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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

 

 

 

 

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.

 

 

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

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DANNY MEYER ELIMINATED TIPPING  OVER TWO YEARS AGO, WHAT’S THE VERDICT?

In October of 2015, almost two and one half years ago, we wrote an article expressing our doubt that “gratuity included would prove productive. The full article is shown below the following update. While the “jury is still out”, the evidence to date seems to support our prediction.

Coincidentally, the Sixty Minutes TV show did another feature on Danny Meyer just three days ago, basically a “puff piece” (well deserved) on his outstanding success with his full service restaurants and founding of Shake Shack. Within the segment was a discussion of his no-tipping policy, his conviction that the back of the house has to be properly rewarded, and how his new policy would help to accomplish that. He acknowledged that his approach might be “early”, just as when he went to a no smoking policy twenty years ago, ahead of the crowd, but he would persevere in this case as well. He reflected positively on the attitude of the staff, old and new. However, what he did not discuss was the effect on traffic, sales, and profit margins.  As an analyst, we have learned over the years, that when management does not discuss the details, they most often are not supportive of the broad strategy. I had some brief contact with an employee of Union Square Hospitality Group (USHG) a few months ago, and he didn’t argue with my suggestion that profit margins at privately held USHG have probably suffered, if the front of the house is paid pretty much the same, the back of the house gets a raise, and total selling prices (included a standard gratuity) are not increased materially.  (Not all of the USHG restaurants have become gratuity-included.)

An article from eater.com crossed my desk this morning. Apparently, Danny Meyer acknowledged recently, while accepting a Workplace Legacy Award, in Plano, Texas, as being a leader “who demonstrates success in people practices and operations, in addition to benefiting employees, organizations and communities”,  that  30 to 40 percent of his serving staff have left. Presumably, the back of the house staff has been more stable, since they now make about 20 percent more than before. He didn’t discuss sales and traffic trends, or operating margins. Since Union Square Cafe closed and re-opened in a new location in the middle of this two year period,  accurate comparisons are elusive. Personally, I have had two great dining occasions at the new Union Square Cafe, so the “hospitality quotient” has not suffered as far as I can tell.

Danny is sticking to his plan, and  can afford to set a high standard within his own restaurants as well as for the industry as a whole. As I said over two years ago, “There is no one better equipped that Danny Meyer to implement this new policy…”

There has so far been no noticeable trend for other restaurant owners to follow his example. Especially within the current environment, with restaurant operators fighting to maintain traffic and profit margins, we doubt that much will change in this regard. We continue to feel that Meyer’s approach will not attract new customers and could cost at least a few. Hardly any restaurant operator can afford to run the risk losing even a modest number of customers, either because they prefer to control the tipping process, or as a result of major turnover among the serving staff.

October 15, 2015

DANNY MEYER ELIMINATES TIPPING. WELL ADVISED? BE CAREFUL OUT THERE!

The talk of the town and the country, among restaurateurs and diners alike is the no-tipping policy that Danny Meyer is about to embrace in his highly regarded full service locations. No one is more respected in the industry than Meyer, with good reason. He has built a great company within the fine dining sector, in addition to launching the hugely successful Shake Shack fast casual chain. If anyone can spearhead the no-tipping approach, it is he, but we have our doubts. In any event, the outcome will not be known for months or even years. There are three constituencies to satisfy here: the employees, the customers and the management. We list the employees first just because they are the face of the company, and continuously display the corporate culture to the dining public. If they are unhappy with the quality of the food served, the performance of the kitchen, their personal compensation and treatment by corporate management, it will be continuously communicated to the customer base.

I’ve been an analyst, investment banker, investor and adviser relating to the restaurant industry for over three decades. This is one of the more radical (call it “contemplated”) “adjustments” to the labor portion of “prime costs” ( food and labor) that I’ve seen in all that time, indeed the dining out culture that has become ingrained in our lifestyle.
It is important to understand the motivation behind Meyer’s (and some predecessors) move. As Meyer has described, the kitchen staff is paid by salary (or hourly) while the servers can make much more money including tips. The back of the house is of course critical to customer satisfaction, so it has to be discouraging and unfair to the kitchen when the servers are celebrating at the end of a great evening, having made hundreds of dollars, and the kitchen staff has made a fraction of that. It is important to understand that labor laws have for years inserted themselves into the tip allocation process, when tips are pooled; in general protecting the servers whose hourly rate is usually below the minimum wage. Tips can therefore not be allocated (more than nominally) to back of the house employees, leaving their compensation to management by way of salaries and bonuses. Assuming that front of the house tips are pooled among servers and their compensation can’t be cut materially, the change implemented by Danny Meyer’s amounts to a compensation raise for the back of the house, and an increase in overall labor costs.
Considering the second “stakeholders”, the customers: Some customers won’t mind if prices go up 20%-30%, including tips, since they were tipping at least 20% anyway, can afford it, and they really like the food and service. They are customers no matter what, which may especially apply to the restaurants managed by Meyer.  Also, some customers don’t like the burden of the tip decision, so will welcome relief from this responsibility. In our opinion, this contingency is small, however. More important is the group that normally tips at perhaps the 15%-20% range, so this price rise will be a noticeable increase in the cost of dining. While some customers will tolerate it, we believe that a material number will not. Traffic is hard to come by, for all retailers, and wise managements are exceedingly thoughtful before implementing price increases. Our conclusion here: this new policy will not increase traffic, and will likely lose at least a few customers for all but the very strongest operators.

The third contingency is corporate management. Without question, the contemplated change will simplify the labor equation; compensate the back of the house more appropriately which will reduce turnover and training, and the burden of coping with governmental oversight. Operating margins are hard to maintain and management must get an appropriate return on investment if they are to prosper. In a better economy, with stronger sales, margin pressure would not be so substantial, but these days there is only one solution to higher costs, and that is higher prices.

Our bottom line: There is no one better equipped that Danny Meyer to implement this new policy, based on his relationships with employees and customers alike. We feel, however, this policy may hurt even him, over time, in terms of customer traffic. Most other full service restaurant companies would be ill advised to follow his lead, in our opinion. The economy, and the competition, is too unforgiving to tolerate what will amount to a material rise in dining prices. If I owned shares in a publicly held full service restaurant company, which I do not, I would be highly suspect of this change that is relatively radical in a very sensitive environment. In any event, even Danny Meyer intends to phase this approach in over a year or more, so this will take a while to play out. In the meantime, we say to restaurateurs and investors alike: be careful out there!

 

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.

SHAKE “SHOCK” (SHAK) – VIDEO FROM 3RD DAY OF NEW LOCATION – KIOSK ORDER & PAY – NO CASHIERS

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SHAKE SHACK “EVOLVES” TO ELIMINATE CASHIERS -PROGRESSIVE TO BE SURE, UNINTENDED CONSEQUENCES WILL TAKE A WHILE TO EVALUATE

Danny Meyer, founder of Shake Shack, is no longer actively involved  in management of this leader within the “fine” casual dining industry.  His cultural influence is no doubt being maintained as one of the restaurant industry’s most progressive voices.

Shake Shack, no doubt anticipating the inevitable material rise in the cost of labor, has just opened a unit at Astor Place in Manhattan which has no cashiers.  You can’t accuse Shake Shack, no doubt channeling its founder, Danny Meyer, of lagging the crowd in terms of anticipating changes within the hospitality industry. Combined with mobile order and pay, about 10 POS “kiosks” allow customers to place orders as well as pay. Cash is not accepted. We took a twenty five second video at 1:00pm today (link below), the third day of operations, panning the store interior. On the viewer’s right is the array of ordering stations. SHAK management is not naive about the need to explain the new system and provide customers as much “training” as necessary, so several employees are circulating among the customers, helping where necessary (including myself). I found the system fairly easy to navigate, and used the chip on my card to pay. The customer then moves to the center of the store, and waits in front of the pass through section where names are called out. Mobile orders presumably are handled over the same counter. There is a drink and condiment station, left of center, where customers can set themselves up as they wait for their orders. There is a modest amount of seating as the camera pans to the left, indicating that the Company feels that most orders will be taken off premises.  I will briefly discuss my reaction after you have viewed the video below:

https://www.dropbox.com/s/r83syu3fhcv79q7/SHAKE%20SHACK%20KIOSK%20ORDER%20%26%20PAY%20-%20NO%20CASHIERS%20-%20VIDEO.mp4?dl=0

The business model is “a-changin”. Danny Meyer literally wrote the book in dining hospitality, “Setting The Table”.  His fine dining restaurants have distinguished themselves from this standpoint and he is appropriately viewed as one of the long time greats in the industry. At Union Square Hospitality Corporation, his elimination of tipping two years ago was his effort to equalize compensation between the back of the house and front, and this (I call it “unresolved”) experiment has continued to this day. USHC, however, is privately held, and the operating margins (which we suspect have suffered) don’t come under the  line by line scrutiny of analysts and investors. Shake Shack (SHAK), publicly held, must bow to the needs, and demands of the publicly held constituents. Growth rates, and operating margins, have to be maintained or valuation will suffer. We can’t prove it, obviously, but SHAK (if still private) might not be moving quite so aggressively in eliminating cashiers (which includes a significant personal “touch”) and going to a production based model.

FROM THE CUSTOMER’S STANDPOINT: SHAK will not lose its cult-like status any time soon. We don’t expect volumes to suffer substantially with this new approach, however: at the end of the day, it’s (mostly) a burger, fries, and shakes, preferred by many, but not by all. Lot’s of Californians  think In and Out is the ultimate, some prefer the fresh cut fries at Five Guys, and the burgers at Schnipper’s here in NYC are pretty good if there is not a Shake Shack nearby. I believe that what has distinguished Shake Shack, as much as anything else, as been the hospitality quotient. Their staff has been a cut above the big three burger chains, just as been the case at Starbucks. Credit the influence of founders, Howard Shultz and Danny Meyer. Cutting to the chase: the absence of cashiers is not going to gain customers, and could cost some.

FROM THE EMPLOYEES’ STANDPOINT: Shake Shack is no doubt going to try to maintain the hospitality experience, as best they can, but eliminating cashiers is not an upgrade. There are lots of young people who correctly view a job at SHAK (or Starbucks) as a stepping stone in the retail/hospitality industry. They get an on-the-job education and get paid (modestly) at the same time. I’ve written about the Starbucks barista who told me “working at Starbucks makes me a better person” and I suspect that there are more than a few Shake Shack crew who feel that way as well. The new business model increases the value of “production” rather than customer contact, so it is going to be a lot less satisfying for that young person who really loves to interact with people, but is now just pumping out product.

Bottom Line: No Cash, and No Cashiers, may be progressive, even necessary, but will likely have unintended consequences, for  employees, customers & shareholders.

 

DANNY MEYER ELIMINATES TIPPING. WELL ADVISED? BE CAREFUL OUT THERE!

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DANNY MEYER ELIMINATES TIPPING. WELL ADVISED? BE CAREFUL OUT THERE!

The talk of the town and the country, among restaurateurs and diners alike is the no-tipping policy that Danny Meyer is about to embrace in his highly regarded full service locations. No one is more respected in the industry than Meyer, with good reason. He has built a great company within the fine dining sector, in addition to launching the hugely successful Shake Shack fast casual chain. If anyone can spearhead the no-tipping approach, it is he, but we have our doubts. In any event, the outcome will not be known for months or even years. There are three constituencies to satisfy here: the employees, the customers and the management. We list the employees first just because they are the face of the company, and continuously display the corporate culture to the dining public. If they are unhappy with the quality of the food served, the performance of the kitchen, their personal compensation and treatment by corporate management, it will be continuously communicated to the customer base.

I’ve been an analyst, investment banker, investor and adviser relating to the restaurant industry for over three decades. This is one of the more radical (call it “contemplated”) “adjustments” to the labor portion of “prime costs” ( food and labor) that I’ve seen in all that time, indeed the dining out culture that has become ingrained in our lifestyle.
It is important to understand the motivation behind Meyer’s (and some predecessors) move. As Meyer has described, the kitchen staff is paid by salary (or hourly) while the servers can make much more money including tips. The back of the house is of course critical to customer satisfaction, so it has to be discouraging and unfair to the kitchen when the servers are celebrating at the end of a great evening, having made hundreds of dollars, and the kitchen staff has made a fraction of that. It is important to understand that labor laws have for years inserted themselves into the tip allocation process, when tips are pooled; in general protecting the servers whose hourly rate is usually below the minimum wage. Tips can therefore not be allocated (more than nominally) to back of the house employees, leaving their compensation to management by way of salaries and bonuses. Assuming that front of the house tips are pooled among servers and their compensation can’t be cut materially, the change implemented by Danny Meyer’s amounts to a compensation raise for the back of the house, and an increase in overall labor costs.
Considering the second “stakeholders”, the customers: Some customers won’t mind if prices go up 20%-30%, including tips, since they were tipping at least 20% anyway, can afford it, and they really like the food and service. They are customers no matter what, which may especially apply to the restaurants managed by Meyer.  Also, some customers don’t like the burden of the tip decision, so will welcome relief from this responsibility. In our opinion, this contingency is small, however. More important is the group that normally tips at perhaps the 15%-20% range, so this price rise will be a noticeable increase in the cost of dining. While some customers will tolerate it, we believe that a material number will not. Traffic is hard to come by, for all retailers, and wise managements are exceedingly thoughtful before implementing price increases. Our conclusion here: this new policy will not increase traffic, and will likely lose at least a few customers for all but the very strongest operators.

The third contingency is corporate management. Without question, the contemplated change will simplify the labor equation; compensate the back of the house more appropriately which will reduce turnover and training, and the burden of coping with governmental oversight. Operating margins are hard to maintain and management must get an appropriate return on investment if they are to prosper. In a better economy, with stronger sales, margin pressure would not be so substantial, but these days there is only one solution to higher costs, and that is higher prices.

Our bottom line: There is no one better equipped that Danny Meyer to implement this new policy, based on his relationships with employees and customers alike. We feel, however, this policy may hurt even him, over time, in terms of customer traffic. Most other full service restaurant companies would be ill advised to follow his lead, in our opinion. The economy, and the competition, is too unforgiving to tolerate what will amount to a material rise in dining prices. If I owned shares in a publicly held full service restaurant company, which I do not, I would be highly suspect of this change that is relatively radical in a very sensitive environment. In any event, even Danny Meyer intends to phase this approach in over a year or more, so this will take a while to play out. In the meantime, we say to restaurateurs and investors alike: be careful out there!