The Race to the Bottom Is Hurting McDonald's and the Rest of Fast Food

By Markets Fool.com

Image source: McDonald's.

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The fast food boom appears to be ending.

After several quarters of strong growth, riding a tide as the economy moved back to full health and overall restaurant sales were solid, comparable sales at major fast-food restaurants have suddenly slowed. McDonald's(NYSE: MCD), which reported its second quarter earlier this week, saw domestic comps fall from 5.4% in the first quarter to 1.8%, as management cited "softening industry growth during the quarter."

AtSonic(NASDAQ: SONC), that figure fell from 6.5% to 2% in its most recent report in June, with the drive-in chain noting that consumer trends slowed in April and May.

Yum Brands'(NYSE: YUM) Taco Bell saw its first same-store sales dip in more than two years as comps slipped by 1%, while they improved modestly at domestic Pizza Hut and KFC locations, up 1% and 2%, respectively.

In May, Wendy's(NASDAQ: WEN) warned of sales in April sparking an industrywide sell-off and projected that comps for the second quarter would be less than 3%, its guidance for the year. The burger chain has not yet reported second quarter earnings.

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A restaurant recession?

Now, some analysts are warning of a restaurant recession. Restaurants are one of the most popular forms of discretionary spending and are therefore often a leading indicator of economic slowdowns. Stifel Nicolaus analyst Paul Westra downgraded 11 restaurant stocks this week, noting a survey that indicated restaurant sales decelerating in 2017.

Other analysts also echoed the call, with Andy Barish of Jeffries declaring that we are at "the top of the restaurant cycle."

Still, with the stock market at an all-time high in the middle of earnings season and a strong jobs report in June, there is not much of a sign of recession elsewhere, and some restaurant chains outside of traditional fast food continue to deliver strong numbers.

Delivery maven Domino's Pizza(NYSE: DPZ) posted 9.9% comparable sales growth in its report earlier this month, and its rivalPapa John'sis expected to post strong results, as well.

The race to the bottom

The restaurants that have seen the most sudden decline in comparable sales are the fast-food burger chains, includingMcDonald's, Burger King, Wendy's, Sonic, andJack in the Box.

McDonald's launch of all-day breakfast last fall swiped share from its rivals, and now the multiple discounts on offer at each chain seem to be pressuring sales. McDonald's had previously launched its McPick 2 menu, which offers two items for $2.50 or $5, depending on the type of item, while Wendy's has launched a four for $4 meal, and Burger King broke the dollar value with a five for $4 combo. Sonic offers a $5 Boom Box, which features a hot dog, junior cheeseburger, fries, and a drink.

The rampant price competition could be hurting business, and several McDonald's franchisees have complained that the boost from all-day breakfast has ended and that they're now deriving only incremental sales from it.

Fast-food companies are essentially competing with each other over the same pool of customers. These are mature businesses, and discounting -- at best -- steals a customer from a rival. At worst, it causes a customer to spend less at your store than they would have without the discount. The end result is downward pressure on sales and profits for the group of competing restaurants, or a race to the bottom, as consumers have been conditioned to expect cheap meals and operators are stuck in a game of chicken. The low prices may not only mute sales growth but can also eat into the bottom line, as operating profits at company-owned McDonald's restaurants were essentially flat last quarter despite same-store sales growth.

For these competitors, there's no easy way to boost margins, and with macroeconomic concerns being lobbed by financial analysts, the future doesn't look so bright for this group of fast-food chains.

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Jeremy Bowman has no position in any stocks mentioned. The Motley Fool owns shares of Papa John's International. 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.