Shake Shack Investors Are Missing the Big Picture

Image source: Shake Shack.

Shake Shack (NYSE: SHAK) stock dipped 6.2% Thursday following the release of its second-quarter earnings report.

Investors were turned off by weaker-than-expected same-store sales growth, as sales at Shacks open 24 months or longer increased just 4.5%, below expectations of 4.9% and down from 12.9% in the year-ago period and 9.9% in the first quarter.

The company had been forecasting decelerating comparable sales, projecting growth of 4% to 5% for the full year, but investors were disappointed as the stock's pricey valuation carries high expectations.

In Shake Shack's case, however, there are a number of reasons why same-store sales may not be the best barometer of the stock's value.

Always a bumpy ride

The comparable-sales figure is often seen as a clear indicator of a retail or restaurant company's performance, because it strips out the impact of new locations and acquisitions. But at restaurants especially, the figure tends to be volatile and is therefore not the best indicator of future performance.

Comparable sales can change from quarter to quarter due to competitive offers, consumer trends, the company's own pricing and marketing, or any number of other factors. Chipotle's management has noted that comparable sales at its stores tend to move in three-year cycles with double-digit growth every three years, though they are not sure why.

Lapping a strong performance the year before, as Shake Shack is doing, is also difficult. It's rare to see restaurants deliver double-digit growth in back-to-back years, especially at high-volume restaurants like Shake Shack as capacity constraints are often already stretched during peak hours.

The comparable base is still small

For most restaurant chains, the comparable base encompasses the vast majority of its locations. That isn't true at Shake Shack. Because of an extended honeymoon period, the company waits two years to include new stores in the comparable base, so only 23 out of 51 company-operated restaurants -- less than half -- were included in last quarter's report. The company also has 44 licensed establishments.

Management has repeatedly stressed that the same-store sales figure is not the best gauge of the company's performance. On the recent call, CEO Randy Garutti said, "If you're only looking at the strength of our same-Shack sales, which have been extraordinary, you'd be missing the real story of our industry-leading AUVs [average unit volumes] and Shack-level operating margins."

On that account, the company's performance was outstanding with record restaurant-level operating margins of 30.8%. Average weekly sales, which include all company-operated restaurants, held steady in the quarter at $102,000. That's a good sign as management has predicted that number, which more than doubles most of its competitors, would eventually fall as the chain spreads out across the country, away from its New York base where operating levels are stronger.

New stores are coming even faster

With the company already delivering annual average unit volumes of $5 million, expectations of same-store sales growth should be reasonable. It's important to remember that Shake Shack's growth will come primarily from new store openings. The company increased its guidance on new-store openings for the year to 18 company-operated locations, up from a previous forecast of 16. Management said it will add at least 18 next year as its real estate pipeline becomes stronger. The burger chain also announced a partnership to license new locations in airports to HMSHost, which should offer a long runway for growth in that valuable space.

With average unit volumes of $5 million and operating margins at 30%, the average Shake Shack contributes $1.5 million annually to the bottom line, compared to an industry mark of less than $500,000. That makes new store openings especially potent for increasing profits, and management is optimistic about its real estate pipeline, saying that its reputation gets it access to premium locations that others don't have.

So while Shake Shack's comparable sales won't break through the roof every quarter, even this quarter, it bested most competitors as the industry warns of a "restaurant recession." Nonetheless, investors should be happy with the accelerating store openings, increasing margins, and strong operating results. The stock's valuation may take a couple of years to grow into, but with its continued expansion, per-share profits could hit $1 by 2018.

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Jeremy Bowman owns shares of Chipotle Mexican Grill and Shake Shack. The Motley Fool owns shares of and recommends 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.