Trends to Watch in the Fast Food Industry

By Daniel B. Kline Markets

In this episode of Industry Focus: Consumer Goods, Motley Fool's Vincent Shen and Daniel Kline talk about some of the major trends that are taking form in the quick service and fast casual restaurant industry. From ever increasing competition to the threat of automation, here is what you need to know.

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A full transcript follows the video.

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This podcast was recorded on Jan. 26, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day.I'm your host, Vincent Shen,and it is Thursday, January 26th. This is my third straight dayin the studio this week,thanks to Austin, our man behind the glass, foraccommodating the packed schedule. We are pre-recording yet another episode so that fool.comcontributor Daniel Kline can join mein studio while he stops by here at Foolheadquarters. Hey, Dan! Happy to have youwith us!

Daniel Kline: Happyto be here, a lot more fun thandoing it over Skype.

Shen: I agree. Inlight of our main topic today,which is major trends that we're watchingin the fast food industry,can you tell me, Dan, what was the last major fast food chain you dined with?

Kline: Chipotle.I wanted to try thechorizo. I've heard complaints,people say it's dry.I think it's really good. It's tasty,it's different, it's a nice change of pace.I think the market --and we'll talk about this a little with trends later on -- ispoised to hate anything Chipotle does. If they came out and said, "It'sfour tacos for $5and we give you a $10 bill when you finish," people would be like, "Ugh, it's costing me ... "it just wouldn't work. So,I think they're making the right moves,and I have been a customer steadily,but they're in a lose-lose situation now.

Shen: Sure. Andevery time I go, maybe a couple times a month --and I usually go for dinner,because there's one really close to my place,and I'm always watching the lines. Pre-foodsafety scandal, the line was always out the door around 7:00 or 7:30. Now,it's gradually building back up, it's a little promising, at least.

Kline: I think it's one of the problems they have. We're also going to talk about this later on the show.If you go to Chipotle, and there's three people in linein front of you, it could take 25 minutes.I think that has hurt them as much as the E coliscandal. That, andevery time they make an announcement, "Chipotle is going to do something new,"I expect them to say, "We'regoing to melt the cheese,"because it's more fun to bring Chipotle home andthrow it in the microwave for eight seconds,and then it's not cold. Theirentire model is built aroundgiving you a cold taco,and you want a hot taco.

Shen: OK. First topic we'll touch on, forthe fast food industry,this is with discounting andsome of the price wars. I know you'vewritten about this. You think about the more traditional chains likeMcDonald's (NYSE: MCD)andBurger Kingand howpeople stillapproach that kind of restaurantwith value in mind,and how the different companies are trying to capture that. Whatis the story here, andlooking at the bigger picture,looking out at least a few years, how do you thinkthis will change? Do you think it's only going to get worse, andmargins are going to get tightened?

Kline: It'sgoing to get worse. It's a tightrope. The number we talked about this morning is,McDonald's, since 2012when it dropped the dollar menu,has lost 10% of its U.S.traffic. It has made up for that in charging more. Theproblem is, if your traffic keeps falling, you eitherhave to keep raising prices orgetting people to spend more or,eventually, you're going to lose business. Thetightrope that everybody is walking is,how do we have attractive values thatbring in customers that are shopping value, orbring in someone who's pretty sure that's what they're going to get,and they add a shake and who knows what else to their meal?

Andthe way it's been working at every place except McDonald's,Wendy'sand Burger King, they'redoing those four or five itemsfor $4 or $5 packages, where you get the burger, the fries, thechicken nuggets and the drink, for $4. The problem is,you're starting to see margin go down on those,because to be fresh, now Wendy's offers adouble cheeseburger in theirs,and somebody else offers bacon on their cheeseburger. Every item you add,every little beef or whatever it is you add in cost, you go from four chicken nuggets to five, takes analready losing proposition and makes it even worse. Andit goes back to, these were originallylimited versions of value, of dollar menu. Youcouldn't buy one item and just spent $3 bypicking and choosing, you have to buy the package. Butit's a very tight line, whereyou and I want to go to lunch,I want to be cheap, you'rewilling to get the extra stuff,and we pick Burger King because I can spend $4 andyou end up buying three Whoppers orwhatever it is you get at Burger King.

Shen: Sure. Itseems, as well, between these companies, there's always this issue ofone-upsmanship with these packages. Somebody started with a four for $4, then it was a five for $4. Before you know it,I think, longer-term, the way that I view it is, thesefast food restaurants generally occupy the lower rungsof the price ladder. That'swhy people tend to like them, the value there. Butthese value-based offerslike theMcPick 2 or the four for $4, they cansometimes bring in new traffic. But if you really think about it,they ultimately reinforce the expectation that thesecompanies and their menus will be very cheap.

Kline: Thebigger success in the fast foodspace has really been innovation. Ifyour Burger King and you can do a tie inand have the Kit Kat Burgerwhere the buns are both Kit Kats,or whatever ridiculous trend you come up with,people will pay for that. So,as you go forward with this, thecorrect play is to do valuesometimes. You want to during slow timesto incentivize people,maybe times that they're out anyway, so say, "Yeah,we have 10 nuggetsat Burger King for $1.49." Whenthat becomes a permanentmenu fixture, then people go and look, "Where can I get thecheapest cheeseburger?" Andthat's a very slippery slope that can end very badly, as it did for McDonald'sfor a lot of years.

Shen: Yeah,I think the innovation that you mentioned is really important.Coincidentally, McDonald's hasactually reported their fourth quarter andfull year 2016 results earlier this week. Whatreally jumped out to me was, for their, obviously they're largest, there'salready a loss of the momentum that they hadfrom all day breakfast. Thethird quarter, their comps were up 1.3%. Secondquarter, up 1.8%. First quarter of 2016, up 5.4%. That was, of course,because the all day breakfast had launchedrelatively recently at that time. You can see it's waning. Andnow, for the most recent fourth quarter, they're down to (1.3%). So, the comps areonly going to get harder as they enter Q1 for 2017. Overall, I feel like there is a lack,maybe, on the service side with kiosks and things like that. We'll talk more aboutthat. But in terms of the menu innovation McDonald's has had very littlesuccess with that. The burger hasn't really changed for many years.

Kline: McDonald's has taken a different strategy. Burger King is doingwhat, in the world of professional wrestling, they would call hot shotting. You takesomething that's going to go big and bright and burn out.Mac and Cheetos isgoing to be the equivalent of having Mike Tysonat Wrestlemania. It'sexciting for a minute,but it has no legs. SoBurger King and Taco Bell andKFC, they'rein this position where they endlessly have to innovate.

McDonald's should be innovating more, but they'vetaken a different strategy. What they'vedecided to do is,they're going to try the three differentsizes of Big Mac,because they found that only20% of Millennials have tried a Big Mac. So,they're going to make a push on that product. But they're also taking the long-range approach of,how do we grow our coffee business? They've been doing that with the $1 forany size coffee, $2 for any small specialty drink. So, they'renot looking at short-term innovations. They're looking at things like all day breakfast, if theyexpand that and add the McGriddle to that menu, can that be asustainable bump?

And I think they should be havingsome gimmick burgers,and because they're McDonald's, they can make a deal with anybody. But,they are taking a smarter approach. At some point, Taco Bell orBurger King is going to have a quarter wherewhatever ridiculous tie in they try,the Funyuns Taco is notgoing to be popular, or theBurger Kingburger served on four Twinkiesis not going to go over well, and they'regoing to have a 10% drop in salesbecause they just can't sustain the gimmick factor.

Shen: Fair enough. So, there's two companies,at least one in particular,that I would consider part of this space,not a burger company, at least,that I think has very much bucked this trend. That'sDomino's(NYSE: DPZ) andPapa John's. Domino's isobviously the one that has seen incredible success. Anybody who'sbought into the stock in the past three or four yearshas probably been very pleased with the results.Domino's annual revenue growth has been in the double digitsor darn close for three years running. Their comps aresimilarly elevatedover the other big players in the industry, theircompetitors. We talk about innovationon the menu. Domino's is in aninstance where they're really embracing technology. They'rereally embracing it like nobody else hasbefore. I think they have something like 14 or 15 or more ways for ordering a pizza from the company.

Kline: From apractical point of view,I would say them andStarbucksareright in the same realm. But,what Domino's has done is they've taken agood enough product --I mean, you and I eat pizza,no one is sitting around going, "You knowwhat my favorite pizza is? Domino's." But, at 11:00 at night, they're going, "Whatpizza can I get that I only have to text an emoji to get?" Not thata lot of people are using gimmickordering, but what they are using is,Domino's has a very innovative app. It's very simple to order, you canprogram a recurring order very easily,and the Pizza Tracker lets you seewhen your pizza is getting made,when it's getting delivered. So, they have a lower-end-of-the-marketproduct. Every town has three pizzaplaces that offer better pizza than Domino's or Papa John's. Butwhat those two companies --Domino's more than Papa John's,but Papa John's is catching up --have done is make it superconvenient.

We talked about this this morning --pizza lends itself very well to this. There aremarkets where you can get McDonald's delivery,but if you live five minutes away from a McDonald's,the fries aren't going to be as good when they get there. Cold pizza is fine. Throwing apiece of pizza in a microwave or toaster ovenis still pretty good. So, theproduct they're selling -- andDomino's and Papa John's are both kind of a doughy pizza --travels well. So they have made a verystrong package. It's not about the pizzabeing the best. It's not about itbeing the cheapest, although they do do a lot of pricing deals. It really is about, "Hey,I'm a little drunk and it's really easyto get a Domino's pizza," or there's50 college kids sitting around studying,let's just order a mess of pizzas, and calling the local place,you have to make a phone call, it's going to take 45 minutes,maybe you have to go pick it up.Domino's makes it very simple, andthat has worked very well.

Shen: Sure. I will add,I was surprised to find,Domino's market share for pizza delivery issignificant at 20%. But that still leaves them apretty decent amount of room to grow. I think they've managed to grab share, especially with their growthin recent years.

Kline: They've been growing -- I don't remember the exact number, but -- about five years U.S. year-over-year growth, andglobally, it's about three years. So, they have a modelthat you can pretty much extend. And what happens is,in a lot of cases, they open a new store,and it's taking off pressure from an existing store. So,they already have a store that'spushing 110% capacity, they open a new one, and it justgrows that business and rolls it intobeing able to get you pizza faster.

Shen: There have been estimates,I believe the company sees, just in the U.S.,potential for as many as 6,000 locations. So, amassive network of stores. But,before we move on to the next topic, one place thatDomino's is facing issues, andthis goes back to our earlier discussion, isultimately,like the burger chains and fast food industry, they are still facing an issue oflacking the flexibility to raise prices. This,obviously, comes from competition of thefirst company we talked about in the show, withChipotle. You have some of thesefast-casual names, better burgers,&pizza, whichI'm a huge fan of here in D.C. Essentially, thosecompetitors have managed to narrow the gapbetween what you're paying forjust a little bit morewith a pretty decent jump in quality.

Kline: I mean, fast casual pizza, we have four chains near me that are Blaze Pizza and a few local ones that do that sort of make-your-ownChipotle concept, and the pizza is all very good,and it's full price, even the ones that deliver,it's very expensive compared to Domino's. ButDomino's and Papa John's do something very subtle in the pricing that you may not think about. The pizza is cheap.You can always get $7.99 two mediums atDomino's, there's always deals on that,but there's never a deal on the salad. There'snever deal on the wacky bread orwhatever it is that they call their bread products that they sell you. Thedessert products might be a throw in,but the soda isn't. So,there's a lot of ancillary items that build up that check. Andas much as their heavily discounted --you're right, there's a ceiling. If Domino's gets to $12.99 for a pizza,you might go, "I'mgoing to go to a better pizza place." Butbecause you're spending so little, it's really easy to throw in thatPapa John's pizza cookie, andpump your check up. So it's a smart strategy. Plus, you'renot going to necessarily order McDonald's or Chipotle for 75 friends,but if you're having a Super Bowl party,Domino's is still pretty convenient, and they'remaking it up in volume.

Shen: Sure. Andfundamentally,it's the same idea from what a McPick 2 hopes to do --bring you in on that value, two pizzas for $8, but then, with everything else on the menu --

Kline: Youget a coffee,you get a shake, you buy a Grimace costume,it could really be anything.

Shen:For our finaltopic of the day,getting more high-tech, is the idea --and this is something that I think we had somepretty fun discussions about in the past -- of fast food workers going away. I thinkwe can't deny that calls for higherminimum wages or something that you seequite often in headlines. Even here in the D.C. region, the cityrecently approved a $15 minimum wage that willgradually reach that level by 2020 in the city. From what I could find for theindustry at a McDonald's,labor costs are a very significant piece of their cost structure,usually around 20% to 25% for these chains. What do you think? Howdo you think this is going to mold things?

Kline: There'sgoing to be two phases of this. Thecurrent phase we're in now is Starbucks,Panera, Dunkin' Donutsthat are using technologynot to take employees out of stores,but to make stores more efficient.Chipotle is starting to do that. TheChipotle order app,where you can mobile order and pay, they're runningseparate lines. The line you see atthe front of the Chipotle where the person makes your food,in the back, there's another one of those. So, they'renot necessarily firing employees,or using less people in stores. They're putting more people into production.

That'swhat Starbucks is doing. So,instead of somebody having to take your orderin the line, they're making your drink,so people go through faster,the store serves more people. That's phase one. Phase two,you're going to start seeing the McDonald's of the world that have bigkitchens and don't need extra production help, they'regoing to start putting ordering in kiosks, and that is going to take their head count down. They'redoing that all across Europe and Canada. So,whereas there might be four or six cashiers, there might be 12 kiosks with one or two employees who are helping you through that,and maybe there's an extra customer service personfacilitating the process. And then,eventually, you're going to start to see, at the wealthier fast food chains, maybe fries atMcDonald's won't be made by human being. Maybe your Big Mac still will bebecause it's customizable and there's a lot to go into it. But, you'regoing to see less labor.I don't see any way around that.

Shen: Sure. Youbring up a really good point.It'll be very much a gradualtransition. Some of the examples you brought up in aMcDonald's with some of the self ordering kiosks, very popular, thePanera Bread we have across the street from Fool HQ here,also a similar situation, I think there's five or six tablets ready to go. Ithelps them turn down the staff.

Kline: Andthis has been happening for 20 years.I'm a slight bit older than you,and when I was a kid and you went to McDonald's and you ordered aCoke,someone poured a Coke. Now, most McDonald's have Coca-Cola Freestyle machines,where not only do I have an enormous amount of choice --I can get diet vanilla root beer andmix it with Fanta orange if I want --all the person at the counter has to do ishand me a cup. So,this labor has been coming out of the fast food process inlittle ways for a long time. Andyou will start to see service being a premium,meaning Starbucks'willingness to have a person make your drink exactly the way you want it,where is Panera Bread just hands you acoffee cup, that's going to be a differentiatorfor some of these brands. So you may see fast casual concepts double down on people and actually charge more for the experience of getting your pizza not made by a robot pizza machine.

Shen: Lookinga little bit further ahead,we have some pretty big names in Silicon Valleyworking to develop better AI,better automation. Obviously,it seems like a very natural next step for that technology to beintegrated more and more into this industry, as we'vediscussed here.I guess I want to talk a little bit about some examples of some of the more high-tech stuff,still very much in the testing stages. One, I found that, for acompany we talked about just a few minutes ago with Domino's, this made me chuckle, they have their DRU, the Domino's Robotic Unit,which is essentially anautomated vehicle --but not a full size car. It has the capacityto hold as many as 10 pizzas in a heated compartment. It can handledeliveries within a 20 mile radius on a single charge. They'realready testing stuff like this.I think it's limited to New Zealand and Australia right now. They'vealso handled some issues with theft, withsecurity cameras, with the locked compartment. But it is, to me, aglimpse of the possibilities.

Kline: I thought you were going five years after thatin the future, where pizza robots are overlords.[laughs] Domino's has been very goodabout what I'll call the concept-car concept. When you go to an auto show andFordis showing anamphibious car that can fly and make you a latte,some of this Domino's technology,even as goofy as when they were delivering you pizzas viareindeer,it's just to get attention, butaspects of it are going to come out. I don't see a world in the near future whereautonomous pizza delivery cars are going to make a lot of sense in most markets. But,automating more of that process. There's no reason a man needs to take the glob of dough andput it into the pizza thing. That could absolutely be a machine that does that. So, you'regoing to see more and more of that. Andthat will make the process more efficient. And yeah,maybe in Manhattan, there'sgoing to be drones and robots. In very densely populated places, you'll see that. But I think a lot of that now is attention-gettinggimmicks. Domino's does not really intent --it's not cost effective to have a drone deliver me a small Cokeand a medium pizza.

Shen: So, last point here, you mentioned on the service side,having that human element be a differentiator, and how the next steps,it seems like right now, the ordering process is becoming automated. But with the food prep, it's still a challenge.I do want to bring up one example that shows that we are there,and it's just a matter ofreaching that mass scale. There's a company I found calledMomentum Machines, based in the West Coast, they garnered some buzzlast year in advance ofopening a restaurant with a robot that could flip 400 burgers an hour,cut your vegetables, and do quite a bit of that process,in terms of the burger prep. So,it really seems likeso many things right now are in the concept stage,and you'll get all these elements of itkind of like how you described, but for these trendswe talked about today, in terms of the competition, some of thediscountingissues thatthe industry faces,but also on the flip side, howthey're trying to tackle increasing costs andthings like that. It's really funny,how all this comes together.

Kline: It'sa question of cost. If you look at how McDonald's makes aMcCafebeverage versus how Starbucks does itversus how a local place does it,Starbucks is a little automated,McDonald's is basically push button, there's no barista,it's the same guy who makes your fries, makes your latte orespresso or whatever it is. But there's very few restaurant chains that canget to this quickly. So, if you are a McDonald's franchisee,and McDonald's comes to you and says, "Good news,you can eliminate 50% of your staff. Bad news, there's a $4 million investment toput in the automated burger machineand all of the other technology." So,this is going to be gradual. You're going to see,like I said before,maybe McDonald's, one of the more successful franchise models,might say to its franchisees "In 2018, you aregoing to automate making french fries and chicken McNuggets,and that's a $200,000 machine," orwhatever the number is. That's not going to fly atWendy's orArby'sor any ofthe less successful, or aSubway, wherethe average franchise owner is making a nice salary, or if they'repaying a manager, they're making $40,000 to $50,000 inprofit. I'm sure some make more. They'renot going to be able to invest. So,this is going to happen,and I'm sure you're going to see some start-up money where it's a pizza place where there's no human,you put your money in and boop boopa robot makes you a pizza. Butit's not like, three years from now, you're going to go to the mallfood court and there won't be people there.

Shen: Yep,definitely lookingfarther out, for sure. Anything else that you would like to end on, in terms of, maybe, other trends that you're watching,things that aren't as prominent now but might be coming up down the line?

Kline: Yeah.I think there's going to be a lot of shake out. Wetalked about fast casual pizza,and I've written about fast casual burgers. There aregoing to be winners and losers in these spaces. There is absolutely room for aChipotle of pizzaand a Chipotle of burgers,and probably a number two and maybe even a number three company,but there's not room for 17. Andjust like we've seensome of the wannabe Chipotle knock-offs suffer,some of these companies are going to go away,or they're going to consolidate. You'realso seeing, in the step above that, in yourChili'sandRuby Tuesday, they'restruggling to find a business model. So,I think you're going to see a lot of restaurant closures. You saw a lot last year,whole chains going out of business. I think that'sgoing to continue, and maybe get worse.

Shen: All right. It was great having you on, Dan. I'mexcited to see some of the continuous changes that I'm sure we'll come through for the industry.

Kline: I think we're going to have to do some field testing on this one.[laughs]

Shen: [laughs] That wraps up the show fortoday, but you can reach out to us and the rest of the Industry Focus crew via Twitter @MFIndustryFocus,and you can also send us questions via email to Peopleon the program may own companies discussed on the show, and The Motley Foolmay have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!

Daniel Kline has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill, Ford, and Starbucks. The Motley Fool owns shares of Papa John's International. The Motley Fool is short Domino's Pizza and has the following options: short June 2017 $140 puts on Domino's Pizza. The Motley Fool recommends Coca-Cola. The Motley Fool has a disclosure policy.