Burgers, Fries and Shakes

Shake Shack (“Shak”) is a burger joint that is much more than a burger joint. It’s tough to describe if you haven’t eaten there.

At the end of 2018, Shak will have about 123 domestic (U.S.) company-owned locations and about 85 Licensed Shacks (the majority of the licensed locations are international, but some are currently located in domestic airports).

With those numbers stated, an investment in Shake Shack is not focused on the current numbers of locations but the potential for future locations. Additionally, an investment in Shake Shack must account for something greater than a flash in the pan burger joint that could easily be replicated. Is there something different about Shake Shack? Can there be many, many more locations, both domestic and international?

Intangibles

If you are choosing what to write about first, the numbers or the quality of Shak’s business, you will most likely select the numbers. Why? Because, numbers are easier to convey. There is a concreteness to numbers that eludes the investor when quality is the topic. Culture and quality are both categories that make a business much more valuable, but are so hard to define or point at.

“Hospitality is in our DNA. We take great pride in our culture and believe that it is the single most important factor in our success. Our mission to Stand For Something Good® permeates throughout every Shack we build, every ingredient we source and every team member we hire. We take care of each other first and foremost so that we can take care of our guests, our community, our suppliers and our investors.”

I am sure McDonald’s has a similar mission statement or some such idea posted on some corporate placard, but you can sense from Shak that there is a little more meaning to its corporate mission.

The “enlightened hospitality” from Danny Meyer (Founder of Shak) does persist throughout the locations of Shak. It shows up in the quality of the burgers, the denseness of the shakes and in each new food item. The aim of each new menu item is to please the customers.

These quality factors mean much more to the future potential and stickiness of the business than the current or possible future numbers that will be discussed below. I do think Shak has these factors going for it. In terms of quality, it’s tough to know how much extra to pay for it (as an investor), but you can sense the quality in the experience and know that it is probably worth it to pay a little extra for such quality.

Numbers:

A sigh of relief that the hard part is behind us. Now the numbers.

Current revenue numbers are $430m TTM and roughly 8.5% operating margins. These profit margins are working off a small base and one would anticipate with further revenue growth, Shak should be able to leverage its cost structure over a greater sales base. Below is the operating margin history of Chipotle. Shak has actually shown much greater operating profits at a lower level of revenue, but the idea of operating leverage is very clear in the numbers below. Chipotle has been one of, if not the most, successful restaurant brands in the past two decades.

Revenue Operating Profit Operating Margins
2006 470 6 1.28%
2007 627 31 4.94%
2008 822 62 7.54%
2009 1085 108 9.95%
2010 1331 124 9.32%
2011 1518 203 13.37%
2012 1835 287 15.64%

Looking at some of Shak’s projections, they are targeting 450 domestic locations. With about 45 store openings per year, Shak would get there around 2025. Consistent with their current licensing strategy, if we estimate about 20-25 licensing openings per year until 2025, Shak would have roughly 450 domestic company-owned locations and approximately 250 licensed locations.

If we assume company-owned locations do about $3.5m AUV at around 12% operating profit with the licensed locations doing $3m AUV and 5% royalty fee on that revenue, and attributing no corporate SG&A to those locations, you get around $228m pre-tax profit and around $170m in net income.

The rough math on these figures look something like this:

Locations AUV
Operating Margin
Operating Profit
Domestic-Company Owned 450 3.5m 12% 189m
Royalty Fee
Licensed 260 3m 5% 39m
228m Total Operating Profit
57m Taxes
171m Net Income

Let’s call this $170m in net income in 2025. Obviously this is dart throwing contest, but it allows us to start somewhere to see if we are in the ballpark.

At a 25x earnings multiple, this would value Shak at roughly $4.3B, which equates to about a 13% compound annual return from today’s prices—roughly.

There are a lot of estimates and assumptions in those numbers. Can Shak have 450 domestic locations and 250 licensed locations? Shak’s AUV is significantly above the industry average today mainly due to their concentration of locations in high-density areas, like NYC and D.C. Will Shak’s AUV be able to hit their targeted $3.5 average AUV when locations begin to open in less densely-populated areas? Can Shak company-owned locations have 12% operating margins, when those locations currently have about 5% operating margins (inclusive of corporate G&A)? Towards the end of the growth period in 2025, will Shak be valued at 25x earnings?

I think each of these questions is tough on its own. Putting them all together makes for a difficult case. Shak really has to execute consistently over a long period of time for all of these assumptions and estimates to play out in our favor and get a 13% return.

I joked a little throughout this post that quality is much more difficult to pinpoint, but at the same time, probably much more important over the long-run. I wasn’t really joking. I do believe that, but I admit that is is very difficult to identify this quality early on and trust that such quality will persist over continued growth. It’s much easier to have a higher quality work environment when there are 100 locations than when there are 1000, especially when 50% of the first 100 are mainly in the NYC/DC metro areas and can be visited frequently by senior-level executives.

An investment in a quality company will almost always look like you are paying too much. The question turns on whether you have paid up for a quality company or merely overpaid for an average business that looks like a quality company early on. When you don’t have a clear answer on this question, it is probably best to let it sit for a while and think about it some more.


Matt Brice can be reached at matt@thesovagroup.com

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