Restaurant Industry Weakness Catches Up to Shake Shack Inc

In this video, the Market Foolery team turns their attention to Shake Shack (SHAK -0.87%) and its fourth quarter and full-year fiscal 2016 earnings results. On the surface, top line growth was impressive, but a closer look at the numbers proved to be necessary.

Is the market still too enthusiastic about this burger upstart? Or should investors just be happy to see growth at a time when most of the restaurant sector is feeling the pinch.

A full transcript follows the video.

This podcast was recorded on March 2, 2017.

Chris Hill: Let's move on to Shake Shack. 

Fourth quarter revenue grew more than 40%, and that's great, until you realize that a lot of that, Aaron, is from new locations opening up. Their same-store sales, just 1.5%. That's not going to get it done.

Aaron Bush: Yeah, that's pretty normal, it seems, these days. But when you realize that last year, it was 11%, that's a pretty substantial deceleration. I think, for the most part, this quarter it was pretty good. The top line was moving in the right direction. That is probably the number one thing investors would want to see. It's still profitable. They just launched a mobile ordering app, which is, I think, David and I were talking about, we wish some other companies would do that. So, they might be a little bit ahead of the game here, which is a good thing. My issue with the Shake Shack is how much optimism is based into the price.

Hill: There's a little less optimism today.

Bush: Yeah, a little less optimism. But still, even compared to a few months ago, it's still not that different.

David Kretzmann: It's 70 times earnings, still.

Bush: Yeah. So, when I see same-store sales dramatically decelerate, labor costs go up and squeeze operating margins, franchising isn't moving the needle, and that's a big part of their strategy now internationally. Competition in the burger space is about as rough as it gets. And I think that as they expand, they'll have more issues standing out. But I think, perhaps, most importantly, there's a pretty wide discrepancy between what's priced into the stock and the economic reality. Just a few numbers, each store, on average, delivers $5 million in revenue. But the market is pricing each store at about $20 million. So, take that for what it's worth. That doesn't entirely include all of the licensing stores, but it's hard to do apples to apples on that. So, that's very aggressive. If you look at the entire system, management has guided investors to expect $1.12 in earnings per share by 2020, which is kind of specific. But right now, Shake Shack is trading at 32 times that, and that is expected to come in two or three years. That's aggressive, and it makes me a little hesitant.

Kretzmann: They did raise their sales guidance for this year by 0.03%, though. Let's not overlook that.

Bush: Wow. Give them some credit.

Hill: I'm going to give them just a tiny bit of credit for that, because when you look at restaurants in general, I'm going to grade them on the curve in that regard.

Kretzmann: At least they're guiding higher.

Hill: Yes, ever so slightly higher, but higher nonetheless.

Kretzmann: The opportunity here with the Shake Shack, right now, they just have 114 locations. Seems like a concept that could be quite a bit bigger than that. So I think that is part of the reason investors are comfortable paying a higher valuation. Some other things I really like with Shake Shack that a lot of other restaurants are in this position, especially smaller concepts like this, they're already free cash flow positive, they have almost $75 million in cash, and no debt. So, they're able to open these new stores through their own cash. They don't have to go into debt, they don't have to issue stock. That's an attractive position, that's a similar position to what Buffalo Wild Wings and Chipotle were in 10 years ago or so. But, certainly, the premium that Shake Shack is commanding today ... you need to see some stronger performance within those locations. But you do have to give the company somewhat of a break, because restaurants have had a very difficult past couple years. But still, 1.5% comps isn't going to get the job done.

Hill: We were talking about Domino's Pizza the other day, and the numbers that they've been putting up. I threw out the question, restaurants are struggling, is part of the reason that restaurants are struggling because companies like Domino's Pizza are making it really easy for people not to leave their homes?

Kretzmann: Everyone who's going to Domino's, yeah.

Hill: Right, that's the thing, they're getting Domino's to come to them.

Kretzmann: Yeah, because Domino's same-store sales in a quarter that has been brutal for most restaurants, even pretty solid concepts, Domino's same-store sales --

Hill: Over 12%.

Kretzmann: Yeah, incredible numbers. And that's an acceleration from the past couple years. So, restaurants need to take more notes from Domino's, because the streak that they're on is unbelievable.

Bush: That's domestic?

Kretzmann: That's domestic.