Buy The Next McDonald's (MSN Money)

Buy the next McDonald's
The burger giant has delivered for investors for years, but there are signs its growth is stalling. Here are 5 competitors that could grow faster -- and the 2 best bets among them.
by Charley Blaine, MSN Money|11/27/2012 5:15 PM ET


McDonald's. The name means burgers and fries, Chicken McNuggets and Egg McMuffins -- to almost everyone in the world.

McDonald's (MCD -0.15%, news) also means a stock that jumped 148% in value between the end of 1999 and 2011, delivering for investors even in the worst of times. It was one of just two stocks in the Dow Jones Industrial Average ($INDU -0.56%) that finished the horrible year of 2008 with a gain.

But the company has hit a wall in 2012. Consumers are wary in a difficult economy. And McDonald's is so big that it's hard to find enough growth to move the needle. That makes it time for investors to look for companies with similar positives and lots more room to grow -- giving them the potential to outperform the Golden Arches over the next few years.

I've found five with that potential: Jack in the Box (JACK +0.54%, news), Sonic (SONC -0.95%, news), Yum Brands (YUM +0.24%, news), Chipotle Mexican Grill (CMG +0.78%, news) and Red Robin Gourmet Burgers (RRGB +1.20%, news). First we'll look at why McDonald's works -- then ask which of these five is most likely to grow into this "next McDonald's."

Why McDonald's is unique
First, we have to acknowledge McDonald's amazing position. The company has a market value of $84.4 billion, the most of any fast-food company and larger than its three largest competitors -- Starbucks (SBUX -0.78%, news), Yum Brands and Chipotle Mexican Grill -- combined.

Some 69 million people a day buy a meal at any of 34,000 McDonald's restaurants in 119 countries -- nearly 48,000 sales a minute. In 2011, company-owned and franchised restaurants generated nearly $86 billion in food sales.

The company has boosted net income nearly 14% a year for the past five years. Dividends have grown 20% a year for five years. If you're happy with a reliable stock paying a 3.6% dividend yield, it's still a solid stock to own.

Sure, performance has been stagnant of late, with Europe a particular problem. The stock is down 14% this year, third-worst among the 30 Dow stocks. Same-store sales fell 1.8% in October, the first monthly decline in nine years. But McDonald's has worked through downturns before. In 2003, for example, shares dipped to the $14 range. They were a steal at that price: They now go for $86.

If you'd bought 100 shares of McDonald's when it went public in 1965 at $22.50 a share and didn't sell through 12 splits, your stake would have grown to 74,358 shares worth about $6.41 million. That's a gain of roughly 285,000%, or 18.4% a year. The total return is larger if you include dividends.

There are three keys to McDonald's success:

Foolproof formula for franchisees. McDonald's has achieved its bulk -- OK, prominence -- by providing its franchisees a nearly foolproof formula for success. Sites are carefully chosen and usually owned by the company, which gets a cut of rents as well as sales.

Menus and preparation processes are standardized. A vast network of suppliers sells the raw ingredients following strict standards.

The assembly-line system of food preparation -- first developed by founders Richard and Maurice McDonald in the 1940s and expanded by Ray Kroc, who started as a franchisee and later bought out the brothers -- ensures a Big Mac in Tours, France, is the same as one in Montgomery, Ala.,

Evolving with the times. Success brings envy, controversy -- and evolution.

In the 1990s, its franchisees, who own 81% of the restaurants, complained that the company was selling too many franchises. McDonald's has been hit with repeated charges that mass consumption of Big Macs, french fries and related fare from other chains was responsible for growing obesity rates. And to social critics abroad, its omnipresent, standardized fare has represented the worst in American culture.

But Mickey D's has adapted. Existing franchises are being modernized with renovated or rebuilt stores, some 900 in 2011 and 1,000 expected this year. To answer dietary critics, it has broadened its menus to offer wraps, salads and fruit; it now sells more chicken sandwiches than burgers. Because McDonald's saw Starbucks' rapid growth as a threat, it now offers the McCafé line of gourmet coffees. And it bends its menus overseas to local tastes.

Financial strength. McDonald's backs up its franchisees with the cash to make improvements to stores and, as important, amazing marketing. It is one of the 15 largest advertisers in the world, with a $2.3 billion advertising budget that dwarfs those of Subway, Burger King (BKW +1.54%, news) and Wendy's (WEN +0.21%, news).

5 competitors, 5 strategies
The "next McDonald's" we're looking for won't look exactly like the one we have. Many of its rivals offer a different slant on fast food -- just as McDonald's reinvented fast food and franchising. One trend that's been growing in recent years is fast casual. You enter and order your food, which is prepared while you wait.

The financial game plans are different. Yum has a small dividend; Sonic, Jack in the Box, Chipotle and Red Robin don't offer dividends as yet.

Here's a look at our five contenders:

Yum Brands (YUM +0.24%, news). While McDonald's shares are down this year, Yum's shares are up about 22%. The company owns the KFC, Taco Bell and Pizza Hut chains and is making a huge and, so far, successful effort to be a major player in China. It has 38,000 restaurants already, mostly franchised, and is betting that its mix of chicken, Mexican food and pizza will succeed in Asia. There's ample room for growth, and while each brand has had problems over the years, all have improved in terms of image and quality.

Still, those brands aren't exactly new and different, so they could be a tough sell if consumers say "been there, done that." If China's economy truly falls apart, so will Yum shares.

Jack in the Box (JACK +0.54%, news). A storied name, Jack remains a small, mostly West Coast chain. The stock has been a pretty good performer, up 20% to $25.10 this year, but it has fallen 12.5% since mid-September when the overall market peaked. It has two lines of business -- Jack in the Box and the Qdoba chain, which offers fast-casual Mexican food.

Like Yum, it faces a potentially nagging problem in that its brand is already well-known. But the smaller footprint eases that worry.

Plus, the company has a lot of real estate, and, wrote Charles Sizemore of the Sizemore Investment Letter recently, Qdoba has the potential to grow quickly, capitalizing on consumer demands for fresher foods.

Sonic (SONC -0.95%, news). A classic drive-in burger chain, complete with carhops, the Oklahoma City company is smallish: only 3,500 stores, 88% franchise-owned. Revenue is less than $600 million a year. The stock, however, has been a winner so far this year, up nearly 38%. It's been digging itself out of a hole caused by the recession and a reputation as the poor man's McDonald's. It has growth prospects in the Northeast and northern Midwest and on the West Coast.

A warning, though: Volatility goes with these shares. They fell 74% between November 2007 and November 2008. They've ranged from $6.50 to $12 or so ever since. Analyst Paul Westra of Cowen & Co. thinks the chain is more vulnerable to the economy than others. Size is an issue. It also has a heavy 8-to-1 debt-to-equity ratio.

Chipotle Mexican Grill (CMG +0.78%, news). This fast-casual chain offers burritos and tacos. It grew from 16 restaurants when McDonald's bought into the company in 1998 to more than 500 when McDonald's sold its position in 2006. It has 1,200 locations in the United States, Canada and the United Kingdom. It is just starting to roll out a new concept: ShopHouse Southeast Asian Kitchen, featuring serving bowls and banh mi sandwiches

Here are the rubs:

• The company's comparable-store sales were up only 4.8% in the third quarter, compared with 8.3% for the first nine months and 11.3% a year ago.
• The company expects less robust growth for the fourth quarter and flat-to-low single-digit growth in 2013.

The stock jumped 1,020% between November 2008 and early April -- but has fallen 41% to as low as $233 before rebounding back to $275. It has lots of cash to finance new growth: nearly $410 million at the end of the third quarter. It has no debt. If you're interested, watch the stock's chart carefully for a bottom -- you want to go in at a relatively low price.

There are plenty of growth opportunities in Europe and Canada for Chipotle stores. It may get an additional boost if the Asian kitchen business works.

Red Robin Gourmet Burgers (RRGB +1.20%, news). Founded in Seattle, the Denver-based company has 463 full-service restaurants (331 are company-owned) concentrating on burgers and a few other entrees, plenty of fries and a full-service bar. On a Friday night, you'll find families celebrating birthdays on one side of the restaurant and couples enjoying a modestly priced night out on other.

The company saw revenue slip 3.2% in fiscal 2008 as the financial crisis hit and profit slid. Business rebounded in 2010 and 2011 and looks poised to finish 2012 with revenue approaching $950 million. The stock is up nearly 13% this year and up 250% from its bottom in November 2008.

Red Robin has lots of room to grow. Most of its restaurants are in the Western United States, British Columbia and Alberta. The company is carefully expanding into the Southeast and into the Northeast.

It is also experimenting with a fast-casual service concept. A number of analysts are watching to see how its Red Robin Burger Works concept fares. These basically offer burgers, fries and desserts that are cooked on the spot, much like Qdoba or Chipotle. They require less space to operate and are able to serve customers quickly. Red Robin has opened five -- four in the Denver area and a fifth near Ohio State University in Columbus. Four more are expected to open in the fiscal fourth quarter.

Take Jack in the Box and Red Robin
McDonald's has three advantages over all these companies: Size, brand and a 3.6% dividend. The cautious investor will still find these shares attractive. The company, however, does face increasingly intense competition from just about everyone from Burger King and Wendy's to Chipotle, Panera Bread (PNRA +0.06%, news) and Starbucks, Lazard Capital analyst Matthew DiFrisco wrote Monday as he cut his rating on the stock to "neutral" from "buy."

So if you're looking for equally solid returns and better growth in the next few years, the best bets look like Jack in the Box and, especially, Red Robin. The other three have bigger question marks to go with their possibilities.

Jack in the Box is in the midst of what appears to be a successful turnaround, with a new brand -- Qdoba -- providing additional growth. Red Robin looks to have a solid strategy that appears to weather economic stress well, and its Burger Works looks to be an innovation with potential.