The Simple Way to Score Fat Profits From Fast Food Stocks

By Larry D. Spears, Contributing Writer, Money Morning • August 31, 2011

Fast food can be an occasional unhealthy indulgence - but fast food stocks can be a healthy dose of profit for your portfolio.

Imagine you were one of the first to buy shares of McDonald's Corp. (NYSE: MCD), the world's largest publicly traded fast food company.

When the "golden arches" opened its doors in 1960, it offered just six menu items - including a 15-cent burger and five-cent fries - at its 102 locations. Now it operates more than 33,000 restaurants in 118 countries and serves more than 64 million customers a day.

McDonald's went public in 1965, selling its shares for $22.50; now its stock trades around $90 a share.

That means today, after 12 stocks splits, 100 shares of the original McDonald's stock that cost you $2,250 would have grown to 74,360 shares worth roughly $6.7 million - and that doesn't even count dividends paid out by the company.

No other restaurant chain has matched McDonald's success, but others have shown phenomenal growth with impressive profits - and I'm going to show you how to find them.

Four Must-Have Factors for Fast Food Stocks

To find a winning fast food stock we have to look at what will drive growth - and related profits - in the future. There are four dominant themes you need to look for.

The most successful chains will have the following traits:

• A clear plan for international expansion - With only a few gaps, the North American and European fast food markets are saturated. Thus, the big chains' major avenue for growth will run through Asia, South America and the Middle East, with China the prime target. (The Red Dragon was recently described by one restaurant marketing executive as "the biggest growth opportunity for the industry this century.")
• A revenue-growth strategy for existing stores - Growth in established markets obviously won't be as strong as overseas, but revenue there will continue to make up the lion's share of the bottom line. The best companies will increase revenue with updated restaurants, new menu items, innovative marketing ideas and customer loyalty campaigns.
• A steadily increasing number of franchise operations - When an individual or local company purchases a franchise, the parent company not only gets a large up-front fee, but it also enjoys reduced expenses, a steady cash flow from franchisee profit-sharing and a sharply reduced level of store-specific risk. The parent really has minimal expense relative to the franchise, except for marketing, advertising and product development (all of which it would be doing anyway).
• The ability to recognize and react to changing consumer attitudes and tastes - A huge block of consumers is becoming more demanding in terms of quality, added value, healthy choices and nutritional standards - something governments are also likely to mandate in coming years. In other words, business as usual may keep the doors open, but it won't fuel the kind of growth needed to generate attractive returns for investors.

Three Winning Fast Food Stocks

Given those criteria and the current market outlook, here's where you should look to add tasty fast food components to your portfolio:

• McDonald's Corp. (NYSE: MCD), recent price $90.79 - This may be an obvious choice, but it's hard to argue with success. Mickey D's strong second-quarter earnings pushed the stock up almost $5 a share in July, and it held most of the gain in spite of the debt-ceiling debacle and resulting market plunge. The company's profit rose 19%, earning $1.41 billion, or $1.35 a share, on revenue of $6.91 billion.

Year-over-year growth in international revenue grew 5.4% despite a shaky global economy. McDonald's is making a major push in China, with plans to double its number of franchises over the next three years. It's also among the first to offer drive-thru service, recognizing China's recent climb to No. 1 in the world auto market, as well as a "McDelivery" service in dense metropolitan markets.

The company is trying to increase U.S. revenue by remodeling restaurants, adding more playgrounds, and redesigning drive-thru operations to increase efficiency. It broadened the menu to include gourmet coffees and milkshakes, and healthier options like putting fruit rather than fries in kids' Happy Meals. McDonald's is also targeting a slightly richer demographic these days, looking to capture some mid-range diners who are scaling back to save money.

Current analyst estimates project full-year earnings for McDonald's to hit $5.21 a share this year and $5.73 in 2012. The $2.44 dividend provides a current yield of 2.7%, and the median one-year price estimate for the stock is $99.00 a share.

• Yum! Brands Inc. (NYSE: YUM), recent price $54.00 - As fast-food giants go, Yum! is fairly new, as it was founded in 1997. However, the company has been a fast-bloomer, riding expansion and buyouts to a global market position ahead of both SUBWAY Restaurants and McDonald's when you add up all five of its operations (KFC, Taco Bell, Pizza Hut, Long John Silver's and A&W All-American Restaurants).

It's also continuing aggressive expansion campaigns throughout the Middle East and Asia. It expects China to provide up to 40% of company revenue within five years. Yum! also expects earnings of $2.86 per share on revenue of $12.23 billion for the year ending in December, with a jump to $3.22 per share on revenue of nearly $13 billion in 2012. Analysts see the stock rising about 18% to between $61 and $66 over the next year. Yum! pays a $1.00 dividend, equating to a yield of 1.9%.

• The Wendy's Co. (NYSE: WEN), recent price $4.99 - On the brink of possible bankruptcy earlier in the year, Wendy's jumped onto the recommended list in mid-June with the $430 million sale of the underperforming Arby's chain. Arby's could never seem to catch the public's interest enough to compete, and putting cheddar cheese spread on roast beef and a bun and selling them two-for-$5.00 hardly attracted the "healthy choice" crowd.

Wendy's got rid of $190 million in debt in the deal and is left with 6,565 restaurants in more than 20 countries. The company has an aggressive overseas expansion campaign on the boards - with most of the new operations involving franchises - and should be able to improve U.S. revenue now that it can focus all its marketing efforts on the Wendy's brand.

Wendy's offers a more varied sandwich line than McDonald's and Burger King, and also has soups, salads, baked potatoes and other specialty menu items that will help it compete without Arby's dragging down earnings.

Current-year revenue is projected at $2.69 billion, netting 14 cents a share in earnings. For 2012, analysts expect the absence of Arby's to drop revenue to $2.51 billion, but earnings to increase to 25 cents a share. Projected price targets for the stock range from $6.00 to $8.00 per share. The eight-cent dividend equates to a yield of 1.6%.

Two Fast Food Stocks to Avoid

As you check out the fast food sector, be sure to avoid these players with weak growth outlook:

• Sonic Corp. (Nasdaq: SONC), recent price $9.54 - Sonic treads similar market waters as McDonald's and Wendy's - except for its assortment of drinks and flavorings it says can be juggled into "398,928 unique flavor combinations." The company introduced this year a much-publicized "Happy Hour" with half-price drinks from 2 p.m. to 4 p.m. daily - a move that increased traffic but so far hasn't boosted revenue, with added food orders not compensating for the drink discount. Sonic also tried a line of specialty hot dogs with only a lukewarm response.

The company's locations are fairly labor intensive since most have only drive-thru windows and car service - with some carhops still on roller skates - and no inside dining areas. Sonic has no international exposure and no global move currently envisioned. Few analysts see the stock moving above $11.50 in the year ahead.

• Jack in the Box Inc. (Nasdaq: JACK), recent price $20.93 - Although it's been around since 1951, Jack shares Sonic's problem of no international exposure. It operates its burger joints and Qdoba Mexican Grills in only 18 states. The vast majority of the restaurants are company-owned. Jack is trying to modernize the image (no more clown head) and attract potential franchise buyers so it can raise expansion capital. That's unlikely to happen in this environment, however, so year-over-year growth in both revenue and earnings - projected at $2.16 billion and $1.53 a share - are expected to fall by roughly 5.9%.

News and Related Story Links:

• Money Morning:
  With Its Laser Focus on China, It's Time to Buy McDonald's Corp. (NYSE: MCD)
• Money Morning:
  Fighting to Feed the Dragon: McDonald's Vs. Yum!
• MSN Money:
  Best, worst fast-food restaurants
• TheStreet.com:
  Bankruptcy Watch: 14 Risky Restaurant Stocks