2023-06-23 11:06:33 ET
Summary
- Shake Shack's current growth trajectory is impressive, with revenue increasing at a CAGR of 28%.
- This is driven by a highly competitive offering, focused on quality beyond the affordable options.
- There are many positive opportunities Shake Shack is exploiting, which should support continued growth.
- Our concern is that SHAK's margins are underwhelming, and evidence suggests sufficient improvement is materially uncertain.
- SHAK's valuation in conjunction with the margin risk makes the business unattractive at the current level.
Investment thesis
Our current investment thesis is:
- Shake Shack (SHAK) has attractive financials, driven by a high-quality offering and a strong customer base.
- Despite slowing economic conditions and increased competition, SHAK's growth trajectory has remained robust.
- SHAK has scope for improvement through further restaurant expansion and technological utilization.
- SHAK's margins are unattractive, with its current valuation implying no upside.
Company description
Shake Shack Inc. owns, operates, and licenses restaurants globally. Its Shacks offers hamburgers, chicken, hot dogs, crinkle-cut fries, and shakes, as well as other products.
Share price
SHAK's share price has experienced periods of outperformance, as a strong growth trajectory encourages confidence in the business. Numerous times, however, the share price has aggressively rerated, primarily due to a softening of expectations.
Financial analysis
Shake Shack financials (Tikr Terminal)
Presented above is SHAK's financial performance for the last decade.
Revenue & Commercial factors
Revenue has grown at an impressive rate in the last decade, achieving a CAGR of 28%. During this period, growth has only dipped below 20% once on an annual basis, driven by Covid-19.
The overarching reason for the strong popularity of SHAK is its innovative approach to the concept of casual dining.
Business model
SHAK's business model revolves around providing a combination of high-quality food, inviting ambiance, and customer-centric service through an elevated dining experience. The company emphasizes sustainable and ethical practices, including sourcing hormone-free and antibiotic-free meat. The quality approach to burgers is an untapped segment relative to the average choice for consumers, given the range of "fast food" establishments offering burgers at a fraction of the price. The likes of SHAK, Five Guys, Honest Burger, etc, have shown that consumers are more than willing to purchase high-quality burgers if the taste justifies the premium.
Shake Shack has a few key competitive advantages, in an industry where it is incredibly difficult to differentiate and built a moat. Its commitment to quality and sustainability resonates with health-conscious and sustainable consumers. Although difficult to quantitatively estimate, the product tastes fantastic and is rivaled by only a few other brands. This has allowed SHAK to develop strong brand recognition and a loyal customer base, providing a solid foundation for growth.
Shake Shack operates in the highly competitive fast-casual/dining restaurant segment. It competes with other established players like Chipotle Mexican Grill ( CMG ), and Five Guys, as well as Domino's ( DPZ ), Burger King ( QSR ), and McDonald's ( MCD ) to a lesser extent.
Restaurant industry
The largest trend in the restaurant industry is the rise of delivery apps, as well as the development of ghost kitchens subsequently. These 3rd party apps have become the new gatekeepers for driving restaurant sales, as consumers are increasingly scrolling to find places to eat rather than driving to their favorite choices. Our view is that this represents a risk for many of the traditional brands, including SHAK, as it increases competition and forces brands to improve their value proposition (to justify the higher prices relative to the greater number of cheaper options). McKinsey research has found that this is value-destroying for Restaurants (See below), but the alternative is to not compete at all (Going direct to consumers or not being on apps at all). Despite the resilient demand, we consider this a key ongoing risk to the business.
Restaurant delivery economics (McKinsey)
There has been a noticeable uptick in the demand for plant-based and alternative protein restaurant options, presenting an opportunity for SHAK to expand its menu offerings. This has been driven by developing knowledge of healthy diets and also a greater focus on the social and environmental impact of actions. Those initially interested in SHAK are unlikely to be meat-eaters, however, the opportunity to expand into a new segment was clear. Imagine the number of friendship groups / relationships that include a non-meat eater. Not providing viable options rules out more than just a potential new customer. Having considered several reviews of the company's vegetarian option, the general consensus is that it is very good . Unlike many of its peers, SHAK has not just put a meat alternative in the middle of two buns but has committed resources to curate several strong options. Contrast this to Five Guys, whose vegetarian option is far less positively regarded ( Quote from a review below ).
The worst thing on the menu, quite predictably, was the Veggie sandwich. Essentially just a pile of vegetable toppings, it tasted exactly like they forgot to add a patty to a burger order, and, out of guilt, threw every other topping in the bin inside a bun.
Further, consumers are demanding variation and menu innovation. This is an interesting trend in recent years that makes you think, why has this not happened sooner? Many of its competitors are running consistent limited-edition products throughout the year. The value proposition is clear; loyal customers will almost certainly try the new items, or at least hear the news and so heighten the chance of a recurring sale. Also, the casual diner may see an interesting product worth trying. Finally, from SHAK's perspective, it can innovate and test out products for future offerings. Notable limited-edition products from SHAK in 2022 include:
- Buffalo Chicken Sandwich and Fries with Buffalo Spiced Fries and Buffalo Spiced Cheese Fries - Synonymous with beef, this is a way to illustrate to consumers the company can also make great non-beef meat options.
- Bourbon Bacon Cheddar Burger and Chicken featuring bourbon bacon jam made with Maker's Mark Bourbon - Reinforcing the image of SHAK being an upmarket offering (and again providing a non-beef option).
- Hot Ones Burger Menu with a spicy version of ShackSauce - Intelligent social media market .
- Non-Dairy Chocolate Shake and Frozen Custard in partnership with NotCo, as well as Caffeinated Lemonades - Illustrating commitment to plant-based foods and also gaging demand for caffeinated products.
The use of technology is becoming an important development required in the restaurant industry. The objective is to utilize digital infrastructure and platforms to enhance customer engagement, streamline operations, and offer personalized experiences. Essentially, companies are seeking to generate increased revenues while also cutting costs. Given the nature of the industry, one may expect the impact to be small, but the scope for improvement is noticeable. Domino's , for example, is leaning heavily on this and expects it to generate further sales in the future.
Opportunities
Key growth opportunities for SHAK include the continued expansion into trending products, such as plant-based, as well as menu innovation.
We also believe store expansion is critical for the business, as organic growth will always be restricted by the nature of restaurant size and footfall. Unlike many of its peers, SHAK still has a significant runway for further locations, especially overseas. Management believes they can reach 450 Shacks in the US, currently at 56% of this ( FY22 financial statements ).
Economic & External consideration
Current economic conditions represent a key near-term tailwind to the company. With high inflation and elevated rates, consumers' finances are being squeezed, encouraging reduced discretionary spending as a means of shoring up finances.
Although we have not entered an official recession, this will inevitably have an impact in the coming quarters, with LTM growth implying resilience. According to Datassential , a third of consumers surveyed intend to dine out less over, and only half plan to maintain their current restaurant-spending habits.
We suspect these conditions will remain, if not worsen, for several more quarters as inflation continues its slow decline.
Margins
SHAK's margins are not great. The company has a GPM of 35%, EBITDA-M of 6%, and a NIM of (2)%. Compounding this is 5 years of negative FCF.
The biggest issue for SHAK has been the ability to transition toward profitability. In recent years, this has been compounded by the impact of inflationary cost increases exceeding menu inflation. Our view is that further price increases are possible but Management looks hesitant, potential to maintain parity with Five Guys, or out of fear of a slowdown in growth.
We suspect as inflationary pressures subside, margin improvement will occur but reaching an attractive level looks uncertain. We have not seen sufficient evidence to suggest this will occur.
Balance sheet
SHAK's net debt/EBITDA ratio has gradually increased over the last decade, as Management has invested heavily in expansion, illustrated in the poor FCF. This is primarily lease obligations and so we are not overly concerned by the increase and suspect the trajectory will continue.
Outlook
Outlook (Tikr Terminal)
Presented above is Wall Street's consensus view on the coming 5 years.
Analysts are highly bullish on revenue, forecasting a growth rate of 16%. This is likely a reflection of continued restaurant growth which looks reasonable to assume based on Management communications.
Further, margins are expected to bounce back and improve. We are less confident in this regard, primarily due to the lack of track record thus far. Q1 Adj. EBITDA-M was 10.9%, which could be the basis for improved margin sentiment.
Industry analysis
Restaurant industry (Seeking Alpha)
Presented above is a comparison of SHAK's growth and profitability to the average of its industry, as defined by Seeking Alpha ( 44 companies ).
The key area of weakness is SHAK's margins, which are noticeably below the average. Many of its larger competitors operate primarily franchises, and so have higher and more resilient margins. We mention this because improvement in the coming years should contribute to outperformance, although the delta remains a concern.
Growth is strong and noticeably higher on a 5-year basis, reflecting the rewards of high capex spending. SHAK is marginally down in the forward period but regardless, we see the company as relatively strong in this regard.
Valuation
Valuation (Tikr Terminal)
SHAK is currently trading at 57x LTM EBITDA and 28x NTM EBITDA. This is marginally below its historical average and clearly represents a significant premium.
Justifying such as high multiple is extremely difficult for businesses but we must consider the business from a wider lens. SHAK has yet to reach $1bn in revenue and only has an EBITDA of $60m. This means it is susceptible to volatile movements based on changes in earnings. If SHAK was to reach its FY25F forecasted adj. EBITDA, it would be trading today at a 3Y forward multiple of 20x, far less insane.
The question thus becomes, is a 20-30x multiple justified in several years time? We believe not. Although the company's trajectory is positive, it continues to grow well, and has a great commercial position, its inability to improve margins is too big of a risk. A company with an EBITDA-M of 8-12% is just not attractive enough. Wingstop ( WING ), for example, has a forward multiple of 46x while having an EBITDA-M of 29%. Without beginning a debate on Wingstop's high valuation, it seems that the additional 18x buys you substantially higher margins and similar growth.
Management
Following activist pressures, SHAK's Management has agreed to work with Engaged Capital. Morgan Stanley ( MS ) upgraded its rating on the stock although stated,
"We're aware that activists and consultants aren't always the unlock some hope for, and we don't have a specific view on these parties at this point , but having a public agreement with defined areas for improvement offers the chance to address at least some items we think are real challenges for SHAK, and eventually drive better operations, cost efficiency and margin upside."
We wholly concur with this succinct assessment from MS, although believe the upgrade in rating is premature.
Final thoughts
Shake Shack is a fantastic restaurant and we genuinely believe it offers one of the best burgers available, especially if you compare it to other chains. This has allowed the business to develop a strong cult following, as well as continued growth through greater consumer awareness. We believe there is sufficient evidence to suggest this trajectory will continue.
The key risk we see is that there is not sufficient visibility of margin improvement, especially to the level required to make this an attractive business.
We suggest this stock continues to be monitored in line with the likes of Wingstop.
For further details see:
Shake Shack: Growth Potential, But Margin Issues Remain