What Is Ailing the Fast Food Sector?

This has been a challenging year for the fast food sector, and recent events have suggested that conditions are actually getting worse. Consequently, McDonald's (NYSE: MCD  ) and Yum! Brands (NYSE: YUM  ) are notable under-performers this year, but with much of the bad news already priced in, is this the time to take a contrarian view?

Fast food, slow markets
There are four main issues that have troubled the sector this year.

First, the bifurcated economic recovery in the U.S. has hit the quick service restaurant, or QSR, sector particularly hard in 2013. Indeed, the issue was specifically discussed in McDonald's last conference call: "We continue to experience a bifurcation of the consumer base. McDonald's core customers skew toward those customers whose disposable income is not rising as much and are spending a little bit less in QSR."

Essentially, there are three ways of examining this issue. The bears will see it as portending an economic slowdown next year. A more optimistic view sees the recovery in the QSRs customer base as merely lagging higher income groups. In other words, growth will ultimately return. A third view sees the issue as reflecting some deeper structural unemployment issues in the U.S. economy, which won't be resolved by a little bit more economic growth.

Second, Europe remains a region of weak economic growth. This may not necessarily worry some specialty retailers or companies with the flexibility to adjust their businesses in line with lower growth. However, McDonald's and Yum!'s KFC are definitively going to be exposed to lower-income earners' spending habits.

A look at McDonald's comparable same-store sales growth reveals much about the underlying conditions.

Source: company presentations

Yum! and McDonald's in China
The third and fourth issues relate to China, and they need to be discussed together because it is not clear which one has had the stronger effect on QSR sales in the country. Yum!'s KFC and McDonald's have seen a noticeable weakness in China this year.

Source: company presentations

The question is whether this has more to do with a combination of KFC's chicken quality supply issues and a bout of avian flu in the country, or more with deteriorating economic conditions.

There is a more in-depth look at Yum! Brands here. Its Pizza Hut unit is doing fine in China, and its restaurant margins only declined 1.9% last quarter, despite a 14% decline in KFC sales. The hope is that once the negative publicity surrounding the chicken quality issue subsides, KFC can then get back to very strong growth next year. Moreover, Yum! bulls will likely point to Burger King's (NYSE: BKW  ) recent comparable sales growth of 3.7% in its Asia-Pacific region, concluding that macro conditions are fine and Yum! just needs to execute better.

Unfortunately, this bullish view is starting to look too optimistic. McDonald's reported a comparable sales decline of 3.2% in China. In addition, McDonald's finally bit the bullet and announced a cutback on capital spending on new restaurants this year, with the principle targets being "China and some of those emerging markets."  Furthermore, Yum!'s same store sales growth was slowing even before the chicken supply issue hit in the winter.

As for Burger King's numbers, it's possible that the company experienced growth because it is relatively under-represented in China, compared to Yum! and McDonald's.

Where next for the industry?
In conclusion, conditions don't look like they are getting better for QSR core customers any time soon. The U.S. economy is improving, but the days of McDonald's being a "trading down play" seem to be over. This trading down effect may have worked in 2008, when the middle classes were facing job insecurity and layoffs, but those issues are slowly being resolved. However, conditions remain difficult for lower-income America.

In addition, Yum!'s problem in China has gone on for longer than expected, and it's starting to look like the macro part of it is larger than originally thought. Investors would do well to exercise caution with the sector, as it could get worse before it gets better.

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