Last week, Shake Shack (SHAK -0.76%) reported second-quarter revenue of $91.8 million, a decrease of 40% year over year, and below analysts' consensus projections of $93 million. Adjusted earnings per share came in at a loss of $0.45, below consensus expectations of a loss of $0.36. The results were clearly disappointing as the stock dropped about 12% on the trading day following the release.
Shake Shack shares are down almost 15% year-to-date (versus a gain of about 2% for the S&P 500) and there are clear signs that risks remain to the quick-service restaurant's future revenue in 2020. The company has withdrawn its guidance for the fiscal year ending Dec. 30, 2020, due to uncertainties around the COVID-19 pandemic.
Let's take a closer look at three of these risks and what they might mean for this restaurant chain's potential as an investment.
1. Restaurants in urban areas face a slower recovery
Shake Shack management explained during the earnings conference call that the level of recovery of its restaurants depends on their locations, with urban locations being most impacted by COVID-19 issues. Revenue from urban locations decreased more than those in suburban areas in the second quarter and those stores are seeing a slower recovery. Urban Shake Shacks made up about half of its roughly 275 restaurants, but they accounted for about 60% of comparable store sales prior to the pandemic.
Revenue from urban Shake Shack restaurants fell 57% vs. a 38% decrease for suburban locations. In July 2020, urban revenue recovered somewhat to a decrease of 50%, while suburban revenue saw a larger improvement as sales there decreased 24%.
"This stark difference in sales performance is something we expect to continue to some degree for as long as COVID-19 continues to impact our cities, our offices and our travel, recreation and entertainment habit," CFO Tara Comonte said on the second-quarter conference call, "and is likely to be particularly true in some of our larger footprints like New York City, Chicago, Los Angeles or Washington, D.C., where some of our previously highest volume Shacks are located."
2. Restaurant closures and rollbacks in certain U.S. areas hitting revenue
Several regions in the U.S. have rolled back or paused the planned reopening of restaurants and other businesses in recent weeks with a resurgence in cases of the coronavirus. California rolled back reopening efforts in 19 of its 58 counties. New York City indefinitely postponed the opening of indoor dining, which was supposed to begin on July 6. These limits will hamper the revenue recovery for Shake Shack's restaurants, which are concentrated in many of the areas that are experiencing rollbacks.
On July 1, California Gov. Gavin Newsom prohibited all indoor dining at restaurants and food facilities in Los Angeles. However, dining outdoors is still allowed. While Chicago allows indoor dining, capacity is restricted to 25% and limited to 50 people per room or floor.
Shake Shack is particularly vulnerable to adverse conditions in New York City and the northeast U.S. The area comprised 44% of total U.S. Shake Shack restaurants as of year-end 2019. Besides COVID-19 related impacts on dining restrictions in these areas, New York City has also had many large protests that could lead to fewer outings to restaurants, whether for outdoor dining or takeout.
3. Higher expenses will continue to impact margins
During the second quarter, Shake Shack saw higher expenses due to "significantly" higher paper and packaging costs, higher beef prices, and delivery commissions. These costs could remain elevated for an extended time and decrease margins. Paper and packaging costs lowered margins by $1.4 million or 160 basis points during the quarter.
The increase in delivery and takeout business, which will continue while any COVID-19 restrictions are in place, meant higher costs for packaging and delivery. Comonte said on the earnings call that the company saw "higher delivery commissions due to mix, but also due to a step-up in blended commission rates and our expanded multi-partner arrangements."
Overall, Shake Shack's revenue recovery could be hampered by its presence in areas more heavily impacted by COVID-19, as well as government orders to slow down restaurant reopenings. The restaurant company's margins and earnings could also experience headwinds from higher costs from increased takeout and delivery sales. These increased risks are something to factor into any decision about whether to invest in shares of this consumer discretionary company.