Which Player to Back in the Fast Food Wars

Investors fought over the IPO shares of Shake Shack Inc. (NYSE: SHAK) like kids fighting over a McDonald's Corp. (NYSE: MCD) Happy Meal.

Initially priced at $21.00 per share, SHAK stock ended its first day of trading up over 100% at $45.90, moved to just north of $52 per share, and even after an inevitable pull back is still ahead nearly 95%.

The very trends that are pumping up SHAK's shares have left those of McDonald's - the most iconic name in hamburgers and perhaps in the entire global restaurant business - becalmed. But a third player might be the best bet of them all.

Barriers to Entry Looking Vulnerable

Competition, changing consumer tastes and habits, and some dismal financial metrics have investors wondering what's next for MCD. More importantly, they signal how investors should play the Golden Arches in the future.

And while it is relatively easy to identify why MCD is losing some momentum in the burger wars, it is much harder to know whether it will be able to reverse course. McDonald's increasingly looks, trades, and tastes like yesterday's news. Yes, it is up slightly on a year-to-date basis, and on a five-year basis it beat the giddy S&P 500 until the index rocketed ahead in mid-2013. Nonetheless, given its recent earnings report admission that its sales fell in 2014 for the first time in three years, Ronald's smile is looking a little forced.

In fact, the 2014 Consumer Reports survey of 21 burger brands ranked Mickey D's dead last. When customers are telling a restaurant that the food stinks, it has a serious problem.

The burger chain's menu is also a mess with over 100 items which takes the "fast" out of "fast food" by making it difficult for customers to order quickly. By trying to compete with everybody rather than with just other burger chains, McDonald's is spreading itself too thin and diluting its brand.

Furthermore, in a culture where its food is already avoided by many people with health concerns - are you really going to a burger joint if you want a salad - McDonald's would be better served being true to its identity and making the best burgers in the world.

Will a New CEO Reverse Its Course?

With a still enormous market cap of $92 billion and a significantly above-market multiple of 19.5x earnings, MCD stock has been treading water for the past two years.

One reason that it has held its ground is the announcement that long-standing CEO Don Thompson would be replaced on March 1 by industry star Steve Easterbrook.

It's going to take more than a new CEO to boost performance, however.

While 2013 and 2014 sales were $28.1 billion and $27.4 billion, respectively, Goldman Sachs expects sales to drop to about $25 billion in 2015 and 2016 due to the stronger dollar and competitive pressures.

Earnings per share, which were $5.59 in 2013, dropped to $4.85 in 2014 and are expected by Goldman Sachs to remain at about that level in 2015 before recovering to $5.23 in 2016.

One Competitor Stands Out

Occasionally a new concept arrives on the scene that captures consumers' imaginations and makes a splash: and that's SHAK. If it successfully executes its aggressive growth model, MCD could find it harder and harder to lure in new customers.

SHAK isn't MCD's only competitor of course.

In fact, what's disturbing is how tough the competitive environment is getting. It may not be a burger joint, but Chipotle Mexican Grill Inc. (NYSE: CMG) is giving MCD competitive fits.

In early February, CMG stock declined by $50 per share after disappointing investors by only reporting 16% same-store sales growth.

Most restaurants would kill for that kind of growth, but when you are trading at more than 50x earnings, investors push away from the table if you serve up anything less than a perfect meal. At the end of 2014, CMG operated 1,755 restaurants throughout the United States. Each of those restaurants is valued at about $12 million.

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CMG stock has been a moon-shot over the past five years, rising sevenfold during that period as the company has expanded its footprint and redefined the fast-food dining space (which has been re-christened the "casual" dining space by Wall Street analysts).

CMG is a great company, and every bit a competitor to MCD, but its growth is destined to slow.  Its stock is very expensive and a dangerous investment at current prices.

At the same time, CMG's success is going to be very difficult for SHAK to replicate.

At 4.5x sales and 100x earnings, the average restaurant is valued at $25 million, which makes SHAK among the most expensive restaurants in the world. Its stock is also very expensive and a highly speculative investment at current prices.

SHAK stock didn't skyrocket on its own merits. Rather, investors convinced themselves that it will become another CMG. It also has a two-class ownership structure that severely limits shareholder rights in this age of enlightened corporate governance, but when investors are fighting for burgers and fries, principles be damned.

CMG remains a more formidable threat but MCD's U.S. same-store sales are still trending slightly positive. The real weakness has been in Asian/Middle Eastern/African markets, where same-store sales were down over 12% partly due to supply problems in China and Japan. The company was also hit by the effects of the strong dollar since it derives a significant percentage of its sales outside the United States.

MCD is certainly a mixed bag. It's problems don't appear to be easily solved, however given its size, scope, and still superior financial muscle, MCD can certainly be counted on to serve its gazillionth customer sometime this decade.

However, the question for us is whether MCD's stock price is still the rock-solid investment it's always seemed.

The Best Alternative to MCD

In view of the company's recent underperformance, it would not be surprising to see McDonald's attract the attention of a serious activist shareholder.

The company is a huge cash generator and returned $6.4 billion to shareholders last year through share buybacks and dividends. The company has targeted $18-$20 billion of capital that it plans to return to its owners in 2014-16.

MCD remains a solid dividend aristocrat, raising dividends in every year since initiating its first payout in October 1987.

That train will inevitably continue to chug along, but with a payout ratio of 67% and profit growth slowing, it's possible increases will turn paltry.

Unfortunately, a 3.5% dividend may be about all of the return investors can expect unless management identifies and builds out the company's strengths.

CMG looks like the better play.

About the Author

Prominent money manager. Has built  top-ranked credit and hedge funds, managed billions for institutional and high-net-worth clients. 29-year career.

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