Shake Shack Inc. (SHAK) is a fast-casual restaurant chain with over 80 locations that has rapidly expanded from its early days as a kiosk in Madison Square Park in 2004. The company differentiates itself by offering high-quality ingredients, milkshakes and alcohol at some locations. Shake Shack stock is down more than 65 percent from its May 2015 high, but it still manages to retain aggressive valuation multiples due to its strong fundamental growth outlook.
Fast-casual is the fastest-growing major segment of the global food service industry. The global food service industry grew 5.4 percent in 2015, while the fast-casual segment rose more than 10 percent, with similar rates observed in the U.S. market. The rate of expansion has slowed slightly in recent years, but it remains in the double-digit range as the base grows and comparable growth metrics become more difficult to maintain. (See also: Why Fast-Casual Dining Is Still on the Rise.)
Fast-casual has grown in part by taking share from quick-service restaurants and full-service establishments. Consumer trends are shifting toward options with higher quality and better nutrition, although price is still prohibitive for full-service meals in many circumstances. Food services are also interesting propositions because they are insulated from several of the eroding factors plaguing other industries. Dining is non-tradable and cannot be outsourced, and the dining experience has been almost entirely resistant to disruptive technologies. (See also: How to Analyze Restaurant Stocks.)
Shake Shack has ambitious goals, targeting 450 locations that are either franchised or company operated. The company opened 30 net units in 2016, and it expects to open a slightly higher number in 2017. The company is forecasting 2 to 3 percent same-store sales growth, most of which is due to price inflation. To keep its growth rate high, Shake Shack is focusing its new openings on prime locations rather than expanding region by region. This strategy will likely lead to more difficulty maintaining growth rates after premium locations are exhausted, but margins could benefit as new locations begin to open in clusters. Shake Shack also has a strong margin profile, with a superior gross margin to its peers and an operating margin of roughly 27 percent for company-operated restaurants. (See also: Shake Shack's Expansion Continues.)
It is clear to see why investors are bullish about Shake Shack, and its outlook justifies a premium valuation. However, there is a limit to the level of speculation that a stock can bear. Shake Shack stock is expensive enough to warrant scrutiny, and it does appear to be an outlier among its peers across numerous valuation metrics. The stock's price-to-book ratio is nearly double the group average. The forward price-to-earnings ratio is over 50, which is very high. A 2.21 PEG ratio indicates that the P/E is high, even adjusting for the growth rate. Enterprise value to EBITDA helps adjust for different capital structures, and Shake Shack is by far the most expensive on that metric. The company's focus on growth has resulted in negative free cash flows, unlike several of its peers. (See also: Key Financial Ratios for Restaurant Companies.)
Shake Shack shareholders are paying a premium to have claim to earnings many years into the future. Speculation is not necessarily bad, but it does bring higher risk to a portfolio, and investors should be aware of this. Shake Shack has excellent growth prospects and strong operational performance with healthy margins, so it can be considered a premier player in a growth industry. There is a plausible long-term investment narrative, but Shake Shack stock is demonstrably expensive due to optimism around its future. (See also: The Best Fast-Casual Restaurants for the Long Haul.)