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CoreLife Eatery— A Brand on the Move
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Click here to view Shake Shack's company description.

In a nutshell:

36% of the stock float was sold short, so the numbers came through "adequately", and the stock didn’t go down, so the short-term traders panicked, covered their positions and drove the stock higher.

Before we look at the facts, we must restate that there is no publicly-held restaurant company that we hold in higher regard than SHAK. However, the company is one thing, and the stock is another.

Highlights of First Quarter 2018:

Comparable sales were up 1.7%, price and mix were important so store level traffic was down 4.2% on top of a negative 3.4% in the first quarter of 2017. Factoring out a promotion in 2017 quarter, traffic was still down 2.2%. Weather was a negative factor but delivery pilots and an early Easter helped a bit.  The table that follows shows line-by-line performance over the last three years, as well as the first quarter.

Shake Shack (SHAK) Reports First Quarter 2018—Stock up 25%—What’s Going On?

As shown in the table above:

As predicted since SHAK came public, average weekly sales for domestic company operated shacks continued lower at $81,000, down 6% year-to-year. Trailing twelve month average unit volumes (AUV’s) were $4.5 million, down $100,000 from the prior quarter. This latter number is predicted to be $4.1 to $4.2 million for all of 2018.

Store level "operating profit," store level EBITDA in essence, was 25% of store revenues, up 28.5% on a 29.6% increase in shack sales, so store level EBITDA contracted .3%. Cost of goods sold was down .5%. Labor was up .2%. Other operating expenses were up .9% to 11.2%. Occupancy and related expenses were down .3% to 8%. Below the store level EBITDA line: G&A was up .9% to 11.9%. Depreciation was up .4% to 6.6%. Pre-opening was down 1.1% to 2.0% (with unit expansion back loaded in 2018). Operating Income was up 15.7% (on an increase in total revenues of 29.1%). Income Before Taxes was up 15.7%, down .7% to 6.6%. After taxes at 19.4% (vs. 30% in 207), after tax income was up 28.9%. Here’s the summary: The stores controlled costs rather well in a difficult sales and traffic environment, the corporate burden was higher and lower taxes salvaged the quarter’s bottom line.

Investors, of course are primarily concerned about the future. Growth is continuing at what we think is accurately described as a "breakneck" pace, with 32-35 new domestic company locations to be opened in calendar 2018 on a base of 90 at the end of last year.  Company guidance was essentially "maintained" for 2018.

Aside from the new openings, total revenue expectations were raised by a nominal $2 million to a range of $446-450 million. Licensing revenue is expected to be $12-13 million vs. $12.4 million in 2017. In terms of line-by-line expectations, as shown in the table above, under "Guidance," same store sales are now guided to 0-1% positive vs. "flat" previously.

AUVs will be $4.1-$4.2 million for 2018, vs. $4.6 million in 2017. Store level EBITDA will be 24.5%-25.5% (affected by the new lower volume units), versus 26.6% in 2017. G&A will be $49-$51M (plus $4-6M for "Project Concrete") or 11.1% (plus 1.1%) of Total Revenues. Depreciation will be about $32 million (7.1%). Pre-Opening will be $12-13 million (2.8%). Adjusted Pro Forma effective tax rate will be 26-27% (vs. 30.0% in 2017 and 19.4% in th4e first quarter of 2018.


Putting this all together for 2018, the Street estimates range from $0.54-$0.57 per share. Growth will be there, but operating leverage will likely not take place either at the store level or after the corporate support. The more interesting part of the exercise takes place in calendar 2019 and beyond. The Street estimate for 2019, according to Bloomberg, is $0.735 per share, up 35% from $0.543 in 2018. While the company has not provided formal guidance for 2019, analysts must be expecting margins to be maintained from 2018 to 2019, both at the store and corporate level. We consider this to be possible, but far from a sure thing.

Looking at the income statement line by line: comps may or may not be flat to up in 2018 or further out, which would of course affect the entire equation. After an astounding rise in late 2015 and early 2016, the sales and traffic picture has been challenged. McDonald’s has gone to fresh beef and Shake Shack is not quite as rare a phenomenon as it was a few years ago. The competition in beef and otherwise, is not standing still.

As shown in the table above, The COGS line has been very well controlled in the area of 28%, but is unlikely to come down materially. Labor is another story, most likely to move higher and the recent test of a "cashier-less" store has apparently not been a resounding success. Other Operating Expenses have moved steadily higher. Occupancy and Other had a downtick in 2017 and the first quarter of 2018 but we see no reason that rents, etc. will come down. The increase in depreciation and amortization from the mid 5% area to the mid 6% area over the last three years has more than offset the decline in Occupancy. The company has guided to a new high of 7.1% of sales in 2018. The corporate burden, recently running at 11.9% is not coming down in 2018 vs  2017 (at 11.1% +1.1% for "Project Concrete") and it remains to be seen whether it comes down as a percent of sales, even in 2020, let alone 201919.

When questioned on the conference call about G&A "leverage" in 2020, management responded: "I think we’re in such an early stage of our growth journey, the right thing for us to do right now is to be focused on that 3 year and then longer term target…..and investing across the business to  make sure we’ve got a strong foundation to execute against those plans. Longer term, sure, further down that growth journey, we would expect to be delivering some G&A leverage…. and so you will continue to spend where we believe it makes sense." 

Our conclusion: G&A leverage is unlikely for the next two years at least. Store level margins are more likely to contract (more than projected) than expand as a result of labor pressure, higher occupancy and other store level expenses. Below the store level EBITDA line, depreciation is increasing which lowers GAAP results.  We shouldn’t ignore the potential for licensing revenues to grow substantially, but this implies an ongoing G&A burden as well (which should leverage over time).  Over the next few years, the expense of flying a dozen trainers to Hong Kong and other overseas locations offsets the licensing income for a while.

The Store Level Model—The Difference Between the Past and the Future

We can all look back fondly to the prospectus of early 2015, describing store level economics from calendar 2013. Manhattan AUVs were $7.4 million, with store level EBITDA of approximately 30%. Non-Manhattan shacks averaged $3.8 million with EBITDA of about 22%. The store level "cash on cash returns" were 82% and 31%, respectively. It is unclear whether that calculation included pre-opening expenses as part of the cash "investment" and most restaurant companies these days, including SHAK do not. It is interesting that the original prospectus provided guidance very much in line with today’s expectations, namely that "since the vast majority of future shacks will be non-Manhattan locations, we are targeting AUVs in the $2.8-3.2 million range, with operating margins in the 18-22% range and cash on cash returns of 30-33% (in line with the 31% pre-2015 history).

The future, that investors are buying into, consists primarily of non-Manhattan stores, augmented to be sure by licensing revenues all over the world (averaging $3.1-3.2 million annually so far). Relative to all important unit level economics, the latest description of investment per store, per the 2016 10-K and 2017 10-K are as follows

Per the 2016 10k—"in fiscal 2016 the cost to build a new Shack ranged from $1.2 to $3.4 million, with an average near-term build cost of approximately $1.8 million, excluding pre-opening costs."

Per the 2017 10k —"In fiscal 2017 the cost to build a new Shack ranged from approximately $1.1 to $3.3 million, with an average near term build cost of approximately $1.7 million, excluding pre-opening costs. The total investment costs of a new Shack in 2017, which includes costs related to items such as furniture, fixtures and equipment, ranged from approximately $1.7 million to $3.7 million, with an average investment cost of approximately $2.2 million.

We don’t know why in the 2017 10-K the Company chose to insert "which includes ….furniture, fixtures and equipment." Also, we have found nowhere a distinction that the non-Manhattan store investment differs materially from those in NYC. Our assumption is that the costs are similar because the non-Manhattan locations we have seen do not look like cheap imitations. The sites are prime and the investment looks to be substantial.

The vast majority of new domestic Company operated shacks will be non-Manhattan and we will assume that they do $3.2 million, the high end of the prospectus’ guidance (and also the high end of the most recent range of $2.8-3.2 million company guidance).  If we use 22% store level EBITDA (which is also the high end of the store level EBITDA 18-22% guidance) that would throw off $704,000 annually.

The total cash investment, including pre-opening of $400,000 would be $2.6 million so the cash on cash EBITDA return would be 27.1% (32.0% without pre-opening). However, depreciation is still a GAAP expense, with good reason since stores must be maintained. 7% depreciation would subtract $224,000 from store level EBITDA, leaving $480,000. An incremental corporate burden of a modest 4% or more would subtract another 128,000 leaving 352,000, before taxes. $352,000 of "G&A burdened" GAAP store level profit (after depreciation) of 13.5% of sales, before taxes. This is obviously a long way from the cash-on-cash returns  of 82% in Manhattan and 31% outside of Manhattan originally cited in the IPO prospectus. It is important to note that the above discussion relates to company operated locations, and licensees have a further expense. As cited earlier, since the average volume of existing licensees is reported to be in the $3.1-$3.2 million range, which could move up (or down), it does not appear that the existing licensees around the world are minting money, at least not yet.

Which Leads Us To: The Sales to Investment Ratio:

Analysts and investors might well remember the age old "sales to investment" ratio, which originally was designed to provide a revenue comparison to the "gross" investment, including land, building and equipment. Since rent is an  "investment’ by the landlord, that overhead must be carried by the operations, so rent expense should be capitalized and added to the cost of leasehold improvements, the equipment package, and even pre-opening expense. The theory is: no matter how skilled the operator is at leveraging his investment, with rent, equipment leases, or borrowing (think "build to suit"), the overhead in terms of occupancy expense must be carried, and that’s where the revenues come in. We assume that SHAK is paying rent of at least $200,000 annually for the high visibility sites outside of Manhattan, which capitalized at 10x (a 10% return to the landlord) would imply a $2 million investment in land, plus perhaps $2 million in leasehold improvement and equipment ($2.2 million in 2017, $1.8M in 2016), plus $400,000 of pre-opening expense, adding up to $4.4 million of gross investment. Not too many analysts would say that $3.2 million of anticipated revenues in non-Manhattan sites is fabulous when compared to the gross investment of  $4.4 million (at least, because we suspect average rents are closer to $300,000 than $200,000, increasing the gross investment by an additional $1 million).  This is called leverage (provided in this case by landlords), and if sales come in 10-20% lower than expectations, the profit margin after depreciation will be negligible. Don’t forget about the "local G&A" and royalties for a franchisee and the incremental G&A burden for company operations. Maybe that’s why 163 franchised Applebee’s just declared bankruptcy. In good times, with a hot brand, it all works, not so much as a brand matures, especially  in a difficult economy.

We hasten to add that the cash-on-cash calculations, incorporating the leverage provided by landlords, and ignoring depreciation, that Shake Shack presents is consistent with the way that most retailers present their "story." We are trying here to separate reality, in terms of sustainable return on investment calculations and from power point presentations. A major reason that a sales/investment ratio of so much less than 1:1 can "work" these days, when many companies ran aground with a sales to gross investment ratio no better than 1:1 is that today’s very low interest rates and very high equity valuations provide almost free capital for expansion, but "this too shall pass."

One Last "Broad Brush" Concern

We know of no other restaurant company, at the size of SHAK, that has expanded company (as opposed to franchised) locations at a 35-40% pace on the existing base, not close to home, let alone nationwide and while supervising worldwide licensees as well. Management could say that going from 44 to 64 company operated units in 2016 and from 64 to 90 in 2017 was even tougher and it gets easier from here forward.  Rather than burden you with "war stories", we will just say that we have heard that argument before. We are not predicting disaster, just unexpected inefficiencies and challenges, not fatal, just requiring periodic "adjustment", therefore providing a substantial extra measure of current risk to this situation.


As you no doubt suspect, while we have the utmost respect for this management team, our conclusion is that SHAK is priced beyond "perfection" at approximately 100x 2018 projected EPS and perhaps 70x what we consider an optimistic view of 2019. If you like EBITDA as a measure, based on "Adjusted Corporate EBITDA" of $65 million  in calendar 2017, the $2.2 billion market capitalization represents 33x trailing twelve months EBITDA. Especially considering that store level economics, while still more attractive than many other restaurant companies, is not as alluring as back in the day when Manhattan locations were annualizing at $7.4 million and paying for themselves at the store level (before depreciation) in fifteen months. Management here is as good as it gets, but they are not magicians. This is still a people business, serving burgers, not providing a proprietary cancer cure.

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