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Jim Cramer is Wrong in Picking McDonald's Over Shake Shack

By Rick Munarriz - Apr 4, 2016 at 11:41AM

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The fast-growing burger chain moves higher after an analyst upgrade, but one CNBC and The Street icon thinks the move is premature.

Image source: Shake Shack.

There's no shortage of naysayers when it comes to Shake Shack (SHAK -3.49%). The fast growing chain has fallen out of favor with investors since peaking nearly a year ago, but it may still be considered overvalued by many conventional measuring sticks.

The stock seemed to catch a break last week after an opportunistic upgrade by Longbow, but then CNBC rock star Jim Cramer shot it down on back-to-back days.

"I still think it's too expensive," he concluded on a video for The Street in explaining Wednesday's upgrade, arguing that Shake Shack is expensive on a per-restaurant basis.     

Cramer elaborated on that viewpoint a day later during his Mad Money show on CNBC, repeating the valuation concern. He called it "ridiculously" valued, nudging investors to snap up McDonald's (MCD 2.74%) stock instead.  

"I prefer McDonald's," he said. "I think McDonald's is the one to buy here."

Now Cramer didn't explicitly say that McDonald's has a more reasonable valuation if you divide its enterprise value by the number of eateries, but it certainly seems to be implied. Cramer probably knows better, but can the same be said about his audience?

A lot of skeptics like to compare Shake Shack to unfit matches in cooking up what the stock should be worth. There are plenty of reasons why Shake Shack and McDonald's can't be valued side-by-side -- and not just because McDonald's is several times larger. 

The biggest beef has to be that most of McDonald's locations are franchisee-owned and operated. Roughly 90% of McDonald's more than 14,000 U.S. burger joints are run by franchisees. That's obviously a lot different than an empire consisting of mostly company-owned units. Shake Shack owns and operates all but 5 of its 49 domestic locations.    

That's a pretty big distinction. Owning the restaurants naturally results in greater revenue and typically net income per location than simply collecting a sliver of the take as a franchising royalty. Both models work. That's not the point. You just can't compare a company that owns just 10% of its restaurants to a concept that is nearly 90% company-owned in the U.S. -- McDonald's owns closer to 20% worldwide, by the way -- if you're going to value them based on market value per location. Cramer is obviously smart enough to know that, but I imagine many of his Mad Money viewers made the incorrect assumption.

However, even if we're going to pit the typical Shake Shack to an average McDonald's there are several factors that justify Shake Shack commanding the much loftier market premium.

  • The average stateside McDonald's restaurant takes in $2.5 million in sales a year. Shake Shack, on the other hand, is forecasting an average of at least $3.3 million this year.
  • McDonald's makes a good chunk of money serving morning commuters. Shake Shack doesn't serve breakfast -- at least not yet.
  • McDonald's offers drive-thru convenience and even more in-store registers than Shake Shack. That makes it even more impressive that Shake Shack is outgrossing Mickey D's, and that's before we get into the larger staffs that need to be paid at McDonald's.
  • Shake Shack is just starting to broaden its menu with the addition earlier this year of its new fried chicken sandwich.

This all translates into juicy growth opportunities for Shake Shack as it expands its hours, offering, and convenience. However, the biggest opportunity for Shake Shack remains in all of the fertile expansion room that it has yet to conquer. It will be able to grow its base at a double-digit percentage clip for years. That obviously isn't going to happen at McDonald's. In fact, analysts see revenue declining by at least 5% this year and again in 2017 at McDonald's. That's a far cry from the better than 23% growth that Wall Street pros are modeling for Shake Shack through each of the next two years.

This doesn't mean that Shake Shack is cheap. Cramer is right to single out its valuation as high. However, sometimes steep markups are worth it.  

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Stocks Mentioned

McDonald's Corporation Stock Quote
McDonald's Corporation
$244.52 (2.74%) $6.52
Shake Shack Inc. Stock Quote
Shake Shack Inc.
$41.76 (-3.49%) $-1.51

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