Description

Shake Shack

Thesis Summary

We believe Shake Shack presents a compelling investment opportunity to invest in a global iconic fast-casual concept, still in the relatively earning innings of growth, with significant whitespace, both domestically and internationally. The combination of industry-leading restaurant-level unit economics and large runway should see substantial revenue growth for years to come. Whilst currently optically expensive at >100x FY19 earnings, G&A leverage should ultimately see currently anaemic group margins/ROIC converge towards their excellent restaurant level margins/ROIC. We believe that a valuation of double the current market capitalization in the next five-seven years is easily achievable using conservative assumptions, with substantial upside in the event that international and domestic TAM are higher than prevailing market wisdom believes.

The Shake Shack story to date

Shake Shack has its origin in 2001, when successful restaurateur Danny Meyer was looking to restore Madison Square Park, overlooked by his Eleven Madison Park restaurant. As part of the restoration, the Parks & Rec committee held an outdoor art exhibition – the first being one called I ♥ Taxi, where old NYC yellow cabs were mounted on large stilts. As part of the exhibit, the artist if requested Danny could run a hot dog stand to accompany the exhibit. It started as a seasonal affair, and for a number of summers in a row, huge lines would form for this humble hot dog cart.

A few years later, Danny sought to make it a permanent kiosk. He expanded the menu, to include burgers, shakes, frozen custard and concretes. However, being Danny Meyer, he wanted to elevate the concept of the roadside burger stands he fondly remembered from his childhood. He used the same high quality, fresh ingredients he used in his restaurants  - for example, the beef used in their burgers is a proprietary mix of chuck, sirloin and brisket, devised by famed butchers, Pat LaFrieda, the very same butcher that provides steaks to Danny’s fine dining restaurants. And thus the concept we now know as ‘Shake Shake’ was born.

Shake Shack proved to be a massive hit, the legendary lines continued with the wait times sometimes being so insane, the company installed a ‘Shack Cam’, so people could get a sense of the wait. They opened a second one a few years later, but they were uncertain if it would be a success, thinking perhaps the park setting or novelty was the reason behind the success of the original. Those fears soon proved misplaced as the second location ended up being more successful than the original Shack.

Not long after, when they were still only at two-and-a-half locations they were approached by Alshaya, a large Kuwaiti franchise operator,  that operates multiple brands across the Middle East. At a time when Shake Shack had little experience in terms of replicating its restaurants and growing operations, he saw the opportunity to partner with Alshaya in order to 1) learn how to replicate their business operations, having been impressed with Alshaya’s replication capabilities and noting that the Kuwaiti outlets of certain western brands were actually in many ways superior to several of the domestic operations and 2) provide an opportunity to see the concept’s growth potential, but in a low risk environment, as he viewed any potential failure abroad as being less of a black mark to the brand. These outlets in Kuwait proved to be a huge success, confirming the strong international potential for Shake Shack and now Danny and Randy (Shack’s CEO and USHQ alumni) realized they had something special on their hands that had huge growth potential.

Subsequent to this Shake Shack, established a two-pronged growth strategy – i) the domestic stores would be company-owned (outside of a few sports/airport concessions), as Shack continued its national roll-out outside and ii) the international stores would be run by master franchise operators, typically with very strong track records.  Shack Shake IPO-ed in early 2015, also raising funds for expansion.

At end of FY19, Shake Shack had  total of 163 domestic stores and 90 international franchise stores. Longer term, Shack management are targeting 450 domestic stores.

Strengths

·        Iconic Brand/Concept: I’ve discussed this in the company history, but the progression of Shake Shack from a humble hotdog stand to a New York City icon is the stuff of legend in the culinary world. Since the dawn of the concept, Shake Shack has been renowned for its long lines and crave-worthy lineup of burgers, fries and shakes, all made with fresh, natural ingredients. As noted in Esquire Magazine at the time of Shake Shack’s IPO, “When McDonald's or Five Guys opens a new "unit," the fact barely registers on local media; when Shake Shack opens a new store, the fact is treated as a story, and even as a news event”  and even five years later this statement is still applicable. Shake Shack’s average domestic AUVs at over $4mn at FY2019, and well above industry peers. Further evidence of Shake Shack’s strong cult following, is its Instagram following, where it punches well above its weight when comparing units to number of followers:

·        Excellent restaurant-level economics: Shake Shack’s excellent AUVs contribute to some of the finest restaurant-level unit economics in the industry. As per their IPO prospectus, “In fiscal 2013, our domestic company-operated Shacks had AUVs of approximately $5.0 million, of which our Manhattan Shacks generated AUVs of approximately $7.4 million with Shack-level operating profit margins of approximately 30% and our non-Manhattan Shacks generated AUVs of approximately $3.8 million with Shack-level operating profit margins of approximately 22%. Historically, our domestic company-operated Shacks have delivered an attractive average cash-on-cash return of 65% and payback period of 1.5 years, of which our Manhattan Shacks generated an average cash-on-cash return of 82% and payback period of 1.2 years and our non-Manhattan Shacks generated an average cash-on-cash return of 31% and payback period of 3.2 years. Since the vast majority of future Shacks will be non-Manhattan locations, we are targeting AUVs in the $2.8 to $3.2 million range, Shack-level operating profit margins in the 18 to 22% range and cash-on-cash returns in the 30 to 33% range”. Since their IPO, the actual unit economics has been on the slightly high side of that guidance, even five years out.

·        Domestic runway/whitespace:

o   Shake Shack currently has 185 domestic company-owned stores, which still represents only the 40% of their goal stated in their IPO to get to at least 450 units domestically.

o   Whilst management has not explicitly raised their IPO guidance on the 450 domestic shacks number, they have to date been quite conservative on growth guidance. At the time of their IPO, they stated that they would look to build 10 Shacks per year – they are now at a ~40 annual run-rate (and were steadily increasing until COVID hit). Furthermore, forward-looking annual unit guidance has usually been upwardly revised on conference calls and we believe the language used in their conference calls reveals certain tells that TAM guidance could be substantially increased at some stage. Some examples include the following excerpts:

§  “I think it's big, John, and we've just gotten started. We were going back and thinking about today to just less than 3 years ago at our IPO where we thought we'd do about 10, 12 restaurants a year domestically and a little less than that internationally. We've way overachieved that, and I think we've overachieved in all the quality, AUVs and op profits that we expected in these last 3 years. So really proud of the team's work on that. We continue to name 450 domestic company-operated sites as our target goal for now. Every time we do something that's a little bit different, a little bit different format or a different place in the country and it works, which every one of our shacks in this country is working very well, we're encouraged to do a little more.” Randy Garutti CEO, 2017Morgan Stanley Conference

§  “We feel like 150 Shacks in this country. It is nothing. We've got a long way to go before we even begin to capture the great opportunity. And with a brand this strong, I can do so many things, I'm really bullish on where we're headed.” Randy Garutti CEO 2019 GS Conference

§  “We only have 167 restaurants that we own in this country. There's less than 200 total in this country. We have a massive opportunity here, abroad, and we're going to continue to grow restaurants. Hard to say when that levels off” …….” We think we haven't even really scratched the surface of this company's opportunity in this country and globally. And we're certainly going to keep going” Randy Garutti,Q4 2019 Earnings Transcript

o   When thinking about what Shake Shack’s domestic footprint may end up looking like, we feel it instructive to look at companies like Chipotle and Five Guys, both companies in the Fast Casual sector, with a broadly similar price point, and in the case of Chipotle I think a lot of similarities in terms of 1) both founders had a fine dining background, 2) both chains noted for their use of high quality natural ingredients, 3) both concepts were ‘accidents’ – in Chipotle’s case , Steve Ells was just looking to make enough money selling mission-style burritos to open a fine-dining restaurant , 4) both have loyal and fanatical millennial customer bases. Chipotle currently have over 2,500 domestic units and are looking to more than double that in the next five years. Five Guys currently has over 1,300 domestic outlets. These both represent many multiples of Shake Shack’s current base.

o   Management has made clear that over the next few years, there will be greater in-fill, which shouls also improve economies of scale and see some COGS and G&A leverage. From the Q2 2019 conference call “We are in 28 states, okay? When we opened one restaurant on Saturday, we opened in Utah, okay, that Shake Shack is out there by itself. That's really hard to run that restaurant. Now it's going to be crazy sales and there was about 1,000 people online on Saturday and a whole heck of a lot of excitement. And that's great. But someday, when we have lots of restaurants in Salt Lake City, a lot of things get better. And that's part of what we need to look at. There's distribution that, over the long term, will help food costs.”

·        We believe there still remains room for introduction of more menu items and/or even possibility of a breakfast daypart (outside of some transit centers) at some point. This has historically not been a focus of management, as bandwidth has (correctly) been focussed on unit-growth, rather than optimizing for same-store-sales. When answering a question posed on the possibility of a breakfast introduction on their Q2 2016 call, Randy stated “Yes, we hope so. We really like the business. We do it just at 6 Shacks today globally, and they're really only in our transit centers. As I mentioned, Fulton Center is sort of half transit center, half normal Shack. So we thought it would be a fun test there, just opened there a couple of weeks ago. So we're just getting started, but we like breakfast a lot. There are no plans today to expand it beyond those transit centers. But we've got our eyes on it. We're learning it. We're testing new products and we're having a lot of fun.” The company also recently opened an Innovation Kitchen, and has successfully introduced Chicken Shack and Chicken bites to rave reviews. The Chicken Shack in particular is rated as amongst the best, if not the best chicken sandwich currently available in the market, demonstrating the team’s ability to add another crave-able item to their tight selection, add some protein diversity and potentially even open up to a market like India at some point in the future.   

·        International franchising opportunity:

o   When discussing the domestic opportunity for Shake Shack, we’ve used Chipotle as a sort of best-case scenario / aspirational target. However, when it comes to the international opportunity, Shake Shack was already running rings around Chipotle, even very early in its life. It turns out that outside of the US, there is not so much interest in Mexican food.

o   Luckily for Shake Shack, the burger concept travels well overseas, as evidenced by the success of other QSRs as well as Shack’s own success to date – Shake Shack Korea and Middle East separately have over 100k followers on Instagram each.  

o   Also, I wanted to share a few of personal anecdotes, that made me very excited about Shake Shack’s international TAM (I should note at this point I live in Melbourne, Australia so I thought this may provide an interesting perspective for those of you who are US-based)

§  Prior to even thinking of Shake Shack as a potential investment, I’d been looking to re-create the Shack Burger at home, and was trying to see if I could get Martin’s Potato Rolls (the buns used by Shake Shack for the Shack burger) in Melbourne. Later when I was on Instagram, I received an advertisement from a local premium butcher, advertising a DIY burger kit that included Martin’s Potato Rolls (and notably advertising they are the buns used by Shake Shack!) …. Wrap your head around that for a moment …… A butcher in Melbourne, Australia (where there are no Shake Shacks or any intention to open near term AFAIK), buying digital inventory for people locally looking for Martin’s Potato Rolls, knowing that they are likely trying to make a Shack Burger ….. that is truly amazing global brand recognition!

§   In Australia, there has been a relatively new chain called ‘Betty’s Burgers and Concretes’. Check out their menu and see if you notice any similarities …. It’s basically a complete rip-off of the entire Shack concept with a beach theme. (Even, the way the lettuce seductively peaks out of the bun to make it more foodstagrammable was copied.) Its also been a huge success. Whilst its hard to get proper data on Betty’s Burgers as it’s a private company, there is some information I was able to obtain from an AFR article, following its takeover by Retail Zoo. They have twenty Australian units and A$120mn sales, implying an AUV of A$6mn … And they plan to open 100 units, on a population of 25mn people. Whilst the transaction price is unknown, it was likely a solid eight-figure amount .. not bad for just ripping off the Shack, and one of the owners just spent $20mn buying a beach-side property off Aussie tennis legend Pat Rafter. I’m pretty sure if the real Shack came here, they’d do very, very well. In fact, outside of maybe In-n-Out (which would never come here anyway), I can’t think of one US QSR/fast casual concept not currently here, that I’m confident would be wildly successful if they opened here (and I’ve been through the lists) ….But I’m confident Shake Shack would be.

§  I was in Singapore in mid January this year. On the way to the airport, the cab driver pointed out a new mall near the airport called Jewel Changi. The mall is a foodie paradise, with are over hundred eateries, including an outpost of London favourite Burger & Lobster amongst others. But there was only one (unsolicited) recommendation from the driver … “Oh you must go to Shake Shack”

·        Millenial preference for fast casual:  In an interview on 60 minutes, Danny Meyers described Shack Shake as fine casual, which was essentially “marrying the ethos and taste level of fine dining with the fast food experience” or in other words, providing 80% of the fine dining taste level, but saving 80% on the bill. James Suroweiki wrote an excellent article in the New Yorker in 2015 titles The Shake Shack Economy. In it he highlights the secular trend amongst millenials, that are willing to pay up for quality food and ingredients and is evidenced across numerous sectors of food +  beverage (Starbuck – coffee, Chipotle/Shake Shack – fast casual, Wholefoods- groceries). 

·        Management: Even prior to the founding of Shake Shack, Danny Meyer was already considered on the greatest restaurateurs of his generation, and the level of respect he commands in the industry is clear, when you see the calibre of chefs that have been willing to collaborate with Shake Shack (David Chang of Momofuku, Dominique Ansel, Massimmo Botturo of Osteria Modena , to name a few).

Whilst there is probably little debate over the strength of Shake Shack’s brand, there is still a great deal of scepticism over the story here (as evidenced by the multiple VIC short write-ups and the relatively high short interest (22% )

The short thesis is largely valuation based and raises the following issues:

·        Whilst Shack AUVs are high, they have been steadily trending down as the average newly opened Shack achieves far less profitability than the existing store base (Since 2012 domestic AUVs have fallen from over $5mn to $4mn). The declining AUVs have also resulted in lower restaurant-level operating margins, due to growing dis-economises of scale at the unit level (primarily labour costs and lease expense spread over lower revenue base at newer units)

·        Over the past few years, same-store-sales have been weak, which can be indicative of a brand that is not healthy

·         There is a limited market outside major cities like NYC for people willing to pay the fine casual premium for a hamburger. This is evidenced in declining AUVs that indicate Shack may be near the end penetrating its potential TAM, than the start.

·        There is already substantial competition in the Better Burger market (In-n-Out, Whataburger, Smashburger, Five Guys, BurgerFi to name a few) and it is a largely commoditized offering

·        In-light of all of the above, Shake Shack’s valuation is far too expensive at > 100x price/earnings

So lets tackle each of the points raised above:

·        Declining AUV/margins: Shack management have flagged since the IPO, that they expect future units will produce on average $3mn AUVs on 20% operating margins. Naturally, this will result in a decline in average store base, as the existing store base that was once dominated by a number of uber-profitable NYC units spreads out over a larger base. Nevertheless, as previously discussed, these are still excellent unit economics and it absolutely makes sense for Shake Shack to continue to open units at these numbers. The more important question, is what the TAM is around these economics, and the indications from management appear promising.

·        SSS: Whilst still an important metric, SSS is far less meaningful to a concept as new as Shake Shack,, where the store base is still so immature. The Shack concept is somewhat unique in that AUVs start at such a high level in absolute terms. Also as Shack fill-ins units in various states, there is also some minor one-off cannibalization effects, but the unit economics in absolute terms remain excellent. We think management is appropriately focused opening new stores, than optimizing for SSS Shack

·         Limited TAM: Whilst we think that the continued success of Shack’s roll-out continues to disprove this point, particularly the success of Chipotle really disproves this point to us. If you read the various short write-ups on Chipotle, this point was made several times as has been proven to be incorrect. We think it will be similarly incorrect to Shake Shack. As discussed above, we think the secular growth in fast-casual is not a fad, and is part of a long-term trend that has occurred in the food and beverage space

·        Better Burgers is competitive/commoditized : How many burger chains would have numerous Michelin Chefs lining up to collaborate on burger projects? How many US burger chains could garner over 100k of Instagram followers in Korea, in year 13 of their concept? We believe Shake Shack’s brand is a very powerful moat, and difficult to replicate. Even Chipotle tried to get in on the Better Burger trend , launching Tasty Made in 2016, but even despite their strong backing and management , they couldn’t get sufficient interest or the economics to work and abandoned it in 2018.

·        Valuation: The main culprit to the high earnings valuation is Shack’s low operating profit margins. The issue here however is not Shack’s restaurant economics, but the investment in G&A and pre-opening costs (14-15% of revenues combined in the past three years). We believe that as Shack continues to grow, this investment in G&A will lever. On Chipotle’s peak operating margins (pre food scare), Shack would currently be only slightly over 20x earnings. In the longer-term we see this as a reasonable goal, given i) Shake Shack has higher restaurant level margins and ii) Shack’s greater potential for higher margin franchising revenue.

COVID impact on Shack

·        Covid has clearly had a negative impact on Shack, given the nature of the concept. The highest AUV Shack’s are in the high traffic areas most impacted by covid. Furthermore, Shake Shack currently has no drive throughs and the timing was awkward as Chipotle was in the midst of transitioning to one deliver partner, Grubhub (this has since been abandoned).

·        In Q2, SSS was down almost 50%, mainly driven by urban locations. At one stage, the cash burn was $800k per week, but there has been sequential improvement and Randy mentioned on the Q2 earnings call that the run-rate had improved to $100k per week at the enterprise level. Shake Shack have also been looking at initiatives, like Shake Tracks and drive throughs down the road in suburban locations.

·        When looking at a framework for analysing the impact on covid, I feel it important to first look at the short-term effects and then contemplate the longer term effects. In the short-term the main concern is liquidity. Management acted well here, immediately drawing down on a $50mn credit facility, and then raising $140mn in a secondary equity offering. They now have a fortress balance sheet, when contemplating future actions. In the longer-term, we feel this ultimately does little to impair the Shack concept, as people go back to gathering at some stage. Covid may actually prove a long-term positive for strongly capitalized players like Shack, who will benefit from less competition and sign more attractive leases. Furthermore, a lot of the investments that Shack is making to get through covid, will also help longer-term with some of the throughput/channel issues that Shack had faced to date, and may even improve SSS/AUVs of certain locations longer term.

Valuation

·        If we assume that Shack opens on average 40 units per year domestically and 25 international franchises, then at the end of 2026, it will have reached its 450 domestic goal with 270 international franchise locations. Assuming incremental AUV of $3mn gets us revenue of $1.45bn by end of 2026. If we assume a 13% operating margin (which is still a material 300+bps discount to Chipotle’s peak margins), we get operating income of almost $190mn. Adding $50mn of international franchise revenue at a 75% margin, gives us a total operating income of $223mn. If we apply a 25x multiple, the forward market cap is $5.6bn, implying a 13-14% IRR over six years.

·        Frankly I assume all the above assumptions will prove to be quite conservative on all fronts – 1) I believe that Shack’s steady state operating margins could well be 100-200bps above Chipotle, 2) I think both domestic and international store count could well be 1,000 + units each and 3) its quite reasonable to expect an exit multiple of 30-40x+, if we are broadly correct on the TAM upside surprise

Catalyst

Revenue Growth, G+A leverage