In late 2019, shares of premium fast casual restaurant chain Shake Shack (NYSE:SHAK) plummeted on the heels of a disappointing third-quarter earnings report that included the company’s slowest comparable sales growth rate in a year, significant margin compression and a reduced full-year comparable sales and margin guide. SHAK stock, which was flying high around $105 just a few weeks earlier, crashed to $55 a few weeks after the print.
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Then, this year, Goldman Sachs turned bullish.
Following an investor presentation from management, the analyst team at Goldman Sachs recently released a hugely bullish report on Shake Shack with a simple yet compelling thesis that went something like this:
Shake Shack reported bad third-quarter numbers because of delivery headwinds related to the company moving from multiple delivery platforms to just one — GrubHub (NYSE:GRUB). Over the next quarter and into next year, those delivery headwinds will turn into tailwinds driven by marketing synergies with GrubHub, while menu innovation and international expansion tailwinds kick in. As that happens, the numbers will improve and Shake Shack’s stock will bounce back.
The market liked the sound of that. In response to the GS report, SHAK stock popped more than 10%. But I’m wary of this rebound.
For one, there are bigger headwinds here than the delivery platform transition alone. I don’t see those headwinds going away any time soon. And SHAK stock is still very richly valued. Ultimately, this combination of persistent headwinds and a full valuation could limit further upside in shares.
Shake Shack Has Some Problems
Bulls want to blame Shake Shack’s bad third-quarter performance — 2% comparable sales growth (the worst in a year), 1.3% two-year-stack comparable sales growth (also the worst in a year), a nearly 300 basis point drop in restaurant-level operating margins (continuing a multi-quarter trend of huge margin compression), and a reduced full-year comps and margin guide — on the fact that Shake Shack went from multiple delivery platforms to one delivery platform in the quarter.
But does one small change really impact all of those financials that much?
No. There are some much larger and longer-running headwinds at play here.
First, new Shake Shack stores aren’t performing up to par. Average weekly sales and average unit volumes have been in decline since 2015, and that decline isn’t moderating. It’s getting worse, because the more Shake Shack grows outside of its core high-income, urban-centric markets, the less well their stores perform on average. No matter how many new chicken options the company adds to the menu, this dynamic won’t change, because it’s built into Shake Shack’s business model of high prices and small portions.
Second, persistent cost pressures — including rising wages, higher delivery packaging costs and food inflation — are weighing on margins. These pressures aren’t going anywhere. The labor market is full, so wages will keep rising. Delivery is the future of fast-food distribution, so those costs are sticking around. Food inflation will keep running higher as demand grows with strong economic activity.
Third, the company is sticking to a cadence of roughly 40 new company-owned stores per year. That’s a problem, because the store base is growing, but the number of new stores being added is not. So the unit growth rate is slowing, which is creating a natural drag on revenue growth rates.
Shake Shack Stock Is Priced Too Richly
All things considered, Shake Shack’s numbers likely won’t bounce back in 2020. If they don’t, SHAK stock won’t bounce back, either, because even after the selloff, shares remain very richly valued.
The average restaurant stock trades around 26-times forward earnings. Shake Shack stock trades at 115-times forward earnings. Bulls will argue that Shake Shack only has 151 locations in America, versus 14,000 for McDonald’s (NYSE:MCD), so SHAK stock deserves its premium valuation because of its huge long-term growth potential.
Fair enough on the face of it. But let’s play that scenario out.
Shake Shack will never be as big as McDonald’s. McDonald’s caters to the entire income spectrum; Shake Shack’s customers are in the $100,000 and up income bracket. Only 30% of American households belong in that bracket, and far less at a global level. But to be aggressive, let’s assume that in a best-case scenario, Shake Shack can one day be 30% the size of McDonald’s.
McDonald’s is a $160 billion company. The 100th McDonald’s store opened in 1959, so to go from 100 stores to where they are today, it took McDonald’s 61 years. Again being aggressive, let’s say Shake Shack can go from its 100th company-owned store (opened in 2Q18) to 30% of McDonald’s size in about 30 to 35 years, implying a roughly $50 billion market cap for Shake Shack by around 2051.
Now let’s discount that market cap target back by 10% per year. That equates to a $2.6 billion market cap today.
Shake Shack’s market cap as of this writing is over $2.6 billion. Even if you assume that Shake Shacks gets to 30% the size of McDonald’s globally within 30 to 35 years (which, to my mind, is a best-case scenario), then SHAK stock today still isn’t undervalued.
Bottom Line on SHAK Stock
Bulls would have you believe that Shake Shack’s bad third-quarter numbers were the result of near-term delivery headwinds that won’t persist for much longer. I don’t buy that. There are much larger- and longer-running headwinds at play that will continue to adversely impact Shake Shack’s growth trajectory for the foreseeable future.
SHAK stock, at a triple-digit forward earnings multiple, isn’t priced for this. As such, I’d be wary of buying into a SHAK stock bounce.
As of this writing, Luke Lango did not own a position in any of the aforementioned securities.
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