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Shake Shack Stock (NYSE:SHAK): Lack of Profits Signals Further Downside
Stock Analysis & Ideas

Shake Shack Stock (NYSE:SHAK): Lack of Profits Signals Further Downside

Story Highlights

Shake Shack’s expansion strategy offers optimistic growth prospects but will keep margins depressed. With no catalysts for higher profits soon, Shake Shack’s stock may have a hard time, going forward.

Shake Shack’s (NYSE:SHAK) inability to generate earnings in a sustainable manner has deterred investors from showing interest in the stock. As a result, shares are currently trading only slightly above their initial public offering level from all the way back in 2015.

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In my view, while Shake Shack’s growth prospects are interesting, the company’s growth strategy will continue to be a headwind in its goal to grow earnings. Hence, the company is likely to have a hard time building shareholder value, which could signal further downside, especially given this is a rising-rate environment we are treading. Accordingly, I am bearish on the stock.

Operating Losses Persist Despite Shake Shack’s Decent Growth

In its most recent Q4 results, the company once again posted relatively pleasing growth metrics, though it still showed operating losses.

In particular, Shake Shack achieved record revenues of $238.5 million, up 17.4% year-over-year. Growth was driven by an increase in the number of locations, as well as higher same-store sales. Specifically, same-store sales grew by 5.1% compared to Q4 2021, while during the year, the company opened 36 new company-operated stores and licensed another 33. This led to year-over-year system-wide sales growth of 15.8% to $364.1 million.

These numbers are quite optimistic for two reasons. Firstly, they indicate that demand for the company’s delicious (though, if I may say, overpriced) burgers is growing, as shown by the same-store sales growth. Further, the significant number of licensed locations opened implies a strong vote of confidence by franchisees in the brand, who deem that Shake Shack’s relevance in the QSR space will continue to expand.

Despite these positive developments, Shake Shack has a really hard time controlling its expenses. In fact, total expenses have consistently exceeded revenues, leading to operating losses. In Q4, total expenses amounted to $244.8 million, or 102.6% of revenues, resulting in the company posting an operating loss of $6.3 million.

Why is Shake Shack Struggling to Reach Profitability?

Given the numbers we just presented, the first question that comes to mind is: why Shake Shack is struggling to post profits? Fortunately, the answer is quite straightforward.

Generating profits at the restaurant level is incredibly hard, and this is true for the industry in general. The only reason that companies in the space, such as McDonald’s (NYSE:MCD) and Chipotle Mexican Grill (NYSE:CMG), are able to generate juicy profits is that the majority of their cash flows come from royalties, property rent, and the distribution of food ingredients paid by their franchisees. For context, about 95% of McDonald’s restaurants are franchised.

As mentioned, in 2022, Shake Shack did open quite a few franchised locations. Still, licensed locations remain an undersized percentage of total locations. The company had 436 locations at the end of 2022, yet only 182 of those were licensed. The difference between collecting high-margin royalties and rent versus being involved with all the costs related to operating the actual locations is why McDonald’s EBITDA margin in 2022 was 51.8%, while Shake Shack’s was a mere 5.4%.

The Path to Profitability is Going to be Costly

For Shake Shack’s profitability to improve, the company will have to shift its restaurant mix towards the licensed side. However, this is going to be a costly journey, as it translates into Shake Shack having to keep opening company-operated locations to expand its footprint first.

Think about it like this: if you are a franchisee, you want proof of concept that a Shake Shack will be highly successful in the location you are interested in opening one. This means that Shake Shack itself will have to take the first step and establish its presence in each and every new market it tries to penetrate before more franchisees see the value of obtaining a license.

Hence, management will have to keep opening new company-owned locations for quite some time before this shift in the restaurant mix starts becoming a reality.

In the company’s Q4 conference call, when alluding to company-operated shacks, Shake Shack’s CEO noted, “This coming year, we expect to open about 40 Shacks, with roughly six of them in this first quarter, having just opened a new drive-thru in Dublin, Ohio and a core Shack right here in New York City in Brooklyn’s Bed-Stuy neighborhood. Currently, we have 24 Shacks under construction.”

This suggests four more company-operated restaurants to be opened compared to last year’s 36, and it’s also more than the 25 to 30 licensed locations the company expects its partners to open this year. Essentially, this confirms that Shake Shack’s restaurant mix will remain skewed to the corporate side. Further, it’s worth noting that in the current highly-inflationary environment, Shake Shack will have an even harder time generating profits.

Unlike collecting high-margin royalties and rent (which can even benefit from inflation), the company will have to bear all incremental operating expenses via its current strategy. And with inflation impacting food ingredients notably, Shake Shack’s bottom line could be compressed even further in the coming quarters.

Is SHAK Stock a Buy, According to Analysts?

Wall Street has mixed feelings about Shake Shack, with the stock featuring a Hold consensus rating based on three Buys, 11 Holds, and one Sell assigned in the past three months. At $57.43, the average SHAK stock price target suggests 2.6% upside potential.

The Takeaway

Shake Shack’s growth prospects appear promising, fueled by the brand gaining traction. That said, as long as the majority of Shack locations are directly operated by the company, margins are set to remain depressed.

In the long run, franchisees may take an increased interest in acquiring licenses which could result in high-margin royalties for Shake Shack. However, there are no catalysts for the company to report higher profits anytime soon.

This can be terrible news in the current environment, as investors want to see real profits in order to confidently value a company and take a position in its stock. This could imply that Shake Shack shares are likely to keep facing strong headwinds from here.

Disclosure

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