When it comes to fast-food burger chains, the first name that likely comes to mind is McDonald’s (MCD -0.03%). After all, the quick-serve restaurant operator has over 41,800 locations across the globe. Its golden arches are one of the most iconic logos in the world, and the company is a marketing machine.
However, McDonald’s stock is not the best investment option in the quick-service hamburger space today — that title belongs to Shake Shack (SHAK -0.24%). So why does this smaller rival have more potential upside? Well, one of the biggest reasons is its smaller size.
Lots of room to grow
One of the biggest growth drivers for restaurant operators is adding new locations, and Shake Shack just has more opportunities to increase its numbers on a percentage basis than a company the size of McDonald’s.
Why is this important? Because stocks tend to be valued in part on companies’ potential for growth, and adding new restaurants increases both sales and profits. Each Shake Shack averages close to $4 million in sales at a restaurant-level operating margin of about 20%, which means each individual company-owned restaurant generates a profit of approximately $800,000 before any corporate-level costs.
With 518 total locations — 334 of them in the U.S. — as of the end of 2023, Shake Shack has a lot of room to add new restaurants. While it is unlikely to ever get close to the size of McDonald’s, it should be able to get to at least a similar size to Five Guys, which has nearly 1,500 locations in the U.S. and sells premium burgers similar to those at Shake Shake. Combined with international opportunities, the company should be able to quadruple its number of locations from here. That is something McDonald’s is unlikely to be able to do, given its size.
Shake Shack plans to add 40 company-owned locations this year and 40 licensed locations. The company-owned ones will primarily be in domestic markets where it already has a presence, while the licensed locations will be in new and existing international markets, as well as domestic airports and rest stops.
Using the McDonald’s playbook
Shake Shack also has a nice opportunity to improve its results by following some initiatives that McDonald’s has already implemented. One such area is drive-thrus, which McDonald’s has been using since the 1970s. Shake Shake has been testing drive-thrus at about 30 locations. The big benefit of drive-thrus is that they speed up the ordering process, which allows restaurants to serve more customers, and thus generate more sales.
In a similar vein, Shake Shack is starting to roll out ordering kiosks — a technological innovation that also has benefited McDonald’s. Kiosks reduce both ordering times and labor costs. Consumers also tend to spend more per visit when ordering from kiosks. Shake Shack said it has been seeing a high single-digit percentage increase in check sizes for kiosk orders versus those placed with traditional cashiers.
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Both stocks should be long-term winners
Over the past couple of years, restaurant operators have benefited from being able to increase prices due to high inflation, often in excess of the increased costs they faced. This has helped push same-store sales higher while boosting profits. The reason profits go up despite inflationary pressure is quite simple. The price increases help restaurants keep their margins, which leads to higher profits.
Even if margins slip a bit, though, profits can still go up. For example, a 20% margin on $85 million in sales is $17 million in operating profit, while an 18% margin on $100 million in sales is $18 million. So if the top line grows by a large enough percentage, profits can rise even if margins shrink, but companies generally try to keep their margins steady or increase them. Not surprisingly, the restaurant industry has enjoyed some good results in this environment.
Now that inflation has moderated considerably, further price increases for both restaurant operators are likely to be smaller than they were in recent years. Shake Shake says it’s looking to increase prices by 2.5% this year, and McDonald’s is talking about low single-digit percentage increases. Both are also expecting to drive traffic growth this year. So while the environment isn’t quite as strong as it was in years past, both companies look well-positioned to continue to drive sales growth.
Both McDonald’s and Shake Shake should be solid long-term performers. However, Shake Shake has more upside potential given its capacity to add more locations and improve its operating efficiency through initiatives such as drive-thrus and kiosks.
