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Forget McDonald's. Shake Shack Is a Better Fast Casual Stock

By Nicholas Rossolillo – Apr 9, 2020 at 7:15AM

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Once the dust settles on the coronavirus pandemic, Shake Shack stock could see a much faster recovery.

The U.S. restaurant industry has long been a bastion for small business ownership, but now it is in a perilous position. There was a brief period near the end of 2019 where Americans spent more eating out than at the grocery store, but that situation has likely already ended. According to industry researcher Black Box Intelligence, grocery store sales were up 73% the week of March 22 compared with the year prior. Black Box says spending at full-service restaurants is down at least 60% in all states. The global efforts to slow the spread of the coronavirus pandemic have created a tragic set of circumstances for most everyone, but economically, the eating-out industry is taking the brunt of the fallout.  

With the spread of coronavirus showing signs of slowing down, there is some small cause for hope of recovery. The world will be left scarred by this event, though, and restaurants especially could be changed for good once the worst has passed. Not even restaurant stalwart McDonald's (MCD -0.41%) has been spared. Its stock is down 15% from all-time highs and was down more in the month of March than during the financial crisis of 2008-09.

Better-burger upstart Shake Shack (SHAK 4.37%) has fared even worse, though. As of April 6, the stock is down 64% from all-time highs and is valued lower than when it became a publicly traded company in early 2015. There are certainly good reasons for the extreme pessimism, but there could be a big rebound in the making for this company once the coast is clear in the battle against COVID-19.

A fried chicken sandwich, fries, and a drink from Shake Shack sitting on a table.

Image source: Shake Shack.

America's love of the burger

In the good times (just a few months ago), when consumers had ample cash to spend and competition in the space was running at its highest, Shake Shack was making serious growth headway. Back in Q1 2015, Shake Shack reported having just 66 locations: 34 domestic company-owned, five domestic franchised, and 27 international franchised stores. At the end of 2019, that total number had surged to 275, with 163 of those company-owned locations in the states, 22 domestic franchised, and 90 international.

Revenue grew over 450% in that time ($595 million in 2019), driven by the new stores but also by generally rising same-store sales (a combination of foot traffic and guest ticket size at existing Shacks). The company had zero debt and $73.6 million in cash, equivalents, and short-term securities. A clean balance sheet to be sure, but the chain's liquidity on hand covers a mere half-a-quarter's worth of operating expense. That's because the bulk of Shacks out there are operated by the company -- akin to Starbucks' model rather than the mostly franchised and low-overhead model employed by McDonald's.

Prep for lean times ahead

In a period of normal economic contraction, Shake Shack could just scale back on its expansion plans to cover its expenses, but the current crisis presents a unique challenge. With its dining rooms shuttered and Shake Shack transitioning to a carryout operating model, revenue is going to decline substantially, and losses are likely to mount. In a recent update, management said that sales during the second half of March were down an average of 70% at company-owned locations. It's a good thing there was no debt on the balance sheet.  

For this restaurant chain, the pandemic is causing an unusually severe economic setback, mainly because the bulk of Shacks are located in the Northeastern U.S. in densely populated cities that are getting hit hardest by the efforts to slow the spread of the virus. Besides taking steps to protect the health of employees and Shack guests, management has halted store development and furloughed some staff. In addition, it has taken a revolving credit facility of $50 million as the company weighs its options with regards to the $2 trillion U.S. stimulus package recently enacted and whether it might qualify for relief.  

The news couldn't be worse for Shake Shack, which explains the precipitous fall in share price. 

A best-in-class restaurant operator

McDonald's, though impacted by the spread of coronavirus, has benefited from its long-established, drive-through business. At the start of the pandemic, McDonald's was the restaurant stock to own. However, don't be surprised if McDonald's stock remains volatile for now. Its debt was $34.2 billion at the end of 2019; cash and equivalents on hand totaled only $899 million. Investors aren't likely to respond well to the actions it will likely need to take to manage its accounts, depending on how long this downturn lasts.  

Despite the current downturn, investors would be remiss to write off Shake Shack's longer-term potential in lieu of the larger burger-chain stock. Thanks to its focus on high foot-traffic real estate and lots of fans, Shake Shack had some of the best sales per store in the restaurant industry at over $3.7 million per location in 2019. Operating-level profit margins were also healthy at 22%. And though free cash flow (what's left after cash operating and capital expenses are paid) was negative $16.7 million last year, taking a break from rapid expansion would return that metric to positive territory once the world can move about freely again.

Thus, while McDonald's has a better operating model for weathering the coronavirus storm, the better-burger movement will also emerge from the crisis and continue giving fast food a run for its money. Shake Shack will need to make adjustments going forward, but I think it could be a big winner for investors in the years ahead.

Nicholas Rossolillo and his clients own shares of Starbucks. The Motley Fool owns shares of and recommends Starbucks. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Shake Shack Inc. Stock Quote
Shake Shack Inc.
SHAK
$47.05 (4.37%) $1.97
McDonald's Corporation Stock Quote
McDonald's Corporation
MCD
$242.76 (-0.41%) $-1.00

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