Consumer

Shelly Banjo is a Bloomberg Gadfly columnist covering retail and consumer goods. She previously was a reporter at Quartz and the Wall Street Journal.

As Chipotle tries to recover from a food-safety crisis, its competitors are no doubt paying attention. But one in particular should take heed: Shake Shack. 

A read through the fancy burger chain's annual financial disclosures filed last week reveals a menu of similarities between it and Chipotle: aggressive growth, an elevated promise to serve better-for-you food, supply-chain challenges, and a potential lack of oversight of certain locations.  

Let me be clear: I'm absolutely not suggesting Shake Shack's burgers are fried up with E. coli or norovirus. But it's a reminder for investors of the risks that come with a fast-growing restaurant chain that operates the way these and similar companies do.

In the decade since it went public, Chipotle went from having around 450 locations to more than 2,000. Back in 2005, it warned investors its future depends on its ability to open new stores. Shake Shack's 2015 IPO served as a similar mandate for rapid expansion: This year, Shake Shack will increase its U.S. store count by 30 percent, with long-term plans to operate 450 stores.

Building Up An Appetite
Shake Shack aims to have 450 stores over the long term
Source: Bloomberg, company filings

That means hiring and training new workers in markets where the company has little to no operating experience, all while trying to keep up standards customers have come to expect, as well as sales and profit margins.

Growing Pains
As Shake Shack expands, it's harder to achieve the same performance as its legacy New York locations
Average unit volumes ("AUVs") are calculated by dividing total sales by the number of Shake Shacks open during the period, and are a metric that helps restaurants keep tabs on how new units are performing relative to the overall chain.

And Shake Shack now has nearly as many locations abroad as it does domestically. The company doesn't operate these restaurants but licenses them to third-party operators in the U.K., Japan, Russia, and across the Middle East. In the latter region, Shake Shack has already had "past and ongoing issues ensuring timely and adequate supplies," it said in the filing. Partly, that's because it has less control over the operations -- its Middle East licensee further subcontracts supply functions to third-party logistics providers. Shake Shack warns investors in the filing it has "limited and restricted communication, preventing us from exercising control or instruction over such entities." 

Even before its food-safety issues, Chipotle's rapid growth and restricted list of suppliers contributed to shortages of premium pork and other ingredients. Shake Shack could be putting itself in a similar bind: It has single suppliers for all of its potato buns, 92 percent of its Shack sauce and 67 percent of its "Shroom Burgers," made of a fried, cheese-stuffed Portobello mushroom patty.

About 76 percent of Shake Shack's ground beef patties -- the core of its products -- comes from only one supplier. Ground beef is one of the biggest culprits of food-borne illness. It can be risky to rely too much on any one beef supplier, in case you have to find a substitute on short notice. (And U.S. Shake Shacks typically keep less than three days' worth of beef patties on hand.)

Howard Penney, a restaurant analyst for Hedgeye Risk Management, pointed out in a recent note that the company's supply chain disclosures are not to be overlooked. When a fast-expanding restaurant chain can't manage growth, it tends to lose its operational integrity, struggling to keep up the quality that made it popular in the first place. (Penney puts a $20 to $25 share price target on Shake Shack, or roughly 45 percent less than its current price.) 

Perhaps learning from Chipotle's food-safety crisis, Shake Shack included a new section in its annual filing this year entitled: "Risks Related to Operating In the Restaurant Industry." It included what could be known as a "Chipotle clause," warning its claims of higher-quality ingredients mean "our guests have high expectations of us, and we could be more severely affected by incidents of food-borne illnesses" and that it may have a harder time recovering from an incident, requiring "significant costs to repair our reputation." 

It's not as if investors have been wildly enthusiastic about the company anyway -- shares have fallen by 24 percent in the past year.

Over-Cooked
Shares in Shake Shack have dropped 24 percent in the past year
Source: Bloomberg

But so far, the discussion on Wall Street has been less about the operational risks of Shake Shack's rapid growth, and more about whether the stock is simply too expensive. Shake Shack is trading at 92 times forward earnings, compared to an average multiple of 26 among restaurant peers, and investors are waiting for its valuation to come back down to reality. Perhaps they should also take another look at the risks that come when a restaurant chain grows too fast, too quickly.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Shelly Banjo in New York at sbanjo@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net