Here's Why You Should Still Avoid Shake Shack Inc.'s Stock

New York City locations such as this Shake Shack at 86th Street and Lexington Avenue are more profitable and carry the weight forrestaurants it opens elsewhere in the U.S. and around the world. Photo: Flickr/Drew XXX.

On second thought, maybe Shake Shack is still a risky investment.

After bidding up the better burger joint's stock more than 10% following its second-quarter earnings report, investors sent its shares careening 15% lower following a secondary offering that sharply discounted the stock's value, indicating that they may still be worried about its sky-high valuation in the face of growth rates that are less than impressive. They would be right to have such concerns.

Shake Shack reported that revenues surged 74% in the period as comparable restaurant sales jumped nearly 13% from the year-ago quarter, while adjusted operating profits more than doubled. It's easy to see why the market was impressed, but a deeper dive into the numbers suggests all may not be what it seems.

Where's the beef?The fast-casual burger palace opened five new restaurants in the quarter -- three here in the U.S. and two internationally -- and 14 total over the past year, contributing to the the big sales jump. But the comparable sales numbers, which would normally support the contention that its business is still rapidly expanding since comps are seen as a more organic measure of growth, help undercut that story.

Comparable-store sales, or, as Shake Shack likes to refer to them, "same-Shack sales," typically eliminate the effects that opening new restaurants has on revenues, since obviously the more stores you open, the more revenues you're going to have.

But comps also take into account a number of other effects that typically don't get as much play. In addition to greater repeat business or store traffic, comparables also represent the impact that product mix has on sales (i.e., whether it's selling more or less expensive items), as well as pricing. A restaurant that's raising its menu prices could show higher comparable sales even if traffic is falling, and that's what's happening at Shake Shack -- though it's still seeing higher customer counts at its restaurants that have been open for two or more years.

Included in Shake Shack's 12.9% rise in same-Shack sales is an 8.6% increase in the average customer check size, which was primarily a result of its raising its menu prices last September and this past January to keep up with rising commodity costs.

Thinning the herdCattle herds started off 2014 at a 63-year low, and because of drought, disease, and demand, beef prices took off last year to record levels, a pace that only accelerated in 2015.

It's hard not to want to sink your teeth into Shake Shack's burgers or its stock at its currently discounted value, but investors might want torethink the latter option. Photo: Flickr/Simon Doggett.

Shake Shack was smart to offset its input costs when it could, as the added interest in its burgers created by its going public helped offset some of the effects that raising prices might normally have, since people wanted to see what all the buzz was about. But investors should be mindful when looking at that jump in comparable-restaurant sales, as only 4.3% of it was due to increased traffic at its stores.

And the rate of same-Shack sales growth has slowed appreciably over time. Comps rose 7.1% in 2012 but slowed to 5.9% in 2013 and then to 4.1% last year. Even with all the attention it's gotten with its IPO, Shake Shack hasn't been able to get many more customers to return to its stores. An argument could even be made that comps would be lower now but for the publicity it's received. Indeed, for the first six months of 2015, guest traffic is up just 3.4%.

Moreover, the numbers aren't expected to improve because it's adding more restaurants that have lower targeted weekly sales volumes than the original stores it opened.

Back then, when Shake Shack was a local phenomenon in New York City, average store volumes were more than $7 million. As it opened more and more restaurants around the country (and world), that figure was cut nearly in half to about $3.8 million, and last year it said new restaurants would be in the range of $2.8 million to $3.2 million in average weekly sales.

No shake, rattle, and rollShake Shack is undeniably popular, particularly in its own backyard. When it had to temporarily close its Madison Square Park flagship restaurant, it admits it gave a lift to its other area restaurants, possibly artificially increasing their contribution.

Shake Shack is not a bad company or business, just an overpriced one. Valued at more than 300 times next year's estimated earnings, but with a slowing rate of sales growth, it's a stock that investors are right to be worried about. The big drop the stock experienced the other day from the secondary offering probably won't be the last.

The article Here's Why You Should Still Avoid Shake Shack Inc.'s Stock originally appeared on

Rich Duprey has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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