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The Simple Reason I Won’t Buy Shake Shack Stock

By Demitri Kalogeropoulos – Apr 24, 2018 at 6:42AM

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Sales are up, but only thanks to a quickly expanding store base.

Shake Shack (SHAK 3.00%) has one of the most attractive sales growth outlooks in the business right now. Wall Street expects the "better burger" chain to boost revenue by 25% in 2018 to mark just a small slowdown from last year's 34% spike. Shake Shack is aiming to double its store base between now and 2020 on the way to eventually reaching 450 locations across the U.S., up from 100 today.

As attractive as those growth targets seem, there's an important factor missing from the Shake Shack investing thesis today. The fast-food upstart isn't posting impressive customer traffic results and, until that metric turns solidly positive, I wouldn't rush to buy this stock.

A man about to bite into a burger.

Image source: Getty Images.

Traffic struggles

Shake Shack endured a 3% customer traffic drop in 2017. That decline was the main reason comparable-store sales fell by 1% for the year. Industry leader McDonald's (MCD -2.90%), in contrast, posted a 1% traffic uptick in the U.S. as comps improved by nearly 4%. Prior to last year, Shake Shack had managed healthy comps gains, with sales rising 4% in 2016 and spiking 13% in 2015. 

The recent comps decline was offset by a quickly growing sales base. In fact, after adding 26 new locations to its footprint, Shake Shack's overall revenue jumped 34% last year. McDonald's, meanwhile, posted a small drop in total sales thanks to its refranchising initiative. 

It isn't exactly fair to stack Shake Shack up against the fast-food titan on these metrics. McDonald's has a massive base of established restaurants, after all. As a result, comps are far more important to its business. In contrast, Shake Shack counted just 43 locations in its base of existing locations last year, and so its customer traffic figure is heavily influenced by the performance of just a small number of locations.

An important metric

However, customer traffic is a critical metric that tells investors a lot about the growth potential of an unproven business. Chipotle, for example, routinely posted surging traffic gains and healthy comps during its early expansion days. That success gave shareholders confidence to believe that the burrito specialist's fast-food concept could grow far beyond the 489 restaurants it operated back in 2005. The chain passed 2,400 in 2017 and only plans to modestly slow its expansion pace this year due to its continued recovery from a food safety scare that sent customer traffic plummeting.

Shake Shack is hoping to make its own aggressive national expansion over the next few years, only without the support of improving traffic numbers at existing locations. Instead, management is projecting flat comps in 2018 and a second straight year of declining traffic. 

Wait and see

There are other good reasons to be cautious about an investment in Shack Shack right now. Its stores haven't yet demonstrated strong appeal outside of the core New York metropolitan market, for one. And key operating metrics including average weekly sales and operating profit margin are bound to decline as the company expands away from that intense geographic focus.

Comps figures are the bigger concern, given that Shake Shack's broader growth plans rely on its ability to stand out in the crowded dining space through innovative menu items, attractive pricing, and a brand that resonates with hungry consumers. Healthy customer traffic would be the best way that the business can show it has these bases covered. Otherwise, it's a stretch to believe the chain can quickly more than quadruple its store footprint in a brutally competitive casual dining industry.

Demitrios Kalogeropoulos owns shares of CMG and McDonald's. The Motley Fool owns shares of and recommends CMG. The Motley Fool is short shares of Shake Shack. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Shake Shack Inc. Stock Quote
Shake Shack Inc.
SHAK
$46.43 (3.00%) $1.35
McDonald's Corporation Stock Quote
McDonald's Corporation
MCD
$236.70 (-2.90%) $-7.06

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