Chicken Won’t Save Shake Shack Inc; Here’s Why

Shake Shack Inc (NYSE:SHAK) reported earnings which disappointed investors, sending the stock down about 8%. Shake Shack is an expensive stock, so expectations are high. This explains why a 37.2% increase in revenues and a 4.5% increase in same store sales was frowned upon. The only way for Shake Shack stock to not crash when a quarter like this is reported is for the stock to become more reasonably valued. One way for this to happen is for the company to continue to report these types of results and have the stock fall after they are released, until finally this moderate growth is understood to be the norm.

The reason why the stock is still expensive is because its post IPO period gave rise to it becoming the most expensive stock in the market. When valuations get that stretched, even good results and a declining stock price cannot get valuations back in line. The stock still trades at a PE of 85.20 for 2016 earnings. Shake Shack is not a technology company, meaning a correction of about 50% is in order for me to get excited about investing in the firm. Even if the company would have reported a high comp number, the stock may still have fallen because the valuation is unsustainable.

The earnings report was the worst type for a growing company. It is ahead of schedule on opening new locations and its traffic growth is decelerating. Shake Shack has a great brand and a great social media marketing strategy, but it isn’t immune to the challenges that face all growing brands. It is difficult to expand store footprint while maintaining quality and excitement. It’s not that the company is oversaturated just yet, although it may be close to doing so in the NYC area. It is that the company has been so creative with its innovative local offerings, which isn’t a scalable strategy. This type of management is great for a small business, but not for a large chain as each store cannot get the same focus as the original ones did.

Another trend weighing on Shake Shack is the growth it is lapping as the high single digit comp growth of Q1 is unsustainable. It’s an amazing situation to see the stock as investors are expecting growth numbers which are almost impossible to attain. You would think the stock would re-price and then expect normalized results, but it is ignoring the weight of reality. The two-year comp growth for Q2 was 17.4%. The market wanted numbers higher than this, which is unrealistic. Traffic was up only 1.2%, but anyone who has been to a Shake Shack in the NYC knows that the lines out the door cannot get much longer. The market should have priced this like a fad and then bid the stock up when it sustained this momentum. Management tried to highlight its impressive sales per shack store and its increased 2016 revenue guidance, but he market would not listen because it expected the impossible.

For the life of Shake Shack stock since its IPO, the company has had to deal with tough comparisons and an expensive valuation weighing on it. Therefore, the points I laid out so far are not new. This isn’t to say they are no important because Shake Shack’s valuation probably is the most important thing driving the stock. Usually when a company reports solid results the stock goes up even if it is expensive. However, Shake Shack’s valuation was so absurd it couldn’t do so.

The new hindrance Shake Shack will have to deal with over the next few quarters is declining restaurant industry sales. As you can see from the chart below, there have been two consecutive quarters of declining QSR traffic growth on a year-over-year basis. This is because the economic cycle is ending.

While the stock market as a whole has been completely ignoring the end of the cycle as it reaches new high, laughing in the face of 1% GDP growth in the first half of the year as if it doesn’t matter, Shake Shack will not get away with the same issues. Shake Shack is an expensive growth stock. When growth stocks stop growing, no investors want to touch them even in a stock market which has been lifting almost everything. In this market, investors would much rather buy a value stock with a dividend over a growth stock if it isn’t growing enough to justify the moniker. Because growth is difficult to come by in this environment, companies that do grow, like Facebook and Google, are getting an even higher premium than they normally would. However, being a restaurant firm, Shake Shack will not be able to mimic the results of those tech giants. I expect the economy to weaken further in the next two quarters which means Shake Shack will face even more headwinds and have further decelerating comp store sales growth.

I know I avoided discussing the company’s operations. The limited time offering bacon shack burger and the new chicken shack sandwich have been major successes. The chicken sandwich diversifies the menu which helps to limit specific inflation risk from beef. However, in a declining restaurant environment, these types of initiatives only serve to help soften the blow of the weak consumer. The blow will still be felt regardless of what the company has up its sleeve.

Conclusion

Shake Shack has an expensive stock, so if results aren’t amazing the stock will fall. This is exactly what happened when the most recent results came out. Investors should have never expected anything greater than 17.4% two year comp sales growth, but we don’t live in a land of “should ofs.” The reality is the stock is still trading at an over 80 PE, meaning another quarter which shows between 4%-5% (guidance) growth in comps will cause the stock to decline further. As a potential investor, I like the story so I’m happy to see it fall to more reasonable levels.

The weakening consumer is an added headwind which can really send the stock tumbling. One could only imagine how much the stock would fall if a negative comp was reported because the environment was so weak. At that point, I would seriously look at the stock as a potential buy, assuming it reacted poorly to the news. Shake Shack’s store growth should continue, but there will be bumps like this along the way. If the bump is large enough, it may finally be the first buying opportunity the stock granted investors in its history of being publicly traded.