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How Shake Shack's Growth May Actually Catch Up To Its Hype

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If any publicly traded restaurant chain other than Shake Shack ( SHAK ) had seen a key sales metric tumble 8% in a single month, as it did in March, it would likely spark an investor panic.

But there's little about Shake Shack that fits into the typical cookie-cutter, fast-casual restaurant chain mold. While Shake Shack's stock has come down from its post-initial public offering moonshot two years ago - as Wall Street debates whether its early formula for success can be repeated again and again - investors seem to be concluding that its outsized per-restaurant profits are too tasty to lose faith.

[ibdchart symbol="SHAK" type="daily" size="threequarter" position="leftchart" /]

Even after that stumble in same-store sales, which measure year-ago revenue from outlets that have been open at least two years, shares of the New York-based chain that sprang from famed restaurateur Danny Meyer's Union Square Hospitality Group are up slightly on the year. They're also near the top of a seven-month consolidation zone.

"While we expect the company to produce current- and long-term positive same-store sales, we at the same time expect a certain level of volatility for these results. However, at the end of the day absolute dollar profits are increasing at a double-digit pace," Piper Jaffray analyst Nicole Regan wrote in a recent note to clients.

Although a multitude of factors contributed to its March sales slump, the simplest explanation is that, despite all the hype surrounding its increasingly well-known brand, Shake Shack is still a relatively small corporation. It has only 72 company-owned outlets and less than $300 million in annual revenue.

Longer Comparisons

Still, Shake Shack restaurants create so much buzz when they open that sales tend to fall off by roughly 5% in the second year, notes Regan. For that reason, the company only adds restaurants to the comparable same-store base after 24 months, while many others add to their base after 16 to 18 months.

Shake Shack reported 32 outlets for the first quarter of 2015, and so it has more than doubled its store count in the last two years. It's one reason the same-store-sales metric so beloved by Wall Street can obscure the important drivers that set Shake Shack apart, particularly at this stage of its growth.

Analysts and management think investors should focus on a number of other metrics. For one, the average check of about $16 at Shake Shack is about 50% larger than it is with other chains, according to Regan. Meanwhile, the company's restaurant unit growth rate is about triple that of its peer group.

"Shake Shack's new units are profitable within a quarter of opening, in contrast to most growth peers," wrote Wedbush analysts Nick Setyan and Colin Radke in a May 18 report.

"This is a company with 72 company-owned restaurants, and we've barely scratched the surface on the 450 that's highly achievable for us," Shake Shack Chief Executive Randy Garutti said on a May 7 earnings call, according to transcripts.

"So that is our focus," Garutti said. "When you look at what - let's just take this quarter. We added $24 million to sales vs. last year (up 42%). Yes, that was offset by a negative comp."

Hot-Dog Origins

Shake Shack sprung from a single hot-dog cart and later a kiosk-style restaurant that opened at Manhattan's Madison Square Park in 2004. In addition to its 72 company-operated restaurants, there are another 58 franchises, mostly in international locations, that are operated by partners. These partners pay license fees to Shake Shack that generated $2.6 million in revenue in the first quarter, up 28.9% from a year ago.

In the first quarter, Shake Shack opened seven company-operated restaurants and seven international licensed Shacks, including two in London and five in the Middle East. For the year, management said it expects to open 23 or 24 company-operated units, up from 22 or 23. They're expected to have average sales volumes of $3.3 million, up from prior guidance of $3.2 million.

Wedbush turned bullish on Shake Shack last month, upgrading the stock to outperform from neutral on May 18, while hiking its price target to 43 from 33. Setyan told Investor's Business Daily that expectations and valuation "have come down to earth."

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"This is not a comp (comparable-store sales) story. It's a unit growth story," Setyan said. Even as same-store-sales growth took a hit, the company has been exceeding expectations for sales volumes at new stores, and that bodes well for Shake Shack being able to meet, if not exceed, its long-term expansion goals. Investors also have, by now, "fully digested" the reality that labor costs will be a headwind for margins as states raise their minimum wage as high as $15 an hour.

Regan explains that the economics of Shake Shack restaurants "remain best-in-class." Only McDonald's ( MCD ) and Chipotle ( CMG ) are even close to the same ballpark of the $3.3 million average revenue per new restaurant expected by Shake Shack, she notes. Shake Shack, she says, has a stellar return on an investment of 30%-plus, meaning it takes just three years to offset the average $2 million development cost.

"Unit-level economics are so strong," Regan told IBD, that she expects the number of Shake Shack restaurants will double over the coming five years. Piper Jaffray initiated coverage on Shake Shack with an overweight rating and 44 target on May 24.

Separate Identities

Shake Shack doesn't just want its restaurants to stand apart from the competition, it wants pretty much each Shack to have its own identity, so that there's a sense of community ownership. Much of that is done through its design efforts.

"There is nobody in our space who is willing or able to design restaurants that look like that and charge $5 for a burger," Garutti said at a June 15 William Blair growth stock conference, while walking investors through about 20 slides showing newer, distinctive looking Shake Shacks. "We have a design aesthetic, a goal to get better and do cooler, more experiential retail than we've ever done."

Among the 2017 crop of restaurants is one in Lexington, Ky., which features a salted caramel shake with Maker's Mark bourbon, which is distilled in the state. That exemplifies the company's effort to collaborate with artisanal producers or famous local chefs and cultivate what Garutti refers to as Shake Shack's "halo effect" that comes from its fine-dining lineage.

Setyan credits Shake Shack management for the "marketing genius of turning this into a lifestyle brand."

"They've done a very good job of positioning the brand as a destination" for a younger, higher-income demographic, he said. Customers can easily justify spending $15 per check because they're comparing Shake Shack to an upscale burger dining experience that costs $20-$35, rather than to cheaper quick-service competitors such as McDonald's.

While unit growth may be the biggest driver of profits going forward, Shake Shack also is taking steps to keep same-unit sales moving in the right direction. Digital ordering accounted for 3% of sales last quarter as the company launched an app for the Apple iPhone, but it's still working on its Android version.


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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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