FOOL ON THE HILL
Quick-Serve Stocks

Whitney Tilson refuses to believe that Subway's Jared has devoured the fast-food sector. In fact, he expects long-term growth for several quick-serves. The price war among fast-food restaurants will soon pass, he argues, and a number of companies in the sector will resume their long-term profitability. You may want your fries dished up hot and now, but you'll have to be patient for these stock returns.

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By Whitney Tilson
February 5, 2003

Sales and earnings in the quick-serve restaurant (QSR) sector have suffered recently, and, not surprisingly, the stocks have followed suit, with many hovering near multi-year lows. Skeptics argue Americans are turning to healthier fare, and the fast-food sector is saturated and will always be plagued by price wars.

I have a different take. (Surprise!) Warren Buffett once wrote that investors have an "unshakable habit [of] looking into the rear-view mirror instead of through the windshield." I agree that someone looking at the past quarter's dismal results would want to avoid QSR stocks, even at today's low prices. But I think a careful analysis of the future will lead one to conclude that many of these beaten-up stocks are very attractively priced.

The big picture
There's scant evidence that a shift toward healthier diets is plaguing the fast-food industry. If anything, Americans (and people around the world) will continue to consume pizza, hamburgers, fried chicken, and the like in greater quantities, and will do so increasingly at restaurants offering speed, convenience, and rock-bottom prices.

So, why is the sector suffering? Two major factors: a lousy economy (the unemployment rate recently surged to an eight-year high of 6%) and a price war by two giants in the sector: McDonald's (NYSE: MCD) and Burger King. I'm not optimistic that the economy will improve anytime soon, but I'm becoming increasingly confident that the insane price war is coming to an end, which should provide a real boost to the profits -- and stock prices -- of QSR companies.

Burger King
I recently spoke with the CEO of one of the companies in the sector, and his assessment of the price war is that it was started by former Burger King owner British drinks conglomerate Diageo PLC, which sought to give earnings a temporary boost so it could sell the company for the best possible price. (A private equity consortium led by Texas Pacific Group bought Burger King in December.)

This analysis makes sense. With 91% of Burger King units franchised, and the parent company earning fees based on revenues, cutting prices is a quick way to juice profits, which boosts revenues (and fees to the parent) -- but at the expense of killing margins for the franchisees. This strategy might work in the short run, but clearly isn't sustainable in the long run.

Burger King will do everything in its power to end the price war for several reasons. First, it simply can't afford it. With nearly 20% of its franchisees in financial distress, the company yesterday announced it hired a franchise-restructuring specialist to help resolve various issues.

Also, the new owners don't have Diageo's short-term mentality -- they need to generate strong long-term cash flow to pay down debt and eventually take the company public.

Finally, Burger King hired a new CEO in December, Bradley Blum, who was previously vice chairman of casual-dining powerhouse Darden Restaurants (NYSE: DRI). Price wars are rare in the casual-dining sector, and Blum made it immediately and publicly clear that he sought to end the one he inherited at Burger King. "I don't like them [price wars]," he said. "They hurt the consumer.... A company cannot be relentlessly focused on quality if they're in a long-term price war. It starts to take people's attention away from innovation, and, over time, I don't think it helps service, either.... You've got to balance price and quality."

McDonald's
But it takes two to end the price war, as evidenced by the fact that Blum felt compelled to cut the price of Burger King's signature Whopper to $0.99 to match McDonald's $1.00 Big N' Tasty burger. Is McDonald's likely to reciprocate and end the war? I think so. Disgruntled franchisees and shareholders (the stock is near an eight-year low), as well as skeptical Wall Street analysts and bond-rating agencies (Fitch downgraded the debt last week) are demanding a cease-fire -- and it appears new CEO James Cantalupo is listening. In a conference call two weeks ago, in which McDonald's announced its first quarterly loss in 37 years as a public company, he said, "We are happy with the Dollar Menu -- but we are not married to any single product on it."

Sure enough, a week later, Dow Jones reported McDonald's was expected to make the Big N' Tasty optional on its Dollar Menu. While Mickey D's hasn't made a formal announcement yet, the report indicates Cantalupo is more sensible than his predecessors, and that the price war is likely to end soon. Burger King's Blum sent the right signal, commenting, "I certainly hope it's the beginning of the end for the price wars."

Investment opportunities
If the price war does, in fact, wind down in the near future, many stocks in the sector will begin to move in anticipation of improved results. (The stock market is always forward-looking, so if you wait for companies to report improved results, you'll miss the opportunity.)

So, what's the best way to profit from the turnaround? Wendy's International (NYSE: WEN), Yum! Brands (NYSE: YUM), and Jack in the Box (NYSE: JBX) -- all well-managed companies with strong brands. Their balance sheets are pounding out substantial free cash flow (even during this downturn), and they're buying back shares -- yet all three stocks are all within a few dollars of multi-year lows.

This chart has some basic data on each company, and below are some quick comments:

                  Off              Market  '03   '02-03 Est.
Company  Price   Peak  Franchised  Cap($B)  P/E  EPS Growth  ROIC
Wendy's  $26.60   36%      80%      $3.1   13.0     +8%      12%
Yum!     $23.17   30%      79%      $6.8   11.3     +8%      18%
Jack     $16.09   53%      19%      $0.6    7.9     -2%      14%

Note: Prices as of Feb. 4 market close. 
2003 P/E based on most recent company guidance.

Wendy's International
Wendy's has a relatively high P/E ratio, despite modest returns on invested capital (ROIC), because it's perceived to be exceptionally well managed and has been on a roll for at least a decade. From 1990-2001, average unit sales rose 48%, higher than Kentucky Fried Chicken (33%), Pizza Hut (19%), Taco Bell (15%), Burger King (14%), and McDonald's (8%). Wendy's also has strong growth prospects, driven mainly by its coffee and baked-goods chain, Tim Hortons, which dominates the Canadian market and is expanding into the U.S.

Yum! Brands
Yum! is the most diversified company in the QSR sector, with three major brands: Pizza Hut, Taco Bell, and KFC. (It also recently acquired Long John Silver's and A&W.) This is both a blessing and a curse: Diversification smoothes earnings, but it also means one chain is typically encountering some sort of weakness, giving investors a reason to shun the stock.

In the five years since PepsiCo (NYSE: PEP) spun off Yum! (formerly Tricon), it has made tremendous progress. It completed a refranchising program that reduced the percentage of company-owned restaurants from 47% in 1994 to 21% today; the restaurant-operating margin has grown from 13.5% to 15.8%; ongoing operating EPS has risen 20% annually; ROIC has jumped from 12% to 18%; and the company has paid down debt from $3.5 billion to $2.4 billion.

Yum! has adopted the sensible strategy of opening no net new units in the saturated U.S. market; instead, it's focusing on converting existing restaurants to "multibrand" units (e.g., KFC and Taco Bell sharing the same building) and pursing 5% to 6% annual net-unit growth overseas, which offers great promise. For example, KFC is the No. 1 brand in China, and Pizza Hut's best market is Korea.

Jack in the Box
As a smaller chain heavily dependent upon hamburger sales, Jack in the Box has been hit hard by the burger price war, yet it remains quite profitable, continues to expand its operations, and has announced plans to buy back 5% of its stock in 2003. I'm bullish on this stock for three reasons: 1) It's really cheap; 2) as a direct competitor to McDonald's and Burger King, it will likely benefit significantly from the end of the price war; and 3) it has launched a refranchising program that will increase its franchised units from 19% of total units to 35% over the next five years. Franchising is a much better business than operating restaurants, so I anticipate that refranchising will boost margins, cash flows, and returns on capital over time.

Conclusion
Investing in the QSR sector today is not for the faint of heart -- no one ever said value investing was easy -- but it should prove to be highly profitable over time.

Whitney Tilson is a long-time guest columnist for The Motley Fool. He owned shares of McDonald's at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or at Tilson@Tilsonfunds.com. The Motley Fool is investors writing for investors.