Starbucks (NASDAQ:SBUX) and McDonald's (NYSE:MCD) are going in very different directions. While the coffee emporium is delivering solid financial performance and optimistic growth prospects, the fast-food juggernaut is struggling in its attempts to reverse the decline in sales.
On the other hand, this dissimilar performance is clearly reflected in valuations. McDonald's trades at a considerably cheaper valuation than Starbucks, and the stock offers substantial upside potential if the company manages to turn things around. So, which company is a better buy in 2015?
Starbucks is steaming hot
Starbucks is truly firing on all cylinders, both when it comes to sales and profits. The company announced a big increase of 10% in sales during the September quarter, fueled by a 5% jump in comparable sales. This marked the 19th consecutive quarter with comparable sales growing at 5% or more, quite an impressive performance for a company as big as Starbucks.
Profit margins are on the rise due to sales leverage and operating efficiency, so adjusted earnings per share increased 23% year-over-year. In a sign of confidence, management raised earnings guidance for fiscal 2015, and Starbucks implemented a mouthwatering dividend increase of 23%.
Even better, the company has recently announced its five-year growth plan, and things look quite exciting for investors in Starbucks. Management believes it can increase sales from $16.4 billion in fiscal 2014 to approximately $30 billion in revenues by fiscal 2019.
While this is clearly an ambitious target, demand strength, brand differentiation, and the company's track record of successful innovation over the years indicate that Starbucks has what it takes to continue generating impressive performance in the future.
McDonald's: not lovin' it anymore
McDonald's is a very different story. The company is facing contracting sales over the last several months, as consumers seem to clearly prefer healthier alternatives in the fast casual category, such as Chipotle Mexican Grill (NYSE:CMG). The company has tried to improve performance via menu innovation, but this strategy is not generating the desired traction among customers. Instead, the quality and speed of the service is under pressure due to increased operational complexity, and the decline in sales is even accelerating.
McDonald's announced a decline in systemwide sales of 6% during November, while comparable sales fell 2.2% versus the same month in 2013. Performance was particularly dismal in the U.S., where systemwide sales fell 3.7% and comparable sales declined by 4.6%.
Management is changing its strategy by simplifying its menu and providing more customization options. In addition, the company intends to improve customer perception regarding the calories and other health implications of its products.
These ideas seem well intended, but turnarounds are seldom easy, especially in such a challenging and competitive industry. Time is running against McDonald's, as the company is clearly losing market share versus the competition, and there is no visible sign of improvement at this stage.
Premium coffee vs. value meal
The argument for choosing McDonald's over Starbucks should be based on valuation. McDonald's trades at a forward P/E ratio of 16, a discount versus the average company in the S&P 500 index, which carries a forward P/E ratio in the neighborhood of 18 as calculated by Morningstar.
The dividend yield is particularly attractive; McDonald's pays 3.7% in dividends at current prices. This looks like a convenient yield considering that the business is financially healthy and McDonald's has an impressive track record of dividend growth: The company has raised payments every year since making its first dividend payment in 1976, accumulating 38 consecutive years of consistent dividend growth.
However, investors need to be careful when hunting for bargains in the stock market. McDonald's has a lot of room for improvement, but there is no hard evidence supporting the fact that the company is on track to recovery, so the fundamentals could easily continue deteriorating over time.
Sometimes you get what you pay for, and unless McDonald's proves that it can change course, Starbucks looks like a much stronger alternative.
Starbucks is a high quality company trading at a premium valuation. The company carries forward P/E ratio around 25, considerably higher than the valuation levels the market is assigning to both McDonald's and the S&P 500 Index. Even after the recently announced dividend hike, Starbucks pays a modest dividend yield of 1.5%.
When it comes to Starbucks, a demanding valuation can limit upside potential in the short term, but sales and cash flows are clearly moving in the right direction. Starbucks certainly deserves to trade at a premium because of its superior quality and growth prospects, so investors in the company should do better than fine in the long term.