SHAKE SHACK (SHAK) -DOWN 14% on 2/25/20, JUSTIFIED ?? – UPDATED WRITEUP
We have written about Shake Shack often over the last several years, invariably praising management for the admirable operating culture that they have created, and have most of the time (more on that) sustained. We suggest you use our SEARCH function on our Home Page for a more complete discussion. In a nutshell, Shake Shack continues to be a fine expansion vehicle, generating a return on investment substantially in excess of the cost of capital. However, aside from the valuation of the stock, which we have always had trouble with, this is not the concept it was five years ago. At the IPO, AUVs were around $5M, generating almost $1.5M of store level EBITDA, an obviously handsome return on $1.8-2.0M invested. Today the stores still cost $1.8-2.0M, but new stores are doing about $3.0M, generating something like 20% EBITDA (probably not at first), still attractive but not what it was and not rationally worth 100x expected earnings. Management is dedicated to continued very rapid growth, which we have predicted would result in substantial inefficiency, to say the least. That is no doubt coming into play, whether as a result of tough comp comparisons, labor shortages, new product missteps, “volatility” from a transition to Grubhub, or even something like the coronavirus. I’m not a a Board member here, but I would have suggested (and I have… here) : “WHAT’S THE RUSH?”. Everybody is already there ahead of you: MCD, BK, WEN, and others. Shake Shack is special, will be greeted warmly as long as operating standards don’t deteriorate, which might be happening as we speak with the strain of an unprecedented expansion rate. You don’t have to grab market share, it’s there waiting for you, and, in the meantime, you retain your cult status. FWIW.
Famously founded by Danny Meyer’s Union Square Hospitality Group in 2001, Shake Shack has been a Wall Street darling since its IPO in January, 2015, SHAK stock consistently selling at the highest valuation among restaurant stocks. CEO Randy Garutti has built an admirable operating culture, at the same time rapidly expanding the brand worldwide. There’s a great deal that could be recounted in terms of describing the culture, but the pillars, as described in the 10K are “Putting Our People First, Creating a Winning Guest Experience, Engaging the Community, and Operating with Purpose.” The system of stores has expanded rapidly from a modest 31 company operated stores at 12/31/2014, 10 of which were located in New York City, doing $7M in annual unit sales, with systemwide store level EBITDA margin at 28.9% in 2015. Five years later, at 12/31/19, there were 163 company locations and 22 licensed locations operating domestically plus 90 licensed international locations. Both company operated and licensed units have been expanding at a rate in excess of 30% annually. The Company expansion rate will be slightly below 30% in the current year. We have suggested repeatedly that there will be inevitable inefficiencies with such rapid expansion. To their credit, management has wisely supported this aggressive expansion rate with a high level of administrative support, but this has precluded the “leveraging” of very rapidly growing systemwide sales into higher operating margins. Store level AUVs have, as management has continuously warned, come down to the range of $3M at new locations, bringing systemwide AUVs to $4.090 in 2019, projected to be $3.7-3.8M in 2020. Store level EBITDA margins have also, as predicted, come down to 22.5% systemwide in 2019, projected to be stable at approximately that level in 2020. The rapid growth continues, with 40-42 new company locations and 20-25 licensed units projected to open in 2020.
UNIT LEVEL ECONOMICS COMMENTARY:
We have included more information than we usually do, since the five year summary provides the most vivid picture of the operating trends. Management has continuously guided to lower AUVs and lower store level margins. They have also been consistent in describing the continued heavy G&A support. We have time and time again described how the cash on cash return on investment has been deteriorating over the last five years, as the investment has stayed relatively constant, but the store level margins have come down so consistently. The reality is that, based on management’s guidance, not much, in terms of the above parameters (AUVs, store level EBITDA, G&A leverage, etc) is predictably going to change for the better.
The addition of international licensed units in 2019 is net of exiting the Russian market. Expectations are for 40 to 42 new company operated locations and 20 to 25 new licensed locations in 2020.
SAME STORE SALES COMMENTARY:
Since there have consistently been menu price increases of approximately 2% annually, traffic has been modestly negative the last several years. The template at the beginning of this article shows quarterly same store sales trends.
RECENT DEVELOPMENTS: per Q4 earnings release and conference call
Sales and margins were disappointing in the fourth quarter, with comps down 3.6%, including a 5.4% decline in traffic. The single most obvious culprit was the “volatility”, as described by management, caused by the switch to Grubhub as the sole third party delivery agent. That transition is about half completed at this point. An unfavorable weather comparison, against good weather last year in the northeast, was also cited. Store level margins also disappointed analysts, with EBITDA at the store level down 210 bp to 20.4%. Cost of goods was 80 bp higher due to higher costs of Chick ‘n BItes, mid-single price inflation of beef , slight inflation in dairy, an increase in paper costs and additional packaging relating to the delivery effort. Labor related expenses were up a relatively modest 20 bp to 28.7%, offset by Other Operating Expenses which were down by 30 bp. Occupancy and related expenses were up a more material 150 bp, driven by the adopton of new lease accounting treatment. Below the store EBITDA line, G&A was up 50 bp to 12.7% and Depreciation was up 90 bp to 7.4%. Adjusted Corporate EBITDA, a non-GAAP measure, was up 2.3% to $14.8M, and Adjusted pro forma net income was $2.2M, or $0.06 per share.
Guidance for 2020 included Revenues of $712-$720M, a 20.5% increase at the midpoint, a low single digit decrease in same store sales, 40-42 new company operated locations 20-25 new licensed sttorese, AUVs for company stores of $3.7-$3.8M (vs. $4.09M in 2019), G&A up 23.4% at the midpoint (more than revenues), depreciation up 31.0% at the midpoint (more than revenues), pre-opening expenses of $14.8M (slightly less than $14.8M in 2019). Store level margins were guided to the area of 22.0-22.5%, approximately the same area as in 2019. Hope was held out that completion of the Grubhub transition could benefit margins, but this seems difficult to document at this point. A great deal of the conference call was devoted to discussion of the transition to Grubhub, but there were no particular conclusions drawn as to exactly when the halfway done effort would be completed, or what the ongoing economic effect would be. Management mentioned several times that they are in the middle of a learning process..
Since there is not much likelihood of materially better store level expenses, and G&A and Depreciation are expected to grow faster than revenues, it is difficult to see how bottom line corporate margins can improve much. That, combined with the very high valuation, is no doubt why the stock is trading down 13-14% this morning.
CONCLUSION: STATED AT THE BEGINNING OF THIS ARTICLE