Down 28% for the Year Despite Record Revenues Last Quarter, Is Shake Shack a Buy?

On the surface, there was a lot for investors to like in Shake Shack's (NYSE: SHAK) second-quarter earnings report. The company logged record revenue of $356 million, slightly above the $354 million analysts were expecting. Adjusted earnings of $0.44 per share also compared favorably to the $0.38 analyst consensus. Not only did the company add 63 stores over the preceding year -- an 11.5% increase -- but it grew revenue at an even faster pace, up 12.6% year over year.

That hardly sounds like a disastrous quarter, yet Wall Street treated it as such with shares cratering nearly 15% the day of the earnings report. The culprit was same-store sales growth of 1.8%, just short of the 2% analysts were expecting.

In the months since, shares have continued to drift downward and are now down 28% year to date. Meanwhike, the S&P 500 is up nearly 15%.

Image source: Company presentation.

Shake Shack's recent share performance has no doubt disappointed many investors, but this company, which grew net income 77% last quarter, has a clear path to glory.

The "single most important trait in a business," according to Warren Buffett

One of legendary investor Warren Buffett's favorite investments has been See's Candy, a confectionary company that's raised prices by about 5% a year since the 1970s. It was able to grow its customer base while doing so thanks to pricing power, or the ability to raise prices without losing customers.

Buffett has long viewed pricing power as critical. In a 2011 interview, he said:

The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10%, then you've got a terrible business.

In its most recent earnings report, Shake Shack grew same-store sales 1.8%, despite raising menu prices 3%. Zooming out, it raised menu prices by 3.5% in 2022, and that was after a 7% price hike in the six months prior.

Even so, revenues have almost doubled since the $203.4 million reported in Q1 2022, despite the flurry of price hikes. And here's a striking statistic: Shake Shack has now grown same-store sales for 18 quarters in a row.

That's pricing power. It's only possible when customers are loyal to a company's product, so it's not surprising that an inMarket study in August found that Shake Shack had the most loyal customer base of all fast-casual dining chains.

It's this customer loyalty that makes the company's expansion plans interesting and potentially a game changer for the stock.

Stores opening at the fastest rate in Shake Shack's history

In January, management announced plans to operate or license 1,500 stores, up from the 330 stores open at the time. While the long-term timeline is unspecified, the company is making strong progress toward its goal this year with 13 new company-operated stores opened last quarter, in addition to nine licensed stores. For the year, management plans to add 80 to 90 new locations.

That's the fastest rate of store openings in the company's 21-year history, and the locations appear to be well-chosen. You can see this with one industry metric: restaurant-level profit margin, or the percentage of revenue that remains after all store-level expenses have been paid.

Last quarter, Shake Shack's restaurant-level profit margin grew by 190 basis points to 23.9%. For context, the average restaurant-level profit margin for the fast-casual dining sector is usually between 6% and 9%. Not only is Shake Shack an industry standout on this metric, but it's growing this margin while adding locations at a record pace.

So the bull case for Shake Shack is simple. This is a company that's growing both revenues and earnings at a solid clip. It's growing margins (while already profitable) and plans to more than triple its store count. And it has demonstrated pricing power that could help it weather ongoing inflation and any sector-specific headwinds.

But there are two flies in the ointment that may make it wise for investors to take a "wait and see" approach to the stock for now.

Richly valued, yet in a downtrend

Despite the recent sell-off, shares are expensive -- perhaps prohibitively so. Shake Shack trades at a price-to-earnings ratio just shy of 200, compared to just 28 for the S&P 500.

Given this lofty valuation, expectations for the company are high. For the third quarter, management is guiding for 20 to 25 new restaurant openings, 14% revenue growth (at the midpoint), and low-single-digit comps growth. A miss on any of these metrics, even a seemingly minor one, could trigger a new phase of the sell-off.

Finally, Shake Shack is a very volatile stock. In 2015, Mad Money host Jim Cramer referred to the company as "Tesla for burgers," a name that still fits in light of the recent trading. Its beta of 1.66 makes it significantly more volatile than the overall market. Investors who wish to buy into this restaurant growth story should recognize that major swings like the 15% plunge following the last earnings report aren't that unusual for Shake Shack.

The company will report its third quarter results on Oct. 30.

William Dahl has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Tesla. The Motley Fool has a disclosure policy.