Competition among fast-food restaurants appears to be on the rise, with chains trying to increasingly differentiate themselves on the basis of price and product. On the other hand, factors such as changing eating habits in addition to volatile energy, food and labor costs could affect profitability. Moreover, most of these chains mainly operate through franchisees and restrictive credit markets could have a negative effect in the business.
Impressive performance
Domino’s Pizza, Inc. (NYSE:DPZ) operates as a pizza delivery business under three segments, with 90% of its domestic operations and the whole international business being franchised. The company is showing a strong international presence, with more than 70 consecutive quarters of positive same-store sales. Its international growth was higher than that of its closest peers, Pizza Hut and Papa John’s Int’l, Inc. (NASDAQ:PZZA).
Among the most lucrative initiatives are digital ordering, a new mobile application and the introduction of pan pizza, a category in which Pizza Hut has been the known the leader. On the downside, some of these initiatives caused costs to rise, which can limit its operating margins. Another factor for higher costs was higher cheese prices.
However, the second quarter’s balance sheet showed amazing figures, with an increase of 10.1% in revenue compared to the year-ago quarter and $0.57 in diluted earnings per share versus $0.47 last year. Moreover, Domino’s Pizza, Inc. (NYSE:DPZ) continued its shareholder friendly policy after repurchasing more than $40 million of its common stock and paying dividends, which during the two quarters of 2013 totaled $11.5 million.
The fact that all of the international business and 90% of domestic operations are franchised provides protection to earnings and hence increases earnings per share and the return on investment. Making investments safer in such a competitive industry always helps.
Are we loving it?
McDonald’s Corporation (NYSE:MCD) is one of the world’s most renowned brands with 34,600 restaurants in 120 countries. The greatest percentage of its locations are franchisees or affiliates and only 6,600 are company units.
McDonald’s second quarter showed moderate improvement compared to last year’s. The US is leading the positive momentum after a great response from consumers to the Egg White Delight sandwich and the premium chicken McWraps.
On the other hand, sales in Europe, Asia/Pacific, Middle East and Africa declined. Global sales increased 1% while consolidated revenue advanced by 2%. Earnings per share increased by 5% as well, up to $1.38. Although figures do not look impressive, I feel confident that in the longer term, the company will be able to generate higher returns on invested capital. Consequently, the company continues its policy of buying back shares and distributing dividends.
I am impressed by the constant innovations in food and beverage made by McDonald’s Corporation (NYSE:MCD). In addition, more efficient kitchens and drive-through locations, free wireless Internet access and restaurant-decor upgrades should help McDonald’s ahead of the competition. A renewed emphasis on value-menu advertising seems to be helping increase customers as well.
The role of China
Yum! Brands, Inc. (NYSE:YUM) is the largest restaurant system in the world with a presence in more than 120 countries and almost 40,000 units. Its main concepts are KFC, Pizza Hut and Taco Bell.
Due to significant lower expenses in the US and the Yum! Restaurants International (YRI) division, costs fell 7.5% year-over-year. In the second quarter, total revenue reached $2.9 billion, declining 8% compared to the year-ago quarter. The outbreak of avian flu in China in April affected sales in the division and, hence, the global results. Negative publicity regarding poultry suppliers in the Asian country are impacting on sales. This plays a key role in the earnings per share, which are expected to decline in 2013 despite the solid results coming from the US and YRI.
However, some initiatives can help boost the business next year. One of the main strengths this company is showing is the expansion and focus on the largest emerging markets with a growing middle class, such as India, China and Russia. As for the U.S., Taco Bell and Pizza Hut seem to be regaining momentum.
Yum! Brands, Inc. (NYSE:YUM) has been carrying out a re-franchising program, which reduces risk in its earnings and facilitates ROE expansion and earning-per-share growth. On the downside, credit volatility could interfere with adding new franchisees. The company’s balance sheet over the last few years shows that this strategy improved operating margins. Moreover, Yum! Brands, Inc. (NYSE:YUM) is focusing on its three largest and most popular brands: Taco Bell, Pizza Hut and KFC, while closing down Long John Silver’s and A&W.
My take
Domino’s Pizza has been showing solid figures for the past few quarters thanks to international expansion, menu innovation and marketing activities. The company is increasing its revenue and boosting its shareholders confidence, so I would definitely start a position in Domino’s.
McDonald’s Corporation (NYSE:MCD) is one of the world’s most famous brands but it isn’t in its best days. Growth seems to be slow and fiercer competition might be taking its toll. Emerging markets appear to be a key to expand and Yum! Brands, although experiencing difficulties in China, might be able to gain some market share from the giant McDonald’s.
Despite the fact that these two companies are not showing great figures, I would say Yum! Brands, Inc. (NYSE:YUM) has more potential to expand and grow and McDonald’s might be a safer investment with a lower return.
Louie Grint has no position in any stocks mentioned. The Motley Fool recommends McDonald’s Corporation (NYSE:MCD). The Motley Fool owns shares of McDonald’s. Louie is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article Fast Food: 3 Picks originally appeared on Fool.com and is written by Louie Grint.
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