Hamburger restaurant chain Shake Shack (NYSE:Shaq) Its long-term vision has only tripled in size. But this may be the most complicated development for shareholders since the company went public a decade ago.
On January 13, at the ICR’s 27th Annual Conference, Shake Shack significantly strengthened its long-term goals. When it went public, management said there might one day be 450 company-owned U.S. restaurant locations. He has made tremendous progress against this original goal. It had just 31 locally owned locations at the end of 2014, but now has ten times that number.
Shake Shack management believes it can have more than 1,500 local company-owned restaurants in the long term. In perspective, that would make it roughly the same size as fellow burger chain Five Guys, and would be much larger than other chains like Carl’s Jr. And Whataburger.
Its importance cannot be understated: This plan represents a complete reimagining of what Shake Shack could be on a large scale. But there is a risk involved with this plan, which is worth noting before we get too excited.
There are two main ways to grow Restaurant business: Businesses can open new owned locations, or they can grant restaurant franchises to third parties. Company-owned locations are more expensive and slower to open. But if the unit economics are attractive, it’s a worthwhile plan. However, as chains become larger and more complex, most choose the franchise model.
To be clear, Shake Shack franchises and licenses restaurants, especially internationally. And it will continue to do so in the future. But the management target of 1,500 is for company-owned sites only. This is more than three times its original goal and represents an approximately 400% increase over its company-owned footprint today.
Main component of Investment thesis Now is whether or not Shake Shack’s unit economics will remain attractive at this scale.
According to management, Shake Shack locations currently average $4.1 million in sales annually, which is known as average unit volume (AUV). Based on preliminary numbers, the company achieved a restaurant operating margin of 22.7% in 2024.
But keep in mind that Shake Shack is concentrated in urban areas. At the end of 2023, 39% of company-owned domestic locations were located in urban areas with potential for increased sales volume. As the company grew, it necessarily expanded into suburban areas, which negatively impacted AUV.
Expanding to 1,500 locations will put more pressure on Shake Shack’s AUV, and management acknowledges that. The long-term goal for AUV is between $2.8 million and $4.0 million. In other words, these newer sites will have a lower sales volume than the average site now.
Shake Shack’s management is on track to achieve a restaurant-level operating margin of 22% over the long term, which is slightly lower than it is now. But it should be noted that although the profit at the restaurant level is good,… total Profit margin is not. Once other company expenses are factored in, gross operating margin is only 3% and has been declining for years.
Let me get this straight: Shake Shack is barely making a profit today despite some good numbers at the restaurant level. However, its massive expansion plans will see some of those restaurant-level numbers get worse, not better, according to management’s own guidance. Therefore, given profits are already modest, future profits may be even more scarce.
A 2006 Boston Consulting Group study indicated that revenue growth was the most important factor for long-term stock performance. But not all growing companies do well. Among the underperforming companies are companies that grew but whose profit margins worsened. This is what Shake Shack is risking with its massive growth plan.
For starters, there’s a huge discrepancy between Shake Shack’s restaurant-level profit margin and its gross profit margin. If management can keep expenses that are not directly related to running their restaurants to a minimum, the gap can begin to close, enhancing overall profitability. That would be good.
Furthermore, Shake Shack is talking about changing how new locations are developed. Future sites could be smaller, have more traffic lanes, and be optimized for productivity. This may make suburban locations more profitable as sales decline.
Low-margin restaurant stocks can only be traded on one turnover. Chains with higher margins get higher ratings. Assuming Shake Shack reaches its goal of 1,500 locally owned restaurants, it’s not unreasonable to think it could generate $5 billion in annual revenue. This is an AUV of $3.3 million and does not represent revenue from franchised locations.
Shake Shack’s market cap is about $5 billion now. If it can squeeze out better unit volumes and if it can boost its gross margins, the stock has clear long-term multiple potential, which is a bonus. But I personally think the plan is risky considering that trading volumes are likely to decline and put pressure on profits.
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John Quast He 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 Disclosure policy.
Shake Shack announces plans to become as big as Five Guys. Here’s why this is a high-risk, high-reward outlook that investors should pay attention to. Originally published by The Motley Fool