Dear Shake Shack: I Knew Chipotle, and Youre No Chipotle

By Markets Fool.com

On Wall Street, as in life, success inevitably breeds imitators. For over a decade now, we have all been witness to the meteoric rise of Chipotle . This, of course, has spawned a plethora of fast-casual organic copy-cats. The most recent of which, Shake Shack , hit the market in February of this year.

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Originally priced at $21, the shares quickly rocketed to $50, only to enter the stratosphere topping out at $92 in May. Since then shares have cooled a bit, recently trading hands at $53 -- over 150% above its original IPO price. Investors are almost certainly hoping that Shake Shack is the next Chipotle -- a fast casual restaurant that will "wow" the Street with consistent store openings and exceptional same store sales growth. Alas, as we shall soon see, Shake Shake is no Chipotle.

The fast casual record so far
I'll be the first to admit that I am a big fan of the "fast-casual" industry. The consumer is clearly a big winner in this trend. We are getting quality, often locally sourced GMO-free food at reasonable prices and fairly quickly. Unfortunately, these enterprises' financial results appear to be all over the map:

LTM Revenue

LTM Net Income

LTM Return on Equity

LTM Gross Margin

LTM Net Income Margin

Shake Shack

$132.1 mil.

($11.6) mil.

(14%)

37.8%

(8.8%)

Chipotle,

$4.441 bil.

$514.9 mil.

25.7%

38.3%

11.6%

Zoe's Kitchen

$188.5 mil.

$0.7 mil.

0.5%

20.6%

0.4%

Potbelly Corp.

$338.9 mil.

$5.2 mil.

3.4%

30.4%

1.5%

Source: S&P CapitalIQ

Hardly awe inspiring. Granted, Shake Shack's recent results are a little skewed due to the costs associated with its recent IPO. However, even taking these costs into account, Shake Shack produced GAAP earnings of $0.03 per share over the last 12 months, and generated a negligible return on equity. The only business on this list that should be of interest to investors is Chipotle, all of its peers seem to fall short in the "profit" department. A point which is further amplified when we take a look at the valuations assigned to these enterprises:

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Recent Price

Enterprise Value/Revenue LTM

Trailing Normalized P/E

Forward Normalized P/E

FY 2017 EPS Estimates

Shake Shack

$53

4.59

376

405

$0.21

Chipotle,

$730

4.53

41.6

36.1

$28.94

Zoe's Kitchen

$41

4.26

N/A

N/A

$0.21

Potbelly Corp.

$13

0.99

54

44

$0.46

Source: S&P CapitalIQ

Arguably, we're still in the "bubble" stage of the fast-casual industry's development. There's just no other explanation for these kinds of valuations. Especially when you weigh the fact that Shake Shack and Zoe's Kitchen are being valued at the same price to sales multiple as the strongest player in the group -- Chipotle. These two restaurant chains are being valued by investors as if they arethe next Chipotle, without the exceptional returns on invested capital that would make such a company obvious.

I know what you're thinking: Zoe's Kitchen, Potbelly, and of course Shake Shack are much younger companies and thus any current losses should be forgiven in favor of future growth. Alas, this argument doesn't hold water either. Just take a look at where Chipotle was 10 year ago.

Chipotle Fiscal Year 2005:

Total Revenue

$627.7 mil.

Net Income

$37.7 mil.

Return on Equity

13.6%

Gross Margin

34.5%

Net Income Margin

6.5%

Source: S&P CapitalIQ

The numbers speak for themselves. Fiscal year 2005 was the last full year Chipotle operated as a subsidiary of McDonald's, just months before it went forward with its IPO in January of 2006. Its size that year was much more comparable to today's fast-casual imitators, and while the results aren't mouth-watering (a 13.6% return on equity is just above average for example), they are clearly superior.

In addition, it could be argued that Chipotle hadn't even hit its stride as an independent company. Operating as a subsidiary of McDonald's, which is a great company but one that doesn't share Chipotle's basic philosophy, no doubt held Chipotle back.

Shake Shack does have some extremely profitable restaurants, but as fellow Fool Jeremy Bowman points out, these hyper-profitable stores that generate over 1.5 times the operating profit of stores located elsewhere in the world, are all located in its home market of New York City. Management has noted in Shake Shack'sIPO Prospectus that they believe planet Earth has room for about 450 Shake Shack locations and that their current plan is to expand the store count to at least that number.

Given Shake Shack's current profitability, and market capitalization of $1.9 billion, it seems that every single bit of this potential future growth is priced in today. We can't say for sure, but insiders probably wouldn't argue with this prognosis: they just filed to sell even more of their shares in a secondary offering following the expiration of the company's IPO lockup period.

Don't take this personally
Shake Shack is a wonderful organization, its employees are happy with management and customers continue to rave about the chain's burgers and shakes. Its founder, Danny Meyer, is a visionary restauranteur who actually studied culinary art and restaurant management in Europe throughout the 1980s, only to return home to open 10 award winning restaurants, one of which was Shake Shack. Any burger chain that actually has a culinary development manager is "ok" in my book as I love a good burger.

However, investors need to think long and hard before adding Shake Shack to their portfolios in the hopes that one day it will replicate Chipotle's success. Shake Shack's valuation is clearly the result of our society's desire for more and more fast-casual options, not due to Shake Shack's inevitable rise to the top of the fast-casual industry.

The article Dear Shake Shack: I Knew Chipotle, and Youre No Chipotle originally appeared on Fool.com.

Sean O'Reilly has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill. 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.