Make fat returns from the fast-food boom

As fast-food culture sweeps the globe, firms in the sector are on the rise. That's yielding some tasty investment opportunities, say Eoin Gleeson and John Stepek.

In America, they call it recession obesity. First, you lose your job and the health insurance that goes with it. Then you start cutting back on expenses. The gym membership goes. Hospital visits are delayed. Out of frustration, you start binging on comfort food anything cheap and filling. Next thing you know you wake up on the couch at 4am, buried under a pile of Crunchie wrappers.

"Eating healthy has been one of the big casualties of this economic downturn," says Harry Balzer, author of the recent 'Eating Patterns in America' report. Sales of crisps in the US are up 22% this year. Tortilla chips are up 18%. And about 30% of meals prepared at home involve a microwave up from 20% in recent years.

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When cash-strapped consumers do leave home, they find solace at their local McDonald's. The fast-food giant has thrived during the recession. And not only in America. In Europe, stressed consumers contributed to a 6.9% rise in same-store sales growth. While other businesses falter, McDonald's is busy refurbishing restaurants and announcing expansion plans. Likewise, sandwich chain Subway plans to add 2,000 new stores to the 1,500 shops it already runs in Britain.

This makes the industry the perfect play for recessionary times, as we've noted in the past. But it's not just the fast-food companies themselves there's also the waste-management firms that they rely on. And beyond the recession, increased demand for convenience food in general, along with more sedentary lifestyles in emerging economies as they continue to urbanise, means demand has never been greater for ways to combat the inevitable side-effects of over-indulgence, such as obesity and related illnesses like diabetes. We'll look at the companies aiming to tackle these problems below.

The rise of fast food

But first, how did we become so addicted to junk food? The obvious answer is that it's cheap (and keeps the children quiet). A recent study by Pew Social Trends comparing McDonald's and Starbucks found that McDonald's was strongly favoured by customers in the 40+ age group with incomes below $30,000 a year. This is a generation that has grown up on McDonald's. But that in turn is a symptom of fundamental lifestyle changes that have occurred over the last 40 years.

In 1972, Americans spent $3bn a year on fast food. Today, they spend more than $110bn. There are two popular explanations for this growth. First, there's the rising number of women in work. Since 1984, for example, the number of women in employment has grown by more than 30% in Britain, according to the Office of National Statistics (ONS). Demand for convenience food has grown alongside demands on parental time, as home cooking falls down the priority list.

The second demographic factor is the growing number of single households. In 2004, there were four times as many people living alone as in 1961, with the average number of people per household declining from 3.1 to 2.4, according to the ONS. A rise in the number of people living alone and going out to socialise more, alongside an increase in general affluence and falling food prices, has pushed up the popularity of eating out. In Britain today, more than 30% of money spent on food is spent outside the home, compared to 20% 15 years ago. In the US, the proportion is closer to 50%.

There have also been radical changes in the fast-food industry during that time. A decade ago in Britain, the eating-out market was still dominated by junk-food outlets and smoke-filled pubs. Now mass-market restaurant chains, such as Pizza Express and Strada, offer services a couple of notches above the burger joints. In turn, fast-food chains have had to work hard to shake off their image as purveyors of artery-clogging slop.

A couple of years ago, the industry appeared to be in full-scale retreat, notes Spectator Business fingered as the guilty party in creating a culture of obesity and threatened with fat taxes to curb its growth.

But now they are back in the vanguard. Rising unemployment has engendered a culture of thrift people might not feel inclined to go without eating out, but they're trading down when they do so. And the recession has also eased the cost of running a fast-food franchise, as the price of raw materials comes down. In the last quarter, Burger King saw its profit margins rise by 40 basis points to 13%, according to Zacks Research, driven by lower food, paper and product costs.

The real growth market for fast food, however, is in the East. China may boast a 5,000-year-old culinary tradition and a $28bn fast-food market of its own, but Western fast-food giants have had plenty of success drawing the urban Chinese into their restaurants.

Fast-food outlets are radiating out across metropolitan centres at a fierce rate. Yum! Brands, owner of battered chicken purveyor KFC, has thrived in a market where consumers have a strong preference for chicken over beef. The group's China division notched up year-on-year sales growth of 20% in 2008, 24% in 2007 and 23% in 2006. That compares to the (still impressive) 8%-9% annual growth it's had in Japan, Britain and Australia. We take a closer look at the firm below.

Chasing a cure for obesity

One side effect of increased consumption of food in general, and unhealthy food specifically, is that people put on weight. The World Health Organisation reckons the number of obese adults worldwide is set to rise to 700 million by 2015, from 400 million in 2005. Currently, about a third of Americans are obese, and Europe's not much better. In the UK, for example, in 1993 16% of women and 13% of men were classed as obese, whereas now the figure for both sexes is thought to be about 25%. (In case you're wondering, by the way, obesity means you have a Body Mass Index which compares your height and weight of more than 30.)

It's not all down to junk food, of course. But that's certainly a factor. And the problem will only grow as people in emerging economies grow wealthier and shift away from living in the countryside and working the land to more urbanised, sedentary lifestyles.

So what? you might ask. Everyone knows what the solution to obesity is: take more exercise and eat smaller quantities of healthier foods. But that's easier said than done. In our convenience culture, it'd be much nicer to just pop a pill and make the problem vanish. That's why the hunt for a safe, effective, weight-loss drug has for years been a holy-grail quest for the pharmaceutical industry.

But as yet, they haven't found it. The history of the diet pill is a long and chequered one. Existing drugs, such as Roche/GlaxoSmithKline's Xenical, can have undesirable side effects, such as incontinence. Others have ended up being pulled entirely, such as Wyeth's Fen-phen, which reached $6bn in sales before it was banned in 1997 after an ingredient was found to cause serious heart problems.

But as analyst Michael King of Merriman Curhan Ford & Co in the US points out, a safe and effective weight-loss drug could generate as much as $2bn in annual sales. So the drug firms have no intention of giving up. And right now there's a boom in the obesity drug area not one, but three small biotechs are battling it out to see who can be first to market with the latest diet pill.

There's Arena Pharmaceuticals (Nasdaq: ARNA), which makes lorcaserin, a drug that stimulates a protein in the brain that makes you feel full. Then there's Vivus Inc (Nasdaq: VVUS), with its Qnexa product; and Orexigen Therapeutics (Nasdaq: OREX), whose Contrave is designed to reduce cravings for food.

As Andrew Pollack reports in The New York Times, investors are most excited about Vivus's Qnexa. Clinical trials show weight loss of 10%-11% after a year, against less than 2% for a placebo. That's better than the results shown by its rivals. However, "the big challenge for Qnexa might be safety". It combines two existing appetite suppressants that have been known to have side effects. Also, the fact that people can take the existing supplements separately "could undercut sales". Contrave from Orexigen has a similar potential sales problem, in that it also combines two existing drugs.

Arena Pharma's big advantage over the other two is that it's a new drug, so it will suffer no competition from generics. Also, clinical trials so far suggest that it has fewer side effects. Michael Murphy on Seeking Alpha is bullish on all three stocks, but reckons Arena will be the first to get its drug to market hopefully filing for approval with the Food and Drug Administration by the end of the year and launching towards the end of 2010. "Due to its sweet-spot profile on efficacy, safety and easy tolerability, plus being a new chemical entity and a single-agent drug, I expect Arena to eventually get about half the US market for obesity drugs."

What's also caused a stir in the sector is that larger rival Amylin Pharmaceuticals, whose obesity drug is at a much earlier stage of development (it's in Phase II clinical trials), has just signed a partnership deal potentially worth $1bn or more with Japanese pharma giant Takeda. Given that all of the above drugs are at later stages of development, that's got analysts and investors waiting with bated breath to see who'll be next.

If you're going to go for just one, we'd suggest Arena has the edge. We first tipped the stock back in March last year at $6.84, and it's now fallen to $4.40. But if you can afford it, you should split your 'obesity' investment across all three. Even if just one is a success, you should make more than enough to cover the costs of the others failing.

Of course, there's no guarantee that any of them will make it to market. So, if you're not keen on betting on biotech tiddlers, Amylin could be an interesting alternative bet. As for large caps, one of the best plays on obesity among the pharma majors is Novo Nordisk, which makes drugs to treat diabetes. We look at both of these stocks in more detail below.

The four best stocks to cash in

McDonald's has enjoyed stellar sales as stressed and cash-strapped consumers throng to its restaurants. But Yum! Brands (NYSE: YUM) has a far stronger position in the fast-growing Chinese market. The operator of Taco Bell, Pizza Hut and KFC recently reported quarterly earnings of 70 cents a share up 21% on the last quarter. Lower labour and food costs (down 9% and 7% respectively) boosted margins. And it wasn't all about cost cutting its Chinese unit saw 32% growth in operating profits, while the US grew by 18%. The firm continues to expand aggressively into China from June to September, Yum! opened 267 new restaurants, 88 in mainland China. The company expects earnings per share (EPS) growth of 10% in 2010. The stock is valued on a forward p/e of 13.8 and offers a 2.5% dividend.

Another interesting play on fast-food restaurants in the US is waste disposal. More particularly, how to get rid of the organic waste generated by the fast food industry - after all, cooking meat generates a lot of fat and you can't just flush it down the plughole. That's what makes Darling International (NYSE: DAR) such an invaluable company to the industry. Darling is America's biggest independent rendering group it's in the business of collecting and handling animal byproducts and grease from restaurants and slaughterhouses in the US, with clients including 10% of McDonald's US branches. It turns this waste into products such as bone-meal, used by farmers as animal feed as a cheap alternative to corn or soybeans.

That's a nice, solid, dependable business. But Darling may soon have another very lucrative sideline. We've long known that you can make a car run on chip fat, but recent research has shown that biodiesel from animal fats is far superior to vegetable oil. Darling recently announced a deal with oil refinery giant Valero Energy to develop a green diesel plant in Louisiana. The project is waiting on news for a loan from the government (which is offering 80% loans for such projects), which may come early this year. In the meantime, Darling has seen its sales from its existing operations leap nearly 100% over the last two years, notes Sham Gad on Forbes' Investopedia. There's about $22m in net cash on the balance sheet and it trades on a forward p/e of 11.5.

Another unpleasant side-effect of growing obesity is a rise in cases of diabetes. "Type 2 diabetes tends to come on in later life as people with unhealthy lifestyles become desensitised to the insulin their bodies naturally produce. It's also the most prevalent form of the disease", says Lex in the FT. So it's little wonder "there are few diseases a drug-maker would rather dominate," as Lex puts it. The main player in the sector is Danish drug-maker Novo Nordisk (Denmark: NOVOB). The Danish drug giant is the world's biggest manufacturer of insulin, and has moved into finding new treatments for type 2 diabetes in recent years. Sales are growing at double-digit rates, and the group enjoys operating margins of around 30%, notes the FT. Novo Nordisk forecast top-line growth of 5%-10% next year. The stock trades on a forward p/e of 15.6 and pays a 1.2% dividend.

As for obesity drugs, a slightly safer play than the biotechs tipped above might be the one company that has actually signed a partnership deal with a major drug firm. Amylin Pharmaceuticals (Nasdaq: AMLN) and Takeda Pharmaceutical have signed an exclusive worldwide deal to develop and commercialise pramlintide/ metreleptin and davalintide, two compounds for the treatment of obesity. The products are in Phase II clinical trials (mid-stage development) and have generated impressive early results. As part of the deal, Amylin will get an up-front payment of $75m from Takeda and, assuming all goes well (of which there is no guarantee), it could receive up to $1bn in future development and commercial milestones, plus a double-digit royalty on any sales.

But what's attractive about Amylin as well as the fact that it has a partner for its drug is that it's not a one-hit wonder. Amylin already has successful drugs on the market. Its biggest product, accounting for 81% of revenue last year, is diabetes treatment Byetta, which is injected twice daily. The drug is co-marketed with Eli Lilly & Co, and the group is trying to gain American approval for a once-weekly version of the product.

This article was originally published in MoneyWeek magazine issue number 460 on 6 November 2009, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.