McDonald's And Yum Are Facing Tough Headwinds

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 marketsThere 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.

Yum! Brands' Challenges Are Bigger Than You Think

It’s been a frustrating year for Yum! Brands’ (NYSE: YUM) investors, as the fast-food giant has faced some significant challenges in China. The country is at the forefront of Yum!'s efforts to shift toward becoming the emerging-market fast food company du jour. Will the company's problems prove temporary, or are there underlying macro-economic reasons for the weakness in the Chinese fast food sector?

Finger-licking buying opportunity?

The investment thesis behind buying Yum! is that its difficulties in China will be swiftly resolved, and the company’s sales and margins will come back strongly in the second half of the year.  If you buy this argument then you must look into the causes of its problems.

Yum!'s issues in China started with a scare over the quality of its chicken supply, and then moved on to consumers being reluctant to eat poultry due to an outbreak of avian flu. The positive case sees these problems as being short term in nature, and the current valuation as being attractive relative to its long term prospects.

A quick look at its trailing P/E ratio:

YUM PE Ratio TTM data by YCharts. 

Superficially, the above suggests the stock is currently expensive. In addition, if you assume it hits its estimate of “mid-single-digit percentage decline” for 2013, then the stock is priced at roughly 23 times forward earnings as I write.

However,  Yum! forecasts its Chinese sales growth to turn positive in the fourth quarter, with 2014 turning into a year of stellar growth because comparables will be a lot easier. If Yum! hits analysts’ estimates of $3.79 in EPS for 2014, then the stock would be trading on a forward valuation of 18.8x earnings.  This makes it look historically cheap, so should you pile in?

KFC disappoints in China 

In its latest results, Yum! reported that its same-store sales for KFC in China were down 20% for the second quarter in a row. However, in its recent conference call, Yum!’s management outlined – in no uncertain terms – that its EPS forecasts were dependent on Chinese sales coming back swiftly for its KFC operations. It also served up a few indicators as to why it feels confident:

• KFC same-store sales in China were down 13% in June, compared to 26% for the second quarter, indicating that the worst may be over.

• KFC made low-teens sequential improvements in same-store sales in China from April to May, and then May to June.

• Yum!’s second major restaurant chain, Pizza Hut, recorded 7% same-store sales growth in China for the quarter, suggesting that KFC’s problems are company-specific, not due to a weakening Chinese consumer market.

• Overall emerging-market-same store sales grew 5% in the quarter 

In order to demonstrate the importance of China to Yum!, here is a chart comparing its quarterly operating profit and the percentage of Yum!'s total operating profit that comes from the country:

Source: Yum! Brands financial statements.

In summary, all of these points suggest that Yum! can turn around performance in its key profit center. But what is the rest of its industry saying?

A twist in the tale

Unfortunately, Yum! isn’t alone in seeing weaker results in China. In fact, its biggest rival, McDonald’s (NYSE: MCD), also started to see its same-store sales growth slowing at the end of 2011. The main difference appears to be that Yum!’s performance notably deteriorated after the chicken supply scare had its effect. However, the downtrend was already in place by then, and it should be noted that McDonald’s Asia-Pacific Middle East Africa (APMEA) sales haven’t been strong this year, either. All the data in the chart is sourced from company accounts.

It’s all very well for Pizza Hut to be generating growth in China, but KFC makes up more than  74% of Yum!’s restaurants in the country.

Moreover, Burger King (NYSE: BKW) also reported some disappointing numbers in its first-quarter results to the end of March. For example, its global comparable same store sales growth fell 1.4%. In addition, its results in Asia-Pacific (APAC) weren’t much better with a paltry 2.7% systemwide comparable sales growth recorded in the region. Furthermore, Burger King argued that the rise in APAC was due to positive performances in Korea and Australia, thanks to a combination of value promotions and programs.

In summary, neither Burger King nor McDonald’s are reporting anything particularly positive on the global sales environment, let alone for the Far East.

The bottom line

Yum!’s peers are seeing difficult conditions in China, so this looks like it is more than a company-specific issue. Yum! is a compelling proposition, but cautious investors will want to take a pass. The company probably will engineer a recovery in China, but it may not be of the magnitude needed to take the stock materially higher.

McDonald's Facing Challenges

The market gets what the market wants and, for the first quarter of 2013, the market has wanted relatively (as compared to treasuries) high yield ‘defensives.’ I use inverted commas because when looking at a stock like McDonald’s (NYSE: MCD) I’m not convinced it is as attractive as the market thinks it is. Furthermore, if you buy a stock because it is fashionable then you better be prepared for any disappointment should fashion change.

McDonald’s Disappoints

It’s been a tough year for the fast food sector, and McDonald’s delivered another quarter of disappointing same store sales growth. Moreover, it described the informal eating out industry as being flat or declining in many parts of the world. So where did it all go wrong? Wasn’t this supposed to be the great defensive stock that proved itself so well in the last recession?

My take on this is that the 2008-09 recession certainly resulted in a significant amount of global unemployment and income insecurity, which fed through into consumers trading down and adjusting their behavior by dining out in cheaper outlets. Such conditions played perfectly into the hands of companies like McDonald’s and Yum! Brands (NYSE: YUM). In addition they had growth opportunities in expansion into China.

Fast forward into 2012 and the trading down has run its course and suddenly comparables are getting a lot harder. The easy growth has gone and the challenges are building. Sales growth from China is slowing, and McDonald’s is having problems adjusting its menu to deal with the slowdown in Europe. I discussed some of these issues at the start of the year.

 A look at its global comparable sales growth for the last few years.

Spot the slowdown?

Market Share Gains

While recognizing that the US market is tough, McDonald’s spent a lot of time trying to convince investors that it was gaining market share in the US. The idea is that the key to its long term growth would be the retention of market share and not necessarily margin or cash flow growth. It’s hard not to think that this is going to have an effect on Yum and Burger King (NYSE: BKW) in the US.

But this isn’t just about the US. The optics in China are becoming cloudy thanks to a combination of the chicken supply problem at Yum’s subsidiary, KFC, and a later outbreak of Avian flu. All of which has caused issues for the rest of the fast food outlets in China. While this is causing some to believe that there is an inbuilt opportunity to bounce back in the second half of 2013, I’m not so sure. If you look at the chart above, McDonald’s APMEA growth was slowing well before these issues kicked in. Indeed, it was a similar story with Yum, so this isn’t just a story of some temporary weakness.

So even while China’s performance is uncertain, there is no let up in investment with McDonald’s planning to open hundreds of restaurants in China in 2013. Similarly Burger King wants to open 1,000 stores in China within the next seven years, and the country is the focal point of Yum’s growth plans. Obviously these companies wont adjust their long term strategic plans based on some temporary weakness, but might it prove a longer term issue?

As for Europe, despite previous efforts to take action in France and Germany conditions remain weak in Europe, and macro challenges in Southern Europe mean that growth will be hard to come by. Only the UK and Russia are performing in a manner that McDonald’s can be happy with.

Where Next for McDonald’s?

I think this is going to be a tough year for the company. Commodity costs are only forecast to go up 1.5-2.5%, but the real driver of earnings growth will be sales growth. Given that the stated strategy is to preserve or gain market share, it is hard to see any significant margin expansion this year. There is a lot of uncertainty with China, Europe remains in difficulty, and the US is becoming increasingly competitive. In conclusion it is hard to make the case that McDonald’s is the kind of defensive play that investors should be chasing, and if the market loses its fixation with yield then it might not be so well supported.