Better Buy: Shake Shack vs. McDonald's

By Jeremy Bowman Markets Fool.com

No two companies may better represent the opposing poles of the fast-food industry thanMcDonald's Corporation(NYSE: MCD) and Shake Shack Inc.(NYSE: SHAK). McDonald's is the biggest fast-food company in the world by sales and market value, and the Golden Arches represent the quintessential burger chain in much of the world. Shake Shack, on the other hand, is one of the companies defining the better-burger space, and its founder, Danny Meyer, likes to call the brand "fine casual." Shake Shack charges more for its burgers than McDonald's, but offers better-quality food.

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While the companies may not compete directly as they focus on different price points, the two brands clearly influence each other. McDonald's has taken several steps to improve its product quality in recent years, including announcing last month that it would switch to using fresh beef for Quarter Pounders in most of the U.S. Shake Shack, on the other hand, takes its influence from the classic roadside burger stand, somewhat like McDonald's in its original incarnation.

Image source: McDonald's.

As stocks, the two have been unexciting in the recent past as both underperformed theS&P 500 over the last year.

MCD data by YCharts.

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The restaurant industry in general has been pressured by food deflation and falling retail traffic while cyclical stocks surged following the election. Let's take a closer look at each of these companies to see which has more to offer investors, as the better buy today.

A new Mickey D's

McDonald's has seen a number of changes since Steve Easterbrook was named CEO two years ago. Easterbrook has elevated food quality by eliminating human antibiotics from the chicken it serves and removing high-fructose corn syrup from its buns. Serving Quarter Pounders made from fresh beef, meanwhile, is set to go national next year. Easterbrook also responded to customer demand by introducing all-day breakfast, which resulted in a surge in comparable sales. Internationally, he's refranchised company-owned restaurants, helping to free up capital to return to shareholders.

While McDonald's stock surged on the success of the all-day breakfast, results have been more muted lately. Comparable sales fell in the U.S. in its most recent quarter, the first period to lap the launch of all-day breakfast, though global comparable sales increased. At home, the company seems to be caught in between chains like Burger King that are beating it on price and fast-casual brands that offer a higher-quality product.

Last week, the management team saw a shakeup as three executives including the chief marketing officer were said to be leaving the company, a sign that the transition may not be happening fast enough to satisfy Easterbrook. While McDonald's seems to be moving in the right direction, the latest results have been less than stellar.

Image source: Shake Shack.

Can Shake Shack live up to the hype?

Shake Shack shares are trading near an all-time low of around $32 after its recent earnings report disappointed the market. Though the company continues to have the best average unit volumes in fast food, at around $5 million, increases in labor expenses have cramped profit growth, and comparable sales have slowed from double digits in 2015 to just 1.6% in its most recent quarter.

Goldman Sachsrecently lowered its price target as analyst Karen Holthouse said the excitement about the brand was waning as it opened second and third locations in existing markets.

That is a concerning report, but Shake Shack management has always warned that average unit volumes would come down as the company expanded away from its home base in New York. Thus far, average unit volumes have been consistent since its IPO, a sign that new stores are faring better than expected.

More important than same-store sales for Shake Shack will be its ability to successfully open new locations. The chain is still small, with 64 domestic company-operated restaurants, and sees room for 450 locations in the country, meaning there should be a long-term growth path ahead.

Which is the better buy?

McDonald's and Shake Shack likely appeal to different types of investors. McDonald's is a blue-chip stock that trades at a P/E of 24 and offers a dividend yield of 2.9%. It's more likely to appeal to more conservative income investors.

Shake Shack, on the other hand, is a much riskier stock with its P/E above 60, making it more suitable for growth investors. It does not pay a dividend.

While McDonald's has made some smart moves under Easterbrook, particularly by introducing all-day breakfast, the company still seems to be searching for its modern identity, and its domestic performance should continue to be weak as industry headwinds persist. As far as Shake Shack goes, the market appears to be underestimating its long-term potential. Its footprint will more than double over the next few years, and the company should grow into its valuation over time. Talk of cannibalization, as Goldman Sachs referred to, seems silly for a restaurant chain with fewer than 100 domestic locations. McDonald's, by comparison, has more than 14,000.

Though income investors will prefer the Golden Arches, Shake Shack's expansion potential makes it the more promising long-term bet.

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Jeremy Bowman owns shares of Shake Shack. The Motley Fool is short Shake Shack. The Motley Fool has a disclosure policy.