SHAK - Shake Shack: Combating Revenue Growth And Rising Cost Challenges

2023-10-03 09:27:32 ET

Summary

• SHAK is a renowned American fast-casual restaurant chain known for high-quality burgers, hot dogs, and sustainability in its operations.
• Recent financial trends show declining revenue growth and EBITDA margins, with concerns about rising build costs, but optimism in recent sales trends and digital initiatives.
• A hold rating is recommended for SHAK due to uncertainties in its growth outlook and valuation.

Summary

Shake Shack ( SHAK ), is an American fast-casual restaurant chain that originated in New York City. SHAK is renowned for its high-quality burgers, hot dogs, crispy crinkle-cut fries, milkshakes, frozen custard, and even alcoholic beverages in certain locations. The chain places a strong emphasis on sourcing premium ingredients and maintaining sustainability in its operations. Over the years, it has experienced significant growth, expanding its presence not only across multiple states in the U.S. but also internationally. The brand is often credited with modernizing the traditional "roadside" burger stand concept with its contemporary approach to food, ambiance, and service.

Over recent years, SHAK's revenue growth rate is on a declining trend. Recent quarterly results further highlight this trend with softer Same Store Sales [SSS]. Concurrently, EBITDA margins have been trending downward as well, influenced by inflationary pressures and the costs associated with rapid expansion. While the second quarter showed a soft SSS, an upward trend was noted by July, attributed to successful promotional campaigns. The upcoming quarter's guidance projects modest revenue growth, aligning with the recent uptick in sales. Amidst these dynamics, rising build costs emerge as a significant concern, even as SHAK seeks to optimize them. To address profitability, SHAK is refining its business model. The emphasis is on digital integration, labor optimization, and streamlined off-premise sales. Given these views, I recommend a hold rating for SHAK.

Financials/Valuation

Over the last six years, SHAK has experienced a diminishing revenue growth rate, declining from 28% in 2018 to 22% in 2022. The cumulative yearly average revenue growth stands at 17%. Further evidence of this deceleration is seen in the recent second quarter results, which display a weak SSS, suggesting that the company may be transitioning towards a maturity phase.

Regarding EBITDA margins, the trend is concerning. The margin plummeted from 18% in 2017 to just 8% in 2022, with a long-term average of 11%. This shrinkage is mainly due to inflationary pressures and SHAK's aggressive expansion endeavors. Nonetheless, there are ongoing efforts by SHAK to manage and optimize costs, a topic to be delved into subsequently.

Based on my view of the business, I anticipate a 19% growth in SHAK's revenue for FY24. This outlook is shaped by the promising SSS trends observed in recent months, especially June and July, boosted by its marketing strategies. Additionally, the company's ongoing digital ventures, menu enhancements, and the management's optimistic revenue guidance for the third quarter further reinforce this projection. Historical data reveals a deceleration in SHAK's revenue growth over the past six years. Although recent SSS figures show promise, they predominantly hover in the low single digits. Given this backdrop, I expect its growth rate to trend towards its annualized average rate.

Turning to EBITDA margins, while SHAK's expansion strategies seem well-aligned, there are undeniable challenges stemming from rising build costs. Encouragingly, steps are in place to manage these costs. With SHAK's outlined profitability-enhancing measures, I foresee margins rebounding to its average of 11%.

As of now, SHAK's forward EV/EBITDA stands at 16.9x, surpassing its peers like McDonald's ( MCD ), which has an EV/EBITDA of 8.9x. This higher multiple can be attributed to SHAK's higher 1-year expected revenue growth rate of 22% vs MCD's 10%. Furthermore, its 2-year expected revenue growth rate of 16% is also higher than MCD's 6%.

Using SHAK's present forward EV/EBITDA, my target price is $57. If SHAK's performance in the upcoming quarters falls below expectations, its share price will face additional downward pressure as its valuation contracts. Therefore, given the lack of a margin of safety and uncertainties regarding its growth outlook, I recommend a holding rating for SHAK.

Comments

SHAK's recent activity paints a mixed picture of its performance. The second quarter showcased a weak SSS of 3.0%, even though system-wide sales impressively grew by double digits of 21.2% year over year. This was influenced by a 1.3% reduction in foot traffic due to a shift away from delivery and higher selling prices. Rapidly exhausted offers, such as the White Truffle limited time offer [LTO], played a role in these results. However, there was an uptick in sales trends by June, propelled by the Maker's Mark LTO, leading to a 4.5% SSS in July. Building on the momentum, the revenue forecast for the forthcoming third quarter is set between $273.5 million and $278 million. The expected growth in Same Shack sales is projected to be in the low-to-mid single digits year-over-year, consistent with the 4.5% observed in July, marking a positive shift from the current quarter's subdued SSS.

In order to drive revenue growth, SHAK is rapidly expanding its presence. While development progresses as planned, concerns arise from rising building costs. The recent quarter saw the inauguration of 23 stores. They aim to double the store openings by the end of the third quarter compared to last year. Yet, the financial landscape is clouded by surging construction costs, now projected at $2.6 million, up from $2.4 million in 2022. Factors like unforeseen expenditures and the integration of drive-thru contribute to this increase. Efforts are underway to scale these costs back to around $2.4 million by optimizing store layouts and construction methodologies, but such adaptations will likely be gradual. On the licensing front, initial projections for 2022 indicated 25-30 openings, but current estimates suggest 35 by year-end.

To address profitability concerns, SHAK is considering a range of strategies. These include amplifying sales via the most lucrative channels, with a strong emphasis on maximizing digital capabilities. Labor efficiency is another focus area, with comprehensive training for new recruits and refining team structures to ensure optimal store staffing. Off-premise sales present further opportunities through the standardization of condiments, reducing packaging overheads, and implementing premium pricing for third-party deliveries. The introduction of kiosks enables a shift in labor from order-taking to other roles, making operations more efficient. Notably, these kiosks have shown to boost revenue through increased average order values, add-ons, premium LTOs, and heightened beverage sales, marking them as SHAK's leading revenue channel. The nearly doubling of kiosk sales on a year-over-year basis emphasizes this even more. Looking ahead, kiosks may soon feature personalized marketing, alcohol offerings, and cash transactions, functionalities not currently available. In addition, SHAK is exploring improvements in off-premise profitability with ongoing packaging trials and considering passing on more delivery-related costs to consumers. Given SHAK's proactive measures to enhance profitability, I anticipate its future EBITDA margin to trend upward. The successful rollout and future enhancements of kiosks, which enable a shift in labor usage, further support this outlook.

Looking ahead, SHAK's strategies to address profitability and control escalating costs will be pivotal in determining its financial stability and market positioning. Investors should remain attentive, particularly to SHAK's adaptability in refining its operational model and its effectiveness in capitalizing on digital enhancements. The evolving landscape presents both potential rewards and inherent risks, making it crucial to observe how SHAK maneuvers these dynamics in future quarters.

Risk & conclusion

One potential upside risk is the accelerated adoption of SHAK's digital initiatives. Should these digital endeavors outperform expectations, there might be a notable increase in sales, potentially driving an unforeseen boost in revenue.

Additionally, a faster and better-than-expected reduction in SHAK's rising build cost could result in higher than anticipated margins, offering a positive deviation from the present financial forecast.

In the past few years, SHAK has witnessed a downward trend in its revenue growth, further emphasized by recent quarterly results showcasing a dip in SSS. Factors such as inflation and fast-paced expansion have put pressure on their EBITDA margins. Despite this, a positive sales shift was observed in June and July, driven by effective marketing strategies. Given the momentum, management guided a positive and conservative third quarter's revenue, mirroring this recent positive shift. However, concerns surrounding escalating construction costs persist, but management is actively addressing it. In order to improve profitability, SHAK is focusing on harnessing digital platforms, improving labor efficiencies, and honing their off-premise sales strategy. Taking all these factors into account, I recommend a hold rating on SHAK as my target price shows that there is a lack of margin of safety. If SHAK were to miss expectations, its valuation will face contraction, leading to share price decline.

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