Shake Shack's (SHAK) popularity in the New York area is unquestioned, but investors seem to be skeptical about its widespread viablity.
The truth is that while the stock was one of the hottest sellers following its IPO last year, peaking at about five times its $21 initial price, Shake Shack is extremely overvalued.
While there are burger joints all across America -- ranging from the ubiquitous McDonald's (MCD) to the regional In-N-Out Burger -- there isn't a proven nationwide market for the type of premium burgers that Shake Shack sells. Consumers are willing to pay a premium price for the company's signature burger because it tastes better than the average burger at, say, McDonald's, but the question is whether that model has national potential, or is Shake Shack just a regional phenomenon.
Premium burgers make sense in large metropolitan areas such as New York City -- Shake Shack's birthplace -- as there is enough competition that a better-tasting burger would justify the higher price. But there is no evidence that model is viable in smaller markets and weaker regional economies.
Jack Mohr, Action Alerts PLUS co-portfolio manager and Real Money in-house analyst, referred to this as a "New York investment bias" -- the idea that since many large investors are based in the area, and fans of the product, they may have an unrealistic view of the world beyond this town. But that bias can run both ways. Look at Chipotle(CMG): it charges a premium for its higher-quality burritos, and lines were consistently out the door before health concerns put a dent in sales.
Most market stories will point to Shake Shack's weak full-year revenue guidance -- between 2.5% and 3% growth vs. Wall Street's 3.1% expectations -- but does a 0.1% guidance miss justify a more than 10% dip in trading today?
Here is what Mohr had to say on CNBC about the company last year, after the stock soared following a second-quarter earnings beat:
By most measures, Shake Shack had a decent fourth quarter.
The company reported that total revenue rose 49.2% to $49.3 million in the fourth quarter. "Same-Shack" sales for the year increased 13.3%. Adjusted net income of $0.08 per share topped analyst expectations by a penny. And the burger chain reported that it opened nine new stores in the fourth quarter alone and the company expects to open 13 new locations next year.
With an eye towards the regionality issue, Shake Shack reported that it plans to enter several new markets in 2016 including Los Angeles, Dallas and a Twin Cities location in the Mall of America.
But, the market knows Shake Shack's valuation "bordered on absurdity," in Mohr's words. The market knew that last year when the stock spiked following its second quarter earnings beat and increased guidance. However, a small crack in the company's façade this quarter, like slightly missing revenue guidance, has resulted in a catastrophic market correction for the shares.
One of the problems with Shake Shack's valuation is that it doesn't really have a close competitor for comparisons. So the high-quality burger chain has been valued like a tech company to this point, Mohr said. Like a tech company, the market has valued Shake Shack based on its sales, but that is not a sustainable gauge for a company growing the way Shake Shack is because of all the new stores it is opening. While store openings can be seen as a plus, common sense tells us the company wouldn't be expanding if it weren't growing in popularity; without the ability to look eight and 10 quarters ahead, it's impossible to know whether that growth is sustainable.
So while Shake Shack investors may be underestimating markets outside the big cities, their caution seems prudent. Shake Shack will have to prove in coming quarters that it is truly here to stay over the long run.
Only time will tell whether Shake Shack's burgers, like its stock, are overdone.
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