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SHAKE SHACK (SHAK) UPDATED WRITE-UP – A FINE COMPANY BUT STORE LEVEL ECONOMICS ARE FADING

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CONCLUSION

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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