There are certain brands, services and restaurants synonymous with an experience. They don’t just sell food or goods-- they sell a lifestyle. Shake Shack (SHAK, Financial) is one of these brands. Born in New York City’s idyllic and storybook Madison Square Park in 2004, Shake Shack has taken the nation by storm, offering an upscale fast-food experience. Unlike lower-end brands like McDonald's (MCD, Financial), a double cheeseburger at Shake Shack will run you almost $10. That certainly qualifies as “upscale” in the fast-dining world.
Since its initial public offering in early 2015, the stock has moved from $21 to $38, an almost two-fold increase. With fairly consistent, albeit somewhat tepid, growth and financials that look relatively solid, Shake Shack is not a bad business by any means. However, its shares are trading at a very high price relative to earnings. Although Shake Shack has seen consistently upward swings in important financials, including revenue, income and EBITDA, we do not see a significant value opportunity in its stock given its already highly inflated price point.
Shake Shack’s financials are solid, showing consistent growth, reasonable expenses and no signs of slowing down – yet, anyway. The company has hit or exceeded earnings expectations consistently. Over the four quarters of 2017, Shake Shack saw four consecutive earnings surprises, 25%, 25%, 13% and 100% respectively.
Let’s highlight the fourth quarter of 2017, where the company saw a 100% surprise on earnings, roundly beating analysts’ expectations to post impressive numbers during the holiday season. Earnings per share has hovered between 10 cents and 20 cents.
Cost of growth
Shake Shack’s growth can be summed up in three words: positive, upward and consistent. Total revenue has grown from $82 million in 2013 to $359 million in 2017 – a more than 400% increase in only four years. That is undeniably fast growth.
Although expenses have grown over the years with expansion worldwide (they now have 162 locations), Shake Shack’s sales growth has outpaced expense growth by over two times, making sure gross income rose every single year, from $18 million in 2013 to $83 million in 2017.
Net income, however, has oscillated between red and black, never exceeding $12 million in the last five years, including a more than $2 million loss in 2017. Why? For one, very high selling, general and administrative expenses from expansion, building and other larger expenses. Shake Shack also has high interest expense and minority interest expense, both of which leave the company without any significant net income. That is perhaps strange for a company trading at a market cap of over $1.5 billion.
While Shake Shack clearly has many financial figures that are positive and could foretell a rosy future, they currently do not make enough of a profit to justify the market cap. But the objects in the mirror are not as rosy as they might seem. Shake Shack is trading way too high relative to its earnings.
The Chipotle trap
Looking at Shake Shack’s high price versus its earnings reveals a massive red flag for value investors – and might raise eyebrows even among growth stock investors. Shake Shack is currently trading at a price-earnings (P/E) ratio of over 90. While price-earnings ratios tend to be higher than usual for restaurant-type businesses, this price-earnings ratio is an issue.
Intrinsically, Shake Shack’s price-earnings ratio is not itself disqualifying, but the company is also not turning any significant profit and could run into serious structural and financial issues in the coming years. We believe Chipotle (CMG, Financial) is a telling example for potential problems. Chipotle is facing very significant struggles, with its stock plunging more than 300 points. Chipotle’s price-earnings ratio is 51; Shake Shack’s is 95.
The Chipotle problem necessitates Shake Shack finding additional paths to growth as it moves forward or face the same precipitous stagnation and decline. Shake Shack is benefiting from the same kind of novelty bump Chipotle got. Street affinity for the glamour of the customer experience and the Shake Shack story both help to boost the stock. People love a good story. But a story can only get a stock so far, and Shake Shack is not pulling anywhere near the kind of earnings per share it needs to justify the pricing. A $21 IPO price was an overly generous giveaway to the company, but the current price of $37 is downright reckless.
The value just is not there for us. If Shake Shack can pull its price-earnings ratio down to maybe 20, then we might start to talk about value opportunities. But until then, it is grossly overvalued. It might successfully avoid the problems of other similar brands, or it might not. Investors should approach with caution.
Disclosure: I/We own no stocks discussed in this article.