If You Can’t Stand the Heat, Get Out of the Kitchen

If You Can’t Stand the Heat, Get Out of the Kitchen

The CPG and QSR sectors have both come under pressure recently with some analysts suggesting that weakening traffic patterns and accelerated food inflation broadly experienced in 2Q16 may be the precursor to a downturn. For perspective, with McDonald’s (MCD) reporting a lower-than-historical 1.8% level of same-store comp growth1 and with company CEO Steve Easterbrook acknowledging a “fairly well-documented consumer slowdown,”2 gone are the days where MCD shares rallied on bullish McMuffin news, as they did in 2015. Challenges appear to be materializing on a number of fronts, after several quarters where menu innovation and value offerings drove positive same-store sales results. Additionally, the proliferation of new concepts — such as Sweetgreen and Cava Mezze Grill — as well as encroaching channel competition could not come at a worse time as restaurant operators adjust to increasing operating and labor costs, which Coleman’s commodity inflation analysts recently explored with a former Chipotle (CMG) executive on the call (MDLZ, KHC, PEP, LNCE) Indigestion From 2015 Food M&A Binge Leaves Little Room For Dessert in 2016.

Fast Food Price

Front and center is the consumer who appears to be in question as the cost of eating out surges fivefold, with grocery deflation and restaurant labor inflation keeping at-home diners favoring their fridges. Following similar warnings from Applebee’s and TGI Friday’s at the mass-market level, McDonald’s, Wendy’s (WEN) and Jack-In-The Box (JACK) all took time out of their earnings calls to highlight this trend, where “limited service meals and snacks are up 5.9%, while food-at-home costs 1.1% less than it did two years ago.”3

On the capital markets, food and beverage M&A activity — the focus of another recent Coleman call — has also quieted down after a flurry of deals last year headlined by the Kraft-Heinz (KHC) merger valued at $45B. In 1Q16, food deal values were down 93.9% from 1Q15 at only $4.1 billion, the lowest value for this sector since 1Q09 with the downward trajectory continuing into 2Q16.4 While many have been surprised at the slowdown, with the only deal of late being Danone/WhiteWave (DANOYWWAZ), the majority of the food and beverage companies continue to transform their businesses, proactively cutting unprofitable categories and realigning to current marketplace realities. This period may best be characterized as dynamic yet introspective as Snyder-Lance (LNCE) and Kraft work to integrate their acquisitions, ConAgra (CAG) spins off Lamb Weston, Pepsi (PEP) grows its Stubborn craft soda line, and virtually every company reformulates their products with healthier ingredients. Given this digestion and transformation period, with the entire sector focused on growth, it stands to reason that once further along in the process, attention will return to the acquisition of emerging brands and premium categories that are resonating with today’s consumer.

Of particular interest to investors and CPG executives is the morning meal, where the so-called breakfast wars are escalating. Ever since McDonald’s launched the opening salvo in September 2015 by announcing all-day McMuffin availability and rival quick service restaurant operators responded with me-too offerings, the consumer packaged foods industry has been working to reboot the breakfast at home food category as Americans continue to shift away from high-carbohydrate cereals towards meat, eggs, and other forms of protein. As the breakfast giants — B&G, General Mills, Post, Kellogg, and Treehouse Foods (BGSGISPOSTKTHS)– build out their new yogurt, energy bar, and breakfast meat offerings and work to cut sugar, the core $7.6 billion per year cereal category has also become a hotly contested battleground. As a case in point, General Mills is repurposing its hallmark Trix Rabbit with a newly introduced “honorary real rabbit” to convey the “Real Rabbit, Real Ingredients” message of the brand, or as some industry analysts call it: “less bad” ingredients. In parallel, with Kellogg looking to capitalize on its Rio Olympic Gymnastics sponsorship with its Red Berries box, with B&G trying to reheat the Cream of Wheat brand, with PepsiCo scouring the cupboard, looking to unlock value in its Quaker Oats assets, and with Post working to integrate its $1.15 billion MOM Brands cereal acquisition, the breakfast category has become a feeding frenzy, (BGS, GIS, POST, THS, K) Cereal Category Getting Rebooted.

Now, as the burger and breakfast wars continue with Chipotle rolling out its better-burger concept, as McDonald’s looks to protect its moat ((MCD, WEN, YUM) McDonald’s Franchisee on QSR Fundamentals), and as the company tinkers with a simpler, healthier McNugget recipe (as discussed in (MCD, WEN, YUM) McDonald’s Multisite Franchisee on Latest Consumer Trends), many shareholders are eager to see whether the company can simultaneously innovate and insulate itself. Looking ahead through 4Q16, all eyes will be on the divergent paths that the QSR operators and CPG brands are taking as well as changing consumer appetites, which are leaning more towards healthier, low-sodium meals, increasingly at home.