Fast food on the menu as cost of living bites
As budget-conscious consumers start to tighten their belts, we explore the impact on the competitive fast food industry, and identify opportunities for investors.
Mentioned: Oliver's Real Food Ltd (OLI), Restaurant Brands NZ Ltd (RBD), Coles Group Ltd (COL), Collins Foods Ltd (CKF), Domino's Pizza Enterprises Ltd (DMP), Domino's Pizza Inc (DPZ), McDonald's Corp (MCD), Papa John's International Inc (PZZA), Restaurant Brands International Inc (QSR), Retail Food Group Ltd (RFG), The Wendy's Co (WEN), Woolworths Group Ltd (WOW), Yum Brands Inc (YUM)
While Australians are cutting back on eating out as cost-of-living pressures bite, cheaper fast food options are still on the menu.
Morningstar director of equity research Johannes Faul says consumers are expected to trade down to more value options rather than stop eating out altogether.
"We expect cost-of-living pressures to weigh on near-term restaurant sales, but for cheaper dining-out alternatives to fare better," Faul says.
That may mean trading a $25 steak night for a cheaper option offered by a quick service restaurant like KFC or McDonald's.
"So, you're just trading down but you still want to eat out," Faul explains.
Aussies are trading down when eating out
Australia's largest supermarket chains Woolworths (WOW) and Coles (COL) have noticed signs of customers shifting to eating more at home instead of dining out as rising food prices, energy bills, mortgage costs and rents hit household budgets.
Outgoing Coles CEO Steven Cain says most people are starting to pull back on their spending at mid-tier hospitality venues, rather than quick service restaurants.
"There's still a lot of Uber Eating going on backwards and forwards with the likes of McDonald's and so on," Cain says.
"I think we will see a bit more of a shift over the next three to six months as these mortgages come off fixed rates and as the energy prices begin to take their toll."
Even when times are tough families still want a dining experience. Picture: AP
It is part of the trading down trend that is also seeing Coles and Woolworths customers increasingly move to cheaper private label products, Faul says.
"It fits with the expectation that if people are still going out to eat or ordering ready-made food, they're probably going to trade down to quick service restaurants, because we're seeing that in food as well with the private labels," Faul says.
Queensland University of Technology retail expert Professor Gary Mortimer says consumers have shifted down from fine dining to more casual dining, and from casual dining at a pub to fast casual - a better quality offering a step above traditional fast food - over the last 18 months.
He points to 'the lipstick effect', that even when times are tough families still want a dining experience.
A cheap fast food meal can often represent better value than replicating it at home, he adds.
Mortimer says Australia's fast food market is highly competitive, with McDonald's, Hungry Jack's, KFC and Red Rooster among the value offerings.
"The area is continuing to be competitive because we've got growth in that sector, and we've got families opting for it when they may have in the past opted for a better quality dining experience," he says.
Wendy's, America's second largest quick service restaurant burger chain behind McDonald's, plans to expand into Australia, flagging the potential for hundreds of restaurants.
Inflation impacting Aussie fast food players
ASX-listed Domino's Pizza Enterprises (DMP) shares have tumbled after price and delivery charge hikes to combat inflation led to customers cutting back on repeat orders, reducing its first-half earnings.
Domino's CEO Don Meij admits the company "didn't get it right" when offsetting increased ingredient costs to protect franchisee profitability, meaning Domino's has been the exception in a buoyant global quick service restaurant market.
Domino's is one of Morningstar's top retail picks.
Faul says Domino's has been losing market share after the price increases made its value offering less appealing to customers, who are also switching to the cheaper carry-out option over delivery.
While Morningstar has cut its near-term earnings estimates for Domino's, Faul sees the pricing issue as temporary.
"We expect Domino's to improve its pricing structure. And we expect same-store sales growth to gradually improve against a backdrop of continued strong consumer demand for fast food."
Domino's is one of Morningstar's top picks among the Australian retailers it covers, with the shares undervalued compared to the $68 fair value estimate.
Faul says while the near-term outlook is uncertain and hinges on a moderation in inflation, the market is overly discounting Domino's significant growth potential.
The company is the largest Domino's franchisee outside of the US, with more than 3700 stores in Australia, New Zealand, Asia and Europe.
Morningstar does not cover the other listed fast food plays which include Crust Gourmet Pizza and Donut King franchise manager Retail Food Group (RFG) and Oliver's Real Food (OLI), an organic fast food chain that recently resumed trading on the ASX after a two-year suspension.
After a 12% increase in first quarter sales, dual-listed Restaurant Brands New Zealand (RBD) says it continues to implement price increases in response to higher costs but margins remain under pressure. It has 376 stores globally including KFC and Taco Bell outlets in Australia and New Zealand.
KFC operator Collins Foods (CKF), which has an April 30 year-end, has also experienced margin pressure from cost inflation. Collins has more than 300 KFC restaurants in Australia and Europe, but in November paused the rollout of new Taco Bell restaurants in Australia.
McDonald's benefits as consumers trade down
American consumers are also trading down from full-service restaurants to quick service restaurants, benefitting the likes of fast food giant McDonald's (MCD).
McDonald's beat market expectations with its first quarter results, as higher menu prices and more customers visiting its restaurants drove a 12.6% rise in global same-store sales amid industrywide traffic declines.
US fast food giant McDonalds screens as overvalued. Picture: AP
Morningstar has raised its fair value estimate for McDonald's to $US260, although equity analyst Sean Dunlop notes the shares continue to look expensive.
"Between a value-focused menu, competitive digital channels (now accounting for 40% of sales in the firm's top six markets), and a modernised real estate footprint, we believe that McDonald's is extremely well positioned to outperform its competitive set against a difficult macroeconomic backdrop."
Dunlop says the US restaurant industry has proven surprisingly resilient despite stout macroeconomic headwinds.
"But between normalising consumer spending patterns, a widening value gap with the grocery channel, and early signs of price sensitivity, we believe that 2023 is shaping up to be challenging."
The best-positioned operators continue to be those with brand-driven pricing power, heavily franchised systems and strong technology platforms, he adds.
Morningstar views the likes of Wendy's (WEN), Yum Brands (YUM) (Taco Bell, KFC, Pizza Hut and The Habit), Restaurant Brands International (QSR) (Burger King, Tim Hortons, Popeyes and Firehouse Subs) and pizza player Papa John's (PZZA) as fairly valued.
The world's largest pizza chain Domino's Pizza Inc (DPZ) remains Morningstar's top pick in the US restaurant space, despite near-term pressure.
Morningstar has lowered its fair value estimate to $US385 following Domino's mixed first-quarter results.
"The move is reflective of a challenging sales environment, with the firm's flagship delivery business (60% of sales, 50% of orders) continuing to suffer as lower-income consumers shift spending toward the cheaper at-home channel," Dunlop says.
Dunlop does not expect a meaningful rebound in Domino's delivery sales until macroeconomic pressures start to abate, likely in mid- to late-2024.
But he says the shares are quite attractive for long-term investors.
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