2023-11-20 00:50:04 ET
Summary
- Shake Shack's 3Q23 results show sustained margin improvement initiatives are working and build costs are expected to decrease.
- Same-store sales grew 2.3% driven by price, offset by traffic and mix.
- I expect SHAK to continue trading at the current valuation when compared to peers.
Summary
Readers may find my previous coverage via this link . My previous rating was a hold as I believed Shake Shack ( SHAK ) was facing several headwinds, such as rising build costs and business model refinements, which may impact near-term financials. I am revising my rating to buy as SHAK 3Q23 results have shown that their margin improvement initiatives are working and build costs are expected to go down.
Financials / Valuation
SHAK’s 3Q23 results are starting to show positive progress. Same-store sales [SSS] grew 2.3%, mainly driven by price (8.6%) and offset by traffic (-4.2%) and mix (-3.5%). Total revenue grew to $276 million on $438.9 million of systemwide sales. Restaurant profit margins improved significantly from 16.3% in 3Q22 to 20.4% in 3Q23. This drove adj EBITDA at the consolidated level from $19.5 million to $35.8 million, an improvement of close to 500bps in margins. Consequently, EPS went from -$0.06 to $0.17.
Based on author's own math
Based on my updated view of the business, I increased my growth expectation for SHAK by 100bps in FY24 to reflect the normalization of pricing growth and management marketing strategy. The bigger change in my model is the revision in margin expectations. FY23, I have revised my expectations to be in line with management’s adj EBITDA guidance, and FY24 to see modest expansion. I am now much more positive about the margin outlook given the outstanding profitability in the quarter. With the continuous adoption of kiosks (refer to my previous post) and the new labor scheduling model, I expect restaurant-level margins to further improve.
Peers overview:
- Yum! Brands (YUM): 17x EV/forward EBITDA, expected to grow at 8% next year, EBITDA margin of 35%
- Restaurant Brands International (QSR): 16x EV/forward EBITDA, expected to grow at 6% next year, EBITDA margin of 27%
- McDonald’s Corp. (MCD): 16x EV/forward EBITDA, expected to grow at 7% next year, EBITDA margin of 54%
When compared to peers that are trading at similar levels, SHAK growth rate clearly outpaces all of them. However, I believe the lower profitability is a factor that is preventing SHAK from trading at a much higher premium. As such, I expect SHAK to continue trading in line with peers at 17x forward EBITDA.
Comments
In my opinion, 3Q23 did very well. The SSS of 2.3% was below management guidance due to slow traffic; however, October's SSS of 3.5% was accompanied by a reacceleration in traffic trends, so the outlook for the SSS in 4Q23 is promising. Price increases appear to be leveling off after increasing by 8.6% in 3Q before slowing to 1% in October. As lucrative as pricing growth can be, volume is more important. With the easing of price, I expect traffic to gradually recover back to normalized levels as well over the next 1 or 2 quarters. 4Q23 SSS is expected to be in the low single digits, as indicated by management, and I anticipate this trend to continue throughout FY24 as the recovery of traffic and mix more than compensates for the easing of pricing.
In addition, with the restart of SHAK’s marketing engine (using promotion to buy traffic), traffic is likely to see a periodic surge in the near term as price-sensitive consumers get attracted. In the 3Q23 call, management comments hinted that marketing ROI has been positive so far, and as such, I expect SHAK to continue ramping up marketing spend. In a normal spending environment, I would not advocate SHAK’s current strategy of promotion, as it cultivates a bad habit among consumers. Over a long period of constant promotion, consumers form the idea to just wait for the next promotion before visiting the restaurant. However, in the current spending climate, I’d say this strategy would work as almost every consumer is conscious about spending; hence, it could be a strategy for SHAK to acquire consumers across all income cohorts.
We've seen strong returns from our free Friday promotion and our Afternoon Happy Hour BOGO shakes plus we've had opportunities to dive deeper in select markets with performance marketing strategies, all of which are driving traffic and sales into our own channels.
We continue to believe that we have a meaningful opportunity to make greater investments in our direct marketing spend to drive sustainable long-term traffic growth. Source: 3Q23 earnings
The financial impact of this discount strategy should be seen as a whole. While gross margin and marketing spend are going to be impacted, the increase in volume should drive operating leverage to offset these costs. Net-net, if it drives growth in absolute EBIT, I think it will be a good strategy.
Rising build costs were one of the concerns I highlighted previously, and I am glad to see management aiming to reduce build costs by 10% in FY24. This is an important "off-financial statement” metric as it impacts the rate of store growth and ROI. The lower the build cost, the easier it is for SHAK to find a location because a lower ROI is needed, which means more stores can be built, thereby driving overall growth. It was noted during the quarter that the majority of SHAK's future store openings will be located along the coasts, targeting markets that SHAK already has presence in rather than venturing into untapped regions. The downside is that this will cannibalize its existing stores. That said, I am positive on this strategy as SHAK will gain a stronger presence in its existing markets, which could drive overall traffic growth at an aggregate level (i.e., per store might be slightly less, but because of more stores in the region, SHAK acquires more traffic in total).
As such, topline should continue to grow healthily. SSS should improve with the easing of pricing growth and an increase in market spend. Stores should continue to open as planned, given the reduced build cost.
My other worry was about profitability, but the 3Q23 results showed that efforts to increase margins were working. I now have a more positive outlook on SHAK’s margin expansion. To reiterate, SHAK reported an adj EBITDA margin of 13% and a restaurant profit margin of 20.4% (consecutive 2 quarters of >20% margin) , both of which saw outstanding growth compared to last year. I think the new model for scheduling workers will lead to significant gains in productivity. The scheduled labor model will improve store-level execution by ensuring that sufficient staff is present during peak times. One, this will make the restaurant run much smoother with fewer errors as the workload on each staff member is now lesser (as compared to having fewer staff). Two, table turnover should increase as food gets served faster (more staff working on the kitchen line). The combination of both drives operating leverage, which in turn drives an increase in profitability.
Risk & conclusion
SHAK promotional strategy could backfire, as I mentioned above, where consumers only come back to the restaurant when there is a promotion going on. Also, the initiative to target existing markets might not see much incremental benefit (i.e., SHAK is already catering to all the possible consumers in the region); as such, the total number of traffic might not go up as much as SSS declines (as cannibalization kicks in). In conclusion, I've upgraded SHAK stock rating to buy. Notably, a sustained >20% in restaurant profit margins indicates initiatives to improve margins are working. I also have an optimistic outlook on SSS as management have seen positive ROI from recent marketing campaigns. Build costs are also expected to shift downwards in FY24.
For further details see:
Shake Shack: Rating Upgrade As Profitability Shows Great Improvement