Every investor wants to buy winning stocks. Unfortunately, faulty reasoning often misguides our search.
Take for instance restaurant giants McDonald's (MCD -0.51%) and Domino's Pizza (DPZ -1.17%). McDonald's stock is about 7% lower than it was this time last year. By contrast, Domino's stock has gone up almost 60% during the same timespan. Given the choice, many investors would decide to buy McDonald's stock at a "discount" rather than "chase" Domino's stock at all-time highs.
This is looking for a value in the wrong places.
Let's take a closer look at why McDonald's stock might not beat the market over the next few years. We can also get look at why Domino's stock still offers value for investors despite its big run-up.
A limited upside for McDonald's
Comparable sales, or same-store sales, are an important metric for restaurant stocks. But companies define the term differently. For McDonald's, it adds restaurant locations to its comparable-store base after they've been operating for 13 months. New stores could take time to ramp up, or sales could be temporarily inflated due to excitement. Therefore, comparable sales is a more stable metric for measuring sales trends.
McDonald's global comparable sales went up 5.3%, 4.5%, and 5.9% in 2017, 2018, and 2019, respectively -- a strong trend for the world's largest restaurant chain. However, the company's revenue actually fell 14% over that span. In fact, trailing-12-month average revenue peaked way back in 2014 and has consistently declined ever since.
Revenue is declining for McDonald's because it has taken thousands of company-owned restaurants and refranchised them. With company-owned locations, restaurant sales are counted as revenue. With franchised locations, only franchise fees count.
McDonald's comparable-sales growth demonstrates it is still a relevant company among consumers. However, by refranchising locations, much of that upside is now retained by the franchisees. Furthermore, by limiting its revenue upside, McDonald's is struggling to grow its bottom line. Net income was essentially flat from 2018 to 2019, as the one-time benefits of refranchising moved to the rearview mirror.
I'm not suggesting McDonald's is doomed. Quite the opposite. Its comparable-sales growth shows its business is fine. And the company will continue modest earnings-per-share growth by repurchasing its stock, and it will keep rewarding shareholders with its dividend, currently yielding 2.4%. But this recipe doesn't look like it will produce market-beating results over the long term.
Don't sleep on Domino's potential
Domino's is largely franchised like McDonald's. But it compensates for this limiting feature by opening new locations. Indeed, another reason to question McDonald's ability to beat the market going forward is its minimal expansion opportunity. It's already the world's largest restaurant chain, limiting how much more it can grow. By contrast, Domino's is still planning on a lot of growth.
By 2025, Domino's aspires to have 25,000 locations worldwide and $25 billion global retail sales. For perspective, the company now has around 17,000 locations and had retail sales of $14.6 billion in 2019. Therefore, it's counting on finding market opportunities for 6,000 more restaurants and it expects sales per location to increase.
Domino's growth plan should be taken very seriously, given its millionaire-making results over the last decade. And there's another reason to buy into management's vision: the company is executing extremely well during the coronavirus pandemic. In the second quarter, Domino's comparable sales in the U.S. grew a whopping 16% year over year, its 37th consecutive quarter of positive U.S. comparable-sales growth.
While no one is cheering the negative effects of the coronavirus pandemic, the strain on independent restaurants must be acknowledged. According to the Independent Restaurant Coalition, 85% of independent restaurants are at risk of closing their doors forever -- they need financial help. One would assume pizza restaurants are included in this grim projection. After all, few independent pizza operations are equipped with digital-ordering technology and a network of delivery drivers like Domino's.
This means Domino's could be in a prime position to steal more market share in the U.S., both with increased restaurant sales and new restaurant location opportunities. In other words, management's growth plan is not only attainable, but it could be accelerated in the near term. This will grow revenue.
The five-year chart below shows what happens when Domino's grows revenue.
Domino's profit margin goes up with higher sales. A higher profit margin results in more net income -- it registered $400 million in 2019. With its profits, Domino's rewards shareholders by reducing its share count and growing its dividend. In the end, market-beating shareholder value is created. It's a trend that should continue as Domino's grows its top line between now and 2025.
Despite trading near all-time highs, Domino's stock is still a good buy and a better buy than McDonald's stock today.