Since I last caught up with Shake Shack (NYSE:SHAK), shares recently started to rally after a sharp sell-off following its third-quarter 2019 report. The better-burger chain is still expanding at a torrid pace, but share prices were in need of a breather after doubling in value through the summer months.
I don't think the pain is quite over yet. It's true that Shake Shack's new locations opening outside of its home markets in the northeastern U.S. are doing well, but it isn't the only fast-casual dining concept trying to capture consumer interest. Signs are mounting that the industry is still shooting itself in the foot with overexpansion, and recent reports indicate that foot traffic at restaurants is weakening once again.
A foreboding report at the end of 2019
Restaurant research group Black Box Intelligence recently released its latest reading on the industry, and it wasn't pretty. Comparable-store sales (or comps, a blend of foot traffic and average guest ticket size) fell 0.14% in the fourth quarter -- including a 2.1% and 5.7% drop in comps and foot traffic, respectively, in the month of December. The weakest region was New England with comps and foot traffic falling an average of 4.4% and 7.6%, respectively.
Reasons for the dismal December are varied, ranging from Thanksgiving falling just a couple of days from the beginning of the month to bad weather -- typically a lame excuse for businesses to make, but for a restaurant, sometimes especially poor weather does keep diners away. Both excuses could very well end up being the case for Shake Shack.
Of course, Black Box Intelligence's report simply provides a broad average, one that Shake Shack could wind up beating. However, even though Shacks do some of the highest sales per location in the industry -- almost up there with the notoriously packed Chick-fil-A -- comps will ebb and flow with the industry averages. Case in point: Shack comps were up 3.6% in both the first quarter and second quarter of 2019 (as industry sales were also in positive territory) but weakened to a 2.0% increase in the third quarter (when Black Box reported industry comps were negative 0.4%). Management also downgraded guidance for full-year comps growth to just 1.5%, which implies a big drop for the fourth quarter and would be in line with the steep drop-off Black Box just reported.
What it means for Shake Shack
The fact that the northeastern states performed so poorly is especially concerning as the bulk of Shake Shack's business is still done there. It is expanding its presence in new markets, but Shacks west of the Mississippi are sparse and on average have not been generating as much in annual sales as the oldest locations in the chain's portfolio, according to management. Thus, if Shack's core sales weaken along with Black Box's indicated trend, the comps figure could wind up looking quite ugly during the fourth-quarter report.
That's important, because comps are an important metric for the restaurant's overall profitability. Higher sales per store mean better operating efficiency and therefore higher average profits. And while Shake Shack investors are primarily betting on sales growth right now rather than the bottom line, average Shack profit margins are still an important metric to watch over the long term. In the third quarter, Shack-level operating profit margin had fallen to 23.1% compared with 25.8% in 2018. A repeat of that decline could be in the cards.
Add to this the fact that the stock trades at a significant premium. Free cash flow is running in the red (negative $29.4 million over the last 12 months) as new Shack openings are prioritized, and shares are at an elevated 4.2 times price-to-sales ratio based on expected full-year 2019 revenue of $596 million. I still think Shake Shack will find ways to grow in the years ahead, and it remains on my 2020 list of stocks to buy, but I'm holding off on a purchase until after it releases specifics on the fourth quarter.