SHAKE SHACK REPORTS Q1’18 – STOCK UP 25% – WHAT’S GOING ON?

IN A NUTSHELL:

36% of the stock float was sold short, so the numbers came through “adequately”, and the stock didn’t go down, so the short term traders panicked, covered their positions and drove the stock higher.

Before we look at the facts, we must restate that there is no publicly held restaurant company that we hold in higher regard than at SHAK. However, the Company is one thing, and the stock is another.

HIGHLIGHTS OF Q1’18:

Comps were up 1.7%, price and mix were important so store level traffic was down 4.2% (on top of a negative 3.4% Q1’17. Factoring out a promotion in Q1’17 traffic was still down 2.2%. Weather was a negative factor in Q1’18 but delivery pilots and an early Easter helped a bit.  The table that follows shows line by line performance over the last three years, as well as Q1’18.

As shown in the table above:

As predicted since SHAK came public, average weekly sales for domestic  company operated shacks continued lower, at $81,000, down 6% YTY. Trailing twelve month AUVs were $4.5M, down $100,000 from the prior quarter. This latter number is predicted to be $4.1 to $4.2M for all of ’18. Store level “operating profit”, store level EBITDA in essence, was 25.0% of store revenues, up 28.5% on a 29.6% increase in shack sales so store level EBITDA contracted 30 bp. CGS was down 50 bp, Labor was up 20 bp, Other Operating Expenses were up 90 bp to 11.2%, Occupancy and Related expenses were down 30 bp to 8.0%. Below the store level EBITDA line: G&A was up 90 bp to 11.9%, Depreciation was up 40 bp to 6.6%, Pre-opening was down 110 bp to 2.0% (with unit expansion back loaded in ’18). Operating Income was up 15.7% (on an increase in Total Revenues of 29.1%). Income Before Taxes was up 15.7%, down 70 bp to 6.6%. After taxes at 19.4% (vs. 30.0% in ’17), Income After Taxes was up 28.9%. The summary is that the stores controlled costs rather well in a difficult sales (and traffic) environment, the corporate burden was higher, and lower taxes salvaged the quarter’s bottom line.

Investors, of course are primarily concerned about the future. Growth is continuing at what we think is accurately described as a “breakneck” pace, with 32-35 new domestic company locations to be opened in calendar ’18 on a base of 90 at 12/31/17.  Company guidance was essentially “maintained” for ’18. Aside from the new openings, total Revenue expectations was raised by a nominal $2M to a range of $446-450M. Licensing revenue is expected to be $12-13M vs. $12.4M in ’17. In terms of line by line expectations, as shown in the table above, under “Guidance”, Same Shack Sales are now guided to 0-1% positive vs. “flat” previously. AUVs, as indicated earlier will be $4.1-$4.2M for ’18, vs. $4.6M in ’17. Store level EBITDA  will be 24.5%-25.5% (affected by the new lower volume units), vs. 26.6% in ’17. G&A will be $49-$51M (plus $4-6M for “Project Concrete”) or 11.1% (plus 1.1%) of Total Revenues. Depreciation will be about $32M (7.1% ). Pre-Opening will be $12-13M (2.8%). Adjusted Pro Forma effective tax rate will be 26-27% (vs. 30.0% in ’17 and 19.4% in Q1’18.

THE FUTURE

Putting this all together for ’18, the Street estimates range from $0.54-$0.57 per share. Growth will be there, but operating leverage will likely not take place either at the store level or after the corporate support. The more interesting part of the exercise takes place in calendar ’19 and beyond. The Street estimate for ’19, according to Bloomberg, is $0.735 per share, up 35% from $0.543 in ’18. While the Company has not provided formal guidance for ’19, analysts must be expecting margins to be maintained from ’18 to ’19, both at the store level and the corporate level. We consider this to be possible, but far from a sure thing.

Looking at the income statement, line by line: Comps may or may not be flat to up in ’18 or further out, which would of course affect the entire equation. After an astounding rise in late ’15 and early ’16, the sales and traffic picture has been challenged. McDonald’s has gone to fresh beef, and Shake Shack is not quite as rare a phenomenon as it was a few years ago. The competition, in beef and otherwise, is not standing still. As shown in the table above, The CGS line has been very well controlled in the area of 28%, but is unlikely to come down materially. Labor is another story, most likely to move higher and the recent test of a “cashier-less” store has apparently not been a resounding success. Other Operating Expenses have moved steadily higher. Occupancy and Other had a downtick in ’17 and Q1’18 but we see no reason that rents, etc. will come down. The increase in D&A from the mid 5% area to the mid 6% area over the last three years has more than offset the decline in Occupancy and the Company has guided to a new high of 7.1% of sales in ’18. The Corporate Burden, recently running at 11.9% is not coming down in ’18 vs ’17 (at 11.1% +1.1% for “Project Concrete”) and it remains to be seen whether it comes down as a percent of sales, even in  ’20, let alone ’19. When questioned on the conference call about G&A “leverage” in ’20, management responded: “I think we’re in such an early stage of our growth journey, the right thing for us to do right now is to be focused on that 3 yr. and then longer term target…..and investing across the business to  make sure we’ve got a strong foundation to execute against those plans. Longer term, sure, further down that growth journey, we would expect to be delivering some G&A leverage…. and so you will continue to spend where we believe it makes sense.” Our conclusion: G&A leverage is unlikely for the next two years at least. Store level margins are more likely to contract (more than projected) than expand as a result of labor pressure, higher occupancy and other store level expenses. Below the store level EBITDA line, depreciation is increasing which lowers GAAP results.  We shouldn’t ignore the potential for licensing revenues to grow substantially, but this implies an ongoing G&A burden as well (which should leverage over time).  Over the next few years, the expense of flying a dozen trainers to Hong Kong and other overseas locations offsets the licensing income for a while.

THE STORE LEVEL MODEL – THE DIFFERENCE BETWEEN THE PAST AND THE FUTURE

We can all look back fondly to the prospectus of early ’15, describing store level economics from calendar 2013. Manhattan AUVs were $7.4M, with store level EBITDA of approximately 30%. Non-Manhattan shacks averaged $3.8M with EBITDA of about 22%. The store level “cash on cash returns” were 82% and 31% respectively. It is unclear whether that calculation included pre-opening expenses as part of the cash “investment” and most restaurant companies these days, including SHAK do not. It is interesting that the original prospectus provided guidance very much in line with today’s expectations, namely that “since the vast majority of future shacks will be non-Manhattan locations, we are targeting AUVs in the $2.8-3.2M range, with operating margins in the 18-22% range and cash on cash returns of 30-33% (in line with the 31% pre-’15 history).

The future, that investors are buying into, consists primarily of non-Manhattan stores, augmented to be sure by licensing revenues all over the world (averaging $3.1-3.2M annually so far). Relative to all important unit level economics, the latest description of investment per store, per the 2016 10-K and 2017 10-K are as follows

Per the 2016 10k – “in fiscal 2016 the cost to build a new Shack ranged from $1.2 to $3.4M, with an average near-term build cost of approximately $1.8M, excluding pre-opening costs.”

Per the 2017 10k – “In fiscal 2017 the cost to build a new Shack ranged from approximately $1.1 to $3.3M, with an average near term build cost of approximately $1.7M, excluding pre-opening costs. The total investment costs of a new Shack in ’17, which includes costs related to items such as furniture, fixtures and equipment, ranged from approximately $1.7M to $3.7million, with an average investment cost of approximately $2.2M.

We don’t know why, in the 2017 10-K the Company chose to insert “which includes ….furniture, fixtures and equipment” . Also, we have found nowhere a distinction that the non-Manhattan store investment differs materially from those in NYC. Our assumption is that the costs are similar because the non-Manhattan locations we have seen do not look like cheap imitations. The sites are prime and the investment looks to be substantial.

The vast majority of new domestic Company operated shacks will be non-Manhattan and we will assume that they do $3.2M, the high end of the prospectus’ guidance (and also the high end of the most recent range of $2.8-3.2M company guidance).  If we use 22% store level EBITDA (which is also the high end of the store level EBITDA 18-22% guidance), that would throw off $704k annually. The total cash investment, including pre-opening of $400k would be $2.6M so the cash on cash EBITDA return would be 27.1% (32.0% without pre-opening). However, depreciation is still a GAAP expense, with good reason since stores must be maintained. 7% depreciation would subtract $224,000 from store level EBITDA, leaving $480k. An incremental corporate burden of a modest 4% or more would subtract another 128k, leaving 352k, before taxes. $352,000 of “G&A burdened” GAAP store level profit (after depreciation ) of 13.5% of sales, before taxes. This is obviously a long way from the 82% C/C in Manhattan and 31% C/C outside of Manhattan originally cited in the IPO prospectus. It is important to note that the above discussion relates to company operated locations, and licensees have a further expense. As cited earlier, since the average volume of existing licensees is reported to be in the $3.1-$3.2M range, which could move up (or down), it does not appear that the existing licensees around the world are minting money, at least not yet.

WHICH LEADS US TO: THE “SALES TO INVESTMENT RATIO”

Analysts and investors might well remember the age old “sales to investment” ratio, which originally was designed to provide a revenue comparison to the “gross” investment, including land, building and equipment. Since rent is an  “investment’ by the landord, that overhead must be carried by the operations, so rent expense should be capitalized and added to the cost of leasehold improvements, the equipment package, and even pre-opening expense. The theory is: no matter how skilled the operator is at leveraging his investment, with rent, equipment leases, or borrowing (think “build to suit”), the overhead in terms of occupancy expense must be carried, and that’s where the revenues come in. We assume that SHAK is paying rent of at least $200,000 annually for the high visibility sites outside of Manhattan, which capitalized at 10x (a 10% return to the landord) would imply a $2M investment in land, plus perhaps $2M in leasehold improvement and equipment ($2.2M in ’17, $1.8M in ’16), plus $400k of pre-opening expense, adding up to $4.4M of gross investment. Not too many analysts would say that $3.2M of anticipated revenues in non-Manhattan sites is fabulous when compared to the gross investment of  $4.4M (at least, because we suspect average rents are closer to $300,000 than $200,000, increasing the gross investment by an additional $1M).  This is  called leverage (provided in this case by landlords), and if sales come in 10-20% lower than expectations, the profit margin after depreciation will be negligible. Don’t forget about the “local G&A” and royalties for a franchisee and the incremental G&A burden for company operations. Maybe that’s why 163 franchised Applebee’s just declared bankruptcy. In good times, with a hot brand,  it all works, not so much as a brand matures, especially  in a difficult economy.

We hasten to add that the cash on cash calculations, incorporating the leverage provided by landlords, and ignoring depreciation, that Shake Shack presents is consistent with the way that most retailers present their “story”. We are trying here to separate reality, in terms of sustainable return on investment calculations, from  power point presentations. A major reason that a sales/investment ratio of so much less than 1:1 can “work” these days, when many companies ran aground with a sales to gross investment ratio no better than 1:1 is that today’s very low interest rates and very high equity valuations provide almost free capital for expansion, but “this too shall pass”.

ONE LAST “BROAD BRUSH” CONCERN

We know of no other restaurant company, at the size of SHAK, that has expanded company (as opposed to franchised) locations at a 35-40% pace on the existing base, not close to home, let alone nationwide and while supervising worldwide licensees as well. Management could say that going from 44 to 64 company operated units in ’16 and from 64 to 90 in ’17 was even tougher and it gets easier from here forward.  Rather than burden you with “war stories”, we will just say that we have heard that argument before. We are not predicting disaster, just unexpected inefficiencies and challenges, not fatal, just requiring periodic “adjustment”, therefore providing a substantial extra measure of current risk to this situation.

CONCLUSION

As you no doubt suspect, while we have the utmost respect for this management team, our conclusion is that SHAK is priced beyond “perfection” at approximately 100x ’18 projected EPS and perhaps 70x what we consider an optimistic view of ’19. If you like EBITDA as a measure, based on “Adjusted Corporate EBITDA” of $65B  in calendar ’17, the $2.2B market capitalization represents 33x TTM EBITDA. Especially considering that store level economics, while still more attractive than many other restaurant companies, are not as alluring as back in the day when Manhattan locations were annualizing at $7.4M and paying for themselves at the store level (before depreciation) in fifteen months. Management here is as good as it gets, but they are not magicians. This is still a people business, serving burgers, not providing a proprietary cancer cure.