(Published Jan. 17 by Bob Ciura)
Growth stocks can be fun while they’re flying high. But as the saying goes, what goes up must come down.
When growth stocks soar to unsustainable levels beyond their earnings growth, it’s only a matter of time before they fall back to Earth, and the higher they rise the harder they crash.
It wasn’t too long ago that Shake Shack (SHAK, Financial) was a darling growth stock. After its initial public offering at $45 per share in early 2015, shares of the high-growth fast food restaurant soared as high as $92 by late May of that year.
But then reality set in. Shake Shack stock has steadily declined ever since to its recent level of $35 per share. The stock is currently below its IPO price.
The bad news is the stock still isn’t a good investment, particularly for dividend investors. One of its main competitors, McDonald’s (MCD, Financial), is a much better stock for income.
McDonald’s is a Dividend Aristocrat – a group of elite businesses with 25-plus years of consecutive dividend increases. You can see the entire list of all 50 Dividend Aristocrats here.
This article will discuss four reasons why I like McDonald’s over Shake Shack.
Reason No. 1: profitability
Shake Shack’s stunning share price rise (and ensuing crash) is a reminder that, ultimately, profits drive stock prices over the long term. No amounts of media hype or analyst upgrades can change that.
Like many growth stocks, Shake Shack is growing revenue at a high rate. For example, sales soared 40% over the first nine months of 2016.
This was due mostly to opening new locations.
Source: January 2017 Investor Presentation, page 18
But Shake Shack’s comparable-restaurant sales, which measure performance at locations open at least one year, rose a much milder 2.9% in the same period.
Source: January 2017 Investor Presentation, page 19
The latter metric is what drove Shake Shack’s share price decline since its IPO. The company continues to open several new stores each quarter, but the performances of these stores fade after a year.
This indicates Shake Shack’s impressive growth may be a fad. Growth after the one-year period significantly tapers off.
Despite its rapid top-line growth, Shake Shack’s bottom line doesn’t have much to show for it. Over the first three quarters of 2016, Shake Shack generated a 4.4% profit margin.
By contrast, McDonald’s highly profitable U.S. business anchors its high margins.
The company’s profit margin was 18.8% over the first nine months of the year. To put this into proper context, McDonald’s essentially generates more than four times as much profit as Shake Shack for every dollar of sales.
One of the main reasons why McDonald’s has stronger profitability than Shake Shack is the benefits of scale. McDonald’s main competitive advantage is that it has more than 14,000 restaurants spread across the U.S.
This enables economies of scale in distribution, supply chain and many other areas of the business. McDonald’s can pressure suppliers to lower costs, which it then passes on to customers with lower prices.
By contrast, Shake Shack is at a much earlier stage of development. It has just 100 locations worldwide and a market capitalization of $1.3 billion.
It will have to invest heavily to grow its store count moving forward. This is likely to keep margins low for awhile.
Reason No. 2: emerging market growth
The second reason I prefer McDonald’s is because the company has a key catalyst for growth that Shake Shack does not have yet, which is growth in the emerging markets.
Both companies have international operations. Shake Shack has about 40 international restaurants in locations including London, Istanbul, Dubai, Tokyo, Moscow, Seoul and more.
But its international store count pales in comparison to McDonald’s, which has an entrenched position across the world. McDonald’s has more than 20,000 restaurants outside the U.S.
With a larger international restaurant base, McDonald’s can establish a stronger image with consumers. This is particularly true in high-growth emerging markets like China and India, where Shake Shack barely registers.
McDonald’s High Growth Markets operating segment is its major growth opportunity. This segment includes the company’s operations in key emerging markets. Since more than half of these locations are company owned, there is significant franchising opportunity there.
Source: McDonald’s Investor Relations
Franchising is a growth catalyst because it provides McDonald’s with a steady stream of royalties each month while passing on most of the maintenance and renovation expenses to the franchisee.
In addition, McDonald’s is growing rapidly in its Foundational Markets operating segment. This includes more mature international markets like Japan.
Source: McDonald’s Investor Relations
Comparable sales in this segment jumped 10.1% last quarter for McDonald’s.
Reason No. 3: valuation
Next up is valuation. McDonald’s is a much safer stock to buy than Shake Shack because the stock is appropriately valued.
McDonald’s trades for a price-earnings (P/E) ratio of 22. This is a reasonable valuation multiple. The Standard & Poor's 500 Index has an average P/E ratio of 26.
For its part, Shake Shack has a P/E ratio of 77. Again, this is because the company is not solidly profitable.
Investors have to pay a sky-high price for Shake Shack even after the massive decline in its share price.
To paraphrase Warren Buffett, price is what you pay, value is what you get.
McDonald’s share price of $121 suggests it has a higher valuation than Shake Shack, but this is a common misconception.
McDonald’s generated earnings per share of $5.32 in the trailing 12 months. Its earnings provide a floor under the share price. This is what investors refer to as a margin of safety.
Shake Shack investors do not have this luxury. With scant profits to fall back on, investor returns are based on the "greater fool theory." This means Shake Shack investors need someone else to buy the shares at a higher price in order to generate positive returns.
This can work for growth stocks so long as the company continues to meet expectations. However, the higher a share price rises, the higher analysts raise their forecasts. If a company fails to keep up, the share price decline can be swift and severe as Shake Shack investors have experienced.
Reason No. 4: dividends
Lastly, McDonald’s hefty profits allow the company to pay dividends to shareholders. McDonald’s has a 3.1% dividend yield, which exceeds the 2% average dividend yield of the S&P 500.
Meanwhile, Shake Shack does not offer a dividend payout to investors. This should come as no surprise since without consistent earnings, it’s impossible to pay dividends.
McDonald’s has a long track record of raising its dividend. It has increased its dividend for 40 years in a row, including a 6% hike in 2016.
Shake Shack is a risky bet. If its growth re-accelerates, the shares could reclaim their former glory. But this is far from guaranteed, and investors don’t have margins of safety.
As a result, for the four reasons mentioned, McDonald’s is likely to be a better investment for investors interested in total returns and is certainly a better investment for investors looking for income.
Disclosure: I am long McDonald's.
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