Shake Shack: Our Long-Term Outperformance Thesis (NYSE:SHAK)

Investment Conclusion

We were highly encouraged by Shake Shack’s (NYSE:SHAK) F1Q2022 financial results. Despite the impact of Omicron on customer demand in January, system sales accelerated significantly driven by uptrends in suburban and even more so in urban markets. In that respect, it is noteworthy that sales associated with SHAK’s Manhattan stores rebounded strongly. Licensing revenues too were solid, propelled by the surge in sales associated with international locations as Omicron receded, and higher foot traffic in domestic locations as Americans resumed normal life, including visiting ball parks, and domestic travel. Consequently, total revenues expanded significantly, somewhat fueled by greater royalty revenues due to the sales upside associated with licensed stores.

Nevertheless, revenue leverage associated with the dramatic increase in sales, and a 3.5% price increase implemented in March, were insufficient to offset cost inflation related to labor and commodities, leading to a decline in margins at the restaurant level and the corporate level. Consequently, SHAK reported an earnings loss for the quarter. With respect to new unit development, the firm launched seven company-operated stores and six licensed units, including one in Nanjing, China.

For the second quarter, considering April trends, we expect the sales momentum experienced over the first quarter to intensify, as urban areas return to pre-pandemic normals, with offices across the nation reverting to regular schedules, and a surge in domestic tourism towards top metros such as New York City, Chicago, and Las Vegas, even as the uptrend in dine-in sales in suburban locations evidenced over the previous quarter persists. Based on sharply higher sales and the flow-through of the price hike over F1Q2022, we expect some offset of inflationary challenges, and consequently margin growth on a sequential basis, and therefore a decrease in net loss/share for the period.

However, we are slightly less optimistic about the back half of FY2022. If our thesis that higher unemployment and a decline in wages is imminent, due to a combination of higher interest rates that typically depresses investments, and on the lower-end an expected surge in employee job applications as Americans now on an average have four weeks of savings left in their bank accounts, premium priced restaurants (such as SHAK), though arguably providing better value for money will suffer, as data demonstrates that folks typically gravitate to lower priced restaurants and experiential restaurants, during times of economic hardship. Moreover, all bets are off in case an economic recession unfolds.

Overall, for the third and fourth quarters, we anticipate lower retail sales growth due to U.S. macroeconomic headwinds, somewhat countered by strong international sales, as SHAK’s target group in foreign geographies is typically affluent, and unlikely to suffer financially, in case an economic contraction surfaces in those regions. Nevertheless, considering that international revenues account for a small fraction of the total, revenue growth will possibly suffer. As a flow-through, even though we expect cost inflation to ease towards the back half of FY2022, margins will probably decline, compared to the second quarter, and reflect in lower earnings and free cash flows for the year.

However, we consider unfavorable economic events that are likely to unfold over the next couple of years, to be irrelevant to SHAK’s secular prospects. Longer-term, accelerated new unit development comprised of company operated stores and licensed stores, will drive most of the growth, with same-store sales playing an ancillary role, increasing sales through: a potential loyalty program, menu innovation, and improved customer convenience. Looking ahead a few years, SHAK will transform into a firm with a substantially larger footprint, both domestically and internationally, reflecting in an exponential increase in retail sales, and consequently higher: margins, earnings, and free cash flows.

The plan is to develop SHAK into the go-to high-end artisanal burger joint in the U.S. and in foreign countries. Undoubtedly, the firm has massive growth ahead of it. Therefore, since the price of a company’s stock is a reflection of its future earnings, we are comfortable with our 1-year Price Target of $136/share (that factors in a 10-year normalized revenue growth rate of 28% and 10-year straight-lined operating cash flows growth rate of 17%), even though it might appear lofty, when compared with current levels. It reflects the stock’s long-term intrinsic value. Reiterate Buy Rating. (Please go through our initiation report “Shake Shack: Strong Long-Term Growth Outlook On Excellent Product” and related notes for our long-term opinion on the stock).

Key Takeaways From The First Quarter

F1Q2022 Results Summary. For the quarter, SHAK reported system sales of ~$310 million (+35.6% over F1Q2021), revenues of ~$203 million (+31% on a year-over-year basis) above analyst expectations of ~$201 million, and loss per share of $0.26 (versus earnings per share of $0.01 during the prior year’s same quarter) below consensus estimates of $0.23. In addition, compared to F1Q2021, same store sales increased by 10.3% over the first quarter. Net loss for the period was ~$10.2 million, versus a net income of ~$1.31 million over the previous year’s same quarter. Restaurant margins of 15.2% increased by 200 bps on a year-over-year basis.

Digital Sales Continued To Deliver. Although, SHAK’s dine-in sales expanded by ~50% over the first quarter, digital sales driven by customer retention/frequency and higher checks, continued to register growth. Given, the persisting outperformance of the channel compared to the pre-COVID days, management continued to invest in tools to enhance customer experience, whether related to online ordering and payment, or associated with curbside, drive-up, kiosk, and delivery transactions.

During F1Q2022, ~43% of total sales were attributed to the digital channel. Digital sales are relatively valuable, as they generate higher margins and customers that order digitally typically transact more frequently and with higher check values. Data demonstrates that checks associated with SHAK’s digital orders are ~25% higher in value than those linked to its non-digital channels.

Geographic Expansion Remains On Track. Despite delays that have pushed back launches of numerous SHAK restaurants to FY2023, the firm expects to open 40 to 45 company operated stores, and at least 23 and up to 27 licensed stores in FY2022. In addition, by the end of the year, SHAK anticipates that it will have 10 drive-thrus, comprised of five that have already been introduced, and five more expected to be operational, towards the back end of FY2022. Moreover, SHAK plans to debut 15 restaurants in Thailand over the next decade. Furthermore, Malaysia is an additional market, the company will pursue over the short-term.

In regard to the current performance of licensed stores, it is noteworthy that besides China which is suffering lockdowns and intermittent market interruptions due to COVID, recovery associated with international stores, all of which are licensed, has been strong, and SHAK’s U.S. licensed business is undergoing a rapid turnaround as well, as airports and stadiums experience increased customer traffic.

Continued To Rely On Menu Innovation As Growth Driver. In order to offset the conclusion of the Buffalo Chicken and Fry limited time offer, SHAK launched a new limited time offer menu item, featuring the firm’s bourbon bacon jam burger and chicken sandwich. In addition, along with partner Maker’s Mark, SHAK introduced its summer menu over the quarter. Moreover, with a view to benefit from the recent momentum in customer demand, the company added several new beverages, including its signature lemonades with a differentiating twist and novel shakes.

Considering that the launch of new and legacy menu items typically generate enough buzz around the brand and lead to material increase in sales, we are glad that SHAK continues to deploy menu innovation as a core strategy to ignite customer demand.

Guidance Appears Reasonable. Based on our analysis, we expect SHAK’s actual F2Q2022 financial results to meet or slightly beat management projections.

For the period, the company anticipates total sales in a range of $227 million to $232 million reflecting a year-over-year growth of 26.4% from the midpoint, and same-store sales growth of between low to mid-teens. In addition, management estimates that total revenues for F2Q2022 will be between $234 million to $240 million, representing an advance also of 26.4% from the midpoint, on an annualized basis. Licensing revenues are expected to come in between $6.8 million and $7.5 million, adjusting for COVID headwinds in China.

Balance Sheet Remains Strong. At the end of F1Q2022, the company had a cash and cash equivalents balance of ~$279 million and $244 million in long-term debt on its balance sheet. In addition, SHAK had a short-term investments balance of ~$79.7 million. In March 2021, the firm raised $250 million through a 0% convertible senior notes offering, due in 2028. SHAK indicated plans to deploy the proceeds primarily for unit development, particularly to build drive-thrus, and to expand the business. Given the strong funding position, we believe the company is unlikely to renege on its debt related commitments over the short-term.

Bottom Line

Although, we are not condoning SHAK’s less than optimized strategies towards business development, with the “we’ll try this and see how it works out because we are well funded” general attitude, it does imply that the company is thinking long-term, with the approach that “we’ll deal with whatever comes our way but eventually get there”. So, overall, SHAK might overbuild stores and then scale back, closing stores if business performance is below average.

With that out of the way, we continue to believe that although premium priced, the brand’s food is highly innovative, unseen at any other burger joints, and with excellent quality. It’s the product that will drive the long-term success of the business, with sufficient sales volume eventually mitigating the margin challenges SHAK has encountered for most of its existence.

Therefore, we’re confident that investment in the firm at current levels will be handily rewarded. Buy Buy Buy.