There's no question big changes are afoot in the fast food industry. The rise of the fast casual segment has brought tremendous growth to companies like Chipotle Mexican Grill (NYSE:CMG) and Panera Bread, encouraged IPO's from smaller chains like Noodles & Company and Potbelly, and put pressure on traditional fast food franchises like McDonald's (NYSE:MCD) and Yum! Brands (NYSE:YUM) KFC and Taco Bell.
Chipotle's recent earnings report is evidence of just how powerful the shift is. During its third quarter, the burrito chain showed off a comparable sales growth of 19.8% -- a level virtually unheard of in the restaurant industry -- as revenue jumped 31% and net income soared 57%, benefiting from a price increase and the huge jump in comparable sales.
On the earnings call, founder Steve Ells shared his thoughts on the company's quarter and what Chipotle's performance says about today's fast food consumer and the future of the industry. As the founder of the company that's disrupted the industry, Ells has perhaps more insight into the industry than anyone so his words should carry weight with both Chipotle investors as well as those of its rivals:
"Our ability to generate such strong sales growth is the result of our commitment to serving the best-tasting food we can. Food that is made with ingredients from more sustainable sources and prepared using classic cooking techniques ...
This formula is unique in the world of traditional fast food in some very important ways. The traditional fast food sector has traded food quality and taste for low cost and ease of preparation. It has aggressively marketed low prices to entice customers to visit more often, which has resulted in the need to reduce cost by cheapening ingredients and by compromising the overall dining experience. We have not made these compromises because our fundamental belief is that in order to provide an extraordinary customer experience, you cannot take shortcuts ...
The gimmicks that have driven the fast food sector for years -- dollar menus, limited-time offers, and merchandising partnerships are not producing results like they used to, as consumers simply want better-tasting, nutritious food and a more compelling experience, not gimmicks. In some cases, these other companies are looking to revamp their branding efforts to change their customers' perception but not the food. Fundamentally, these are shortsighted reactions that seem out of touch with what customers want: better food and more compelling dining experience."
It's hard to argue with that theory when McDonald's is seeing comps at its U.S. locations slide by more than 3% while Chipotle's are soaring. A Consumer Reports survey in July of 65 fast food chains confirms Ells' beliefs, finding that fast food consumers have begun to value quality above price. McDonald's was last on the list of burger joints surveyed, while Chipotle found itself at the top of the fast casual bunch. KFC, Sbarro's and Taco Bell also ranked near the bottom.
Perhaps more importantly, the trend toward fast casual is being pushed by millennials, who are only growing in size and spending power. The survey found that millennials are more inclined than their parents' generation to go out of their way for a good meal, and are more concerned about the quality of the food they're eating.
That means that this trend is only likely to pick up as the country's demographics change.
Why this is terrible news for McDonald's, KFC, and the rest
McDonald's and its ilk have already taken steps to emulate the fast casual chains, by remodeling their restaurants to look more modern and introducing new menu items such as Wendy's pretzel bun and natural-cut fries.
McDonald's, for one, is no stranger to reinventing itself having borrowed from Starbucks in its McCafe line and introduced trademark items over the years including the Egg McMuffin and Chicken McNuggets, as well as healthier items such as salads and snack wraps.
But while the Golden Arches can mimic Chipotle's minimalist decor, delivering fresh, high-quality food in the way that Chipotle does will be difficult, if not impossible. Chipotle prides itself on having no microwaves, can-openers, or freezers. McDonald's is a restaurant for the industrial age, built on a frozen supply chain, and automated operations that include pre-heating food and keeping it warm in hot holding units before serving. The investment it would take for the company to reinvent itself in order to compete with Chipotle on food quality would be enormous. It's not going to happen. As Ells said, traditional fast food will make efforts to change the consumer perception but not the actual food.
And that will continue to be a problem for McDonald's and the older fast food chains. Consumer demand is shifting and these companies are not meeting the needs of new consumers, i.e. millennials. The shift to healthier eating is evident as well at the grocery level as organic food sales are soaring; clearly this is no fad.
For McDonald's and the others, that's reason enough to suspect today's tough times are not just a speed bump, they're the new normal.
Jeremy Bowman owns shares of Chipotle Mexican Grill. The Motley Fool recommends Chipotle Mexican Grill, McDonald's, Panera Bread, and Starbucks. The Motley Fool owns shares of Chipotle Mexican Grill, Panera Bread, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.