2023-11-03 10:38:59 ET
Summary
- Shake Shack reported satisfactory Q3 results, with record system-wide sales, strong revenue growth, and another quarter of margin recovery.
- Meanwhile, the company remains confident in its ability to reduce its build costs for its class of 2024 and is planning another year of industry-leading growth in 2024.
- However, recent beats have been helped by lapping easier comps and it's a tougher setup in Q4/Q1 with wage increases in core markets, less pricing, and lapping highly successful LTOs.
- In this update, we'll dig into the Q3 results, why its upcoming quarters could be more challenging, and whether SHAK is a buy after its Q3 beat.
Just over five months ago, I wrote on Shake Shack (SHAK), noting that any rallies above $66.20 would provide an opportunity to book some profits. And although this was the right move as the stock has since reversed sharply below this level, this was a terrible call in hindsight as the stock rallied much further than I expected to $80.50 before running into selling pressure. The strong performance could be attributed to a solid margin recovery and better same-shack sales than I expected, helped by its enormously successful White Truffle Burger and Bourbon Bacon Burger, but the stock has since corrected sharply in line with its industry peers. In this update we'll dig into the Q3 results, the stock's updated valuation, and whether it's worth owning ahead of what will be another year of industry-leading growth in 2024.
Q3 Results
Shake Shack released its Q3 results this week, reporting quarterly revenue of $276.2 million (+21% year-over-year), and record system-wide sales of $438.9 million (+24% year-over-year). The strong growth was driven by another busy quarter for development (25 net new openings, made up of 10 domestic and 15 licensed shacks) and the company reported 2.3% same-shack sales which translated to 8.5% growth on a two-year stacked basis. That said, this still translated to a 4% plus traffic decline in the period which was similar to the negative traffic we saw industry-wide, with Shake Shack calling out unfavorable weather, headwinds from infill from new openings, and the lapping of multiple digital promotions from Q3 2022.
Shake Shack - Quarterly Revenue - Company Filings, Author's Chart
As for company commentary, the company noted that it had a softer September after selling out of its Bourbon Bacon Burger. Fortunately, it enjoyed a better October with 3.5% same-shack sales and flat traffic, and it was more cautious with a 1% price increase after lapping price from last year given the more difficult macro outlook. On a positive note, margins improved meaningfully in Q3 to 20.4% (Q3 2022: 16.4%) helped by menu pricing, which resulted in significantly lower food & paper, labor, and other expenses as a percentage of sales. In addition, the company is now working to tackle the supply chain and further labor efficiencies to look for further savings. The other positive mentioned was that kiosk sales were up 140% year-over-year, work is underway to aim for better up-selling with its kiosks, and it's seeing labor cost improvements with a more refined labor staffing system.
Shake Shack - Shack Level Operating Margins - Company Filings, Author's Chart
Finally, for development progress, Shake Shack opened 10 new domestic shacks in the period, hit the major milestone of opening its 500th shack this quarter ,and saw licensing revenue improve to $11.2 million, a 35% increase year-over-year. That said, when it comes to company-owned restaurants, it is working to reduce build costs which have crept up meaningfully (~$2.6 million which is up 30% on a three-year basis), with the company noting that several of its 2023 class restaurants came in significantly over budget. Shake Shack noted on its past two calls that it is hoping that it can reduce costs by up to 10% for its 2024 class, which would certainly be a step in the right direction, but it remains to be seen whether the company will be successful with sticky labor inflation and a tougher environment for openings (delays/permits) overall called out by most brands.
Shake Shack - Total Domestic Shacks & Net New Shacks - Author's Chart
Industry-Wide Trends & Recent Developments
One key theme across the industry has been deflation in the market basket for some restaurant brands, especially those with a higher weighting towards chicken and pork in the market basket. However, Shake Shack has been less immune in this department given the inflation we've seen in fry costs and beef, with Shake Shack noting that fries were up over 15% year-over-year, and beef was up low double digits year-over-year and mid-single digits sequentially. In fact, the company noted that although some areas of its market basket cooled, it expects "added pressure in areas such as fries, dairy and beef". It also stated that these pressures are likely to persist, "with notable risk around beef which it does not contract" . So, with Shake Shack choosing to be careful with pricing and going with 1%, the setup isn't ideal vs. some other brands.
Elsewhere, from a top-line standpoint, Q3 traffic was down over 4% and bounced back to flat in October, helped by marketing. However, we can see in the below chart that Shake Shack has seen its traffic worsen throughout the year (grey line), similar to what we've seen from seated diners' growth according to OpenTable. And while October improved after a tough start according to OpenTable data, it has since turned sharply lower and we've now seen nearly four months with no uptick back into positive territory (seated diners' growth) for this data. Obviously, this is not a direct correlation to Shake Shack's traffic, and the company appears to have bucked some of the softness in October. Still, with industry-wide traffic rolling back over at the same time as Shake Shack sees pricing rolling off (which benefited same-shack sales in previous quarters), it could be more difficult to lap its 5.1% same-shack sales from Q4 2022.
Seated Diners Growth United States & Shake Shack Traffic - OpenTable, Company Website
Expanding on this point, the other negative trend we've seen is that quick-service traffic has held up relatively well throughout the year and outperformed casual dining traffic, suggesting that trade-down beneficiaries were more insulated. However, quick-service traffic went sharply negative in August and September, suggesting some consumers might be getting tapped out and reducing frequency altogether. And while SHAK is sandwiched between quick-service and most casual dining brands from an average ticket standpoint, promotional activity has ticked up, creating a tougher environment for all brands. So, with consumer behavior changing negatively (even quick-service is seeing a traffic decline), and Shake Shack not benefiting from being a trade-down beneficiary which might be more immune like Popeyes' Chicken or McDonald's ( MCD ), it's tough to be as optimistic about traffic and same-shack sales in November through January.
Finally, from a bigger-picture standpoint, holding the line on labor could be much more difficult in 2024 and 2025. This is because California will raise its minimum wage to $20.00 as of April and New York will raise wages further, with a planned increase to $17.00 in 2026 (New York City, Long Island, and Westchester County) and $16.00 by 2026 in the rest of New York State. And given that these two markets make up over 30% of Shake Shack's system, this will certainly be a headwind going forward (especially combined with beef cost headwinds short-term), with the initial and more immediate impact showing up in its Q2 results. On a positive note, the company noted that it is seeing "its best hourly and manager retention in years". In addition, its applicant flow has doubled and kiosks continue to deliver above expectations, providing some sales leverage and margin help as they're consistently carrying higher tickets and are its highest-margin channel.
Valuation
Based on ~43 million shares and a share price of $58.00, Shake Shack trades at a market cap of ~$2.50 billion and an enterprise value of ~$2.97 billion. This places Shake Shack near the middle of the pack in terms of valuation among quick-service names, behind growth stories like Dutch Bros ( BROS ), and CAVA ( CAVA ), but well ahead of names like Portillo's ( PTLO ) and Jack In The Box ( JACK ). However, despite its sharp decline from its all-time highs of $125.00 per share, SHAK continues to trade at one of the richer multiples sector-wide. In fact, the stock is currently trading at over 130x FY2024 earnings estimates ($0.44) and ~19.5x EV/EBITDA using FY2024 estimates (~$152 million), making it far more expensive than franchisors and trade-down beneficiaries like Restaurant Brands International ( QSR ) and Yum! Brands ( YUM ).
Shake Shack - Historical EV/EBITDA Multiple & Current Multiple - TIKR.com
Obviously, some of this premium can be tied to the fact that Shake Shack is an iconic brand with considerable white space (domestic & licensed business) and its industry-leading unit growth rates (75 restaurants for 2024 would imply another year of 15%+ growth). Plus, as the chart above shows, SHAK's historical multiple since going public is 30.0x EV/EBITDA, well above its current forward multiple. Still, I think a more conservative multiple in the current environment is 20.0 - 22.0x EV/EBITDA, given that not only are SHAK's margins well below peak levels (~20% vs. ~28%) but also because the current macro backdrop and interest rate environment have led to a reset in multiples with alternatives to equities. And if we use the mid-point of the range at 21.0x EV/EBITDA and FY2024 estimates of $152 million, I see a fair value for SHAK of $63.10.
Although this points to a 9% upside from current levels, I am looking for a minimum 25% discount to fair value when it comes to mid-cap growth stocks, and ideally closer to 30% for those in the consumer discretionary space. However, even if we use the low end of this range (25%) and apply this discount to SHAK's estimated fair value, this points to an ideal buy zone for the stock of $47.30 or lower, suggesting SHAK is nowhere near a low-risk buy zone even after its ~30% correction. And while the stock could continue to trade at a premium multiple and build on its recent rally off its lows, I currently see far more attractive options elsewhere in the market, with one example being Aritzia (ATZAF)(ATZ:CA) which trades at just ~7.0x CY24 EV/EBITDA with significant insider buying.
Aritzia Insider Buying - SEDI Insider Filings
Summary
Shake Shack enjoyed another quarter of margin improvement in Q3 with a 400 basis point increase year-over-year, and while traffic trailed off in the second half of Q3, it appears to have bounced back in October according to company commentary. That said, the company's margin improvement over the past few quarters has been on the back of relatively easy comparisons and the next two quarters will be challenging. This is because Shake Shack is contending with rising beef costs, lapping its highly successful Hot Ones LTO through October 2022, its White Truffle LTO in Q1 2023, and combating a tougher macro backdrop (weaker consumer). In addition, it will have to lap this premium LTO in Q1 without the benefit of high single-digit pricing, with price exiting October at ~3.5%. Hence, while Q3 was a little better than I expected, it's tougher to be optimistic about its Q4-23 and Q1-24 results.
Assuming SHAK was trading at less than 16x EV/EBITDA at the lower end of its range where it's typically found buying support, there might be reason to ignore these headwinds and own the stock. However, it's hard to argue that SHAK is offering any margin of safety here at ~19.5x FY2024 EV/EBITDA, and one could actually argue the stock is expensive relative to other names that have been battered over the past two months in the Retail Sector. In summary, I continue to see more attractive bets elsewhere in the market and I would view any rallies above $66.00 before February as profit-taking opportunities.
For further details see:
Shake Shack: A Decent Quarter, But Traffic Declines Persist