Value Investors Club / Shake Shack Inc. (SHAK)

Description

We are presenting SHAK here as a long thesis. The company has drawn attention from many

short sellers and bearish analysts for its current valuation. We agree that the current price

leaves little margin of safety, but it strictly depends on your time horizon. We believe this

company still presents good value for long-term patient investors.

Shake Shack began as a hot dog stand in the Madison Square Park as a public project led by

restauraneur Danny Meyer, who was best known for a number of ﬁne dining restaurants like

Gramercy Tavern and Union Square Cafe in New York City. Danny is one of those leaders who

is compassionate and passionate about the hospitality business, advocating quality and the

philosophy of “serving people right”. While Danny is the spiritual leader behind the scene,

Randy Garutti is the CEO of the company. We like what we see from the Shack management,

and we recommend anyone interested in the company to check out their talks online and read

Danny’s book “Setting the Table”.

VIC members “dsteiner84” and “pcm983” already presented good amount of information on the

company from short side, and RV Capital recently presented this company as a long pitch in

their 2018 January letter to investors. With adequate information on the board already, I am

going to be brief in explaining our thesis.

The Burger Business

Despite its relatively small size, Shake Shack is aggressively expanding its global footprint,

selling burger, fries, milkshake, ice cream (and beer, dog food, etc.)

The company operate most of its domestic stores but currently license out all of its international

stores to strong foreign partners (more on this later). SHAK currently has 159 stores worldwide,

with 90 company-operated stores and 69 international licensed stores as of 2017FY.

Growth over the past few years look great, but primarily due to the small base it started off since

its IPO. Total revenue has been growing from $57M to $359M (44% CAGR) through the year

2012 to 2017 and total store counts growing from 21 to 159 (50% CAGR) during the same

period. While these numbers are expected to slow down, management recently guided goal to

reach at least 200 domestic and expand into more markets to get to 120+ international licensed

stores by 2020.

“It’s better to be roughly right than precisely wrong.” We are asking, where is the value? We

clearly aren’t trying to buy net assets at cheap discounts, but rather paying a premium for a

business that is expected to compound cash ﬂow for a period of time. We are buying the

growth.

The ﬁrst and important factor in every thesis is tax rate. Being a domestic chain SHAK

previously faced a tax rate of 40%, and this has clearly changed after the recent tax reform by

Trump administration. SHAK management expects a 26~27% tax rate for the company. This is a

huge boost to the equity value if the company manages to pull off the long-term growth.

The company is still at an early cycle of its growth trajectory, therefore allocating much of its

resources on marketing, developing software, training, and pre-opening. All of these are real

expenses that should not be ignored, but if we are looking at the true economic of the individual

stores, they actually look decent in terms of ROI.

From its 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. (2014 S-1)

For better reference, Chick-ﬁl-A generates about $3.98M AUV (2015), McDonald’s generates

about $2.4M AUV (2016), the bad student Wendy’s makes about $1.78M (2016). Chipotle

generates about $2.42M AUV in 2015 before the e.coli crisis, and the number dropped to

$1.94M in 2017.

How much does SHAK make? SHAK generates AUV $4.7 million for its US stores, with the ~18

stores in Manhattan generate an AUV of $7 million. This is ridiculously high for a burger chain,

and the management themselves were honest about the hype in order to manage people’s

expectation.

“It’s not sustainable. It surprised us all.”

“Longer-term, given the increased penetration of target-volume Shacks, we are targeting AUVs

in the $2.8 to $3.2 million range and Shack-level operating proﬁt margins in the 18 to 22%

range. Taken together, we are targeting long-term revenue and Adjusted EBITDA growth of over

20% after 2015.”

(2015 Conference Call)

The company currently generates ~$4.7M AUV across the US. Even if we assume AUV of ~

$3M, the company is able to generate enough cash to payback the original store in roughly 3

years. This is still a far better ROI than many of the stores out there with inferior cash-on-cash ROI on its store.

The once crown jewel Chipotle costs around $850,000 to develop and

construct a store per 2005 prospectus, and even if we assume the cost didn’t rise with inﬂation

(a bold assumption), the cash ﬂow generated by each store (~$300K pre-e.coli) implies more ~3

year of payback period.

Some people question that SHAK only serves a much smaller TAM given its premium pricing.

It’s no question SHAK serves a different group of customers than those McDonald’s (32,000+

stores) or Starbucks (27,000+ stores) is serving, some of these other chains also have many

times more stores in the US ALONE, with ~6,300 stores for Taco Bell, 2,100 for Chick-ﬁl-A, 805

for Whataburger, 4,160 for KFC, and 2,221 Chipotle in the US by 2016.

While SHAK management stated its goal to reach 450 domestic store, we would not ever

consider SHAK if it only has proven success the US market. The international licensed store

changes the story of this investment. Even though domestic SHAK offers decent ROI, we much

prefer the asset light model from the licensing business. Shake Shack has presence in Middle

East, Europe, United Kingdom, and is actively growing its footprint in Asia. This is pure proﬁt

coming from various markets that can be used for domestic expansion.

The international licensed Shack generates $3.33M AUV as of 2016FY. The company began its

international expansion when the Middle East partner ﬁrst knocked on their door to request

licensing. The popularity of SHAK in other countries have led to further licensing with multiple

strong partners within their own markets. SPC Group in Korea is a global food company with

30+ brands and 6,000+ stores worldwide including Jamba Juice, Basikin Robbins, Dunkin

Donuts, etc. They had their ﬁrst Korea Shack in 2016, and is expected to expand to 25 Shacks

in Korea by 2025. Many of these partners have experience opening stores for other franchises.

A new partner SHAK collaborates with is Maxim Caterers, which is a renowned food company

operating Starbucks in Hong Kong and China. Maxim will start rolling out its ﬁrst store in Taipei,

Hong Kong, and Shanghai during 2018/19. The market is huge and the licensed partners look to

grow for the years to come.

We do not have contact with the SHAK management, but have made multiple visits to the

Shacks in US, UK, Dubai, Korea, and Japan. The partners have done great job connecting with

local markets and showing consistency of the quality. We have people living in Korea and Japan

that constantly update us with video of the stores outside of peak hours. Also, trafﬁc data is

available for many Shack stores on Google Map. We ﬁnd it convenient in monitoring the

popularity of various locations across the world.

To sum up the thesis, the per-store economic looks great and the runway seems long growing

from only 159 stores in 2017. However, the company is already hitting a high mark with $4.7M

AUV domestically. We have no idea how fast and how big of a decline we will experience in the

coming years, but the stock is likely to take a hit anytime the sales trend down to a normal AUV

level. Therefore, we expect it to be a roller coaster ride and do not recommend it for anyone with

a short horizon.

I hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

-time

-faster store count growth

-new licensed store partners for international expansion

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			2018	2019
Price:	38.48	EPS	0	0
Shares Out. (in M):	37	P/E	0	0
Market Cap (in $M):	1,431	P/FCF	0	0
Net Debt (in $M):	-91	EBIT	0	0
TEV (in $M):	1,340	TEV/EBIT	0	0