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There was a time, not too long ago, when burger chain Shake Shack (NYSE: SHAK) was one of the market’s premier growth stocks. Investors fell in love with the story of a small burger-and-fries company with an almost cult-like consumer fan base. The perception was that Shake Shack would be able to compound its growth and hugely expand its locations all across the country, then eventually the world.
Investors quickly projected massive growth for the company, and soon bid the stock up to irrational levels. After going public in early 2015, shares of Shake Shack raced from $40 to above $90 in the span of a few months.
Unfortunately, those perceptions simply didn’t match the reality. Shake Shack shares fell 12% on Tuesday after the company reported fourth-quarter earnings after Monday’s closing bell.
Shake Shack Growth: Expectations vs. Reality
Shake Shack was a small company when it went public, and to the dismay of investors, it remains a very small company. Management has chosen to be very selective with the opening of new restaurants. This has disappointed investors, and explains why the stock is down to $37 per share, even though the company beat earnings expectations for the fourth quarter.
Last quarter, Shake Shack reported adjusted earnings of $0.08 per share, beating expectations by one cent. Revenue also came in above forecasts.
The company expanded its system-wide unit count by 33% last year, which is a truly impressive number on a percentage basis. The bad news is that at the end of the fiscal year, there were just 84 Shake Shack locations in the world.
Management plans to increase its global unit count by another 23% in 2016. But again, that will amount to just 20 new stores.
Normally, that wouldn’t be a problem. Shake Shack is being financially prudent by focusing only on the highest-value locations that can generate satisfactory sales and margins. But when the stock was trading near $90 per share it held a market capitalization in excess of $3 billion – close to the market value of close competitor Wendy’s (NASDAQ: WEN).
For the sake of comparison, Wendy’s currently operates more than 6,400 restaurants worldwide. Shake Shack is a high-growth company, but the simple reality was that its unit count and growth could not support such a lofty valuation.
Shake Shack did grow total sales by 60% last year, thanks to 13% growth in comparable store sales, which measures sales growth at locations open at least one year. Still, the company lost $8 million last year, or $0.65 per share. Again, this is a reality check for investors – aggressive growth plans are costly to implement.
Management has laid out a relatively soft outlook for the current year. Despite plans to meaningfully increase unit count, Shake Shack expects comparable sales to increase just 2%-3% this year. Total revenue is expected to grow 27% at the top end of the company’s 2016 guidance. Again, normally this would be impressive – but not for a company that grew at more than double that rate last year.
These growth rates would be a notable accomplishment for a larger company. But when expectations are high, it’s not good enough. These are hardly growth rates representative of a momentum stock that deserves a stratospheric valuation.
Investors Need to Reset Expectations
From a fundamental perspective, there is nothing wrong with Shake Shack. The company is growing sales and units, its brand remains highly popular, and it enjoys a strong reputation among consumers for its 100% all-natural, antibiotic-free Angus beef burgers.
But the stock is down by nearly half just from last July. That’s because investors are getting hit with a rude awakening. Shake Shack simply isn’t at the point where it can be valued on the same scale as its much larger competitors. It might still get there, but that will take much longer than investors seem willing to tolerate.
It’s very difficult to value Shake Shack, because the company continues to lose money. Its uneven growth trajectory means investors should brace for much more volatility in the stock, especially when it releases earnings. That means only those investors willing to take significant risk should consider buying the stock.
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