Shake Shack is Riding for a Fall, Will Probably Dilute

(originally published on 5/9/15 – chart updated to represent current quote)

Shake Shack has had an unbelievable run since its IPO, almost quadrupling from its pricing at $21. Investors are paying no mind to the company’s valuation, believing SHAK will eventually grow into its $821 million market cap. While that may be true over the longer term, I think the chance for downside into the company’s upcoming earnings far outweighs the chance for upside. Here’s a glance at the amazing run that Shake Shack has had since its IPO. Technically, its IPO was priced at $21, making this week’s pricing a nearly 350% gain. SHAK briefly touched under $40 during February of this year, but since then has exploded to the upside.


The market will be watching SHAK closely as it reports earnings next Wednesday, May 13th, after the bell. The main question on the mind of investors will be: does the company’s valuation this early in its life cycle justify a reasonable path of growth for the company to fill out in coming years? The main question QTR is asking himself into earnings: is it more reasonable to assume that SHAK will report metrics that will cause the stock to move up or down?

By looking at the market this year, combined with comparing SHAK’s valuation to similar casual dining giants early on in their life cycle, QTR believes there’s likely more chance of seeing downside after SHAK reports its results next week. I believe that too much of a rosy outlook for too long of a period is priced in at today’s prices. Despite the company’s enormous $821 million market cap, consensus estimates expect the company to lose ($0.03) this quarter on revenue of just $33.9 million. Expected top line growth remains the driving force behind the Shake Shack bullish outlook. The bottom line isn’t expected to grow significantly for years to come. Estimates are for just $0.05 in earnings and $0.09 in earnings for the full years 2015 and 2016, respectively. On the long side of this trade, one is assuming a significant amount of time will pass and SHAK’s operations will grow uninterrupted. Even if they beat, shares could fall. The valuation is the key issue that an investment in SHAK hinges on, and I believe SHAK has far more value as a short here than it does as a long.

Playing off of the weakness that fast food has seen lately, SHAK has become one of the casual dining favorites for burgers and shakes. Its appeal is in the quality of the food and the environment in which it’s served. It’s a casual style (a hybrid between fast food and restaurants), similar to Chipotle, which offers a little more in terms of quality and service than traditional fast-food restaurants. The casual dining concept has become one of the biggest drivers of the restaurant industry. Stocks like LOCO and CMG have rallied during their lifespan, and old traditional dining favorites like Darden and Ruby Tuesday struggle to find the same traction.

To try and determine whether or not SHAK’s valuation has gotten ahead of itself, I went back and looked over similar companies like Chipotle and Panera, to try and determine what PE is appropriate this early on in a company’s growth. This is what Chipotle and Panera’s PE ratios have looked like over the course of the last 10 years. Granted, one must remember that Chipotle had about 500 locations when McDonald’s divested of its operations and it went public.

When I further compare SHAK’s location size, current market cap, forward PE, and price to book valuation to its peers, it becomes clearer how extraordinarily valued the company is – even for a company that is expected to produce rapid expansion nationwide. The early stage of SHAK’s growth seems to be compelling investors to pay far beyond the industry norm from a price/earnings and price/book multiple basis.

Granted, companies like Chipotle and Panera are now much further along in their growth cycle, so the bull argument revolves around SHAK being able to grow into their valuation. I think the market’s valuation of LOCO shows that even with some additional location growth, SHAK’s valuation may have to fall.

Company Locations Market Cap Forward P/E (highest) Price/Book
Chipotle (CMG) 1,750 $19.47B 30.39X (79X) 9.14X
Panera (PNRA) 1,800+ $4.90B 26.76X (47X) 6.66X
El Pollo Loco (LOCO) 399 $981.27M 32.79X (75X) 4.66X
Shake Shack (SHAK) 63 $821.15M 767.11X 66.07X

I know that the company has ambitious plans of growing, but in today’s market, I think a price to book of 66X and about 767X 2016 earnings is far too ambitious – even for a “sure thing” growth story.

This is purely a perspective argument at its core. Bears look at the numbers and say the glass is half empty and that there’s too many risks that could prevent the company from growing at the rate it’s supposed to for the next 3-5 years. Bulls look at the fact that the company is starting to expand westward and that Shake Shack could someday be worth the same $5 billion to $19 billion market cap as Panera or Chipotle. I think that if it happens, that growth is much further down the road for Shake Shack. While I think that the longer term view of the company may be bullish as you extrapolate growth out over a 5-10 year period, I think the common sense trade into this earnings report is one of caution.

There are also other caveats that I’ve considered:

  • SHAK’s valuation continuing to hold up isn’t just a product of the company’s numbers, it’ll be a product of the entire market holding up. So far, 2015 hasn’t shown investors that it’s going to be a particularly bullish year for the Dow.
  • SHAK is hardly at the beginning of the fast casual dining trend. The format, which gained popularity in the early 2000’s, is now prevalent in most major U.S. cities with several chain restaurants to choose from (Chipotle, Qdoba, Panera, Cosi, Potbelly, Pei Wei, California Pizza Kitchen, etc.).
  • SHAK’s food and menu are both highly revered, but it’s also generic and in direct competition with many fast food outlets (McDonald’s, Burger King, Wendy’s). Though the quality may be better, SHAK still has to compete with others in the “burger and fries” segment of fast and casual food. Chipotle and Panera’s unique menus give them pockets of organic growth not only because of their fast casual nature, but due to lack of competition in Mexican fast food (where Taco Bell is the main competitor) and in specialty soups and sandwiches with focus on bread (no prominent fast food competitor). On the other side of the coin, Chipotle competes directly with Qdoba for fast casual Mexican.

SHAK is loaded with $32 million in debt with just $2.68 million in cash. I think the company will take a good look at potentially raising cash now that its valuation in the market has gotten bigger. Such a financing, if undertaken, could be dilutive for shareholders and continue to make it tougher for the company to grow into its valuation. I think SHAK is way out ahead of itself for the time being, and the chance of SHAK pulling back on a small miss (or even a small beat) is far too great to keep QTR from buying into the stock heading into earnings.

Disclosure: No position