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Shake Shack Is Growing, but Is the Cost to Grow Worth It?

Nicholas Rossolillo, The Motley Fool

New York-based roadside-style burger joint Shake Shack (NYSE: SHAK) recently put the final wrap on 2018, notching a rebound in same-store sales growth along with the rest of the restaurant industry. Sales looked good, but profit margins remained challenged -- due in large part to a difficult business landscape for the dining-out segment of the economy. With headwinds expected to persist in the new year, there are better places for restaurant investors to put their money.

2018 was just OK

Total revenue soared 28% in 2018, a stellar number by any measure. However, most of that growth was due to the opening of 34 new company-operated locations in the U.S. and 15 franchised locations -- a 31% increase in the total number of Shacks. Paired with a 1% increase in same-store sales (a combination of average foot traffic and guest ticket size), it all added up to a big boost over 2017.

Metric

Full-Year 2018

Full-Year 2017

YOY Change

Revenue

$459.3 million

$358.8 million

28%

Operating expenses

$427.6 million

$325.0 million

32%

Earnings (loss) per share

$0.52

($0.01)

N/A

Adjusted EBITDA profit margin

16.1%

18%

(1.9 pp.)

Same-Shack sales increase (decrease)

1%

(1.2%)

N/A

YOY = year over year. Pp. = percentage point. Data source: Shake Shack. Chart by author.

The problem? As Shake Shack expands beyond its core market in the northeastern states, new Shacks are selling less on average than some of the older stores. Profit margins have also been dragged down by pre-opening costs, not to mention wage increases enacted across many states during 2018. Thus, while the chain has swung to a full-year profit because of all of the new stores, its average store-level profit fell.

A man eating a hamburger.

Image source: Getty Images.

An industry problem

Aside from the conundrum of growing the base of stores but at lower margins, Shake Shack is also facing ample competition, especially in the "better-burger" segment of the restaurant universe. Industry overexpansion has been a problem for years, and while same-store sales inched higher in 2018, it masked a nagging problem: foot-traffic declines.

That's the problem at Shake Shack, too. Same-store sales rose 1% in 2018, but that was due to menu price hikes and a favorable menu item mix. Same-store guest foot traffic actually declined 2.7% last year: worse than the industry average. That is not exactly a warm and fuzzy metric for a fast-growing and hyped chain. 

An investor may start to wonder, with operating profits at new locations falling and restaurants around the country fighting over a limited number of patrons, is expansion really worth it? Shake Shack management thinks so, continuing to tout its progress even though sales and traffic figures aren't differing much from the industry average. More new store openings are on the way this year -- 36 to 40 company-operated locations here in the U.S. and 16 to 18 franchised locations, most of which will be overseas. Shake Shack will open its first-ever international office in China to help foster growth in Asia.

Opening lots of new stores will be a heavy weight on Shake Shack's operating margin for some time, although management says those costs will eventually level off. Nevertheless, with same-store sales and traffic not exactly topping the norm, Shake Shack could be spending good money on dubious measures. Plus, most new Shacks will be opened in existing markets for the chain. That runs the risk of cannibalizing foot traffic from existing stores and further damaging the company's profit margin. Growth comes with risk, but for Shake Shack, the strategy is starting to look like growth at any cost. That could be a dangerous game for investors to play.

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Nicholas Rossolillo and his clients have no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.