Three food stores in my favourite shopping precinct have closed. Several other shops remain vacant, unable to secure a new tenant after their fast-food operator closed.

This week I noticed two cafes have closed in another nearby shopping strip. Other food stores there look like they are just surviving, judging by their low patronage.

Expect a spike in insolvencies for fast-food stores, cafes and restaurants in the next 18 months. That’s terrible for hard-working owners and franchisees, and an opportunity for food giants that can grow in tough conditions, and for investors.

Four main forces are hurting small food operators:

1. First, a softening economy is bad for retail sales and consumer sentiment. Fast food is easier to cut as consumers fret about high household debt, low wages growth and headlines that suggest Australia is headed for recession.
2. Second, rising operating costs are hurting margins. Store rents remain elevated, energy prices are rising and food stores that survived by underpaying staff have problems. I suspect the business model of some food joints is not viable if staff are paid correctly.
3. Third, the food-ordering and delivery platforms are taking a bite out of margins. Uber, Menulog and Deliveroo have been a Godsend for food operators that have the right product for home delivery. For others, food platforms have taken a third of their revenue and cannibalised margins as people who would have bought directly from the store buy online.
4. Rising competition is the fourth factor. Every shopping-centre revamp these days comes with a new food precinct. Suburban food operators, unless they have a compelling product, struggle to compete. Worsening traffic congestion and insufficient parking compound the problem.

It’s not all bad news. Population growth is good for fast-food stores and changing eating habits bode well for the long term. Consumers are snacking more, cooking at home less and eating out more often. Sadly, many food operators won’t last long enough to benefit from these trends.

McDonald’s, Kentucky Fried Chicken, Domino’s and other fast-food brands are not immune to these problems. But their economies of scale, brand, menu and latent pricing power help them maintain growth in tough markets – and in some instance, take market share.

One can imagine consumers trading down from pricey restaurants to casual-dining outlets in the next 18 months if the economy weakens and consumers spend less. Or from mid-market casual-dining chains to cheaper fast-food options.

Also, as some local food operators close, the fast-food giants, which have a high proportion of stores in the suburbs, should benefit marginally from reduced competition.

As I have previously written for The Switzer Report, McDonald’s, KFC and other fast-food giants have much to gain from home-delivery services. And Domino’s investment in its own ordering and delivery technology could prove a long-term masterstroke.

I have written favourably about Collins Food and Restaurant Brands NZ over the past three years for this Report and, more recently, on Domino’s Pizza Enterprises.

Collins Food has starred with a 27% annualised total return over three years. The stock is up from a 52-week low of $5.52 to $8.45 this year alone.

Restaurant Brands NZ, taken over this year by Global Valar (a subsidiary of global casual-dining operator Finaccess Capital) was another terrific performer. Its return over one year is 26%.

Domino’s Pizza Enterprises is down 18 per cent over year. Morningstar’s fair value of $52 compares to the current $43.32. Domino’s FY19 result was broadly in line with market estimates, but food-delivery platforms are weighing on its growth. Although the stock looks a touch undervalued, it’s hard to find a near-term catalyst to re-rate the price.

Here are my two preferred fast-food ideas:

1. McDonald’s Corp (NYSE: MCD)

The fast-food leader has jumped from a 52-week low of US$156 to US$217, continuing a five-year rally. An improving US economy for much of that time and a successful strategy to increase McDonald’s online presence has underpinned the share-price gains.

McDonald’s outperformance is another reminder of its defensive qualities. The company continues to lift sales each year as it innovates its menu and customer experience. Investors are paying a premium for McDonald’s “safe-haven” qualities.

McDonald’s is not cheap. At US$217, it is on a forward Price Earnings (PE) multiple of 24 times. The Price Earnings Growth (PEG) ratio is four. Those valuation metrics are high for an incumbent fast-food operator with solid rather than spectacular earnings growth.

An average share-price target of US$232, based on the consensus of 28 US broking firms, suggests McDonald’s is marginally undervalued at the current price. The majority of brokers have Buy recommendations. Market expectations for McDonald’s are high.

Performance, of course, is relative. Although impressive, McDonald’s rally has lagged rivals such as Wendy’s, Shake Shack, Chipotle and Yum! Brands Inc in the past year. McDonald’s is trading on a lower PE than several of its key listed peers because it has slower growth prospects.

Still, I know which stock I’d rather own if global equity markets tumble and the US economy slows. Gains might be slower from here, but McDonald’s rally has further to run.

Chart 1: McDonald’s Corp

Source: Yahoo

2. Collins Food (CKF)

The ASX-listed Collins Food looks like a French fry compared to McDonald’s. With a $985 million capitalisation, Collins suits experienced investors who understand small-cap risks.

Several factors underpin my favourable view on Collins. The biggest is KFC’s entrenched position as one of Australia’s top fast-food brands. Love or hate it, KFC has a strongly differentiated product, a knack for menu innovation and an exceptionally loyal customer base.

Moreover, Collins Food is achieving solid same-store sales growth (up 3.7% year-on-year in FY19) and growing sales through store rollouts and online deliveries. Sixty-four KFC stores around Australia now deliver through Deliveroo and Menulog, and more will join them.

Collins Foods’ rollout of Taco Bell stores in Australia offers another growth engine. It’s early days; only four restaurants opened in the second half of FY19. And Taco Bell has failed a couple of times before in Australia, and giant Mexican chains have never taken off here.

That could change over the next five-10 years as customer palettes evolve and more people favour spicier international food. Growth in mid-market Mexican casual-dining restaurants, such as Salsas Fresh Mex, suggests Taco Bell’s re-entry into Australia might be third time lucky.

Collins Foods’ international growth strategy has long-term appeal. It owns 17 KFC stores in Germany and 20 in The Netherlands, and has a conservative strategy to grow organically in those markets, both of which are under-represented in the fried-chicken category.

Same-store sales in Europe disappointed with a 3.7% fall in the FY19 result, impacted by underperforming promotional campaigns and fewer value offers than the prior year.

Occasional setbacks are likely in Collins Foods’ European operations as it establishes a footprint in new markets and expands overseas for the first time. Offshore expansion will slow in FY20 (only 1 new KFC restaurant in Germany will open) before 4-5 open in following years.

Longer term, I expect Collins Food to build a larger network of company-owned KFC stores in Europe and expand to other countries as it establishes scale in that market.

Unlike many small caps, the well-run Collins Food is not “betting the farm” on an aggressive international expansion strategy, meaning it has scope to experiment with new store formats and menus, learn about new markets and customers, and recover from setbacks.

Collins Food is not cheap. A trailing PE of 22 is high for a small-cap industrial in a lower-growth sector. Collins’ average annual PE over the past three financial years has ranged from 14.5 to 17.

The Return on  Equity (ROE) has averaged about 12% in that period, Morningstar data shows. That’s solid, but not enough to justify continued strong share-price gains from here. Collins needs to get its ROE moving higher to lift its intrinsic value and ultimately its share price.

An average share-price target of $7.47 suggests Collins is overvalued at $8.45. That’s based on a consensus of five broking firms and a sample that is too small to rely on. Like many small caps, Collins has limited coverage from stockbroking analysts and fund managers.

Collins looks due for share-price consolidation or a pullback after this year’s rally. Patient investors should watch and wait for better value; any sustained price weakness would be an opportunity to buy one of the more impressive small caps on ASX.

Chart 2: Collins Food

Source: ASX

Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 3 September 2019.