Burger chain restaurant shake cabin (NYSE: SHAK) Its long-term vision has just tripled in size. But it could be the most complicated development for shareholders since the company went public a decade ago.
On January 13, at the 27th annual ICR conference, Shake Shack significantly increased its long-term goals. When the company went public, management said it might one day have 450 U.S. restaurants. It has made tremendous progress toward its original goals. As of the end of 2014, the company had only 31 directly operated stores in the country, but the number is now 10 times that number.
Shake Shack's management believes the company can have more than 1,500 domestic owned restaurants in the long term. For perspective, that would make it about the same size as fellow burger chain Five Guys, and significantly larger than other chains like Carl's Jr. and Whataburger.
Not to be underestimated: The plan represents a radical reimagining of Shake Shack's scale. But there are risks to this plan, which are worth noting before getting too excited.
There are two main ways to grow a restaurant business: A company can open new, owned restaurants, or it can franchise restaurants to third parties. Opening a company-owned store is more expensive and slower. But if the unit economics are attractive, it's a worthwhile plan. That is, as chains become larger and more complex, most people choose the franchise model.
To be clear, Shake Shack owns franchises and franchises, especially internationally. This will continue to be the case in the future. But the 1,500 target set by management is only for company-owned stores. That's more than three times its original goal and a nearly 400% increase from the footprint the company currently has.
A key component of the investment thesis now is whether Shake Shack's unit economics remain attractive at this scale.
According to management, Shake Shack stores currently average $4.1 million in annual sales, or average unit sales (AUV). The company's restaurant-level operating margin will be 22.7% in 2024, according to preliminary data.
But keep in mind that Shake Shack is concentrated in urban areas. As of the end of 2023, 39% of its domestic company-owned stores are located in urban areas, with high sales potential. As the company grows, it is bound to expand into suburbs, which has a negative impact on its AUVs.
Expanding to 1,500 locations will further put pressure on Shake Shack's AUVs, something management acknowledges. AUV's long-term goal is $2.8 million to $4 million. In other words, these newer locations will have lower sales than the average location today.
Shake Shack management is targeting long-term restaurant-level operating margins of 22%, just slightly below current levels. But it's worth pointing out that while profits at the restaurant level are good, Comprehensive Not so with profit margins. Once you factor in the company's other expenses, its overall operating margin is just 3% and has been declining for years.
Let me get this straight: While Shake Shack's numbers are otherwise good, it's barely profitable today. However, based on management's own guidance, its massive expansion plans will cause some of these restaurant-level numbers to get worse, not better. So given how razor-thin margins are already, future profits are likely to be even scarcer.
A 2006 study by the Boston Consulting Group noted that revenue growth is the most important factor in a stock's long-term performance. But not all growth companies perform well. Some of the underperforming companies grew but saw profit margins deteriorate. That's the risk with Shake Shack's massive growth plans.
First, there's a big gap between Shake Shack's restaurant margins and overall margins. If management can keep expenses not directly related to running a restaurant to a minimum, the gap can begin to close, improving overall profitability. That would be great.
Additionally, Shake Shack is discussing changing the way it develops new stores. Future locations could be smaller, offer drive-thru service, and be optimized for throughput. This could make suburban areas more profitable at lower sales.
Low-margin restaurant stocks can only trade at one time sales. Chains with higher profit margins have higher valuations. It's not unreasonable to believe Shake Shack could generate $5 billion in annual revenue, assuming it achieves its goal of opening 1,500 company-operated restaurants in the country. This equates to $3.3 million AUV and does not take into account franchise store revenue.
Shake Shack's market capitalization is currently close to $5 billion. If it can squeeze out better unit sales, and if it can improve its overall margins, the stock has clear long-term, multiple multiple potential, and that's the payoff. But I personally think the plan is risky given the potential for sales to fall and put pressure on profits.
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Jon Quast has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
Shake Shack announces plans to expand to five-person location. Here's why this is a high-risk, high-reward vision that investors should pay attention to. Originally posted by The Motley Fool