Better Buy: Shake Shack Inc. vs. Yum! Brands

By Markets Fool.com

The restaurant sector may not be the sexiest industry in the stock market, but for investors looking for solid growth opportunities, restaurants offer some alluring options.

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Spending on food outside of the home has steadily outgrown grocery-store expenditures over the past few decades, and Americans now spend more at restaurants and bars than they do in traditional supermarkets.

Restaurants have also been a key driver in retail sales growth as general retail sales are up 2.6% this year, but sales at restaurants and drinking places are up 6.4% through the first half of the year according to the Census Bureau.

For several years now, spending at restaurants have outpaced over retail sales, and that trend is likely to continue as surveys have indicated and millennial, and even consumers generally, prefer to spend money on experiences rather than things.

Today, as part of our "Better Buy" series, we're taking a look at two popular restaurant chains,Shake Shack Inc(NYSE: SHAK) andYum! Brands(NYSE: YUM), which represent two ends of the fast-food spectrum. With fewer than 100 stores worldwide, Shake Shack is perhaps the smallest restaurant operator on the stock market, while Yum, the parent of KFC, Taco Bell, and Pizza Hut, is the biggest restaurant chain in the world by number of locations with nearly 43,000.

Let's take a look at what each of these companies brings to the table.

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Image source: Shake Shack.

Making a name for fine casual

Shake Shack jumped on the public markets last year sparking mouthwatering anticipation for the popular burger chain's stock. Shares ran up more than four times the IPO over the next four months before giving back much of those gains as the company's sky-high valuation became too much for investors to stomach.

Today, Shake Shack still trades at a triple-digit P/E, but the company's track record has been impressive as it's beaten analyst estimates in every quarterly report, most times by a wide margin, and last year same-store sales jumped 13.3%.

Shake Shack is unlike its competitors in other ways as well. The company's brand equity is virtually unparalleled as the brand's buzz precedes it in nearly every new market it enters, helping to ensure long lines when it opens its doors. That's a major reason why the company has been able to sustain average unit volumes of $5 million, close to double in any other fast food chain in the country. Its brand power is evident in social media as well. For example, Shake Shack has 297,000 followers on Instagram, almost as many as Chipotle, which has more than 20 times the number of restaurants.

Founder Danny Meyer credits the brand's success to fine casual, the company's own extension of fast casual, marrying the gourmet ingredients of a fine dining restaurant with the convenience and comfort of fast food. It's proven to be a winner with Shake Shack's restaurants generating nearly $1.5 million in operating profit on average last year.So far, the only constraint on the stock seems to be the company's ability to open new stores. It expects to open 16 new domestic company-operated restaurants this year, growing its base by 36%.

A familiar way to play to China

While Shake Shack has wrapped itself in the fine casual banner, Yum! Brands may be the example in the market of a traditional fast-food company as the inventor of foods such as the Doritos Locos Taco, stuffed crust pizza, and KFC Double Down has avoided many of the fast casual trends. While Yum's restaurants have had middling success in the U.S. in recent years, China has been its primary engine of growth, contributing about half of the company's revenue as its Chinese stores are company-owned while most of its others are franchised.

Recently, the Chinese business has come under trouble due to a series of food safety scandals which sent sales tumbling and thus prompted management to arrange for a spinoff of the Chinese business this October. That move will give investors the options of investing in American brand aiming for growth in China, or an entrenched restaurant operator bent on refranchising nearly all of its stores at home. Following a trend in the fast-food industry, that should help generate a steady cash flow and protect investors from the vicissitudes of operating performance and the broader economy.

Yum currently offers a 2% dividend yield, but I'd expect that to grow after the spinoff as the company has shown its commitment to returning capital to shareholders in the past with a plan to repurchase up to $4.2 billion in stock, or about 12% of its market value.

And the better buy is...

Ultimately, Shake Shack and Yum! offer different things for different investors. Those looking for a high-valued growth stock will prefer Shake Shack, while investors interested in steady cash flow and stability would be better off with Yum! Brands. The China spinoff offers a third option as a way to play China with a familiar American brand. Personally, I believe Shake Shack offers the most upside potential due to its brand power and growth potential. While its valuation could still shake the stock, as the company adds stores and builds sales, its profits should accumulate to justify its high price tag.

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Jeremy Bowman owns shares of Chipotle Mexican Grill and Shake Shack. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.