- Comp sales may be very impressive but there weren't enough participating restaurants in the last results.
- The more the fast-casual segment improves, the more restaurants you are going to see start up in this space.
- As food prices are costs for Shake Shack, beef prices must remain subdued for the chain to remain competitive.
With Shake Shack Inc. (NYSE:SHAK) stock now trading at just over $36 a share and well off its January lows, the question remains whether the stock is a good long set-up or still a stock laden with risk. Brokerage firm Longbow research recently upgraded the stock to a buy stamping $48 a share as their price target. Did the market over-react to the company's bearish guidance for 2016? Maybe but there is no getting away from the fact that Shake Shack is still down over 13% over the last month and it was its softer top line guidance ($237 million to $242 million) that really caused the share price carnage.
The "Shack's" recent earnings illustrated again that the market is only interested in forward-looking guidance irrespective of how strong sales and earnings come in at. In fact, the company reported top-line number of $51.1 million which was a 49% increase YoY. Furthermore, comp sales grew by 11% which is outstanding for this industry. There is no doubt that Shake Shack is growing fast but is it enough to justify its valuation is another question. At the moment the burger chain is benefiting as a result of excellent same store sales growth, more company-owned units and gradual price increases. Can this growth last? I'm not so sure and being the investor I am, I normally stay away from stocks such as these due to too much future growth being already priced in. Its all about protecting the downside in investing and Shake Shack, in my opinion, still poses plenty of risk to the downside. Here are three scenarios where the stock would shed another 30%+ minimum off its present $36 stock price.
Firstly, we have to take the comparable store base (only 21 units) with a pinch of salt as we are not going to be able to really gauge the potency of the brand until there are at least 100-150 units in the mix. We already saw that the chain isn't firing on all cylinders in international markets yet and the same may very well happen in different US states in the near future. This is why I believe the company's unit level margins of 28%+ are still not credible. The shacks have obviously been a huge hit in New York (where the chain undoubtedly has a cult following) but can the success be modeled across multiple US cities? It is possible as other fast casual chains like Chipotle Mexican Grill (NYSE:CMG) have proved in the past but even the Mexican Grill's earnings multiple never surpassed 70 - something we can't attest to Shake Shack.
Secondly, the fast-casual restaurant industry is increasing rapidly and one should expect more start-ups in this industry if the trend continues. Traditional powerhouses such as McDonalds (NYSE:MCD) have lost meaningful market share since 2013 and, as a result, Shake Shack's competitor Panera Bread (NASDAQ:PNRA) was able to report the 10th largest revenues of US restaurant chains in 2014. While many investors believe that increasing market share for the fast casuals will be good for Shake Shack, I don't see it this way. Why? Well, the lack of growth in the US commercial real estate market will mean landlords will continue to offer deals to would-be tenants and Shake Shack's recent IPO illustrated that there is plenty of capital available for start-ups in this sector. Switching costs are practically non-existent and barriers to entry are way lower than other industries.
However, this brings its own set of problems which I'm sure Shake Shack will encounter soon enough. Firstly, fierce competition in this sector has meant many chains have resorted to aggressive discounting from menu items in order to protect market share. Chipotle, for example, is giving away free burritos at the moment in an attempt to regain market share after its own escapades. This is why I feel that over time (if the Fast-Casual uptrend continues), I find it hard to believe that Shake Shack will be able to increase its prices indefinitely. Furthermore, remember that more costs are coming this year due to the company recently hiking pay rates. Therefore, remember that higher fixed costs coupled with a need to cut menu prices (would cut even steeper if a recession hit) would definitely lower the share price from here.
The third risk that investors should be aware of is commodity inflation (primarily beef) which has continued to rise since January of this year (was up 3% last year). Fast-casuals over the past few years have been enjoying lower food prices but this could be a thing of the past if the Fed continues its dovish stance which would definitely weaken the dollar over time which would most certainly put a floor on food commodities. Could rising food costs be compensated by stronger international sales? Maybe, but it's a risk I would rather not take as there are plenty of other restaurant chains with lower valuations and stronger revenues.
To sum up, I would recommend refraining from entering into a position in Shake Shack stock at the moment. The risks are evident and worrying trends such as more minimum wage agreements in more states, commodity inflation and heightened competition are bound to stop the restaurant chain's excellent sales comps growth at present. Investors should also keep a close eye on operating margins. There is still plenty of growth priced into the Shake Shack share price and any hiccup will surely drag this stock lower (as guidance did after its last set of earnings.)