SHAK came public at $21 a little less than 3 years ago, ran to a high above $90 in June of 2015, and has been in a trading range between $30 and $50 during 2016 and 2017. The stock was “fully valued”, to say the least, at $90.00 compared to the $0.32 per share reported in 2015 and $0.46 in 2016. It is obviously more rationally valued in the high 40s versus the Street estimate of $0.52/share in 2017 and $0.54 in ’18, which could turn out to be $0.65-.66 with the new tax bill. This leaves SHAK valued at about 70x a “tax adjusted” estimate of EPS in ’18. We hasten to point out that, in our mind, there is no other publicly held restaurant company that has more well regarded management, a better store operating model, and a virtually unlimited runway for future expansion. However, a number of the operating parameters (such as AUVs, store level margins, and EPS growth rate) are “coming down to earth” Furthermore, the very aggressive growth of company units (35-40% on the base) has its own set of risks. In fact, we can think of no other restaurant company, in the last thirty or forty years that has expanded from 90 to 125 or so high volume company operated stores, in diverse geographical markets, without a noteworthy degree of inefficiency (to say least). As admirable as this operating team is, we suspect that the Street estimates going forward will prove to be overly optimistic, that same store sales, AUVs, and correlating store level margins will be at least modestly disappointing. It therefore becomes a question of what the stock is worth, in terms of the current P/E relative to the expected, and the actual, growth rate of EPS and EBITDA over the next several years. The last time we opined, early in ’17, with SHAK in the low 30s, it was on our “watch list” as a potential buy. In the high 40s, with EPS growth in ’18 lower than it was, and what we perceive as continued operational risk from the unprecedented rapid expansion of company units, we consider SHAK fully valued. 70x expected ’18 (“tax reform adjusted”) EPS more than adequately values this fine management team, and the ongoing value of the Shake Shack brand.
SHAK: Company Overview (2016 10-K)) Q3’17 Release, Q3’17 Conf.Call
Shake Shack Inc. is a New York City-based chain begun as a hot dog cart in 2001, to raise funds to renovate a city park, by founder Danny Meyer, the legendary restauranteur and chairman of the Union Square Hospitality Group. At the end of 2016, SHAK (which came public in early 2015) operated and licensed 114 units in 16 states including Washington, D.C. and 13 countries generating system-wide sales of $403M. The company bills itself as a fine casual operator with a core menu featuring premium hormone- and antibiotic-free burgers, chicken and hot dogs, crinkle-cut fries and handmade shakes, frozen custard & specialty beverages. It also serves beer and wine.
SHAK devotes significant resources in the creation (including collaborating with top chefs) and testing of items to supplement its core menu with LTO’s and enhancements derived from seasonal and local products to provide novelty, drive return visits and also for brand awareness. For example, in April 2016, to promote the brand in the Washington DC, Maryland and Virginia area, the company teamed up with a celebrated chef of Chinese cuisine to offer “Crispy Peking Chicken” (crispy chicken breast, on a n LTO basis only in area stores. The company is also investing heavily in technology to provide customers with state of the art mobile conveniences.
Given the company’s commitment to all-natural proteins that are hormone- and antibiotic-free as well as vegetarian fed and humanely raised, which inherently has some of the same supply chain risks as Chipotle, the company stipulates it has established rigorous quality assurance and food safety protocols throughout its supply chain and that it further addresses its risks by limiting the number of suppliers for major ingredients. For example, in 2016 all beef patties were purchased from 7 suppliers (70% was purchased from one of them) and it has 10 butchers located throughout the country to produce burgers fresh daily. As to distribution to the stores, the company contracts with a single broadline distributor which is responsible for supplying over 80% of core food and beverage ingredients and all paper goods and chemicals to each Shack from 12 regional distribution centers.
Of the company’s $268.5M of revenues in 2016 96.6% was generated by the company’s 64 stores (all domestic), while the balance was licensing revenues from the 50 licensed units (7 domestic, 43 international). The company believes there is the potential for at least 450 domestic units. In 2016 the company units averaged $4,981K (down from $5,367K in 2012 (an average skewed by high proportion of Manhattan units with AUV’s>$7M). Indeed, the concept’s exceptional brand appeal, as evidenced by press and social media acclaim, has broadened its acceptance domestically and internationally. The company has continually predicted that AUVs would come down as more locations opened away from the original NYC region, and that has finally been the case during Q2 and Q3’17. Store level profitability, though still among the highest in the restaurant industry has, has come down as well, as expected, from an impressive 28.3% in calendar ’16. Shack units, which are all leased, average 3,000-3,500 sq ft (seating for 75-100) and require a cash outlay of $2.M including our estimate of pre-opening expense. In 2017 company earlier in the year planned 22-23 new units, year generating AUV’s of “at least $3.2M and Shack-level operating profit margins of at least 21%.” As it turns out, 24-26 company units will have opened, at those expected AUVs and store level profits. Even at these modest levels of productivity, materially lower than had been the case through calendar ‘16, cash-on-cash returns would be about 30%.
Considering the modest number of stores in the system, and as a public company for less than 3 years, its continuing robust unit level-performance, including locations far from its NYC roots, is probably the best current gauge of SHAK’s promise. The company’s heavy SGA and pre-opening expense, typical of an early stage enterprise, still weigh on margins. To this point, the consolidated EBIT and EBITDA margins in 2016 were only 10.4% and 15.8%, respectively, down from 11.0% and 16.4%, respectively, in 2015. Similarly, ROE, at 10.1%, while not all that impressive to date, is still expected to expand as a critical mass is reached that more efficiently carries the G&A structure necessary to support the rapid unit growth.
SHAK’s balance sheet debt includes $13.2M of deemed landlord financing (essentially capitalized lease obligations), $34.8M of deferred rent, and $2.6M of other long term liabilities, against $231.8M of equity. The company also has a $280.1M tax liability payable on behalf of its pre IPO Series B shareholders as they convert their shares into Series A shares. SHAK is financing its rapid growth (24-26 company stores in 2017) internally which consumes virtually all its cash from operations together with cash on hand.
Shake Shack came public on 1/29/15, selling 5.75M shares at $21.00 per share. The stock traded, parabolically, to over $90.00 by May’15, came down to $30.00 in early ’16, has traded in a range from the low 30s to low 40s since, before breaking out to the high 40s recently. A secondary offering was done on 8/12/15, 4.0M shares for selling shareholders, at $60.00/share. There is no dividend. There has been very consistent “insider” selling from late ’15 to the present.
SHAK: Recent Developments: Per Q3’17 Earnings Release, New Slide Deck, Conf. Call
In its Q3’17, SHAK generally met expectations for revenues, comps and EPS, though not “surprising” on the upside to the extent that it has often done in its first two years as a public company. Company revenues grew 26.9% YOY on a negative 1.6% comp (on top of a positive 2.9% in “16Q3 and what will be 38-41% company operated unit growth in ‘17. Since stores don’t enter the comp base until 2 years after opening, the comp base is small (only 39 of 89 US company stores). Traffic in Q4 was down 3.8%, offset by price increases of 2.2%. This pattern of higher ticket and slowing traffic is consistent with the industry, but in SHAK’s case the price increase has been relatively modest with the ticket mix boosted by premium LTO’s. AUVs for domestic company operated Shacks decreased noticeably, for the second quarter in a row, to $91,000/week, versus $103,000 in Q3’16. Shack level EBITDA decreased 160 bp to a still admirable 27.2%. In terms of “prime costs”, CGS was down 10 bp to 28.3% in Q3, Labor was up 80 bp to 26.1%. Other Operating expenses were up 90 bp to 10.1%. Occupancy and Related expenses were down 10 bp to 8.3%. Below the store operating line, G&A was down 90 bp to 9.7%. The Company continues to point out that the averages have likely been boosted by units opened in high density markets, and continues to guide to $3.2M annually for upcoming units.
Adjusted pro forma net income was up 13.1% in Q3’17. Adjusted EBITDA was up 19.9%, Net Income A.T., increased 15.7%, all less than the revenue increase of 26.9%, as a result of lower store level EBITDA margin. At the unit level, labor costs have been up all year because of increases in the compensation structure implemented at the beginning of the year. The company proudly proclaims it already pays above current and minimum wage levels, a policy that allows it to attract and retain high caliber employees.
Management raised guidance slightly for FY17 revenues to $354-355M-$353M, as a result of extra openings, more than offsetting slightly lower comps.They also increased the guidance for licensed openings in ’17 to 18, up from 15 previously. They guided to store EBITDA of 26.5-27.0%, 50 bp lower on the top of the range.
Preliminary, and partial, guidance for ’18, included 32-35 new company domestic openings and 16—18 licensed stores, 36-40% and 24-26% on the respective base. AUVs of the new stores are guided at $2.8-3.2M, but management confirmed that both classes of ’16 and ’17 are annualizing above that range. During the conference call discussion, management confirmed that store level labor will continue to rise, modest price increases will likely be offset by traffic headwinds, cost of goods will deleverage slightly, short term at least. Below the store level EBITDA line, higher technology expense (the mobile app, ordering kiosks, etc.), training and other pre-opening expense, the bi-ennial manager retreat, a new corporate office, and “materially higher” depreciation expense will drag on bottom line results. As management put it, “across the board, it is a year of investment”. As indicated in our conclusion, this discussion leads us to believe that margins, at the store level and bottom line, are more likely to be lower than higher.
The conference call discussion included:
- 20% of new company stores in’18 will be in new markets, and in various formats: 1/3 urban, 1/3 free standing, and 1/3 in premier mall/lifestyle centers.
- The licensing program, with premier partners abroad, is especially successful in South Korea and Japan, less so in the Mideast, with new arrangements in Hong Kong, Macau and Shanghai.
- Innovations include split kitchens to get more throughput, kiosk only cashless approach (at Astor Place in NYC), ongoing mobile app development and emphasis, delivery pilots with DoorDash and Caviar.
- Corporate office moving, with a new innovation center for menu creation and kitchen design.
- There was discussion of new disclosure, by region, of AUVs and store level margins. Basically, the $5.0 AUV generates 28% store level EBITDA margin, 56% C/C first year return, 78% thereafter. Even at $2.8-$3.2M AUV, there is an 18-22% store EBITDA, with 14% C/C in year 1 and 34% thereafter. The point the company makes: even at the lower AUVs, which may apply to many new stores, the long term returns are excellent. Whether that is enough to satisfy analysts, at 60 or 70x expected earnings, remains to be seen.
Overall, we consider SHAK to be one of the best managed companies in the fast (or “fine”) casual restaurant segment, especially considering their relatively early stage which includes almost unprecedented unit growth of company stores. The “culture” is in place, but is not taken for granted by management. When unit level growth is so high, we suggest that many expenses are shuttled (or arbitrarily allocated) between unit level and corporate support. For example, trainees (charged to pre-opening) help out in existing stores (possibly reducing hours for more experienced crew), supervisors (charged to corporate) spend a lot of time in relatively young locations. The result of these examples would be store profits overstated, offset by higher pre-opening and higher corporate G&A. A “steady state” situation is not really in place, but in this case, no matter how expenses are allocated, the 9 months of 2017 pre-tax operating income, at $28.0M, or 10.7% of revenues, with corporate EBITDA at 16.6% is an admirable starting point from which to leverage the situation over the long term. Store level margins have become to come down, with the expected lower volumes at new stores, but the G&A percentage against higher overall sales will no doubt be leveraged over time, though possibly not in ’18. Licensing revenue of $9.1M for 9 months of ’17 certainly helps, but there was no doubt material G&A expense against that contribution and licensing income is not going away. Putting it all together, we can’t think of another restaurant company, over the years, that has produced results this impressive at a similar stage.
SHAK stock is a somewhat different discussion. See our comments above for our current conclusion.