While Wall Street seems agog with the chain founded by celebrity restaurateur Danny Meyer, there doesn't appear to be a foundation to support Shake Shack's potential $560 million valuation.
Investors would do well to be wary for these six reasons before taking a bite out of this glorified burger stand:
- The market is becoming saturated with "better burger" restaurant
- Stores are opening at a faster clip than revenue is rising
- Sales growth is slowing
- Average unit volume at restaurants is declining, sometimes dramatically
- Beef costs are rising
Better burgers abound
Shake Shack's roots are found in a single hot dog cart supporting the redevelopment of Madison Square Park in Manhattan in 2001, but three years later a permanent kiosk opened for what the company calls a "modern day 'roadside' burger stand."
Today it is riding the coattails of the "better burger" trend exemplified by the likes of The Habit Restaurants (NASDAQ:HABT), In-N-Out Burger, and Smashburger. According to the market researchers at Technomic, the better burger category accounted for 3.3%, or $2.4 billion, of the $72 billion in 2013 sales at U.S. burger chains in general -- but growth in the segment soared 10.4%.
Yet the concept might be peaking. Technomic said Five Guys' revenue growth slowed to just 5% in 2013 from 14% the year before because of "the segment's maturity as larger metropolitan markets hit saturation." This follows Fuddruckers filing for bankruptcy in 2010 and Back Yard Burgers doing the same in 2012.
Not so beefy sales growth
Shake Shake's growth mirrors the trajectory of the better burger craze, going from that single kiosk to 63 restaurants in nine countries and 34 cities in just over 10 years. But as the number of new restaurants opened at a rate of 79% annually for the past three years, total revenue had a compound annual growth rate of just 62%, meaning sales growth has come almost wholly through opening new stores.
Meanwhile, same-restaurant sales growth is slowing. In 2012, comps rose 7.1%, then slowed to 5.9% growth in 2013, and to just 3% through the first nine months of 2014.
Furthermore, average unit volume, or the sales generated at each restaurant, is also falling. Company-owned locations had AUV of $5 million in 2013, but only because they are skewed toward its seven Manhattan-based Shake Shacks where AUVs ran north of $7 million. In the other 24 restaurants it owns, that volume only averaged $3.8 million. Since most future Shake Shacks won't be plopped in the middle of Times Square, the chain expects AUVs to range between $2.8 million to $3.2 million.
Internationally licensed Shake Shacks did record a better AUV of $6.1 million in 2013, but that that was also down sharply from $9.6 million the year before as it opened lower-volume Shacks.
In short, Shake Shack has created a successful local phenomenon where it has developed a loyal following of customers. While it has been able to more or less replicate that model elsewhere, even globally, it doesn't always carry the same devotion experienced in its own backyard.
Breaking the habit
Wall Street seems enamored with Shake Shake's IPO, perhaps because of a familiarity bias, but that doesn't mean this is a stock worth buying.
When similarly positioned The Habit went public last November, its stock was also inflated by talk of fast growth and expansion. Offered at $18 a share, the stock opened at $36, went as high as $44 a stub, and today is back down around $30 a share.
No doubt Shake Shack, particularly because of all the hype around its IPO, will also make a grand entrance to the public markets. But investors would do well not to chase this one up. The ability to continue generating sales levels seen to date will grow more difficult amid thick competition and headwinds caused by record-high beef costs.
Retail fresh beef prices averaged a record $6 per pound in December, up more than $0.08 per pound from November's record price, which was higher than the record price hit in October. In fact, December was the tenth month of record beef prices in 2014.
While Shake Shack has been able to pass along some of the higher costs to its customers, it can't do that indefinitely, and absorbing higher prices will impact margins. Plus, it sources roughly 87% of its beef from one supplier. Should there be a problem with that supplier, Shake Shack could be caught short.
Not better for your portfolio
Pick your poison -- better burger stands on every corner to slowing growth, rising costs, supplier concentration, and dubious staying power -- Shake Shack presents significant risks. It might not be just a flash in the pan restaurant chain, but it doesn't look to be a beefcake stock, either.
Follow Rich Duprey's coverage of all the restaurant industry's most important news and developments. He balks at paying inflated prices, whether it's for burgers or stocks. He also has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.