Americans have a big appetite for fast food; that's no fresh news. In fact, the industry generates sales of $680 billion per year based on data from Consumer Reports.
This colossal market provides all kinds of opportunities for investors, ranging from an industry giant with massive cash flow such as McDonald's (NYSE:MCD) to innovative growth players offering big room for expansion, like Chipotle Mexican Grill (NYSE:CMG) and Shake Shack (NYSE:SHAK).
McDonald's is clearly not the hottest play in the sector right now. Consumers are moving away from big fast food chains toward smaller players in the fast-casual category: restaurants that offer higher quality and fresher ingredients. In this context, McDonald's suffered a 1.9% decline in global comparable sales for the first four months of 2015.
Management is implementing a series of initiatives to improve the customer experience and revamp the menu, such as kiosk ordering, premium burgers, and more options for menu customization. These ideas seem well-intended and in line with industry trends. However, implementation is key, and it's too early to tell if McDonald's can bring customers back to its stores with these moves.
The good news for investors is that McDonald's stock looks quite attractive in terms of valuation, especially when considering dividends and buybacks. McDonald's pays a dividend yield of 3.5% at current prices, and it has increased its dividend for 38 consecutive years, so it has proven its ability to distribute more and more cash through all kinds of scenarios.
The company is planning to return between $8 billion and $9 billion to shareholders in 2015 via dividends and buybacks. McDonald's has a market capitalization in the neighborhood of $93 billion, so investors will receive about 9% of the company's market value via cash flow distributions this year. This supersized yield is quite tasty, and it shows that McDonald's offers considerable upside room if management can reignite growth.
Chipotle Mexican Grill
Unlike McDonald's, Chipotle is doing remarkably well, but the stock is trading at a demanding valuation. Chipotle carries a forward P/E ratio of about 30, a considerable premium versus the average valuation near 18 times earnings for companies in the S&P 500 index.
However, make no mistake; Chipotle can easily justify an above-average valuation on the back of its spicy financial performance and abundant growth prospects. The company is arguably the most explosive success story in the restaurant industry over the last decade; Chipotle has increased sales exponentially, from $628 million in 2005 to $4.1 billion in 2014.
Performance for the first quarter of 2015 was quite impressive, too. Total revenue grew 20.4% on the back of a 10.4% increase in same store sales, and Chipotle opened 49 new restaurants during the period.
Chipotle raised menu prices in the second quarter last year, so year-over-year comparisons will be tougher for the rest of 2015. However, the long term growth story in Chipotle Mexican Grill looks remarkably exciting. Considering the strength of demand, Chipotle still has significant room for expansion in the U.S. Besides, the company has barely taken its first steps in international markets.
In addition, Chipotle is expanding into Asian cuisine and pizza with its ShopHouse and Pizzeria Locale concepts. If management can replicate with these new ventures at least a fraction of the success it has achieved with Chipotle, this could open the doors for massive growth opportunities.
Shake Shack is considerably smaller than other industry players. The company has only 66 systemwide stores, of which 34 are domestic company-operated, five are domestic licensed and 27 are international licensed units. This makes Shake Shack look minuscule in comparison to the more than 1,800 stores owned by Chipotle and the massive global presence of McDonald's, which has nearly 36,300 locations in 125 countries.
A smaller size means higher risk and volatility for investors, but Shake Shack also offers enormous room for growth. Management believes it can bring the store base to at least 450 restaurants in the U.S. alone, so a position in Shake Shack stock offers the opportunity to bet on a high growth restaurant chain while it's still in its early stages.
Shake Shack operates in the fast casual category. The company's signature items are its all-natural, hormone- and antibiotic-free burgers, hot dogs, crinkle-cut fries, shakes, and frozen custard. The business is firing on all cylinders. Total revenue grew 56.3% to $37.8 million in Q1 2015, and restaurant-level operating margin jumped to 25.7% of revenue, versus 23% in the same quarter last year.
This kind of growth rarely comes for a cheap price. Indeed, Shake Shack trades at a stratospheric valuation when looking at the stock price in comparison to current sales and earnings. However, rapid sales growth and expanding profit margins could be powerful drivers for investors in Shake Shack stock over years to come.