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SHAKE SHACK REPORTS Q3 – STOCK DOWN 19%, WHAT TO DO NOW ?

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SHAKE SHACK REPORTS Q3 – STOCK DOWN 19%, WHAT TO DO NOW ?

GAAP earnings per share were $0.31 vs. $0.17 for the quarter, $0.70 vs $0.56 for nine months. Just fine, right ? Comps for the quarter were up 2.0%, a fraction of a point light, but 1.2% of the gain was traffic, which is better than many peers. Unit growth of company stores and licensed locations is meeting expectations. So what’s the problem ?

First, it’s the unit level economics, which has been coming down to earth, as management has long predicted. Secondly, and probably  most important, an unprecedented (for SHAK) level of uncertainty as to how comps and margins are going to develop over the the foreseeable future.

Before going into the details, we refer readers to our multiple warnings here (use the “Search” function on our home page). We are most proud of our mile high overview: We can recall no restaurant company, over our four decades of industry involvement, that has expanded company stores at a 35-40% rate without major inefficiencies, at the very least. There are lots of issues, from that standpoint, here, but it seems like the state of flux within the third party delivery area has combined, in a material way,  with the predictable pressure of growing a system so quickly. It’s been said many times, how a crisis develops: “very slowly and then very quickly”. This is not a crisis in terms of SHAK’s survival, but it is in terms of the credibility necessary to maintain a price earnings multiple over a hundred times expected earnings.

Some operating details: While diluted EPS was up, for both three months and nine months, Operating Income and Income Before Taxes was down. Above those numbers, almost every operating line item was worse for both the three months and nine months. For the three months: Food and Paper costs were up 80 bp to 29.0%, Labor was up 30bp to 27.3%, Other Operating Expenses were up 80bp to 12.4%, Occupancy was up 80bp to 8.2%, G&A was down 20bp to 10.8%, Depreciation was up 40bp to 6.6%. Average weekly sales was 80k per week, down from 86k. Shack level Profit Margin (EBITDA) was down 270bp to 23.1%. Corporate Adjusted EBITDA margin was down 300bp to 14.8%.

Equally important to the deterioration in store level, and corporate, margin was the revision of guidance, seemingly minor in magnitude, but crucial when a stock valuation is so high. For the full ’19 year, store level margin was lowered to 22.0 to 22.5%, from approximately 23.0% and comp sales were guided to about 1.5% from about 2.0%. Especially since the year is so far along, a modest change in the year’s guidance implies a materially weaker Q4.

On top of all the above, management, on the conference call, described the uncertainty related to transitioning to the strategic partnership with Grubhub, further investment in the digital/mobile technology, an ongoing Project Concrete investment (mostly capitalized), the effect of cannibalization, likely higher commodity costs, predictably higher labor costs, the absence of G&A leverage through ’20 and ’21.

All of this contributes to the likelihood of minimal earnings progress over the next year or two. Considering that ’19 has been an “investment” year, and the likelihood that, in spite of continued major unit growth,  ’20 and ’21 may not be much different, reality seems to be setting in among analysts and investors.

In the interest of getting this summary to our readers in a timely fashion, we will leave it there. We encourage interested readers to read the full earnings call transcript, as well as our previous commentary on this subject.

THE STOCK

In terms of SHAK stock: Considering that the EPS consensus estimate for 2020 (per Bloomberg, at the moment) is $0.66 per share (and that may be reduced further), vs. $0.65 in 2019, down from $0.71 in 2018.  SHAK, trading down 19% as this is written, at about $68,  is still about 100 times next year’s EPS. Combining the now evident uncertainties with the reservations previously described in our writings, SHAK seems to be, still, far from a bargain price.

Roger Lipton

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SHAKE SHACK (SHAK) STOCK UP 16% – SHOULD YOU CHASE THE BREAKOUT? – UPDATED WRITE-UP

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CONCLUSION: provided here, repeated from report dated 3/22/19 (provided in entirety below). No difference, except SHAK is $86 instead of $55.

SHAK came public at $21 a little less than 3 years ago, ran to a high above $90 in June of 2015,  “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 somewhat more rationally valued today versus the Street estimate of $0.60/share in 2019. We point out, once again, that, in our mind, there is no other publicly held restaurant company that has more well regarded management, a still attractive store level 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”. Most noteworthy, as we point out below, the cash on cash EBITDA return on investment for stores currently being developed, is less than half of what it was in calendar 2016, in the wake of the 2015 IPO. This should be no surprise, and correlates to the deterioration of the Sales;Investment Ratio, as detailed at the end of this article.  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 at this rate 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 continue to be overly optimistic.  We consider the Shake Shack brand and its fine management team more than adequately valued at over 90x expected ’19 EPS and 33x trailing EBITDA.

Q2’19 – RECENT DEVELOPMENTS: Per Q2 Reported Earnings Release and Conference Call

The second quarter was released on Monday, August 5th, and SHAK is trading up over 15% on Tuesday, which can most accurately be termed a “relief rally”, with long term growth prospects overcoming operating parameters that are in almost all cases contracting. The single most significant operating result that was above “expectations” was same store sales, up 3.6%, within which traffic grew 1.3%. As a result, SSS guidance for the year was raised from “1 to 2%” to “approximately 2%”. That is not surprising, since 3.6% was also reported in Q1, and therefore implies a slowdown to not much more than “flat” in the second half. Management noted that the 1.3% traffic increase was positively impacted by the timing of Easter as well as continued strength in digital channels.  More on sales expectation for the year, and beyond, later.

In summary: Total Revenues increased 31.3%. Company Store Sales increased 31.0%. Licensed Revenues increased by 42.9% (representing 3.2% of total Revenues). Average weekly sales for domestic company-operated stores decreased (as expected) to $85,000 from $89,000 in Q2’18. Operating Income decreased to $11.9M from $13.0M. Shack level operating profit (EBITDA) increased 13.7% YTY but decreased as a percentage of Shack sales 380 basis points to 24.4%. G&A expenses increased to $15.4M from $12.6M, decreasing as a percentage of sales from 10.8% to 10.1%. Net Income Before Income Taxes was $12.2M vs $12.8M. After lower taxes, Net Income was $11.1M vs. $10.6M. After income attributable to non-controlling interest, Net Income Attributable to Shake Shack, w as $9.0M vs $7.6M. Diluted EPS was $0.29 vs $0.26. Interestingly enough, Adjusted Pro Forma Net Income, adjusting for reallocation of non-controlling interest and normalizing taxes, was down to $10.2M vs $10.9M for Q2, and was down in the first half of ’19 to $15.2M from $16.6M. These summary numbers are the result of continued very rapid expansion of locations, including international licensing, and installation of an infrastructure (including Project Concrete) to support this growth.

In terms of changes in guidance: Other than a slight uptick in SSS expectations(to be expected after 3.6% in Q1 and Q2), company openings are now expected to be 38-40 (instead of 36-40), licensed openings are to be 18-20 (rather than 16-18), and shack level EBITDA margin for all of ’19 is now expected to be close to 23% rather than a range of 23-24%. For context, the first half of ’19 generated an EBITDA Shack margin of 22.9% so the second half is not expected to show any material improvement in this regard. Company operated AUV is expected to be at the higher end of the previously provided $4.0-4.1M range for the full year.

The quarter, and expectations, line by line:

Food and Paper Cost were up 90 bp to 29.0%, partly because of Chick’n Bites, lapping about 30bp of non-recurring benefit in ’18. Was 50 bp better than Q1’19. Will improve a little in Q3 vs. Q2. Increased delivery creates higher paper and packaging costs. On balance, no reason for improvement in Q3 & 4.

Labor and related expenses were up 90 bp to 27.7%, better than Q2, and will improve further in Q3 vs. Q2. No reason for improvement YTY in Q3.

Other operating expenses were up 40 bp to 11.3% -primarily delivery commissions and marketing expense. No reason for improvement in the near term.

Occupancy and Other expenses were up 140 bp to 8.0%, lapping a 70bp non-recurring benefit from ’18. 70 bp  was a result of non-cash deferred rent adjustment. No reason for improvement to come, YTY.

G&A expenses were $15.4M vs. $12.6M, down 70 bp to 10.1%, $500k of Project Concrete was expensed, ($500k also in Q1) and $2.3M (160 bp) of Project Concrete was capitalized. Operating Expense of Project Concrete will be $3-3.5M for all of ’19, with an additional $4.5-5.0M capitalized (was quoted as approximately $4.0M at the end of Q1). So Second Half will carry Project Concrete “expenses” of $2-2.5M vs $1.0M in H1. With more Project Concrete expenses (as well as capitalized items) to come, no reason to expect leverage against sales, especially with SSS to be less impressive in H2 than H1.

Depreciation expense was up 40 bp to 6.4%, no reason for improvement to come.

Income Tax Expense was down 120 bp to 0.7%, will revert back to projected 26-27% in H2.

Per Q2’19 Conference Call: Regarding Same Store Sales expectations:

Discussion on the conference call involved the planned rollout of the partnership with Grubhub, the potential handoff to Grubhub in various markets, and the potential effect on SSS. Also, relative to SSS comparisons: “We do expect to see some volatility in our delivery sales in the remainder of the year. Sales comparisons get tougher in the fourth quarter as we lap strong digital channel performance, in particular delivery”, and a positive impact from weather during the busy holiday period.”

Relative to licensed locations, their SSS expectations and potentially AUVs which will in turn affect licensing revenues: “we expect to see the impact of some more acute honeymoon decreases in a number of these Shacks in 2020…..including Shanghai, Singapore, the Phillipines and Mexico that we expect to come down in the next year”.

Domestically, pertaining to AUVs and Same Store Sales: “As we look toward the back half of this year, we will be lapping may of our 2018 first to market openings, which may have a greater impact exiting the honeymoon periods than is typically experienced.”

Regarding Project Concrete in 2020, “With continued investments in 2020 as we add modules and broaden the scope of this important infrastructure upgrade…..it is important to note that we are still very much in the investment stage of our long term growth journey. Suffice to say that strong sales delivering G&A leverage in 2019 is not a trend we necessarily expect to mirror in 2020….particularly while we see so many opportunities for strategic reinvestment ahead.”

CONCLUSION PROVIDED ABOVE (AND BELOW)

Roger Lipton

FULL REPORT FROM 3/22/19 FOLLOWS:

CONCLUSION – as of  3/22/19

SHAK came public at $21 a little less than 3 years ago, ran to a high above $90 in June of 2015,  “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 somewhat more rationally valued today versus the Street estimate of $0.60/share in 2019. We point out, once again, that, in our mind, there is no other publicly held restaurant company that has more well regarded management, a still attractive store level 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”. Most noteworthy, as we point out below, the cash on cash EBITDA return on investment for stores currently being developed, is less than half of what it was in calendar 2016, in the wake of the 2015 IPO. This should be no surprise, and correlates to the deterioration of the Sales;Investment Ratio, as detailed at the end of this article.  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 at this rate 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 continue to be overly optimistic.  We consider the Shake Shack brand and its fine management team more than adequately valued at over 90x expected ’19 EPS and 33x trailing EBITDA.

Postscript – There has been some recent publicity relative to an experiment at SHAK regarding a four day work week for store level employees. Based on management’s public statements, it is premature to make a judgement, would apply to store management (rather than hourly employees) to allow them to have more of a “life”. With more details yet to emerge, this initiative seems to be an admirable corporate objective but we doubt that it will have a material positive impact on the cost of labor.

COMPANY BACKGROUND

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 2018, SHAK (which came public in early 2015) operated and licensed 208 units (up from 63 in 2014, 35% compounded) in 26 states including Washington, D.C. and 13 countries generating system-wide sales of $671M. 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. During 2018, a new premium burger or chicken item was featured throughout. Individual items were Griddled Chick’n, Smoked Cheddar BBQ items, Hot Chick’n, and a Trio of Featured Shakes. Additionally, new items are inspired by local favorites and special events, such as: Veggie Shack, BBQ Pulled Pork, Chick’n Bites, Montlake Double Cut burger in Seattle, the Golden Gate Double Shack for the Palo Alto opening, and customized Concretes for individual markets. The company is also investing heavily in technology to provide customers with state of the art mobile conveniences.

The company continues its 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. It has established rigorous quality assurance and food safety protocols throughout its supply chain and it further addresses its risks by limiting the number of suppliers for major ingredients.  For example, in 2018 all beef patties were purchased from 8 suppliers (56% was purchased from one of them) and it has 8 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 84% of core food and beverage ingredients and all paper goods and chemicals to each Shack from 19 regional distribution centers.

Of the company’s $459M of revenues in 2018, 96.9% was generated by the company’s 124 stores (all domestic), while the balance was licensing revenues from the 84 licensed units (12 domestic, 72 international).   The company believes there is the potential for at least 450 domestic units. In 2018 the company units averaged $4,390K (down from $4,598K in 2017 and $5,367K in 2012, skewed by the 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 ’17 and ’18. Store level EBITDA profitability, though still among the highest in the restaurant industry has, has come down as well, as expected, to 25.3%from an impressive 28.3% in calendar ’16. Shack units, which are all leased, average 3-4.000 sq. ft (seating for 75-100) and require a cash outlay of $2.55M including our estimate of $350k of pre-opening expense.  In calendar 2018, 49 locations opened systemwide, growth of 31% on the base of 159. In calendar 2018, 34 company opened domestic stores opened, 38% on the base. As described later in this report, restaurant level EBITDA returns are materially lower, as a percentage of sales and in terms of cash on cash returns, on stores being built today than those in the base when SHAK came public in early 2015. Comp sales have been virtually flat over the last two years, with traffic down by several points, but only 61 locations, out of 84 domestic company stores are in the comp base as of 12/31/18.

SHAK’s balance sheet debt includes $87M of cash and marketable securities, $20.8M of deemed landlord financing (essentially capitalized lease obligations), $47.9M of deferred rent, and $10.5M of other long term liabilities, against $273.4M of equity.  The company also has a $197.9M 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 internally which consumes virtually all its cash from operations together with cash on hand.

SHAREHOLDER RETURNS:

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, traded in a range from the low 30s to low 40s until mid ’18 when it broke out to a high near $70, traded back down to $40 by Dec’18 and has recently firmed up into the mid 50s. 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.

RECENT DEVELOPMENTS – 2018 REPORT – MATURATION, AS PREDICTED

Shake Shack recently reported their fourth quarter and year. It was very much as management had predicted, reflecting modest same store sales gains, cost pressures at the store level as well as continued high administrative expense level to support very rapid expansion. New locations, heavily weighted in Q4, opened at strong levels, which held the year’s AUV of domestic company operated locations at $4.39M, down from $4.598M, about 100k higher than the previous guidance. We should interject here that this “beat” might have been at least partially the result of heavy openings (17 out of 34 for the year) in Q4, including the honeymoon effect of 17 out of 124 total stores in the year’s AUV.

Rather than dwell on Q4, which followed the trends of the individual quarters, the full year’s result is probably most informative. 34 domestic company stores were opened against a base of 90. Same shack sales were up 1.0% and traffic was down about a percent. Shack level profit (EBITDA) was 25.3% of sales, down 130 basis points YTY.  AUVs were down 4.6% to a still impressive $4.39M. For the year, Cost of Goods was down 10 bp to 28.3%. Labor was up 110 bp to 27.4%. Other Operating Expenses were up 130 bp to 11.6% partially offset by Occupancy Expenses which were down 80 bp to 7.3%. G&A expense was up 60 bp (not “leveraging” yet), and depreciation expense was up a noteworthy 30 bp to 6.3%. Pre-opening expense was constant at 2.7%, averaging about 350k per store. Pretax Operating Income was down, $31.7M (6.9% of revenues) vs. $33.8M (9.4% of revenues). Diluted EPS was $0.52 per share, not comparable to last year (with its adjustments).

Following the above numbers, management presented “adjustments”, which brought the “adjusted pro forma net income” to $0.71 per share.

Rather than itemize the adjustments, we think it is more productive to focus on the store level operating metrics. New stores, as predicted, are opening at levels closer to $3M than the current $4.4M domestic company AUV. Store level EBITDA of new stores is closer to 20% than the 25.3% of ’18. Accordingly, management is guiding, for ’19, to AUVS of 4.0-4.1M, with store level EBITDA of 23.0-24.0%. This guidance could prove to be conservative, but realistic expectations is lower relative to past years. This is a result of guidance, including total revenues up 28-29%, SSS of 0-1%, including 1.5% price. There will be a continued aggressive opening pace (36-40 new company openings plus 16-18 licensed), G&A of 66.4-68.2M, up 26-29% (leveraging slightly against the revenue gain), depreciation expense up 40% or more (higher investment per store?), pre-opening expense of $13-$14 M (a constant 350-360k/store).

Relative to Q4’18 and ’18 as a whole, and implications for ’19 and ’20, our bottom line is that, based on cost expectations at the store level, corresponding lower store level margin, combined with ongoing corporate spending to support the aggressive growth plan, it will be hard for SHAK to show improvement in net income per share. Of course, we are of the old school, unable to lose (we almost wrote “shake”) our attachment to Generally Accepted Accounting Principles.

Our contribution to the dialogue is that, while the revenues per store have been, as management predicted, coming down, the investment per store is going UP.  The following three short paragraphs are copied from the ’16, ’17 and ’18 10k filings.

 Construction: per the ’16 10K

“A typical Shack takes between 14 and 16 weeks to build. In fiscal 2016 the cost to build a new Shack ranged from approximately $1.2 million to $3.4 million, with an average near-term build cost of approximately $1.8 million, excluding pre-opening costs. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

 Construction: per the ’17 10K

“A typical Shack takes between 14 and 20 weeks to build. In fiscal 2017 the cost to build a new Shack ranged from approximately $1.1 million to $3.3 million, with an average near-term build cost of approximately $1.7 million, excluding pre-opening costs. The total investment cost of a new Shack in fiscal 2017, which includes costs related to items such as furniture, fixtures and equipment, ranged from approximately $1.6 million to $3.7 million, with an average investment cost of approximately $2.2 million. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

Construction: per the ’18 10K

“A typical Shack takes between 14 and 20 weeks to build. In fiscal 2018, the total investment cost of a new Shack, which includes costs related to items such as furniture, fixtures and equipment, ranged from approximately $1.4 million to $4.0 million, with an average investment cost of approximately $2.2 million. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

Editor’s comment: With depreciation guided to increase by more than 40% in ’19, it’s possible that the investment per store is moving higher still.

WHAT DOES IT MEAN?

You can see that, while there have been some changes in wordings (your interpretation is as good as mine), the $1.8M average investment, as described in the ’16K is a lot lower than the $2.2M investment of ’18. AUV in ’16 was $4.981M, virtually flat with ’15. The pre-opening expense seems to have been about constant at 350k/location. Back in ’16, the store level EBITDA was 28.2% (down from 29.1% in ’15).

So: the store level EBITDA cash on cash return in ’16 (adding the $350k of pre-opening to the $1.8M cost of construction) was 28.2% of $4.981M which implies $1.4M, an awesome 65% of the total $2.15M investment. (No wonder the new issue went to $90/share.) Today, however, the 23% expected EBITDA margin (at most) on new stores doing $3.3M (at most) would be a 29.7% cash on cash return. People…..this is a big difference, and this could be the best case. 

Another measure: The Sales: Investment Ratio

Often forgotten these days, the original Sales:Investment ratio was designed to determine how Revenues covered TOTAL occupancy expenses, including capitalization of the rent expense (which is the landlord’s investment). Back “in the day” a sales:investment ratio of less than 1:1 was considered less than ideal, unless a restaurant was selling flour and water and tomato sauce (for example) rather than protein, allowing for lower food cost to subsidize higher occupancy expense. Over the years, especially as interest rates have been suppressed, “cash on cash” returns have most often been used as a performance measure, and we have presented that parameter earlier in this article. However:  the average rent in 2018 was $309,000 annually for SHAK’s first class locations. Capitalized at 8x, that would be an incremental investment of $2.47M, and brings the total GROSS INVESTMENT, including pre-opening expense, to approximately $5M per location. As we’ve seen, revenues of $5,6, or 7M at early locations allowed for an impressive store level EBITDA, but it’s equally obvious that revenues modestly over $3M per location will generate much lower returns after high occupancy expenses, and that is demonstrably happening.

CONCLUSION: Provided at the beginning of this article

Roger Lipton

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SHAKE SHACK (SHAK) REPORTS Q1’19 – REVENUES UP, NOT PROFITS !!

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SHAKE SHACK (SHAK) REPORTS Q1 – REVENUES UP, NOT PROFITS

On March 22, 2019, we updated our basic writeup on Shake Shack, and, provided a conclusion that is more “reserved” than most of the analyst and investor commentary. This once spectacular concept is coming down to earth, as a result of industry wide economic realities, a highly aggressive expansion plan that is guaranteed to have inherent inefficiencies, and store level economics that are not what they once were. We provide below our complete analysis from 3/22/19, with the most important ingredients provided just below our Q1 summary:

RECENT DEVELOPMENTS – Per Q1’19

Guidance was adjusted just slightly for ’19, overall Revenues by about 1%, and comp sales by about 1%, due to Q1 comps that came in at 3.6%, including traffic up 1.6%. Cutting through certain adjustments and changing tax rates, we like to look at pretax income, which was $2.546M, down from $3.508M. Though analysts and investors don’t seem to care much, at SHAK or many other companies, preferring to focus on Adjusted numbers, Q1’19 after tax fully diluted GAAP earnings per share for common stock was $0.08 vs. $0.13.

The key for us is store level economics. Cost of Goods was up 140bp to 29.5%. Labor was up 110bp to 28.9%. Other Operating Expenses were up 90bp to 12.1%. Occupancy was up 50bp to 8.5%. Depreciation was up 20 bp to 6.8%. G&A “leveraged”, improving 140 bp to 10.5%. Management continues to predict store level EBITDA margin of 23-24% for all of ’19, but that number was 21% in Q1, down 400bp year to year. If the full year is going to get back to 23-24%, there will have to be very healthy margin improvement later in the year. Looking at the line by line pressure in all the key ingredients during Q1, and management’s admission in their supplemental materials that “labor inflation, increased regulation in key markets combined with higher costs in new Shacks remain a headwind for margin”, their 23-24% guidance could be a “reach”. Supporting management’s expectations that AUVs and store margins will moderate over time, with an annual AUV of about $4.1M by the end of ’19, Average Weekly Volume in Q1 was 79k, down from 81k in Q1’18.

There is, of course, a bright side to this story, including strong international licensed development supported by recent openings in Shanghai and Singapore. Digital channels, including delivery, have very large long term potential. Menu innovation is a key strategic focus, and can impact sales materially, though the recent nationwide well received launch of Chick’n Bites was apparently underpriced and hurt margins. The admirable “commitment to excellence” in terms of personnel development, will no doubt pay off in the long run but likely also has a short term impact on operating margins.

We need not itemize today the long list of operating initiatives that continue. The main point today is that our previous expectations continue to play out in early ’19. Every indication is that the rest of ’19 and then 2020 will provide more of the same. We stand by our Conclusion from 3/22/19, which goes as follows:

FROM 3/22/19 – CONCLUSION (with SHAK at $55, vs $59 today)

SHAK came public at $21 a little less than 3 years ago, ran to a high above $90 in June of 2015, “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 somewhat more rationally valued today versus the Street estimate of $0.60/share in 2019 (lowered to $0.57 5/13/19). We point out, once again, that, in our mind, there is no other publicly held restaurant company that has more well regarded management, a still attractive store level 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”. Most noteworthy, as we point out below, the cash on cash EBITDA return on investment for stores currently being developed, is less than half of what it was in calendar 2016, in the wake of the 2015 IPO. This should be no surprise, and correlates to the deterioration of the Sales;Investment Ratio, as detailed at the end of this article.  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 at this rate 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 continue to be overly optimistic.  We consider the Shake Shack brand and its fine management team more than adequately valued at over 90x expected ’19 EPS and 33x trailing EBITDA.

From 3/22/19

Rather than itemize the adjustments (for ’18), we think it is more productive to focus on the store level operating metrics. New stores, as predicted, are opening at levels closer to $3M than the current $4.4M domestic company AUV. Store level EBITDA of new stores is closer to 20% than the 25.3% of ’18. Accordingly, management is guiding, for ’19, to AUVS of 4.0-4.1M, with store level EBITDA of 23.0-24.0%. This guidance could prove to be conservative, but realistic expectations is lower relative to past years. This is a result of guidance, including total revenues up 28-29%, SSS of 0-1%, including 1.5% price. There will be a continued aggressive opening pace (36-40 new company openings plus 16-18 licensed), G&A of 66.4-68.2M, up 26-29% (leveraging slightly against the revenue gain), depreciation expense up 40% or more (higher investment per store?), pre-opening expense of $13-$14 M (a constant 350-360k/store).

Relative to Q4’18 and ’18 as a whole, and implications for ’19 and ’20, our bottom line is that, based on cost expectations at the store level, corresponding lower store level margin, combined with ongoing corporate spending to support the aggressive growth plan, it will be hard for SHAK to show improvement in net income per share. Of course, we are of the old school, unable to lose (we almost wrote “shake”) our attachment to Generally Accepted Accounting Principles.

Our contribution to the dialogue is that, while the revenues per store have been, as management predicted, coming down, the investment per store is going UP.  The following three short paragraphs are copied from the ’16, ’17 and ’18 10k filings.

 Construction: per the ’16 10K

“A typical Shack takes between 14 and 16 weeks to build. In fiscal 2016 the cost to build a new Shack ranged from approximately $1.2 million to $3.4 million, with an average near-term build cost of approximately $1.8 million, excluding pre-opening costs. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

 Construction: per the ’17 10K

“A typical Shack takes between 14 and 20 weeks to build. In fiscal 2017 the cost to build a new Shack ranged from approximately $1.1 million to $3.3 million, with an average near-term build cost of approximately $1.7 million, excluding pre-opening costs. The total investment cost of a new Shack in fiscal 2017, which includes costs related to items such as furniture, fixtures and equipment, ranged from approximately $1.6 million to $3.7 million, with an average investment cost of approximately $2.2 million. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

Construction: per the ’18 10K

“A typical Shack takes between 14 and 20 weeks to build. In fiscal 2018, the total investment cost of a new Shack, which includes costs related to items such as furniture, fixtures and equipment, ranged from approximately $1.4 million to $4.0 million, with an average investment cost of approximately $2.2 million. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

Editor’s comment: With depreciation guided to increase by more than 40% in ’19, it’s possible that the investment per store is moving higher still.

WHAT DOES IT MEAN?

You can see that, while there have been some changes in wordings (your interpretation is as good as mine), the $1.8M average investment, as described in the ’16K is a lot lower than the $2.2M investment of ’18. AUV in ’16 was $4.981M, virtually flat with ’15. The pre-opening expense seems to have been about constant at 350k/location. Back in ’16, the store level EBITDA was 28.2% (down from 29.1% in ’15).

So: the store level EBITDA cash on cash return in ’16 (adding the $350k of pre-opening to the $1.8M cost of construction) was 28.2% of $4.981M which implies $1.4M, an awesome 65% of the total $2.15M investment. (No wonder the new issue went to $90/share.) Today, however, the 23% expected EBITDA margin (at most) on new stores doing $3.3M (at most) would be a 29.7% cash on cash return. People…..this is a big difference, and this could be the best case. 

ANOTHER MEASURE: THE SALES/INVESTMENT RATIO

Often forgotten these days, the original Sales:Investment ratio was designed to determine how Revenues covered TOTAL occupancy expenses, including capitalization of the rent expense (which is the landlord’s investment). Back “in the day” a sales:investment ratio of less than 1:1 was considered less than ideal, unless a restaurant was selling flour and water and tomato sauce (for example) rather than protein, allowing for lower food cost to subsidize higher occupancy expense. Over the years, especially as interest rates have been suppressed, “cash on cash” returns have most often been used as a performance measure, and we have presented that parameter earlier in this article. However:  the average rent in 2018 was $309,000 annually for SHAK’s first class locations. Capitalized at 8x, that would be an incremental investment of $2.47M, and brings the total GROSS INVESTMENT, including pre-opening expense, to approximately $5M per location. As we’ve seen, revenues of $5,6, or 7M at early locations allowed for an impressive store level EBITDA, but it’s equally obvious that revenues modestly over $3M per location will generate much lower returns after high occupancy expenses, and that is demonstrably happening.

READERS CAN ACCESS FULL WRITEUP ON 3/22/19, FROM HOME PAGE, CLICK THROUGH “PUBLICLY HELD COMPANIES” FOR LISTING

Roger Lipton

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SHAKE SHACK (SHAK) REPORTS – MIXED BAG, CONCEPT MATURES, AS MANAGEMENT PREDICTED – HERE’S SOME SERIOUS FOOD FOR THOUGHT !

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SHAKE SHACK (SHAK) REPORTS – MIXED BAG, CONCEPT MATURES, AS MANAGEMENT PREDICTED

Shake Shack reported their fourth quarter and year. It was very much as management had predicted, reflecting modest same store sales gains, cost pressures at the store level as well as  continued high administrative expense level to support very rapid expansion. New locations, heavily weighted in Q4, opened at strong levels, which held the year’s AUV of domestic company operated locations at $4.39M, down from $4.598M, about 100k higher than the guide. We should interject here that this “beat” might have been at least partially the result of heavy openings (17 out of 34 for the year) in Q4, including the honeymoon effect of 17 out of 120 total stores in the year’s AUV.

Rather than dwell on Q4, which followed the trends of the individual quarters, the full year’s result is probably most informative. 34 domestic company stores were opened against a base of 90. Same shack sales were up 1.0% and traffic was down about a percent. Shack level profit (EBITDA) was 25.3% of sales, down 130 basis points YTY.  AUVs were down 4.6% to a still impressive $4.39M. For the year, Cost of Goods was down 10 bp to 28.3%. Labor was up 110 bp to 27.4%. Other Operating Expenses were up 130 bp to 11.6% partially offset by Occupancy Expenses which were down 80 bp to 7.3%. G&A expense was up 60 bp (not “leveraging” yet), and depreciation expense was up a noteworthy 30 bp to 6.3%. Pre-opening expense was constant at 2.7%, averaging about 360k per store. Pretax Operating Income was down, $31.7M (6.9% of revenues) vs. $33.8M (9.4% of revenues). Diluted EPS was $0.52 per share, not comparable to last year (with its adjustments).

Following the above numbers, management presented “adjustments”, which brought the “adjusted pro forma net income” to $0.71 per share.

Rather than itemize the adjustments, we think it is more productive to focus on the store level operating metrics. New stores, as predicted, are opening at levels closer to $3M than the current $4.4M domestic company AUV. Store level EBITDA of new stores is closer to 20% than the 25.3% of ’18. Accordingly, management is guiding, for ’19, to AUVS of 4.0-4.1M, with store level EBITDA of 23.0-24.0%. This guidance could prove to be conservative, but realistic expectations is lower relative to past years. This is a result of guidance, including total revenues up 28-29%, SSS of 0-1%, including 1.5% price. There will be a continued aggressive opening pace (36-40 new company openings plus 16-18 licensed), G&A of 66.4-68.2M, up 26-29% (leveraging slightly against the revenue gain), depreciation expense up 40% or more (higher investment per store?), pre-opening expense of $13-$14 M(a constant 350-360k/store).

Relative to Q4’18 and ’18 as a whole, and implications for ’19 and ’20, our bottom line is that, based on cost expectations at the store level,  corresponding lower store level margin, combined with ongoing corporate spending to support the aggressive growth plan, it will be hard for SHAK to show improvement in net income per share. Of course, we are of the old school, unable to lose (we almost wrote “shake”) our attachment to Generally Accepted Accounting Principles.

MORE IMPORTANTLY: OUR CONTRIBUTION:

Our contribution to the dialogue is that, while the revenues per store have been, as management predicted, coming down, the investment per store is going UP.  The following three short paragraphs are copied from the ’16, ’17 and ’18 10k filings.

 Construction: per the ’16 10K

“A typical Shack takes between 14 and 16 weeks to build. In fiscal 2016 the cost to build a new Shack ranged from approximately $1.2 million to $3.4 million, with an average near-term build cost of approximately $1.8 million, excluding pre-opening costs. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

 Construction: per the ’17 10K

“A typical Shack takes between 14 and 20 weeks to build. In fiscal 2017 the cost to build a new Shack ranged from approximately $1.1 million to $3.3 million, with an average near-term build cost of approximately $1.7 million, excluding pre-opening costs. The total investment cost of a new Shack in fiscal 2017, which includes costs related to items such as furniture, fixtures and equipment, ranged from approximately $1.6 million to $3.7 million, with an average investment cost of approximately $2.2 million. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

Construction: per the ’18 10K

“A typical Shack takes between 14 and 20 weeks to build. In fiscal 2018, the total investment cost of a new Shack, which includes costs related to items such as furniture, fixtures and equipment, ranged from approximately $1.4 million to $4.0 million, with an average investment cost of approximately $2.2 million. We use a number of general contractors on a regional basis and employ a mixed approach of bidding and strategic negotiation in order to ensure the best value and highest quality construction.”

Editor’s comment: With depreciation guided to increase by more than 40% in ’19, it’s possible that the investment per store is moving higher still.

WHAT DOES IT MEAN??

You can see that, while there have been some changes in wordings (your interpretation is as good as mine), the $1.8M investment, as described in the ’16K is a lot lower than the $2.2M investment of ’18. AUV  in ’16 was $4.981M, virtually flat with ’15. The pre-opening expense seems to have been about constant at 350k/location. Back in ’16, the store level EBITDA was  28.2% (down from 29.1% in ’15).

So: the store level EBITDA cash on cash return in ’16 (adding the $350k of pre-opening to the $1.8M cost of construction) was 28.2% of $4.981M which implies $1.4M, an awesome 65% of the total $2.15M investment. (No wonder the new issue went to $90/share.) Today, however, the 23% expected EBITDA margin (at most) on new stores doing $3.3M (at most) would be a 29.7% cash on cash return. People…..this is a big difference, and this could be the best case. 

We have copied below our conclusions after recent quarterly reports, which we stand by. More importantly, the latest information, as disclosed in the ’18 10K and management’s guidance going forward, provide investors with more food for thought (no pun intended). We saw that one analyst referred to SHAK as the next Krispy Kreme, which it’s not, but SHAK isn’t what it used to be.

Roger Lipton

CONCLUSION – from 8/7/18 after SHAK had run down 11% following Q2 report

SHAK ($56) has come down (11%) 23because it has been priced beyond “perfection” and never should have run up after Q1. The concept, as good as it is, can be expected to do an AUV somewhere between $3-3.5M per unit as the system is built out. Store level EBITDA will end up in the 20-23% range. A 23% EBITDA generation on $3.25M of sales would be $747K of EBITDA, or a 37% store level cash on cash return on the $2M investment , an admirable operating model.  If we look down the road a few years to when SHAK has a couple of hundred units, growing not quite so fast, and growing after tax earnings and EBITDA at perhaps 25% annually, the stock might have a 40x multiple on expected after tax earnings. The problem is that the P/E on ’19 EPS estimates (that could be a reach) is twice that. It will therefore take SHAK several years beyond ’19, until 2022, for the fundamentals to catch up with today’s stock valuation of $2B.  Of course, it’s possible that the P/E on next twelve month earnings could be even higher than it is currently, but the P/E range that the stock sells at will likely be contracting as time goes on. This expectation is under the optimistic assumption that there are no major mistakes along the way, in which case there would obviously be an immediate major adjustment downward.  This discussion may be one reason why there has been almost continuous liquidation of common shares by insiders and private equity owners, to the tune of hundreds of millions of dollars ever since SHAK came public early in 2015.

CONCLUSION – From 5/10/18, after SHAK had run up 23% following Q1 report

As you no doubt suspect, while we have the utmost respect for this management team, our conclusion is that SHAK ($58) 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.

 

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

The long term investment appeal of well established franchising companies is accepted by the investment community. Most of the prominent franchisors’ equities sell at price to trailing twelve month EBITDA multiples in the mid to high teens (Denny’s (DENN), Dine Brands (DIN), Dunkin’ Brands (DNKN), Pollo Loco (LOCO), McDonald’s (MCD), Restaurant Brands (QSR), Wendy’s (WEN), even higher in a couple of instances Domino’s (DPZ), Shake Shack (SHAK), Wingstop (WING), lower in a number of “challenged” situations like Jack in the Box (JACK), Red Robin (RRGB), Brinker (EAT), Fiesta Rest. (FRGI).

The attraction of asset light franchisors revolves around the presumably free cash flow for franchisors, a steady stream of royalty income unburdened by capital expenditures to build stores. The operating leverage is at the store level.  Franchisees are responsible for building the stores, then controlling food costs, labor, rent and all the other operating line items. Franchisors receive the royalty stream and have the obligation of supporting the system with brand development, site selection advice, marketing support, and operating supervision. These supporting functions, it should be noted, are optional to a degree, and we have written extensively about system support sometimes being short changed by corporate priorities such as major stock buybacks.

THE CURRENT WORD, IN THE FIELD, AS WE HEAR IT

We acknowledge that in every franchise system there will be some operators less satisfied than others. In the same way, customer reviews on Yelp or Facebook are more frequently written by critics. Bad news is more noteworthy and more customers are inclined to criticize than applaud, so we have to listen to the complaints but dig further for the reality. With that in mind, we hear the following from franchisees of various restaurant systems:

“I’ve been in this business for thirty years, and I’ve never seen it this bad. Everyone is making money but me; the landlords, the franchisor, the banks. My margins have been killed, and I’m up against my lending convenants”.

“All the franchisors want to do is build sales to build their royalties. The dollar deals are trading people down. My franchisor doesn’t care about my margins. I can’t maintain my margins, especially with the increasing cost of labor, let alone build it”.

“The franchisor is putting pressure on me to sell, even though I’ve always been considered a good operator, with high performance scores. I’m up to date on my development agreement, but they want somebody else to take me out, and the new buyer will agree to what I consider to be a ridiculously aggressive development contract”.

“The franchisor has replaced experienced long term field support with lower priced (and inexperienced) younger people. They’re cutting corporate overhead, but these kids, who never ran a store, are telling me to how to control costs.””

“I’m doing my best with the development objectives, but it is almost impossible to build stores with today’s economics. Rents are too high, labor costs are killing me, and I can’t raise prices in this promotional environment”.

“As if things aren’t tough enough, I’m being nickeled and dimed with demand for higher advertising contributions and fees on services (including software) that I thought would be provided”.

The valuations provided to the publicly held companies do not reflect the situation as described by the admittedly anonymous franchisees. The commentators quoted above don’t want to aggravate their franchisor, and we don’t want to be unfair or misleading to particular companies by relying on just a few conversations, though they do support one another. For the most part, franchisees are strongly discouraged from talking to the press or investment community. The companies will say that “competitive” issues require some secrecy, but there are few secrets in this industry.

The optimistic view, as represented by the valuations in the marketplace, is that the comments above are not typical or representative of the health of the subject franchise systems. Allow me to provide a short story which leads to a suggestion.

A SHORT STORY

Twenty six years ago, in 1992, IHOP had just come public. I was a sell side analyst, thought the numbers were interesting and the stock was reasonably priced. The company, led by the now deceased CEO Kim Herzer, invited me to attend their franchisee convention, which I did. I obviously had the opportunity to interface with many franchisees and it was clear that, while all was not perfect, the franchisor was providing a great deal of support that was embraced by an enthusiastic franchise community. IHOP stock tripled over several years for me and my clients who owned millions of shares. I attended several more of their annual conventions and maintain some of those relationships to this day. Obviously, the conviction I gained from their open attitude was critical to the success of the investment. I should add, that many of those buyers in 1992 owned the stock for many years, not living and dying on quarterly reports.

THE SUGGESTION

As you are no doubt by now anticipating, my suggestion to publicly held franchising companies: open up your franchisee conventions to the investment community. The companies may quickly respond that lenders are already invited to franchise conventions, but franchisees are unlikely to express their system oriented concerns when they are making a pitch to a potential lender. Companies may also respond that their lawyers think it would be a bad idea, not consistent with full disclosure and analysts would be getting “inside information”. Let’s not allow the lawyers to provide “cover”. A good lawyer will provide a solution to the problem, not just provide the pitfalls. Analysts attending a franchise convention are not being told what sales or profits are going to be. Attending a franchise convention is  a “channel check”, no more than talking to a supplier or customer of a manufacturing company, which any decent analyst will do.

The anecdotal critical comments, as described above, have likely been heard by others, but may be atypical of most restaurant franchising companies. There are no secrets in this business. One of the investment appeals of this industry is its transparency. Notable news is going to leak out anyway. The objective of any publicly held company is to build stock ownership by well informed investors. Investment analysts pride themselves on their ability to “build a mosaic”, enhance the information provided in quarterly reports, SEC filings, and conference calls, with “channel checks”. What channel check would be more pertinent than meeting the franchisees of a company that is dependent on franchisee success? Putting it another way, and taking the highest valuation relative to EBITDA as an example: Wingstop (WING) is a company I have the highest regard for. However, you could call it irresponsible to pay almost fifty times trailing EBITDA for Wingstop stock (and I haven’t) if I couldn’t talk to franchisees of my own choosing?

There’s no particular need to invite this writer if I’m not considered influential enough. I have not spoken to these analysts on this subject, but qualified industry followers such as David Palmer, Nicole Reagan, Matt DiFrisco, David Tarantino, Jeff Bernstein, Andy Barish, Bob Derrington, Mark Kalinowski, Michal Halen, Gary Occhiogrosso, Howard Penney, Jonathan Maze, Nicholas Upton, John Hamburger and John Gordon provide the beginning of an invitation list.  I rest my case.

Roger Lipton

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SHAKE SHACK REPORTS Q2 – STOCK DOWN 10% – WAS IT THAT BAD?

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SHAKE SHACK REPORTS Q2 – STOCK DOWN 10% -WAS IT THAT BAD?

Before discussing Q2, we refer you to our conclusion from the extensive report we wrote on 5/10. For those readers with an active interest in SHAK, we encourage you to read the full report.

CONCLUSION – From 5/10/18, after SHAK had run up 30% following Q1 report

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.

SECOND QUARTER RESULTS

The report was generally in line with analyst expectations, which were largely echoing management guidance. Same store sales were up 1.1% (on top of a 1.8% decline a year ago), which might have been a fraction of a percent less than some analysts hoped for. What might have cooled the ardor was that traffic was down again, 2.6% this time. Keep in mind that only 50 Shacks are in the comp base, less than half the company operated system. Also in line with guidance, but a small dose of reality, average weekly sales for domestic company stores declined 3.3% to a still impressive $89,000. Again, as predicted, store level profit (EBITDA) declined 60 bp to 28.2%, or 27.5% normalized for the one time benefit of deferred rent. Importantly, G&A expenses increased to 10.8% of revenues, up from 10.6%, and, especially with the expense of “Project Concrete”, are unlikely to be leveraged by the higher sales in the next year or so. Of course, the tax burden was lower than a year ago, 17.5% versus 29.2%, allowing net income after taxes to be up 29.1%. More indicative of the current operating progress is the operating income that was up a more modest 10.9% and “adjusted EBITDA” that was up 12.9%. Management here is, appropriately, “playing the long game”, investing in corporate functions as well as store level management and crew (with industry leading compensation levels) to build on the admirable operating culture that is  in place.

Guidance for the balance of 2018 was maintained, and that was part of the problem. Analysts were hoping, and the stock price was discounting, an improvement in some of the operating expectations. Cited were some delays in getting the last portion of the stores planned for 2018 opened in time to contribute to results this year.  Other than that, the costs of Project Concrete, to be spread over 2018 and 2019, was increased from $4-6M to $6-8M.

We can’t resist pointing out that management is fortunate that analysts seem willing to treat a substantial “investment” in G&A,  dubbed “Project Concrete” as a non-recurring event, as if additional infrastructure will not be necessary as Shake Shack expands their brand around the world at what we consider a breakneck pace. It’s good to be “king”, with probably the highest  investment community regard (and valuation) among publicly held restaurant companies.

For more background information, we refer readers to our discussions dated May 10th and our full descriptive report dated  12/13/17.

Current Conclusion

SHAK has come down because it has been priced beyond “perfection” and never should have run up after Q1. The concept, as good as it is, can be expected to do an AUV somewhere between $3-3.5M per unit as the system is built out. Store level EBITDA will end up in the 20-23% range. A 23% EBITDA generation on $3.25M of sales would be $747K of EBITDA, or a 37% store level cash on cash return on the $2M investment , an admirable operating model.  If we look down the road a few years to when SHAK has a couple of hundred units, growing not quite so fast, and growing after tax earnings and EBITDA at perhaps 25% annually, the stock might have a 40x multiple on expected after tax earnings. The problem is that the P/E on ’19 EPS estimates (that could be a reach) is twice that. It will therefore take SHAK several years beyond ’19, until 2022, for the fundamentals to catch up with today’s stock valuation of $2B.  Of course, it’s possible that the P/E on next twelve month earnings could be even higher than it is currently, but the P/E range that the stock sells at will likely be contracting as time goes on. This expectation  is under the optimistic assumption that there are no major mistakes along the way, in which case there would obviously be an immediate major adjustment downward.  This discussion may be one reason why there has been almost continuous liquidation of common shares by insiders and private equity owners, to the tune of hundreds of millions of dollars ever since SHAK came public early in 2015.

Roger Lipton

 

 

 

 

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SHAKE SHACK REPORTS Q1’18 – EXPANSION POTENTIAL, ALSO SIGNIFICANT RISK – UNIT LEVEL ECONOMICS SLIPPING

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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.

 

 

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DANNY MEYER, NO TIPPING FOR OVER 2 YEARS NOW, HOW’S IT DOING?

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SHAKE SHACK (SHAK) – SELLS OFF AFTER EARNINGS REPORT – WHAT’S GOING ON?

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SHAKE SHACK SELLS OFF AFTER EARNINGS REPORT – WHAT’S GOING ON?

We have written many times of our admiration for this company, founded by the legendary Danny Meyer, in terms of the employee culture, operating skills, and their successful management of an extremely aggressive expansion plan. The “cult” of Shake Shack goes far beyond their NYC roots, and openings literally worldwide have supported this notion.

In a nutshell: when a stock is “priced for perfection” ($37) at over 70x calendar 17 earnings and over 60x estimated ’18 earnings, all operating parameters have to be “in gear”, hopefully accelerating, certainly not decelerating. That means: same store sales and traffic, unit growth rate, store level margins, new unit “productivity” of sales and margins.

We don’t have time here to go into all the details of the current results, but in a nutshell: reality is setting in:

Management has continually pointed out that AUVs away from NYC will be closer to $3M annually than the incredible $7M/store within their hometown. It was pointed out that store level EBITDA would be closer to 20% rather than the previous 30% range, at the lower levels. Analysts, and investors heard this, but haven’t wanted to exactly believe this, as  new stores continued, until recently, to open materially above $3M, and average volumes held close to $5M. We will come back to this parameter shortly.

Yesterday, the third quarter report met estimates of earnings, same store sales were down, but a little less than expected, due to menu price increases, traffic was down more, but the expansion rate was increased for next year. Labor costs are up, as expected, especially since SHAK prides themselves on treating employees very well. Overall store level margins are expected to contract further, and G&A expense will not decline as a percent of sales due to the acclerated rate of company store expansion (35-40%) on the base. All of this could be “accepted” by analysts and investors, but here’s the rub:

Each quarter the Company tells us what the weekly AUVs were for domestic company operated stores. This is the way it has gone:

Q3’16    $103,000     Q3’15   $103,000               even

Q4’16     $90,000       Q4’15    $89,000               +1.1%

Q1’17      $86,000      Q1’16    $90,000               -4.5%

Q2’17       $92,000      Q2’16    $102,000            -9.8%

Q3’17       $91,000      Q3’16    $103,000            -11.7%

Clearly, new units are opening “lower”, by our calculation, at about $3.3M. Analysts explored this development on the conference call, and the company confirmed that this range applies, has been predicted all along. The supplemental slides showed that the cash on cash return for a store at $2.8M -$3.2M is 14% in the first year(after $400,000 of pre-opening expense) and 34% thereafter. While more than acceptable, this is a sobering reality compared to the 56% year one cash on cash return for a $5.0M unit, with 79% thereafter. Since the aggressive expansion plan is obviously focused on markets away from NYC, analysts have to assume that the margins will more rapidly approach the lower numbers than they had previously modeled. This is especially true since management was very clear that labor expenses will continue higher, commodities will provide no relief, and corporate G&A will be ratcheted upward to support growth and technology requirements.

In summary: Only the growth rate, of units, is “in gear”, accelerating in fact. Same store sales and traffic are challenged, which is an industry wide issue, store level margins at existing stores won’t improve and will be materially lower at new stores, and G&A won’t be leveraged in the short term. Worst of all, new stores are opening at the previously predicted lower volumes, which removes the possibility of earnings surprises on the upside. A case can also be made that a growth rate, for company stores, of this magnitude, has its own set of dangers, in addition to the more predictable unit level challenges. Investors and analysts have appropriately, in our view,  reacted cautiously to the latest news.

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