There's a Downside to Shake Shack's Evolution Away From New York City

Shake Shack (NYSE: SHAK) recently announced first-quarter results that were embraced by Wall Street. The upstart burger chain didn't solve its customer traffic challenge, but its latest numbers gave investors hope that market-thumping growth pace could continue, and that the company might just reach management's aggressive goal of doubling the store base by 2020.

The first quarter figures also showed that some important operating metrics will worsen as the company extends its restaurant base outside of its core New York City roots.

Let's dig in to the results.

A decent growth quarter

Revenue spiked 29% to maintain about the same growth pace from the prior 12 months. As usual, most of those gains came from a rising store base. Shake Shack's store count jumped to 168 this quarter from 127 a year ago. Its comparable-store footprint, or locations that have been open for at least 24 months, increased to 44 from 32.

Those existing restaurants are looking a bit healthier right now, as comparable-store sales growth, or comps, accelerated to a 1.7% pace from 0.8% in the prior quarter. Increased prices played the biggest role in that boost, with a 6% price spike helping overcome continued struggles with falling guest counts. Customer traffic dropped 4.2%, compared to a 3.2% dip in fiscal 2017.

The slight improvement in growth didn't do much to close the gap with rival chain McDonald's, whose sales rose 5.5% during the same period. But the rebound does imply that Shake Shack might avoid its second straight year of falling comps.

Growing pains

Shake Shack's earnings profile is shifting as the company moves its store base outside of its intense geographic focus on New York City. The share of the restaurant base located in that metropolitan area dipped to 36% from 41% in the prior quarter, and that shift pushed average weekly sales down to $81,000 from $86,000 since the new openings weren't in as densely populated markets.

Reduced sales volumes joined with a few expense challenges to push overall profitability down. Shake Shack allocated more cash toward wages while spending heavily on its digital sales strategies. As a result, operating margin fell to 6.6% of sales from 7.3% last year.

Yet the burger chain still generates impressive profits. Restaurant-level margins, which describe profitability on a per-unit basis, held steady at 25% of sales. Chipotle's comparable metric was 20% in the most recent quarter.

Keep an eye on profits and traffic

CEO Randy Garutti and his executive team said the sales growth acceleration at existing restaurants marked a solid start to the year. As a result, management now believes Shake Shack will see a tiny uptick in comparable-store sales in 2018 rather than the flat performance they had predicted back in February. Meanwhile, the chain is planning its biggest year yet of store launches, and these include new markets such as Seattle and San Francisco.

The good news is that these openings are spreading out Shake Shack's sales base so that it isn't so dependent on conditions in the northeastern part of the country. But while upcoming store launches include big metropolitan areas like Houston and Los Angeles, they'll still pinch average sales volumes and profitability. Those challenges, plus ongoing struggles with falling customer traffic, put even more pressure on Shake Shack's store expansion strategy to deliver on management's optimistic growth targets.

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Demitrios Kalogeropoulos owns shares of McDonald's. The Motley Fool is short shares of Shake Shack. The Motley Fool has a disclosure policy.