Starbucks vs McDonald's: which company is a better fit for the portfolio

Two world-famous chains - Starbucks and McDonald's - have different approaches to doing business. The former is struggling with falling sales and trying to regain customer loyalty, while the latter has already become more efficient. Independent analyst Mikhail Zavaraev discusses what an investor should consider when adding shares in these companies to his portfolio.

Last September, Brian Niccol took office as CEO of Starbucks, and the very next day he wrote a letter to the company's partners, customers and stakeholders entitled "Back to Starbucks. The essence of his appeal was that the world-famous coffee chain has somewhat "drifted away from its essence" and does not fully satisfy the demands of customers, primarily regular customers. It was an urgent call for something to change. It did not come out of nowhere: even a cursory glance at the company's financial indicators shows that not everything is going smoothly.

Starbucks' revenue at the end of last year was almost unchanged - $36.2 billion, growth of less than 1%, net profit for the same period amounted to $3.76 billion, minus 8.8% in annual terms. Last year, the company faced a decline in customer traffic and began to frequently introduce various discounts and promotions to win back customers - and this after several years of price increases.

Starbucks' latest reporting for its fiscal third quarter (ended June 29) showed that things are not improving. The company reported a 2% year-on-year drop in comparable sales in the US, the sixth consecutive quarter of decline. In China, the second-largest market for Starbucks, they rose 2%, driven by an increase in the number of transactions. But it was offset by a decline in the average check amount as the company cut prices to compete with the Luckin Coffee chain.

Revenue and EPS were $9.46 billion and $0.5, respectively, while analysts expected the numbers to reach $9.3 billion and $0.65. Compared to the same quarter last year, earnings per share decreased by more than 45%.

Niccol himself argues that the numbers simply don't yet reflect the real positive changes that continue to gain momentum.

Starbucks has been actively increasing the number of coffee shops - last quarter the company opened 308 new establishments, and their total number currently amounts to 41,097. As a result, the chain's quarterly revenue grew by 4% year-on-year, but so far this is little consolation for investors.

Quotes Starbucks since the beginning of the year added 2.3%, although the S&P 500 index for the same period rose by 9.6%. For the last five years, the company's shares have essentially traded in a sideways range, albeit with very wide boundaries of $85-125. Over the five years, the quotes have grown by 17.8%.

By comparison, another representative of the restaurant industry is McDonald's. Since the beginning of the year, its shares have grown in value by 4%, and over five years - by 46%. Yes, this is also noticeably lower than the growth demonstrated by the S&P 500 index, which has roughly doubled over the years.

McDonald's is now also implementing the strategy "Accelerating the arches", which it announced at the end of 2023. Among other things, it involves increasing the network to 50 thousand restaurants by 2027 (now more than 44 thousand) and the number of active consumers - from 150 million to 250 million, which, among other things, will allow to maintain the annual revenue growth rate at 2.5% while continuing to increase operating margin.

At the end of the second fiscal quarter (ended June 30), McDonald's revenue grew by 5% year-on-year to $6.84 billion, slightly exceeding analysts' expectations ($6.71 billion). The growth was due to franchise restaurants, while the revenue of food outlets operated by the company itself remained at the same level as last year. The company's net income increased by 11% to $2.3 bln. Comparable sales in the world increased by 3.8%, in the US - by 2.5%.

The comparison between Starbucks and McDonald's is by no means accidental. Both companies operate in the same industry, albeit in different segments; they are global chains with a comparable number of points of sale. Their customers overlap to some extent. They are influenced by the same macroeconomic factors, although Starbucks' sensitivity to changes in the economic situation is somewhat higher.

That seems to be where the similarities end, and the fault lies in the rather different business models, as well as the greater foresight of McDonald's management.

With business models, the situation at first glance looks extremely simple: you either own and operate a restaurant, sell a franchise, or use some mix of the two. Both McDonald's and Starbucks use a mix of strategies. However, the fast food chain has 95% of its restaurants franchised, while Starbucks independently operates 53% of its coffee shops.

And this is a very important distinction that has a direct impact on business performance. Even the increase in the share of franchised restaurants from 81% to 93%, which occurred between 2015 and 2018 as part of McDonald's financial recovery plan, gave the company a significant improvement in business margins.

Perhaps it makes sense for Starbucks to use the recipes that McDonald's successfully applied 10 years ago. In the meantime, the coffee chain is partially copying what McDonald's is implementing to further increase the profitability of its business: changing the menu, increasing customer loyalty, digitalization, etc.

In 2013-2014, McDonald's faced the fact that the efficiency of its business in America began to sag noticeably. And the USA is precisely the region where, historically, the company itself has managed most of the restaurants. The origins of the problems are quite simple: it is difficult to maintain high quality standards when the network becomes very large. Plus, doing business in such a mature and highly competitive market brings additional challenges. After all, the number of chain restaurants in the U.S. even began to decline starting in 2015.

As a result, the management made a very simple decision: to hand over the restaurants to franchisees, who are often much more responsible in managing the business, and to focus on other tasks. As a result of this decision, the company's revenue fell from $28.1 billion in 2013 to $19.2 billion in 2020 (although the impact of the first wave of the pandemic also had an impact here).

At the same time, the company has become noticeably smaller, but significantly more efficient. The number of McDonald's employees has decreased from 440 thousand in 2013 to 150 thousand at the moment. For comparison, the franchise network employs more than 2 million people. The logic behind the management's actions is very simple: why spend valuable resources on full-fledged restaurant management, the efficiency of which inevitably deteriorates as the chain grows, if you can sell a franchise, strictly control its conditions and quality standards, while obtaining extremely high performance indicators for the business as a whole.

We can simply compare in practice the current performance of the seemingly fast-growing Starbucks and McDonald's.

- Starbucks' 2024 sales were $36.2 billion, McDonald's revenue was $25.9 billion.

- McDonald's net income for the same period was $8.2 billion, more than double that of Starbucks ($3.76 billion).

- McDonald's net profit margin has been above 30% for the last two years. At the end of the second quarter it amounted to 32.2%. At Starbucks the indicator is at the level of 7.2%, and it is declining for the sixth quarter in a row.

- McDonald's operating margin has been consistently above 45% for the past two years, while Starbucks' operating margin was only 10.45% at the end of the last quarter. By comparison, McDonald's operating margins and net profit margins, even at their 2015 lows, were 27.1% and 16.1%, respectively. And although part of the growth of the company's business efficiency indicators was caused by a noticeable reduction in the tax burden in the United States during the first term of Donald Trump's presidency, it did not help Starbucks significantly.

- Due to the fact that both McDonald's and Starbucks have been actively buying back their own shares with borrowed funds in recent years, their equity is now negative. Accordingly, a comparison by return on equity (ROE) would be incorrect. But in terms of return on assets, McDonald's is again on the side of McDonald's: 13.3% vs. 7.6%.

- Just because of the ongoing share buybacks and the accompanying build-up of debt, there is a question of the financial strength of the companies. And from this point of view McDonald's again looks a bit more preferable. Its debt/EBITDA ratio is currently 4.17 compared to Starbucks' 4.82. In turn, McDonald's interest coverage ratio is 7.85 versus 7.15 for Starbucks. The higher this ratio, the greater the company's "margin of safety" in terms of debt service. In general, the debt load of both chains looks more than moderate, which, among other things, is confirmed by their credit ratings.

It should not be forgotten that McDonald's real capital may be noticeably higher than the accounting capital, because the company has long been not only and not so much about food. The chain is quite reasonably called a real estate company, because three years ago it owned about 70% of the chain's buildings, and the income from their rental accounts for about 36% of revenue, according to Skyline Properties. Naturally, the properties are accounted for at book value, although their actual value is likely to be much higher.

Nevertheless, despite all the problems, Starbucks continues to trade with very high multiples, which are noticeably ahead of similar indicators of the more stable and profitable McDonald's. Thus, the current P/E multiple (price to earnings ratio) of the coffee chain is 40.4, while that of the fast-food restaurant chain is only 25.85. By comparison, the S&P 500 index has a 29.85 multiple. Starbucks' forward P/E is also higher - 32 versus McDonald's 24.57. The EV/EBITDA ratio of these companies are at 22.37 and 18.9, respectively. And by this indicator, the coffee chain looks more expensive.

The forward dividend yield of Starbucks is also higher - 2.66% versus 2.33% for McDonald's. However, this figure does not take into account the volume of share buybacks, which the restaurant chain still has high, despite a significant increase in interest rates in recent years.

One of the few multiples by which McDonald's trades noticeably above Starbucks is P/S (capitalization to revenue ratio). The gap between them is almost three times, but again due to the much more efficient business of the fast-food restaurant chain.

From the point of view of current growth potential on the horizon of the year both companies look about the same: judging by the average target for McDonald's, the growth potential of its shares is 10.6% compared to the closing price on August 12. For Starbucks, it's 6.4%. But, I think, few managers have a question, which company's securities make sense to add to their portfolios.

McDonald's is much better suited for portfolio diversification. The company's beta (shows how volatile the securities are) is only 0.5, while Starbucks' beta is around 1. That is, the shares of the fast-food restaurant chain in a way look like a protective asset.

Does not constitute an investment recommendation.

This article was AI-translated and verified by a human editor