As the economy springs back to life and gas prices have plummeted, restaurants have become one of the stronger industries out there, benefiting from the increase in discretionary income. For the first time ever, Americans are spending more at restaurants than at the grocery store, and the trends should continue to favor the industry due to the improving economy and the habits of millennials.
Fast casual chains in particular have caught the eye of investors. Chipotle Mexican Grill has increased more than 10-fold since its 2006 IPO, while more recent IPO's like Zoe's Kitchen and The Habit Restaurants now fetch prices more than 100 times earnings. With prices skyrocketing and valuations looking more suitable to biotech stocks, some critics have said that a bubble may be afoot. Below, three of our analysts select a restaurant stock that could soon get sliced and diced.
Rich Duprey (Shake Shack): Fast-casual burger joint Shake Shack (NYSE:SHAK) has so far crushed my suggestion to avoid its IPO in January. In the face of rising beef costs, slowing sales growth, declining average unit volumes, and a market saturated with better burger chains, I said an investor would be wise to pass on the risks associated with an investment.
And Shake Shack rewarded my skepticism by quadrupling its IPO pricing. Ouch!
While that hurts, I'm going to double down on the rationale behind my claim the restaurant chain is vastly overvalued.
As Shake Shack opens more restaurants outside of the New York City area, we're probably going to see average week sales and average unit volumes decline. It's already happening as we saw last year -- average unit volumes of domestically-operated restaurants dropped 8% to $4.6 million while average weekly sales fell 7% to $89,000. Comparable sales also continued slowing, falling from 5.9% to 4.1%.
While its recent first quarter results showed a 7% increase in weekly sales from the year ago period, they're actually flat with the fourth quarter, which suggests they may be leveling off. And comps were 11% higher in the quarter, but mostly because of price hikes Shake Shack initiated, passing along its own higher costs to customers. There's only so much consumers will pay for hamburgers before they seek out alternatives.
At a market cap of $3.37 billion, Shake Shack's 66 restaurants are valued at approximately $51 million each. For comparison, Chipotle Mexican Grill has a $19.5 billion valuation and operates more than 1,800 restaurants valued around $11 million per restaurant. Each of McDonald's 36,000 restaurants are valued at around $2.6 million.
If the market valued Shake Shack like McDonald's, the better burger shop would need about 1,300 restaurants. If it was valued like Chipotle, then it would need more than 300 locations.
Shake Shack is new to the market, people are enthused about its admittedly good-tasting burgers, and investors see this as a niche growth market. But they're wildly overvaluing the chain, and its stock is poised for a big reset in the future.
Tim Green (Sonic): While small, fast-growing restaurant chains like Shake Shack are all the rage these days on Wall Street, Sonic (NASDAQ:SONC), a chain of over 3,500 drive-in restaurants founded in 1953, has been similarly, and irrationally, hyped-up. Over the past three years, shares of Sonic have jumped nearly 300%, despite essentially no revenue growth at all. Today, Sonic's P/E ratio stands at 36.
One big problem with this valuation is that Sonic's store count has been shrinking since 2010. The company does expect to grow its store count in 2015 and plans to open 34-44 new franchise units. But the company will also undoubtedly close some stores – in 2014, 43 franchised units were closed, resulting in a net decrease in the store count. For a chain of 3,500 stores, any store count growth in 2015 won't move the needle.
Sonic's restaurants have been performing well recently. During the second quarter, the company posted 11.5% same-store sales growth, an impressive figure. But in the long run, expecting anything better than low-to-mid single-digit same-store sales growth is overly optimistic.
Sonic isn't some new, exciting restaurant chain. It's been around for a long time, and sustaining these strong results will be difficult. The company has guided for low-to-mid single-digit same-store sales growth for the rest of 2015, which is more in line with what to expect in the long run .
To justify a P/E ratio of 36, there needs to be a compelling growth story, and Sonic just doesn't deliver. Store count growth will be extremely slow, same-store sales growth will likely moderate, and while there's room to improve margins, even a doubling of per-share earnings would leave Sonic's stock overpriced, given the company's growth prospects.
Sonic's drive-in model and its franchising strategy clearly work. In fiscal 2014, the company managed an operating margin of 17.9%, and even during the financial crisis, Sonic remained profitable. But the huge surge in the stock price over the past few years doesn't make much sense, and reality will eventually catch up with the stock.
Jeremy Bowman (BJ's Restaurants): Though it may not have the name recognition of Shake Shack and some other upstart restaurant stocks, BJ's Restaurants (NASDAQ:BJRI) still has potential for sticker shock. The California-based casual dining chain sports a P/E near 40, about on par with Chipotle, but without the same growth potential. In its most recent quarter, BJ's revenue ticked up 9% on a 3% increase in comparable sales.
Management has improved cost structure, leading to profits more than doubling in the last quarter, but the upside seems limited as the company's performance is still average for the industry. The first quarter's comp increase marked just the third consecutive of rising comps, meaning that this time last year that figure was falling, and its overall operating margin at 5.8% is mediocre.
BJ's future is staked on new restaurants -- it expects to add 15 this year, growing the store base by about 10% -- and improvements from its Project Q initiative to boost productivity and cost control. That initiative is showing results, but top-line growth is not guaranteed. The chain is opening restaurants around the country, but a national expansion strategy seems questionable for a relatively unknown and undifferentiated brand.
The bottom line here is if investors want to pay up for a restaurant stock, they can find better quality businesses elsewhere.
Jeremy Bowman owns shares of Apple, Chipotle Mexican Grill, and HABIT RESTAURANTS INC COM CL A. The Motley Fool recommends Apple, BJ's Restaurants, Chipotle Mexican Grill, and Zoe's Kitchen. The Motley Fool owns shares of Apple, Chipotle Mexican Grill, and Zoe's Kitchen. 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.