Description

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This is not a recommendation to buy or sell shares.  Our views are subject to change without notice and we may trade in any manner, whether consistent or inconsistent with this recommendation.  The information below is from public sources.  We have not independently verified this information and we make no representations as to the accuracy or correctness of any such information.  We undertake no obligation to update any information below.

Recommendation: Short Shake Shack (NYSE: SHAK) - $21 PT

Investment Thesis

The recently IPO’d Shake Shack represents a compelling short opportunity. This stock represents a classic case of the Wall Street/NY Metro Area bubble causing euphoria about what is actually a fairly ordinary business. At its current valuation, Shake Shack is essentially being valued using the same multiples typically reserved for high-flying tech stocks. While Shake Shack is a good restaurant and the food is quite good, it does not fit the profile for a restaurant that has the capacity to expand around the country in size comparable to well-known chains (e.g. Chipotle). A full meal at Shake Shack can easily come out over $10, and while this is not a big factor in areas like NY, Northern New Jersey, some areas of CT, etc., it certainly is a factor in the American heartland. Chipotle has demonstrated quite clearly that the optimal price point is for a full meal to cost < $10. Additionally, given the large number of competing burger chains, especially recent launches such as Umami Burger, it is hard to imagine that Shake Shack is the most likely to be successful across the country. Shake Shack has already picked most of the low-hanging fruit in its new openings, and will struggle to find attractive opportunities going forward. I expect AUV’s for newly opened stores to be disappointing and to be substantially lower than the targets set out in the S-1 (AUV’s of $2.8MM-$3.2MM).

Company Overview

Shake Shack considers itself a modern day “Roadside Burger” chain, with 31 company owned shacks currently in operation, and 32 licensed shacks in operation, for a total system of 63 Shacks in operation. Shake Shack has taken a unique tack in its expansion from only a few stores just a few short years ago; it has opened a number of new locations in the U.S. that are company-owned while licensing the rights to a number of new locations in exotic international locales such as The UAE and Saudi Arabia. This stands in stark contrast to the more traditional approach of exhausting U.S. growth opportunities before pursuing international markets. Shake Shack’s menu is comprised of burgers, hot dogs, fries, custard, and shakes. Shake Shack is also known for its special shack sauce. Shake Shack’s corporate structure is somewhat complicated; the full break-down can be found below, but essentially investors in the public shares do not have a large voting interest in the company. The company’s corporate structure is somewhat complicated relative to how simple the business is: essentially the original investors have voting control over the company with special class B shares. The voting structure is similar to a lot of other closely held start-ups (e.g. Facebook). Since a large majority of the initial funds raised by the company came from PE, the company is sensitive to tax efficiency on the corporate level and for investors. The company came up with a way for the early investors to maintain the pass-through status of their investment by having an incorporated holdco where voting takes place as well as an LLC opco where the economics of the business are distributed. This avoids corporate taxes for the early investors as they can receive distributions from the opco. Below is a table laying-out the corporate structure.

Ways for the Short to Work

·       Earnings – Shake Shack used the JOBS act to avoid disclosing too much financial information. As a result, the company only released two years of full year results (2012 + 2013) and released results for the first 9 months of 2014. I think that Shake Shack’s average AUV will start declining rapidly as the stores being opened outside of the top tier locations start factoring into the financial results. Essentially, the data released in the prospectus do not present an accurate picture of the company because there are now more stores opened, with probably 10 more being opened in 2015. If AUV data indicates the new stores are not nearly as successful, I think investors will begin to see that the model is not scalable outside of prime locations like Manhattan, Greenwich, Miami, etc.

·       Issues with supply chain – Shake Shack prides itself on using high quality beef. From the prospectus:

One of the most underrated accomplishments of Chipotle is its ability to source meat to all of its locations that meets its quality standards. I think Shake Shack may struggle to expand its supply chain to new locales as it looks to open more stores.

·       Continued growth/success of competing “better burger” chains such as Umami Burger and Five Guys. This should make it apparent to investors that the space Shake Shack is operating in is filled with formidable competitors offering comparable products. Additionally, an IPO of one of the other new chains may put pressure on Shake Shack.

·       Early investors start selling once the lock-up expires to take advantage of the lofty valuation. For them to sell, they can either exchange their interests in SSE Holdings, LLC for regular SHAK shares or can be redeemed for cash based on a VWAP price of SHAK, at the company’s discretion. I doubt Shake Shack would redeem too many holders with cash since they just completed an IPO and need cash to grow the business.

Financial Overview

Valuation Key Points

• As the financial metrics above show, the valuation of Shake Shack is way overdone. Shake Shack’s valuation is largely driven by high AUV’s (Average Unit Volume) both in Manhattan and outside of Manhattan. The AUV’s in Manhattan are not going to be replicated anywhere else in the country. Additionally, Shake Shack’s non-Manhattan AUV’s are misleading because the stores that have been opened are in choice locations such as Northern New Jersey, Miami, Las Vegas, etc. There are a limited number of locales in the U.S. that can generate such high AUV’s. I think going forward SHAK will have to turn to less desirable locations where the operational performance will be substantially worse than the operational performance seen in the current non-Manhattan locations.
• I think Shake Shack’s valuation does not account for the fact that competition in the “Better Burger” market is quite robust. The following quote highlights this growing trend: “There’s definitely this whole new niche that’s emerged,” said Bob Goldin, an executive vice president at Technomic. “In the next 12 to 24 months, we’re going to start seeing signs of saturation” among the better burger chains, Goldin said. “You’re going to see a shakeout.” (http://www.bloomberg.com/news/articles/2012-03-21/l-a-burgers-invade-new-york-as-economy-rebounds-retail) The chart below shows a recent consumer reports survey of the best burger chains in the U.S. Shake Shack failed to make the list.
• I picked a target price of $21 because I think it is a much fairer valuation in the context of the true market opportunity to expanding Shake Shack across the country. The table above details what the valuation would look like at a $21 share price. I think this is a far more reasonable considering where comparable companies trade.

Risks

• As the float for this stock is somewhat small, the stock could be volatile in the near-term, with a potential for short squeezes
• AUV decline takes longer than expected to show through in financials – i.e. growth slower than expected

Note on Trading Dynamics:

Right now Shake Shack is an expensive stock to borrow, with the cost of borrow hovering at near 50%. This should continue to decline as more shares free up over time, given the IPO was very recent. Additionally, this dynamic is exacerbated by the small float issued in the IPO. Nevertheless, I expect the cost of borrow to come down to the 30-40% range over time. Additionally, once listed options start trading for Shake Shack, I expect that to be a decent alternative to shorting the stock (the stock has not been too volatile so implied volatility for the options should not be too expensive, though the cost of borrow may make them still somewhat expensive). Taking advantage of the opportunity to short Shake Shack will require some opportunistic trading and possibly the use of options. I have put together this investment memo to provide a valuation framework and overview of the company in preparation of the risk/reward becoming attractive for shorting the stock or using options to bet against it.

Catalyst

• Earnings release – rapidly declining AUV’s become apparent
• Lock-up expiration – should be sometime in August