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Why McDonald's Isn't Shake Shack, and Probably Shouldn't Be

Wall Street wants McDonald's to be more like Shake Shack, the hamburger purveyor in New York that just filed for an initial public offering that could value it at a billion dollars. But perhaps instead, Wall Street should let McDonald's be McDonald's and be careful about whether Shake Shack is a burger bubble.
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Why McDonald's Isn't Shake Shack, and Probably Shouldn't Be

Wall Street wants McDonald's to be more like Shake Shack, the hamburger purveyor in New York that just filed for an initial public offering that could value it at a billion dollars. But perhaps instead, Wall Street should let McDonald's be McDonald's and be careful about whether Shake Shack is a burger bubble.

Shake Shack serves premium burgers, fries and shakes to a mass clientele - think Five Guys or In-N-Out Burger - and describes itself as a "modern day 'roadside' burger stand." The chain was started by celebrity chef Danny Meyer in 2004 with a hot dog cart in New York. Since then, Shake Shack has grown to 36 restaurants in the United States, five of which are franchisees, and 27 outside the United States, mainly in the Middle East.

If the chatter about Shake Shack's billion-dollar valuation is true, it would rival that of a technology startup. It would translate into $37 million for each owned store, 185 times 2013 earnings of $5.4 million and seven times 2013 sales of $140 million. Even if the valuation is half that, those are still some amazingly heady numbers.



In short, with this talk, it appears that Wall Street is about to line up for Shake Shack.

Then there is McDonald's.

McDonald's, with a market value of $90 billion, has more than 35,000 restaurants in more than 100 countries. While Wall Street appears to love Shake Shack, it disdains McDonald's.

McDonald's is valued much lower than its peer restaurant companies. According to S&P Capital IQ, Chipotle is valued at 26.5 times forward earnings before interest, taxes, depreciation and amortization, while Shake Shack would be valued at more than 300 times forward earnings at a billion-dollar valuation. McDonald's is valued at 10.3 times forward EBITDA, lower than all of its peers, including Wendy's, Red Robin, the combined Burger King and Tim Hortons, and Yum Brands.

To be fair, McDonald's has not given the Street a lot to cheer about recently. It reported that its same-store sales for November declined by 2.2 percent globally and 4.6 percent in the United States, compared with those in the month a year earlier. Not only that, the company has had significant international difficulties, with stores closing in Russia because of political turmoil there and sales declining in China because of concerns about the safety of beef from one of the company's suppliers.

With Shake Shack and other quick casual chains like Chipotle getting all the love, it is no surprise that McDonald's is feeling the pressure to be more like the young burger phenom. The Street.com, for example, recently posted an article titled "What Struggling McDonald's Could Learn From Shake Shack and Five Guys," while MarketWatch had one titled "How McDonald's Helped Shake Shack Go Public." To read these articles, you would think McDonald's was about to be tossed into the dustbin of history by Shake Shack, Chipotle and the other fast-casual chains.

There is also talk of shareholder activism. McDonald's has a low debt level and throws off tremendous cash, which could make it a target for a share buyback or some other financial maneuver. In addition, its low multiple makes it ripe for an activist to come in and try to engineer a quick boost in its market value.

However, these tricks typically work at companies that are not in turnaround mode, and while McDonald's is not about to go under, it has embarked on a turnaround plan that involves a simpler menu with fewer choices and high-quality ingredients. McDonald's is responding to the conventional wisdom that consumers, particularly millennials, want food that is perceived as higher quality. McDonald's, which itself started as a roadside burger stand, is responding by emulating Shake Shack and Five Guys, but not entirely. The beloved McRib, for example, will remain in the menu rotation.

But this all raises the question of whether McDonald's should even go down this road.

First off, McDonald's is not Shake Shack. It has a lower price point: The average check size at McDonalds is about $5 while a Shake Shack meal - burger, shake and fries - is $13 in the United States, according to Eater.com. McDonald's is also in the fast-food category, while Shake Shack is in quick casual - which it calls fine casual - with Chipotle, another highflier.

McDonald's simply can't be Shake Shack, which has no ambitions to expand to 35,000 restaurants. What McDonald's can be is a big company that adjusts to changing tastes but still serves customers who don't want to spend a lot. Moving up in price is not going to work for McDonald's current customer base.

Second, there should be some recognition that the Shake Shack IPO is all about speculation. For a recent example, consider the IPO of Fairway, the New York grocery chain, in 2013. The company, with 12 stores, was valued at $825 million. This was extraordinarily high but based on the belief that a New York premium grocery store with unbelievable New York store revenue could conquer the world.

It hasn't worked, and Fairway is now trading at $3 a share, a drop of 83 percent over the last year.

People who invest in Shake Shack are hoping to replicate Fairway, but successfully. This hope is fueled by a Wall Street burger craze. Habit Restaurants, which operates the Habit Burger Grill, raised $90 million in November. Shares of the chain, which has about 100 restaurants, are trading at $30 a share, up from the $18 IPO price.

But there are warning signs. Shake Shack's Manhattan restaurants generate an average of $7.4 million a year in revenue, but its other restaurants bring in only $3.8 million. And it faces rivals like In-N-Out Burger, Five Guys and other burger chains like Habit. All this competition comes even as beef consumption has been declining in the United States. Even Shake Shack itself estimates that its market in the United States is only about 450 restaurants, about 1.3 percent the number of current McDonald's restaurants.

This does not mean that Shake Shack is not a successful business, or that it will not be worth a lot of money. It is just that it has a lot to accomplish to justify a lofty valuation. It may succeed, but it may end up like Fairway if the burger hype turns out to be a bubble. Wall Street should be more careful.

As for McDonald's, the more Wall Street expects it to be like Shake Shack, the more off the mark it is likely to be. Instead of trying to transform McDonald's, perhaps Wall Street should take a harder look at its premium burger fetish.

© 2015 New York Times News Service



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