After 2Q21 results, Shake Shack remains 70% + overvalued

I reiterate a choice of Danger Zone which recently published results for the 2Q21 calendar. Despite exceeding the highest estimates, this company lacks differentiation and seems increasingly unlikely to realize the profits implied by its share price. Shake Shack

SEQUER
is in the danger zone.

Shake Shack has over 70% drawbacks

I put Shake Shack in the danger zone in June 2019. Since the initial report, the stock has outperformed 18% as short against the S&P 500. After strong income growth in 2Q21, investors may think Shake Shack is a good investment. However, when I look below the surface, I find that Shake Shack continues to seem overrated.

What works for the business: Given the unprecedented economic shutdown across the world in 2Q20, it’s no surprise that Shake Shack reported impressive year-over-year revenue growth in 2Q21. Revenue jumped 104% year-on-year and sales at the same cabins were up 53% year-on-year, which is actually slightly lower than the consensus estimate of 55%.

On a non-GAAP basis, Shake Shack’s adjusted EBITDA fell from – $ 8.8 million in 2Q20 to $ 21 million in 2Q21, although investors should note that Shake Shack’s adjusted EBITDA suppresses the real costs of doing business, such as stock-based compensation, and is a misrepresentation of the real profits of the business.

Going forward, Shake Shack expects sales growth to continue at a rapid pace, with the 3Q21 forecast midpoint implying a 51% year-over-year revenue growth rate.

What does not work for the company: Any bullshit on Shake Shack’s “growth story” ignores that consumers were spending less in places even before the pandemic. Average weekly sales rose from $ 96,000 in 2016 to $ 79,000 in 2019, before dropping to $ 58,000 in 2020. In 2Q21, Shake Shack reports an increase in weekly sales of $ 72,000, which does not not exceed 2019 weekly sales.

Additionally, Shake Shack has a long history of selling in the same shacks through price increases, rather than increased consumer interest. While 2Q21 saw a 62% year-on-year increase in guest traffic, I don’t have to look far to see that in 1Q21, guest traffic was down 12% year-on-year as the mix price and sales was up 18% year-over-year. If Shake Shack can’t get customers back to well above pre-pandemic levels, I see no realistic way to justify the expectations built into the course of its action.

Beyond consumer interest, Shake Shack’s focus on differentiation in an unmarked hamburger / fast casual industry remains costly, the company has not achieved any economies of scale, and its profitability almost ranks last among its many competitors, as shown in Figure 1.

Figure 1: The competition from Shake Shack is formidable

Shake Shack’s food and paper costs, labor and related expenses, other operating expenses and occupancy expenses and related expenses accounted for 80% of revenue in the first half of 2021, up from 76%. % compared to TTM and 69% in 2016.

Total charges, which also include general and administrative costs, depreciation, pre-opening costs and impairment and losses on asset disposals, represent 102% of sales for the first half of 2021, compared to 90% of revenue in 2016. In other words, as Shake Shack grows, its business becomes more expensive to run.

In some ways, the rapid boom in casual dining reminds me of the early days of the craft beer industry. There are many different concepts fighting for market share. However, the big difference for the fast casual industry is that large national / global companies prefer to replicate your offerings rather than buy the business. Large companies have long been able to introduce competing products quickly and easily. In other words, the buyer’s premium, or a White Knight buyer’s hope, is low for Shake Shack.

Shake Shack is priced to outperform its bigger, more profitable industry peers: To justify its current price of $ 90 / share, Shake Shack must:

• improve its after-tax net operating income (NOPAT) margin to 10% (equal to Chipotle’s TTM margin and well above Shake Shack’s TTM margin of 0.1% or 6% 2019 margin), and
• increase revenue at a CAGR of 30% through 2027 (nearly 3 times the expected industry growth through 2027).

In this scenario, Shake Shack would generate $ 3.9 billion in revenue in 2027, which is 5 times its TTM revenue and 6 times its pre-pandemic 2019 revenue. At $ 3.2 billion, Shake Shack revenue would outperform its industry peers such as Red Robin Gourmet Burgers

RRGB
(RRGB), Cracker Barrel Old Country Store

CBRL
(CBRL), Brinker International

TO EAT
(EAT) and Texas Roadhouse

TXRH
(TXRH). See Figure 2 for a comparison of Shake Shack’s implicit earnings in this scenario with its peers.

I think it’s overly optimistic to assume that Shake Shack will reverse years of deteriorating margins (even before COVID-19, NOPAT’s margin fell in 2017, 2018, and 2019) while growing revenues three times faster than the whole sector. In a more realistic scenario, detailed below, the stock presents a significant downside risk.

Figure 2: Shake Shake’s implied income relative to its peers

SHAK has more than 61% disadvantages if the consensus is right: if I assume that Shake Shack’s:

• NOPAT’s margin improves to 6% (equal to the level before the 2019 pandemic) and
• revenue is increasing at consensus rates in 2021, 2022 and 2023 and
• turnover grows by 22% per year in 2024-2027 (continuation of consensus estimates 2023), then

the share is worth $ 35 / share today – a drop of 61% from the current price. This scenario still implies that Shake Shack’s NOPAT quadruple from 2019 levels (the highest in company history). If Shake Shack fails to improve margins (likely given that labor costs should weigh on profitability) or increase revenue at consensus rates, the downside risk is even higher. .

Figure 3 compares the company’s historical NOPATs and implied NOPATs for the two scenarios I presented to illustrate how high expectations in Shake Shack’s share price remain. For reference, I am including the NOPAT TTM from the Texas Roadhouse and Cheesecake Factory peers

CAKE
(CAKE).

Figure 3: Historical vs Implicit Shake Shack NOPAT

More than 70% downside if revenue growth slows after 2024 If I instead assume that revenue growth slows beyond 2023, Shake Shack’s action has even more downsides. In this scenario, Shake Shack’s:

• NOPAT’s margin improves to 6% (equal to the level before the 2019 pandemic) and
• revenue is increasing at consensus rates in 2021, 2022 and 2023 and
• turnover increases by 22% in 2024 (continuation of the 2023 consensus), by 20% in 2025 and by 15% in 2026 and 2027, then

the share is worth $ 27 / share today – a 70% drop from the current price.

Each of the above scenarios assumes that Shake Shack’s annual change in invested capital is 9% of revenue each year in my DCF model. For context, Shake Shack’s invested capital averaged 19% of 2016-TTM revenues and invested capital has grown by 19% compounded annually since 2016.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation for writing about a specific stock, industry, style, or theme.