As far as fast-casual restaurant concepts go, Shake Shack (NYSE:SHAK) lacks many of the characteristics Wall Street usually looks for in its favorite stocks. Customer traffic isn't surging higher at existing locations as it did back in Chipotle's (NYSE:CMG) high-flying days in 2015. And profitability is declining, rather than rising as it has for McDonald's (NYSE:MCD) over the past few years.
Yet Shake Shack stock outperformed the market in 2017 and is valued at a significant premium over peers like Chipotle, McDonald's, and Yum Brands (NYSE:YUM).
Let's break down the two biggest reasons for this valuation gap.
Heady sales growth
Shake Shack reported a minor comparable-store sales decline in 2017 while McDonald's improved its comps at a blistering 5% pace. Customer traffic fell by 3% at the better burger chain's locations, too, which could be taken as a worrying sign of struggles to stand out in the crowded fast-food industry.
However, Shake Shack's base of existing restaurants is tiny compared to its total sales footprint and to the footprint of more established chains. That's mainly a consequence of the fact that management doesn't add a new store to its same-store sales base until 24 months after its launch. As a result, just 43 locations out of its 159 stores in operation were part of its existing store base last year.
Thus, for now investors have opted to focus on overall sales growth over the narrower comparable-store sales figure. That metric tells a more encouraging story. Revenue spiked 34% last year as Shake Shack aggressively expanded its footprint, and sales have soared to $359 million from $57 million in 2012, which translates into an impressive 44% compound annual gain over the past five years.
Profitability is moving in the wrong direction, dipping to 26% of sales last year from 27% in 2016. Worse still, CEO Randy Garutti and his team predict that trend will continue as the chain expands beyond its heavy focus on the New York metropolitan area that tends to produce unusually high sales volumes. In fact, restaurant-level profit margin should drop for the third straight year in 2018, executives warn, dipping to between 24.5% and 25.5% from its peak of 29% in 2015.
We're still talking about impressive profitability, though. Yum Brands' comparable figure is 17%, and Chipotle's margin peaked at around 28% in those heady days in 2015, when the burrito chain's biggest challenge was processing orders quickly enough to avoid customer walkouts during the peak lunch hour period.
Too high a price
Given its solid economic returns, there's a good case to be made for significant long-term profit growth here -- especially if management can efficiently bulk up its sales base over the coming years. Shake Shack is aiming to double the number of stores it operates to 200 by 2020, on the way toward the 450 locations that executives believe the market will eventually support. That amounts to an over 30% rate of annual unit growth, although sales and profits will expand slower as the base moves away from the New York region.
That bright outlook makes Shake Shack's premium (of 69 times earnings compared to a P/E of 24 for McDonald's and 22 for Yum Brands) seem more reasonable. Still, I wouldn't be a buyer of the stock today. Ultimately, Shake Shack's aggressive growth targets will depend on the franchise continually winning new customers. And until the company can show strong traffic and comps growth, it's an open question as to whether the franchise has what it takes to become a national, much less global, brand.
Demitrios Kalogeropoulos owns shares of Chipotle Mexican Grill and McDonald's. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. The Motley Fool is short shares of Shake Shack. The Motley Fool has a disclosure policy.