Shake Shack Inc (NYSE:SHAK) shares are getting shaken again.
After hours on Monday, the stock slipped 5% on a secondary offering, as the six-month lockup period after the IPO expired. On Tuesday, however, the stock recovered those losses and finished the session up nearly 7%. Even after a 6% decline on Friday, Shake Shack shares ended the week with big gains. Clearly, euphoria remains for shares of the gourmet burger chain, and there are a number of reasons why.
The brand has a cult-like following that's virtually unmatched in the industry. Shake Shack's following on social media sites like Instagram rivals that of the most well-established fast-food brands despite having only a fraction of their stores. Its average unit volume of $4.5 million towers over its peers. By comparison, No. 2 Chick-Fil-A brings in about $3 million in sales per store. And Shake Shack founder Danny Meyer literally wrote the book on restaurant hospitality.
Shake Shack certainly has its fans, but that alone does not a great stock make. McDonald's, by far the most valuable restaurant chain in the world, has over 35,000 locations, while Shake Shack had only 66 as of the end of April -- and only half of those are company-owned.
In order to be the stock market giant its adherents hope it will be, the company will have to grow many times over, and along the way it must transition from being a boutique brand to a mainstream one.
Shake Shack today
The burger chain's buzz owes in part to its genesis in Manhattan, a tourism mecca. For years, it had just one location in Madison Square Park that consistently received hordes of visitors and the long lines that go with it.
As Shake Shack has expanded, it's found that its Manhattan locations have been significantly more profitable than stores outside New York. In fiscal year 2013, Manhattan Shacks delivered an average operating profit of $2.2 million while non-Manhattan Shacks brought in an average of $840,000.
However, profit from Shacks outside of Manhattan will be key going forward as domestic growth will come from non-Manhattan Shacks. Ultimately, the company's management expects to open at least 450 locations nationwide.
The Krispy Kreme trap
In the early 2000's, Krispy Kreme shares were soaring, up 840% from its IPO thanks to big expansion plans, as it hoped to triple its number of stores in North America to 825. However, a combination of overextending the brand by selling donuts in supermarkets, a lack of support for franchisees, and shifting consumer tastes caused the stock to sink more than 90% from its peak as losses piled up.
The lesson for Shake Shack and other hot brands seems to be that consumer tastes can be fickle and over-expansion can kill buzz. As the company loses its scarcity, it will have to work hard to retain its appeal.
These days, burgers are trendy, and Shake Shack isn't the only better-burger chain gunning for growth. Five Guys jumped from just a dozen locations to over 1,000 in a decade. Smashburger now has more than 300 outlets and is growing fast, while fellow IPO Habit Restaurants also has big burger ambitions.
So far, Shake Shack is managing its expansion appropriately, growing at a measured pace, adding just 10 new domestic stores a year, carefully selecting sites and customizing them, and ensuring that the brand is curated.
Where the company is headed
At the current rate of expansion, hitting 450 stores will take more than a decade, but if the company reaches the mark, here's how the financials could play out.
If Shake Shack is able to maintain strong average unit volumes of around $4 million at that point in time, it would get $1.8 billion in revenue from the domestic company-operated segment. At a reasonable restaurant-level operating margin of 25%, that would generate $450 million in operating profit.
Depending on how well the company controls general and administrative expenses, the remaining operating profit could be anywhere from $200 million-$300 million, leaving the company with approximately $140 million-$210 million in net income (after taxes), plus the profit from internationally licensed Shacks.
That leaves a modest upside for the stock at its current market cap of $2.1 billion. Of course, there could be room for more than 450 restaurants in the long run. But management will have to execute on the expansion plan and preserve its brand strength along with it.
So far, it's working, as same-store sales jumped 11.7% last quarter. Keep an eye on that figure as well as average unit volumes. If those keep moving higher, that will be a sign of success in Shake Shack's growth, but any weakness could spell trouble for the stock. Like Shake Shack's loyal customers, investors are expecting only the best.
Jeremy Bowman owns shares of The Habit Restaurants. 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.