The Worst Might Not Be Over For Shake Shack, But There Are Silver Linings

Shake Shack Inc. (SHAK) reported Q1 2020 earnings yesterday, and earnings came in higher than Wall Street estimates. Shares were up 2% during market hours and have so far gained another 2% in the pre-market session. It seems as if investors are looking past Covid-19 fears, which is evident from the positive sentiment toward SHACK stock in the market. On the contrary, Beat Billions believe the worst is yet to come for Shake Shack and other restaurant chains, for reasons that will be discussed in this analysis. At the same time, we have uncovered some positive developments that could improve the long-term earnings potential of the company.

The first quarter was always going to be okay for the company

Investors need to remind themselves that Shake Shack reported earnings for the first quarter of the year, which was never flagged as a period that would see a drastic drop in earnings. Nation-wide mobility restrictions were introduced only on March 23 in the United States, meaning the restaurant industry was operating in full flow in the first quarter, save for a few days. The enthusiasm surrounding SHACK stock following yesterday’s earnings report seems to be an overreaction as the worst might be yet to come.

Investors ideally need to focus on the second-quarter earnings to determine whether SHACK stock is an attractive investment at the current price level.

Year-over-Year numbers will look bad for the second quarter

There’s no doubt that every investor is looking at growth metrics to decide whether to show some love for a company or not. The data we have at the moment points to a messy second quarter for Shake Shack, thanks to the measures taken by governments across the world to curb the spread of the virus.

On May 4, the company reported improving sales figures from a week-over-week perspective.

This is definitely a positive sign, and the increase in sales was largely attributable to the growth in digital sales.

Investors, however, need to look beyond this weekly performance figures to gauge a measure of the numbers the company will report for the second quarter. In the most important regions for the company, Shake Shack is experiencing a massive year-over-year drop in sales.

Source – Earnings presentation

This provides an early indication of what to expect when the company reports Q2 numbers. If YoY numbers are disappointing, there’s every chance for a massive drop in the SHAK stock price.

Shake Shack sales might remain under pressure even when restrictions are eased

A bet on Shake Shack stock is a bet on things to return to normalcy. However, an important characteristic of the post-coronavirus era is left behind by many investors in their analysis of Shake Shack stock.

If we are to go by the example set by China, it’s reasonable to assume that the United States will be up and running once again within a few more weeks. To refresh your memory, Wuhan, the original epicenter of the virus, was in lockdown for two months before restrictions were eased in the first week of April. Going by this, we can assume that America will start moving once again sometime close to the fourth week of May. That’s not too far away!

So far, so good.

What many investors are not factoring in is the possibility of a sales slump even when Shake Shack opens its doors to customers! This is exactly what is happening in China. Residents of Wuhan, for example, are still reeling from the losses and are not leaving their houses unless otherwise it’s absolutely necessary to go out. Dining out, apparently, does not fall into this “absolutely necessary” category.

Two weeks ago, the New York Times interviewed a few residents from Wuhan who confirmed their fear of a second wave of Covid-19, which is the primary reason behind the reduced business activities even after the province was declared free of the virus.

Beat Billions holds the opinion that the situation in the United States will be similar. With over 100,000 projected deaths in the U.S. alone, it’s fair for restaurant-goers to remain cautious and avoid public gatherings for many more months to come.

Another factor that could limit Shake Shack’s earnings potential is the expected limitations that would be announced by the state government. None of the restaurants would be allowed to operate at full capacity to ensure social distancing policies are adhered to, and this is not good news for Shake Shack. Comparable store sales will likely decline in the next couple of quarters, which could lead to a sell-off of the shares.

The silver linings among the dark clouds

Amid this chaos, investors can find consolation by the efforts taken by the company executives to increase its digital presence and widen its distributing partner network. For instance, the company has opened make-shift drive-throughs to boost sales as dining rooms remain closed. This is a very positive development as buying food from drive-throughs, in fact, is the most preferred method of Americans to buy food.

Source – The Wall Street Journal

In addition, Shake Shack has shifted to a multi-partner strategy, integrating UberEats, DoorDash, Caviar, and Postmates to deliver food. Previously, the company exclusively partnered with GrubHub. This increased distribution network should reward the company in the long term by generating sustainable earnings as industry dynamics are rapidly changing in favor of food delivery.

Beat Billions’ take on SHAK stock

The recent enthusiasm on Shake Shack shares, in our opinion, is a misrepresentation of what to expect from the company when it reports Q2 earnings. In the most likely scenario, the company will report disappointing returns. However, the company has taken some bold measures to cut the losses and to boost sales, which would prove to be long-term tailwinds for the company. Focusing on drive-through sales and delivering food to the doorsteps of customers are two of the most noteworthy initiatives taken by the company to minimize the impact of Covid-19. While we still believe these measures will do little to help Q2 sales, the company will continue to benefit from these initiatives for many years to come.

With this in mind, Beat Billions believes waiting for a better opportunity to go long on Shake Shack stock is the right decision.

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