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Shake Shack Inc. (NYSE: SHAK) has become the most successful IPO of 2015. The fast-casual burger chain has seen a total return of 236% from its offer price of $21. The Shake Shack stock price immediately opened up at $49 a share and skyrocketed 119% in its first day of trading. It is up 53.9% since then.
The company’s latest earnings reportalso beat Wall Street expectations. In its second-quarter report, Shake Shackposted earnings per share (EPS) of $0.09, above estimates of $0.03. Its year-over-year revenue and same-store sales growth jumped 75% and 4.5%, respectively.
But the Shake Shack stock price’s meteoric rise over the last seven months has come from nothing but conjecture. According to Money Morning Chief Investment Strategist Keith Fitz-Gerald, the company is a perfect example of the market’s inclination to inflate stocks based solely on hype.
“Shake Shack remains a highly speculative company at best, and not the investment millions of people think it is,” Fitz-Gerald noted.
Here are five reasons why you should avoid SHAK stock…
The Shake Shack Stock Price Is Overvalued, Reason No. 1: Insiders Are Bailing
Many of the Shake Shack IPO investors just announced they’re going to sell off their shares.
On July 20, one day before the IPO lock-up expired, Shake Shack filed for a secondary offering of up to 4 million shares. A secondary offering means Shake Shack’s biggest investors, including company chairman Danny Meyer and private equity firm Leonard Green & Partners, are about to sell off their huge stakes in the company.
“If these insiders believed the Shake Shack stock price was cheap and that the company had better days ahead, they’d be holding on or even buying more,” Fitz-Gerald explained.
That’s a huge red flag for retail investors like you and me. The massive sell-off will drastically lower the SHAK stock price, resulting in huge losses for traders like us who bought in late.
This next chart shows why Shake Shack’s valuation is overinflated compared to McDonald’s Corp. (NYSE: MCD) and other fast-casual restaurants…
The Shake Shack Stock Price Is Overvalued, Reason No. 2: The Valuation per Location Is Inflated
SHAK stock trades at an unwarranted premium compared to other fast-food competitors. The company’s forward price to earnings (P/E) ratio and price/earnings to growth (PEG) ratio are 10 times higher than those of Chipotle Mexican Grill Inc. (NYSE: CMG) and McDonald’s.
Those metrics conclude that each Shake Shack location is worth $50 million. That’s illogical considering how little the company has grown during its seven months on the market.
“If the Shack is going to achieve a McDonald’s-like valuation per location, the company would have to open approximately 864 restaurants representing a 1,170% expansion from the 68 locations they operate today,” Fitz-Gerald said.
The Shack Shake Stock Price Is Overvalued, Reason No. 3: Labor Costs Are Increasing
It’s simple – high labor costs will eat into Shake Shack’s profit margins.
According to the Houston Chronicle, a typical restaurant’s labor costs are around 35% of the restaurant’s total sales. Afterward, roughly 30% goes to food, 30% to operational costs, and only 5% is left over as profit.
That means a restaurant raking in $700,000 in annual sales will only see a profit of $35,000. As labor costs go up due to a rising minimum wage and other factors, the profit will only go down.
It’s all downhill from there. Revenue declines, margins rise, profits fall, and quarterly earnings start to reflect all of it.
The Shake Shack Stock Price Is Overvalued, Reason No. 4: The Food Isn’t Worth the Price
There’s no doubt Shake Shack’s burgers have been selling like crazy lately. The company posted $46.6 million in sales last quarter, marking a 77.9% increase from the year-ago period.
But Shake Shack’s sales are being fueled by hype, just like its stock. The company’s menu is expensive compared to other burger chains, so it’s only a matter of time until the Shake Shack fad blows over and sales start to diminish.
“If you don’t harness the innovation that built your business, your customers will lose interest and find alternatives,” Fitz-Gerald mentioned. “This is especially true for restaurants.”
The Shake Shack Stock Price Is Overvalued, Reason No. 5: The Company Isn’t Expanding Enough
Shake Shack will never be able to grow into its inflated $2.4 billion valuation. That’s because the company isn’t opening new locations at a quick enough pace.
The chain expects to open another few hundred stores over the next couple of years. If you assign it a generous 50% profit margin for a $9 burger, it needs to sell 480 million burgers across 73 locations in a year to justify its valuation.
After opening only five new U.S. stores last quarter, it’s ridiculous to think Shake Shack can sell that many burgers and live up to that valuation.
“What’s happening with Shake Shack is a very serious warning that the markets have become frothy and that investors are chasing hot ideas rather than results,” Fitz-Gerald explained.
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