Trends to watch in the fast food industry

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.

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 day in the studio this week, thanks to Austin, our man behind the glass, for accommodating the packed schedule. We are pre-recording yet another episode so that contributor Daniel Kline can join me in studio while he stops by here at Fool headquarters. Hey, Dan! Happy to have you with us!

Daniel Kline: Happy to be here, a lot more fun than doing it over Skype.

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

RELATED: America's most hated chain restaurants:

Kline:Chipotle. I wanted to try the chorizo. 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 -- is poised to hate anything Chipotle does. If they came out and said, "It's four tacos for $5 and 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. And every 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-food safety 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 line in front of you, it could take 25 minutes. I think that has hurt them as much as the E coli scandal. That, and every time they make an announcement, "Chipotle is going to do something new," I expect them to say, "We're going to melt the cheese," because it's more fun to bring Chipotle home and throw it in the microwave for eight seconds, and then it's not cold. Their entire model is built around giving you a cold taco, and you want a hot taco.

Shen: OK. First topic we'll touch on, for the fast food industry, this is with discounting and some of the price wars. I know you've written about this. You think about the more traditional chains like McDonald's (NYSE: MCD)and Burger King and how people still approach that kind of restaurant with value in mind, and how the different companies are trying to capture that. What is the story here, and looking at the bigger picture, looking out at least a few years, how do you think this will change? Do you think it's only going to get worse, and margins are going to get tightened?

Kline: It's going to get worse. It's a tightrope. The number we talked about this morning is, McDonald's, since 2012 when it dropped the dollar menu, has lost 10% of its U.S. traffic. It has made up for that in charging more. The problem is, if your traffic keeps falling, you either have to keep raising prices or getting people to spend more or, eventually, you're going to lose business. The tightrope that everybody is walking is, how do we have attractive values that bring in customers that are shopping value, or bring 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?

And the way it's been working at every place except McDonald's, Wendy's and Burger King, they're doing those four or five items for $4 or $5 packages, where you get the burger, the fries, the chicken 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 a double 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 an already losing proposition and makes it even worse. And it goes back to, these were originally limited versions of value, of dollar menu. You couldn't buy one item and just spent $3 by picking and choosing, you have to buy the package. But it's a very tight line, where you and I want to go to lunch, I want to be cheap, you're willing to get the extra stuff, and we pick Burger King because I can spend $4 and you end up buying three Whoppers or whatever it is you get at Burger King.

Shen: Sure. It seems, as well, between these companies, there's always this issue of one-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, these fast food restaurants generally occupy the lower rungs of the price ladder. That's why people tend to like them, the value there. But these value-based offers like the McPick 2 or the four for $4, they can sometimes bring in new traffic. But if you really think about it, they ultimately reinforce the expectation that these companies and their menus will be very cheap.

Kline: The bigger success in the fast food space has really been innovation. If your Burger King and you can do a tie in and have the Kit Kat Burger where 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, the correct play is to do value sometimes. You want to during slow times to incentivize people, maybe times that they're out anyway, so say, "Yeah, we have 10 nuggets at Burger King for $1.49." When that becomes a permanent menu fixture, then people go and look, "Where can I get the cheapest cheeseburger?" And that's a very slippery slope that can end very badly, as it did for McDonald's for a lot of years.

Shen: Yeah, I think the innovation that you mentioned is really important. Coincidentally, McDonald's has actually reported their fourth quarter and full year 2016 results earlier this week. What really jumped out to me was, for their U.S. business, obviously they're largest, there's already a loss of the momentum that they had from all day breakfast. The third quarter, their comps were up 1.3%. Second quarter, up 1.8%. First quarter of 2016, up 5.4%. That was, of course, because the all day breakfast had launched relatively recently at that time. You can see it's waning. And now, for the most recent fourth quarter, they're down to (1.3%). So, the comps are only 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 about that. But in terms of the menu innovation McDonald's has had very little success with that. The burger hasn't really changed for many years.

Kline: McDonald's has taken a different strategy. Burger King is doing what, in the world of professional wrestling, they would call hot shotting. You take something that's going to go big and bright and burn out. Mac and Cheetos is going to be the equivalent of having Mike Tyson at Wrestlemania. It's exciting for a minute, but it has no legs. So Burger King and Taco Bell and KFC, they're in this position where they endlessly have to innovate.

McDonald's should be innovating more, but they've taken a different strategy. What they've decided to do is, they're going to try the three different sizes of Big Mac, because they found that only 20% 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 for any size coffee, $2 for any small specialty drink. So, they're not looking at short-term innovations. They're looking at things like all day breakfast, if they expand that and add the McGriddle to that menu, can that be a sustainable bump?

And I think they should be having some 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 or Burger King is going to have a quarter where whatever ridiculous tie in they try, the Funyuns Taco is not going to be popular, or the Burger King burger served on four Twinkies is not going to go over well, and they're going to have a 10% drop in sales because 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's Domino's (NYSE: DPZ) and Papa John's. Domino's is obviously the one that has seen incredible success. Anybody who's bought into the stock in the past three or four years has probably been very pleased with the results. Domino's annual revenue growth has been in the double digits or darn close for three years running. Their comps are similarly elevated over the other big players in the industry, their competitors. We talk about innovation on the menu. Domino's is in an instance where they're really embracing technology. They're really embracing it like nobody else has before. I think they have something like 14 or 15 or more ways for ordering a pizza from the company.

Kline: From a practical point of view, I would say them and Starbucks are right in the same realm. But, what Domino's has done is they've taken a good enough product -- I mean, you and I eat pizza, no one is sitting around going, "You know what my favorite pizza is? Domino's." But, at 11:00 at night, they're going, "What pizza can I get that I only have to text an emoji to get?" Not that a lot of people are using gimmick ordering, but what they are using is, Domino's has a very innovative app. It's very simple to order, you can program a recurring order very easily, and the Pizza Tracker lets you see when your pizza is getting made, when it's getting delivered. So, they have a lower-end-of-the-market product. Every town has three pizza places that offer better pizza than Domino's or Papa John's. But what those two companies -- Domino's more than Papa John's, but Papa John's is catching up -- have done is make it super convenient.

We talked about this this morning -- pizza lends itself very well to this. There are markets 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 a piece of pizza in a microwave or toaster oven is still pretty good. So, the product they're selling -- and Domino's and Papa John's are both kind of a doughy pizza -- travels well. So they have made a very strong package. It's not about the pizza being the best. It's not about it being 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 easy to get a Domino's pizza," or there's 50 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, and that has worked very well.

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

Kline: They've been growing -- I don't remember the exact number, but -- about five years U.S. year-over-year growth, and globally, it's about three years. So, they have a model that 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's pushing 110% capacity, they open a new one, and it just grows that business and rolls it into being 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, a massive network of stores. But, before we move on to the next topic, one place that Domino's is facing issues, and this goes back to our earlier discussion, is ultimately, like the burger chains and fast food industry, they are still facing an issue of lacking the flexibility to raise prices. This, obviously, comes from competition of the first company we talked about in the show, with Chipotle. You have some of these fast-casual names, better burgers, &pizza, which I'm a huge fan of here in D.C. Essentially, those competitors have managed to narrow the gap between what you're paying for just a little bit more with 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-own Chipotle 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. But Domino'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 at Domino's, there's always deals on that, but there's never a deal on the salad. There's never deal on the wacky bread or whatever it is that they call their bread products that they sell you. The dessert products might be a throw in, but the soda isn't. So, there's a lot of ancillary items that build up that check. And as 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'm going to go to a better pizza place." But because you're spending so little, it's really easy to throw in that Papa John's pizza cookie, and pump your check up. So it's a smart strategy. Plus, you're not 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're making it up in volume.

Shen: Sure. And fundamentally, 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: You get a coffee, you get a shake, you buy a Grimace costume, it could really be anything.

Shen: For our final topic of the day, getting more high-tech, is the idea -- and this is something that I think we had some pretty fun discussions about in the past -- of fast food workers going away. I think we can't deny that calls for higher minimum wages or something that you see quite often in headlines. Even here in the D.C. region, the city recently approved a $15 minimum wage that will gradually reach that level by 2020 in the city. From what I could find for the industry 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? How do you think this is going to mold things?

Kline: There's going to be two phases of this. The current phase we're in now is Starbucks, Panera, Dunkin' Donutsthat are using technology not to take employees out of stores, but to make stores more efficient. Chipotle is starting to do that. The Chipotle order app, where you can mobile order and pay, they're running separate lines. The line you see at the front of the Chipotle where the person makes your food, in the back, there's another one of those. So, they're not necessarily firing employees, or using less people in stores. They're putting more people into production.

That's what Starbucks is doing. So, instead of somebody having to take your order in 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 big kitchens and don't need extra production help, they're going to start putting ordering in kiosks, and that is going to take their head count down. They're doing 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 person facilitating the process. And then, eventually, you're going to start to see, at the wealthier fast food chains, maybe fries at McDonald's won't be made by human being. Maybe your Big Mac still will be because it's customizable and there's a lot to go into it. But, you're going to see less labor. I don't see any way around that.

Shen: Sure. You bring up a really good point. It'll be very much a gradual transition. Some of the examples you brought up in a McDonald's with some of the self ordering kiosks, very popular, the Panera 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. It helps them turn down the staff.

Kline: And this 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 a Coke, 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 and mix it with Fanta orange if I want -- all the person at the counter has to do is hand me a cup. So, this labor has been coming out of the fast food process in little ways for a long time. And you 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 a coffee cup, that's going to be a differentiator for 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: Looking a little bit further ahead, we have some pretty big names in Silicon Valley working to develop better AI, better automation. Obviously, it seems like a very natural next step for that technology to be integrated more and more into this industry, as we've discussed 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 a company 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 an automated vehicle -- but not a full size car. It has the capacity to hold as many as 10 pizzas in a heated compartment. It can handle deliveries within a 20 mile radius on a single charge. They're already testing stuff like this. I think it's limited to New Zealand and Australia right now. They've also handled some issues with theft, with security cameras, with the locked compartment. But it is, to me, a glimpse of the possibilities.

Kline: I thought you were going five years after that in the future, where pizza robots are overlords. [laughs] Domino's has been very good about what I'll call the concept-car concept. When you go to an auto show and Ford is showing an amphibious 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 via reindeer, it's just to get attention, but aspects of it are going to come out. I don't see a world in the near future where autonomous 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 and put it into the pizza thing. That could absolutely be a machine that does that. So, you're going to see more and more of that. And that will make the process more efficient. And yeah, maybe in Manhattan, there's going to be drones and robots. In very densely populated places, you'll see that. But I think a lot of that now is attention-getting gimmicks. Domino's does not really intent -- it's not cost effective to have a drone deliver me a small Coke and 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 of reaching that mass scale. There's a company I found called Momentum Machines, based in the West Coast, they garnered some buzz last year in advance of opening 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 like so many things right now are in the concept stage, and you'll get all these elements of it kind of like how you described, but for these trends we talked about today, in terms of the competition, some of the discounting issues that the industry faces, but also on the flip side, how they're trying to tackle increasing costs and things like that. It's really funny, how all this comes together.

Kline: It's a question of cost. If you look at how McDonald's makes a McCafe beverage versus how Starbucks does it versus 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 or espresso or whatever it is. But there's very few restaurant chains that can get 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 to put in the automated burger machine and 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 are going to automate making french fries and chicken McNuggets, and that's a $200,000 machine," or whatever the number is. That's not going to fly at Wendy's or Arby'sor any of the less successful, or a Subway, where the average franchise owner is making a nice salary, or if they're paying a manager, they're making $40,000 to $50,000 in profit. I'm sure some make more. They're not 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 boop a robot makes you a pizza. But it's not like, three years from now, you're going to go to the mall food court and there won't be people there.

Shen: Yep, definitely looking farther 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. We talked about fast casual pizza, and I've written about fast casual burgers. There are going to be winners and losers in these spaces. There is absolutely room for a Chipotle of pizza and a Chipotle of burgers, and probably a number two and maybe even a number three company, but there's not room for 17. And just like we've seen some of the wannabe Chipotle knock-offs suffer, some of these companies are going to go away, or they're going to consolidate. You're also seeing, in the step above that, in your Chili's and Ruby Tuesday, they're struggling 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's going to continue, and maybe get worse.

Shen: All right. It was great having you on, Dan. I'm excited 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 for today, 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 People on the program may own companies discussed on the show, and The Motley Fool may 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!