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Roger’s Restaurant Review, Shake Shack Writeup

April 3rd, 2017 · No Comments

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.

Roger’s Restaurant Review, Shake Shack Writeup, dated 3/28
By Roger Lipton with permission @ www.rogerlipton.com

SHAKE SHACK
March 28, 2017 Corporate Research shak,shake shack

Conclusion
SHAK came public at $21 a little over two years ago, ran to a high above $90 in June of 2015, and has been in a trading range between $30 and $40 during 2016 and early 2017. The stock was “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 more rationally valued in the low 30s versus the Street estimate of $0.51/share in 2017 (which we judge could more likely be exceeded than missed). While we are not yet ready to “pull the trigger”, there is no other publicly held restaurant company that has more well regarded management, a better store operating model, and a virtually unlimited runway for future expansion. Barring a major general market crash, we don’t expect SHAK to trade for a P/E of less than 30-40x expected earnings. Currently at 65x ’17 estimated earnings and 52x ’18 estimates, SHAK is unlikely to run away on the upside. Especially since ‘17Q1 is unlikely to surprise on the upside, with the difficult comp comparison (+9.9% in ‘16Q1), ongoing development expenses in a seasonally slow quarter, there is probably no rush at this price level. However, for all the positive reasons we have enumerated below, readers can consider SHAK to be on our active “Watch List.”

SHAK: Company Overview (2016 10-K) (Jan’17 ICR Investor Presentation)
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 2016, SHAK (which came public in early 2015) operated and licensed 114 units in 16 states including Washington, D.C. and 13 countries generating system-wide sales of $403M. 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. For example, in April 2016, to promote the brand in the Washington DC, Maryland and Virginia area , the company teamed up with a celebrated chef of Chinese cuisine to offer “Crispy Peking Chicken” (crispy chicken breast with Maketto hoisin sauce (WTF? 😊), pickle, cucumber and scallion) on a LTO basis only in area stores. The company is also investing heavily in technology to provide customers with state of the art mobile conveniences. It is currently rolling out a mobile order –and- pay app nation-wide, which, in its first 6 weeks, accounted for 6% of sales.

Given the company’s commitment to all-natural proteins that are hormone- and antibiotic-free as well as vegetarian fed and humanely raised, it has some of the same supply chain risks as Chipotle in that rapid growth could outstrip its ability to manage the quality of many small producers. At this stage of its development, the company stipulates it has established rigorous quality assurance and food safety protocols throughout its supply chain and that it further addresses its risks by limiting the number of suppliers for major ingredients. For example, in 2016 all beef patties were purchased from 7 suppliers (70% was purchased from one of them) and it has 10 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 80% of core food and beverage ingredients and all paper goods and chemicals to each Shack from 12 regional distribution centers.

Of the company’s $268.5M of revenues in 2016 96.6% was generated by the company’s 64 stores (all domestic), while the balance was licensing revenues from the 50 licensed units (7 domestic, 43 international). The company believes there is the potential for at least 450 domestic units. In 2016 the company units averaged $4,981K (down from $5,367K in 2012 (an average skewed by 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. Moreover, even with lower AUV’s, store level profitability has improved with store-level EBITDA margins expanding 270bps in the last five years to 28.3% in 2016. Shack units, which are all leased, average 3,000-3,500 sqft (seating for 75-100) and require a cash outlay of $2.3M including our estimate of pre-opening expense. In 2017 company plans 22-23 new units generating AUV’s of “at least $3.2M and Shack-level operating profit margins of at least 21%.” Even at these modest levels of productivity, materially lower than has so far been the case, cash-on-cash returns would be about 30%.

Considering the modest number of stores in the system, and as a public company for just over 2 years, its continuing robust unit level-performance, including locations far from its NYC roots, is probably the best current gauge of SHAK’s promise. The company’s heavy SGA and pre-opening expense, typical of an early stage enterprise, still weigh on margins. To this point, the consolidated EBIT and EBITDA margins in 2016 were only 10.4% and 15.8%, respectively, down from 11.0% and 16.4%, respectively, in 2015. Similarly, ROIC, at 11.6%, while not all that impressive currently, is no doubt poised to expand rapidly as store growth allows more of their outstanding store level returns to fall to the corporate bottom line.

SHAK’s only balance sheet debt is $2M of deemed landlord financing (essentially capitalized lease obligations) added at the end of 2016 for 8 stores under construction. When added to the capitalized value of its other operating leases, SHAK’s ratio of lease-adjusted debt to EBITDAR of 2.8X in 2016 is the same as peers PNRA and SBUX. The company also has a $272.5M 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 (22-23 company stores in 2017 or ~35%) internally which consumes virtually all its cash from operations together with cash on hand. In 2016 CFO at $54.3M financed all but $0.1M of capex.

SHAK: Recent Developments (16Q4 Release) (16Q4 Conf Call)
In its 16Q4, SHAK generally met expectations for revenues, comps and EPS, though not “surprising” on the upside to the extent that it has often done in its first two years as a public company. Company revenues grew 43.5% YOY on 1.6% comps (on top of 11% in “15Q4) and 54% domestic unit growth. Since stores don’t enter the comp base until 2 years after opening, the comp base is small (only 30 of 64 US company stores). Traffic in Q4 was down 1.4%, offset by price increases of 3.0%. This pattern of higher ticket and slowing traffic is consistent with the industry, but in SHAK’s case the price increase has been relatively modest with the ticket mix boosted by premium LTO’s and the declines in traffic has been relatively modest. In terms of “prime costs”, CGS was 28.% in Q4, down 80bp, while labor and related expenses were 26.6%, up 160 bp YOY. Regarding other line items: “other operating” was up 90bp to 10.5%, occupancy and related expense was up 90bp to 8.9%. Importantly, while average weekly sales (AWS) have been expected to decline, AWS for the quarter were up 1.1% at a still very impressive $90,000. The Company continues to point out that the averages have likely been boosted by units opened in high density markets, and continues to guide to $3.2M annually for upcoming units. Sales trends were “strong throughout October, November….softened in December….holiday shift contributing about 80bp of pressure, as well as comparatively colder weather in the Northeast..”

Below the top line, higher expense—administrative and pre-openings—has prevented leveraging the 29% YOY quarterly growth of restaurant-level EBITDA (25.4% of shack level sales in Q4 and 28.3% in all of 2016) to the corporate bottom line. Adjusted pro forma net income was up 11.6% in Q4. At the unit level, labor costs have been up all year because of increases in the compensation structure implemented at the beginning of the year. The company proudly proclaims it already pays above current and minimum wage levels, a policy that allows it to attract and retain high caliber employees. The pre-opening expense increase was due to the accelerated opening pace in the year as well as higher unit costs incurred in entering new markets.

In the 16Q4 conference call, management again discussed its evolving LTO strategy for boosting ticket and margins. The Bacon Cheddar Shack ran successfully through Q4 into January. In Q1’17 Barbecue ShackmeisterBurger, Chick’n Shack and Barbecue Fries have been introduced. New seasonal shakes include Mud Pie, Mint Cookies and Cream, and Salted Vanilla Toffee flavors. Management continues to test breakfast at a handful of locations, such as Penn Station in Manhattan. It also testing delivery at two mid-town Manhattan locations (test including third party delivery services). The mobile app was launched in Q4, with a promotional push in January ’17. A free burger was redeemed 90,000 times through February, translating into 6% of overall sales, the average transaction has been up by 15% over normal, and over 25% of app users have already visited again. The Company notes again that these initiatives, while promising, pose execution challenges in the company’s already busy kitchens. Management points out that a core menu item is removed for each LTO addition to reduce strain on the kitchen. Internationally, it reported progress in Japan and Korea, with continued softness in the middle east, its largest non-domestic region.

Management raised guidance slightly for FY17 revenues to $349M-$353M, an increase of about 30%, on 2-3% comps, including 1.5-2.0% price. It guided to 22-23 new domestic units plus a net 11 new licensed Shacks. It also guided to continued deleverage at the unit level to EBITDA of 26.5-27.5%, primarily on higher labor costs. New locations are still expected to generate AUVs of at least $3.2M and Shack level EBITDAs of at least 21`%. G&A is expected to be $38-39M and D&A at about $22M.

Summary
Overall, we consider SHAK to be one of the best managed companies in the fast (or “fine”) casual restaurant segment, especially considering their relatively early stage which includes almost unprecedented unit growth of company stores. The “culture” is in place, but is not taken for granted by management. When unit level growth is so high, we suggest that many expenses are shuttled (or arbitrarily allocated) between unit level and corporate support. For example, trainees (charged to pre-opening) help out in existing stores (possibly reducing hours for more experienced crew), supervisors (charged to corporate) spend a lot of time in relatively young locations. The result of these examples would be store profits overstated, offset by higher pre-opening and higher corporate G&A . A “steady state” situation is not really in place, but in this case, no matter how expenses are allocated, the 2016 pre-tax operating income, at $27.8M, or 10.4% of revenues, with corporate EBITDA at 15.8% is an admirable starting point from which to leverage the situation over the long term. Store level margins will likely come down over time, on somewhat lower volumes and with not quite so much support from corporate, but the G&A percentage against higher overall sales will no doubt be reduced as well. Licensing revenue of $9.1M certainly helped, but there were no doubt material expenses against that contribution and licensing income is not going away. Putting it all together, we can’t think of another restaurant company, over the years, that has produced results this impressive at a similar stage.
SHAK stock is a somewhat different discussion. See our comments above for our current conclusion.

About the Author:
Roger Lipton
is an investment professional with over 4 decades of experience specializing in chain restaurants and retailers, as well as macro-economic and monetary developments. After earning a BSME from R.P.I. and an MBA from Harvard, he began following the restaurant industry as well as the gold mining industry. While he originally followed companies such as Church’s Fried Chicken, Morrison’s Cafeterias and others, over the years he invested in companies such as Panera Bread and shorted companies such as Boston Chicken.
For more information please contact: WWW.ROGERLIPTON.COM OR
WWW.LIPTONFINANCIALSERVICES.COM

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