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Does Shake Shack's Stock Deserve to Be Soaring Right Now?

"Better burger" shop Shake Shack (NYSE: SHAK) has rallied more than 20% since hitting its low point in September, and its third-quarter earnings report had shares running higher, before giving back some of the gains.

Yet does Shake Shack deserve to be doing so well? Although it recorded higher profits for the period, sales came up short, and it continues to experience shortfalls on comparable sales, customer traffic, and average weekly sales. With rival The Habit (NASDAQ: HABT) reporting negative comps for the first time in 15 years even as fast-food outlets such as McDonald's (NYSE: MCD) and Burger King show rising sales, it's further proof the bubble has burst on the so-called better-burger fad.

Image source: Getty Images.

Nonetheless, Shake Shack will be accelerating the number of new restaurants it opens, increasing them from 24 to 26 this year to 32 to 35 next year. The only way the hamburger stand is able to report higher sales -- and revenue was up 26% in the third quarter -- is to open new locations here and abroad. Along with raising prices, it gives the illusion of a rising top-line number.

That sinking feeling

Yet investors need to pay attention to what's going on below. "Same Shack" sales, as the restaurant calls comps, fell 1.6% for the period. While that's better than the 2.6% decline analysts anticipated, it's the third straight quarter they've been negative, and a year ago comps were up 2.9%. Worse, customer traffic is in a tailspin, tumbling 3.8%, significantly worse than the 0.7% last year. Had the chain not raised prices, results would have been worse across the board.

Data source: Shake Shack quarterly SEC filings. Chart by author.

Moreover, despite systemwide sales that jumped 22% in the quarter, average weekly sales plunged almost 12% to $91,000, down from $103,000 last year.

This is not the direction Shake Shack needs to be heading in. While it's not a picture of a company in dire financial straits, and it's arguably better off than many of its rivals, it's also clear the restaurateur doesn't deserve the premium the market still accords it.

A valuation as pricey as its burgers

Shake Shack trades at 59 times trailing earnings and 65 times next year's estimates while going for nearly four times its sales and more than 100 times the free cash flow it produces. In comparison, The Habit trades at 39 times earnings and 52 times estimates, but it also goes off for only a fraction of its sales. Both are still clearly overvalued, but Shake Shack more so.

The problem for the dining niche remains overbuilding, which Shake Shack is contributing to. Where once it had seemed to be the more conservative outfit by keeping the number of new restaurants opened relatively modest, it now appears to be caught up in the expansion race, too.

Image source: Shake Shack.

The Habit, though, is going to be slowing its new store openings, albeit only slightly, reducing the number from around 33 this year to 30 next year. It's also not going to be going into many new territories, preferring instead to concentrate on markets in which it is already successful. It says one-quarter of the new locations will be in markets it already operates.

Belaboring the point

Shake Shack is also facing rising costs, primarily on labor, which it partially created for itself by raising minimum starting wages. But soon it's going to be facing greater labor costs because local governments are increasing them, too. New York City, for example, will be raising the minimum wage to $15 per hour at the end of next year. While Shack-level operating profit rose 20% year over year, operating margins crumpled by 110 basis points.

To get in front of it, Shake Shack is introducing self-ordering kiosks at a test site in New York, and while it will have a full staff that will make at least $15 per hour, it's easy to see how the introduction of automation will squeeze out the need for having high-cost labor on hand.

When comparable sales are falling, fewer customers are visiting, and the amount of sales each restaurant generates falls, keeping staffing levels static when machines can do the same job for less doesn't make sense.

Shake Shack's stock represents a value it doesn't deserve to have and sooner or later the market will cause it to revert to a more appropriate lower level.

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Rich Duprey has no position in any of the stocks mentioned. The Motley Fool is short shares of Shake Shack. The Motley Fool has a disclosure policy.