Shake Shack Announces Plans to Become as Big as Five Guys. Here's Why This Is a Risky, High-Reward Vision That Investors Should Pay Attention To.

Hamburger restaurant chain Shake Shack (NYSE: SHAK) just tripled the size of its long-term vision. But it could be the most complicated development for shareholders since the company went public a decade ago.

On Jan. 13 at the 27th Annual ICR Conference, Shake Shack significantly boosted its long-term targets. When it went public, management said that there could be 450 company-owned U.S. restaurant locations someday. And it's made tremendous progress against that original goal. It only had 31 domestic company-owned locations at the end of 2014, but it now has ten times that many.

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Shake Shack's management believes it can have more than 1,500 domestic company-owned restaurants long term. For perspective, that would make it roughly the same size as fellow burger chain Five Guys, and it would be far bigger than other chains such as Carl's Jr. and Whataburger.

It can't be understated: This plan represents a complete reimagining of what Shake Shack can be at scale. But there's risk involved in this plan, which is worth noting before getting too excited.

What's the risk with 1,500 locations?

There are two main ways to grow a restaurant business: Companies can open new company-owned locations, or they can franchise restaurants to third parties. It's costlier and slower to open company-owned locations. But if the unit economics are attractive, it's a worthwhile plan. That said, as chains get bigger and more complex, most opt for the franchised model.

To be clear, Shake Shack does franchise and license restaurants, particularly internationally. And it will still do so in the future. But the 1,500 goal from management is for company-owned locations only. That's more than three times its original goal and represents a nearly 400% increase from its company-owned footprint today.

A key component for the investment thesis now is whether or not Shake Shack's unit economics will still be attractive at that scale.

According to management, Shake Shack locations currently average $4.1 million in sales annually, which is known as average unit volumes (AUV). And based on preliminary numbers, the company achieved a restaurant-level operating margin of 22.7% in 2024.

Keep in mind, though, that Shake Shack is concentrated in urban areas. At the end of 2023, 39% of its domestic company-owned locations were in urban areas with the potential for higher sales volume. As the company has grown, it's necessarily expanded into suburban areas, negatively impacting its AUV.

Expanding to 1,500 locations will further strain Shake Shack's AUV, and management acknowledges this. It's long-term target for AUV is between $2.8 million and $4.0 million. In other words, these newer locations will have lower sales volume than the average location now.

Shake Shack's management is guiding for a 22% restaurant-level operating margin long term, which is only modestly lower than it is right now. But it's worth pointing out that while the restaurant-level profit is good, the overall profit margin is not. Once factoring in other company expenses, its overall operating margin is only 3% and has declined for years.

Let me put it plainly: Shake Shack barely makes a profit today despite some otherwise decent restaurant-level numbers. However, its huge expansion plans will see some of these restaurant-level numbers get worse, not better, per management's own guidance. Therefore, considering profits are already modest, future profits may be even scarcer.

A 2006 study from The Boston Consulting Group noted that revenue growth was the most important factor for stock performance over the long term. But not all growth companies do well. Among the underperformers were companies that grew but whose profit margins worsened. And that's what Shake Shack risks with its massive growth plan.

Two things that could make this all worthwhile

For starters, there's a big disparity between Shake Shack's restaurant-level profit margin and its overall profit margin. If management can keep to a minimum the expenses not directly related to running its restaurants, the gap can start to close, boosting overall profitability. That would be good.

Moreover, Shake Shack is talking about changing up how it develops new locations. Future locations can be smaller, have drive-throughs, and be optimized for throughput. This might make suburban locations profit more with lower sales.

Low-margin restaurant stocks can trade at just one times sales. Higher-margin chains get higher valuations. Assuming Shake Shack reaches its 1,500 domestic company-owned restaurant goal, it's not unreasonable to believe it could generate $5 billion in annual revenue. That's an AUV of $3.3 million and doesn't account for revenue from franchised locations.

Shake Shack's market cap is almost $5 billion now. If it can squeeze out better unit volumes and if it can boost its overall profit margins, then the stock has clear long-term, multibagger potential, which is the reward. But personally I think the plan is risky considering volumes will likely drop and put pressure on profits.

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Jon Quast 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 a disclosure policy.