Once seen as a very strong industry riding the secular trend of Americans moving away from cooking at home, the restaurant sector is starting to feel growing pains. With U.S. population growth slowing and immigration becoming more difficult, same-store traffic declines are backing restaurant companies into a corner. The choice is simple: continue to open new units faster than your customer base is growing spending on food, or admit to investors that the growth they have come to expect is over.
High-flying fast casual burger chain Shake Shack (SHAK) has made the decision that, despite dozens of burger places popping up everywhere across the country, the name of the game remains growth. In fact, despite having fewer than 85 locations in the U.S. as of June 30th, the company now has two units open at the bustling King of Prussia mall outside Philadelphia.
Some bulls on the company will likely reference the Starbucks phenomenon whereby that chain purposely opens locations near each other in order to reduce the size of waiting lines during busy peak times. But this is different. Shake Shack has told its investors that it sees room for 450 locations in the U.S. alone. If your ultimate goal is to build 9 locations in every state, it probably does not make a lot of sense to have two in the same mall.
The bigger point has large implications for the industry. As more and more big box anchor stores close their mall locations (Sears, JC Penney, Macy’s, etc), landlords are trying to fill the spaces fast. And with so many bricks and mortar retailers struggling to compete in the e-commerce world, restaurants are an easy way to fill space.
It should not be hard to see the problem with this plan in the long run. With minimal population growth and declining mall traffic, over time there will be less of a need for restaurants at these locations, not more. And yet the industry continues to grow seats far faster than consumer spending. We are seeing the result already; less traffic per location, and thus less revenue and falling profits.
Shake Shack might be able to get away with overbuilding for a while, mainly because the chain started in New York and is brand new to most consumers as they expand across the country. But five years from now we are likely to look back and see that it was silly to have two Shake Shacks at King of Prussia (assuming mall trends continue in a similar trajectory).
As a long-time investor in the restaurant space, the current landscape is challenging. On one hand, Wall Street is giving many companies (not Shake Shack) meager valuations due to falling customer traffic. On the other hand, if the industry continues to build new locations for the sake of growth (and not due to demand exceeding supply), it will make it hard for any chain to post impressive financial returns.
How should investors approach these dynamics? Well, it looks like the franchising route might be the best way to limit downside risk. While lower sales will impact royalty streams for the franchisor, fixed cost deleveraging will impact the bottom line far more severely, and that will sting the franchisee first and foremost.
Shake Shack management would argue otherwise. In fact, during their latest conference call they bragged about having a second unit at King of Prussia mall. Essentially, they argue that it was a wise move as long as they sell more burgers cumulatively with a second location. After all, if the demand is there, why not book the sales?
However, this assumes that the demand will be steady and/or rising over time. Once Shake Shack loses its “newness” and more competing chains invade their turf targeting the same customers, we could very well see demand for their burgers fall considerably. Enough that two locations make little sense.
Full Disclosure: No position in Shake Shack, but positions may change at any time