Investors Are Betting Big Against Shake Shack -- Should You Join Them?

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Shake Shack (NYSE: SHAK) went on a wild ride after its IPO in Jan. 2015. The stock priced at $21 per share, more than doubled on its first day, then doubled again to the low $90s by late May. But the euphoria soon faded, and the stock dropped back to the mid-$30s over the following two years.

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Many investors expect that pain to continue, with 52% of the float -- shares available for trading -- being shorted as of June 9. That makes Shake Shack the third most shorted stock on the New York Stock Exchange. Is that pessimism justified? To find the answer, we'll ask three simple questions about the fast food chain.

How fast is this burger joint growing?

Shake Shack's headline numbers look great. The company has beaten top and bottom line estimates in every quarter since its IPO. Its revenue rose 61% in 2015, 41% in 2016, and is expected to rise another 33% this year. Those growth figures easily crush comparable restaurant chains such as Habit Restaurants, which posted 22% sales growth last year.

However, Shake Shack's comparable-store ("same-shack") sales fell 2.5% last quarter. Same-shack sales measure the sales growth of stores opened for two full years -- which is unusual since most chains gauge comps growth from locations open for more than 12 to 13 months.

This tells us that Shake Shack's 42% sales growth during the quarter came from new store openings. Between the first quarters of 2016 and 2017, the company's system-wide store count rose 44% -- from 88 to 127.

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But opening new stores to drive revenue growth has its downsides -- expenses begin to mount. That's why analysts expect Shake Shack to grow its earnings by just 9% this year -- compared to 28% growth in 2015 and 44% growth in 2016.

Opening too many licensed locations (44% of the total store count last quarter) too quickly can also affect the consistency of the food and service. Labor costs as a percentage of revenue also rose 240 basis points annually to 27.6% last quarter, indicating that the company's increased headcount will continue weighing down margins.

That's all troubling when we consider that Shake Shack's average weekly sales at domestic company-operated locations dipped 4% annually to $86,000 during the quarter, and that the company sees same-shack sales remaining nearly flat this year. Habit, by comparison, posted 1% company-owned comps growth last quarter and anticipates 2% growth for the full year -- which makes it a healthier-looking business than Shake Shack.

Compounding the problem: Research firm InMarket recently reported that Shake Shack ranked lower than Subway, Au Bon Pain, Chick-fil-A, A&W, Sbarro, and Long John Silver's in terms of customer loyalty.

This means that once Shake Shack opens fewer stores, its weak same-shack sales will result in an abrupt decline in revenue growth. Shake Shack responded to InMarket's study by noting that more than 55% of its customers visit more than once per month, but that figure likely needs to be much higher to drive positive same-shack sales.

What's Shake Shack's game plan?

In addition to company-specific issues, Shake Shack faces an ongoing slowdown in domestic restaurant traffic. Black Box Intelligence, a restaurant industry data company, recently reported that restaurant same-store sales fell for the fourth straight month in May. During last quarter's conference call, Shake Shack claimed that comp trends were also "influenced by cold weather" in its biggest markets -- which presumably kept consumers away from restaurants.

Looking ahead, Shake Shack's strategy includes leveraging its mobile app (which launched late last year) to reduce wait times, expanding its menu with newer products like its ChickenShack sandwich (which targets Chick-fil-A customers), and moving into additional states and markets abroad.

But those plans all face potential problems: Mobile apps can simply shift lines over to the mobile pick-up counter, expanding the menu can reduce the quality of its core products, and expanding too quickly can saturate the market -- which is already crowded with other rival chains like Habit Burger, In-N-Out, and Five Guys.

Is the stock overvalued?

Shake Shack currently trades at almost 70 times trailing earnings, which is higher than Habit's P/E of about 59 and the industry average of less than 30 for restaurants. Its forward P/E of 63, which accounts for the projected slowdown in its earnings growth, doesn't look much better.

Based on the weak comps growth, rising expenses, questionable customer loyalty, and high valuations, it's easy to see why the stock is so heavily shorted.

I personally believe that it's too risky to short a stock that has over 50% short interest, since any positive news about the company can spark a short squeeze. But I also think that Shake Shack remains far too risky to buy, unless it grows its same-shack sales to prove that its aggressive expansion plans won't simply drive its earnings off a cliff.

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Leo Sun has no position in any stocks mentioned. The Motley Fool is short Shake Shack. The Motley Fool has a disclosure policy.