:WEN) and Burger King (BKW) are increasingly losing market share to fast casual restaurants like Chipotle Mexican Grill (NYSE:CMG) and Panera Bread (NASDAQ:PNRA). The appeal of fast casual chains lies in its novelty and value. Consumers will find that fast casual restaurants offer a cleaner dining atmosphere and more pleasant customer service experience. The fast casual dining experience combines fast food-style service with a theme and decor more associated with a full-service restaurant. They benefit from the same streamlined process that makes fast food operations so efficient and profitable. Like fast food, the fast casual chains are also affordable but tend to offer a higher degree of local sourcing and food tracking than their more conventional fast food rivals. “More success in fast casual is leading to greater frequency and competition in the segment,” says Technomic Executive Vice President Darren Tristano.

And most fast casual restaurants, compared to their fast food counterpart, will sound like the more appealing option if consumers had a choice between the two. What would you choose if you had the option between:

· Chipotle and Taco Bell?

Chiptole, I don’t have to explain.

· Five Guys Burgers and McDonald’s/Burger King?

Five Guys sports the look of a modern-day fast food burger joint that invented an original menu structure to make the presentation of its offerings more appealing than any eatery of its kind. Loyal customers of McDonald’s and Burger King can be satisfied. But when they step into Five Guys for the first time, they may feel different.

· Panera and Starbucks (SBX)?

This is debatable. Starbucks and Panera are both bakery-cafes serving similar items with a similar purpose. But Panera has upped the ante on Starbucks with a nicer décor, more freshly baked items including bread, and better customer service. Yes, Starbucks may be the standard of everyday life in coffee but you will find it is not the same compared to Panera, which overall, is an expanded version of Starbucks.

As a consumer, do you feel anything differently about consuming fast food today than you did a few years ago? These questions depend on our personal opinions and to a degree, our morals. For all the negatives, fast food industries still have the loyal population to keep business running at a high level. But in the minds of health-conscious consumers, things could be slowly shifting.

Disclosure: Brian Zen owns stocks in WEN, MCD, SBUX.

About the author:

Matthew Indyke and Brian Zen
SUPERINVESTOR.net is an investment research co-op for next-generation super investors, analysts, and advisors.

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