RESTAURANT STOCKS – INDUSTRY OUTLOOK IS CLARIFYING, STOCKS UP FROM LOWS, HOW MUCH RECOVERY IS DISCOUNTED? WITH A FRESH LOOK AT SHAKE SHACK

Our readers have no doubt noticed that we have had very few writeups on individual companies over the last six to seven months. The whole world is in a “workout” situation and restaurant companies are no exception. Aside from the fact that we don’t know what current balance sheets look like, what operating margins can be expected, how much more sales recovery can be expected and the mix between dine-in and off-premise, everything is perfectly clear. However, we expect to know a lot more with the release of the third quarter results and should be able to make some informed judgements at least as far as the next twelve months.

AT THE MOMENT

The stock prices of the most prominent restaurant companies have recovered a great deal of the sharp decline in February and March, of course with a great deal of variation between companies. Most of the restaurant companies are selling much below their highs early in the year. You will not be surprised to know that Chipotle, Wingstop and Papa John’s are a lot higher than in mid-February. You might be surprised to know, however,  that Dunkin Brands, Brinker, Pollo Loco, McDonald’s, Del Taco, and Yum China are also higher, though more modestly.

TODAY’S VALUATION VS. PRE-PANDEMIC

The following exercise is designed to compare today’s valuation relative to the current best guess of calendar 2021 earnings, compared to the valuations as of 2/15/2020 (before the pandemic hit) relative to “normalized” 2020 earnings, meaning the earnings that were expected in 2020 as of 2/15/20. For the purpose of “normalizing” the 2020 earnings (ex the pandemic’s effect), for the first look we simplistically added 10% to the reported TTM ending 12/31/2019 (or as close to that date as we could calculate). Going forward from here, we used the earnings consensus estimate, per Bloomberg, LP as of today, for 2021, to calculate today’s P/E multiple of forward earnings. To compare earnings 14 months out to the 2020 earnings as of 2/15/20, which were 10.5 months out, if earnings are growing at about 10% annually, we have reduced the forward multiple (calendar 2021) by 5% to bring it roughly in line with the forward multiple as of 2/15/20.  Keep in mind, this initial look is to help us focus on the individual situations that might be most overvalued or undervalued compared to pre-pandemic. As the table below shows, the apparently most overvalued stocks, relative to pre-pandemic levels, are Shake Shack (SHAK) and BJ Restaurants (BJRI). The apparently most undervalued are Wingstop (WING) and Papa Johns’s (PZZA). With this first look in mind, we will fine tune our view of the current situation for each of these four companies, none of which are we currently long or short. We are drawn first to Shake Shack (SHAK), for which the market is apparently discounting quite a recovery.

Shake Shack (SHAK)

Shake Shack (SHAK) has been provided by the capital markets with a great opportunity to raise capital with minimal dilution, as well as allowing pre-IPO shareholders with great liquidity at a high valuation. We have consistently praised management for the culture they have built within a very rapidly growing worldwide system. The halo created by founder Danny Meyer and his team led by Randy Garutti has been maintained, even though modest traffic declines, even before the pandemic, were a fact of life. Earnings per share were $0.71 and $0.72 in calendar 2018 and 2019 respectively, though millions of dollars were capitalized as investment in SG&A (e.g.Project Concrete). We have written many times about how the extraordinarily favorable store level economics, driven early by New York City locations doing approximately $7M annually has been (as Company management predicted) come down materially since the IPO. We encourage readers to SEARCH on our home page for more details, but in essence, new locations, pre-pandemic were doing a little over $3M annually, with store level EBITDA less than half of what they were before and immediately after the IPO.

With that very quick summary in mind, the consensus estimate, as of 2/15/20 was not materially more than the $0.72 of 2019, because traffic was lagging, margins were coming down (as management had predicted) with the more modest new unit volumes, and SG&A was still being built up to support 35-40% unit growth of Company locations. Shake Shack found themselves more exposed than almost everyone else to the effects of the pandemic, since many of their locations are in malls and destination sites, with heavy rents, no drive-thrus and relatively little delivery or curbside pickup before the pandemic.

Management has done an admirable job of adjusting to the new reality. Digital ordering, curbside pickup, and delivery have all been expanded, and there has been sequential improvement from the disastrous lows of March and April through July when the Company reported their Q2 results. With so many urban and destination locations, the sequential improvement has been material but more modest than many peer competitors. SSS were down 64% in April, down 42% in May, 42% in June and 39% in July. Digital sales represented 62% of total Shack Sales in July, with 800,000 first time digital purchasers between March and July, four times higher than a year earlier.

Even so, Q2 same shack sales were down 49.0% and overall sales (including non-comp units) were down 39.5%. There was a predictable operating net loss of $18M and negative EBITDA of an adjusted $8.8M.

There has been no public update of sales trends since the Q2 report, but it is safe to say that the third quarter will be another substantial operating loss (Bloomberg, LP estimates $12.3M), since 50% of the store base and 60% of SSS prior to Covid-19 are in urban locations, plus non-traditional locations in airports and stadiums are still a drag.

In spite of the operating loss so far this year, the Company has no liquidity concerns because they raised about $146M through common stock sales in April. The pleasure of a high valuation is that equity can be raised with minimal dilution. Cash and cash equivalents as of 6/24/20 was $173M vs. $37M on 12/25/19. The number of shares issued and outstanding grew from 34.4M to 38.2M, up only 11%.

There are lots of other operating details we could provide relative to company efforts to adjust to the situation at hand, but analyst consensus estimates provide a pretty good general idea of expectations going forward. Estimates call for a loss in 2020, then profits of $0.11 per share in 2021. There are no current estimates beyond 2021, but it is obviously questionable how quickly Shake Shack can re-invent itself sufficiently to deal with the world as it has changed. Not only are sales trends uncertain but margins are equally in doubt.

At the current price of $68/share, the market capitalization of the equity is $2.8 billion. The $173M of cash could be deducted, still providing an enterprise value of over $2.6 billion. Let’s assume that SHAK can re-acquire something like its previous high valuation, perhaps 50x earnings per share and 25x EBITDA. The Company would need $52M of earnings ($1.36 on the current share base) and $104M of EBITDA to support the current stock price. Based on the obvious uncertainty relative to the newly evolving business model, we don’t know when (or if) that will happen.

Roger Lipton

P.S. The next company we will explore, at first glance within our table above, undervalued, is Wingstop (WING)