Shake Shack

Culture, quality, growth.

Original date of the Spanish Thesis: 04-07-2021

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The Shake Shack review is one of the ones I was most looking forward to, probably due to my passion for burgers and the incredible feedback I have received from all those who have tried them. I hope to try them soon, since the pandemic thwarted a trip to New York.

Before doing so, I already considered that it was trading at expensive multiples, but I wanted to get a good understanding of the business to see if in the future, it could be a candidate to enter the portfolio. So, here is Shake Shack.

Story

Today's thesis I'm sure will be familiar to burger lovers, as they are highly regarded for their taste and considered some of the best in the world.

Let me introduce you to Shake Shack. I assure you that if the thesis does not convince you, at least I will have whetted your appetite.

Shake Shack was founded in 2001 in the center of the world, in New York, by Danny Meyer, who had already successfully managed some of the most successful restaurants in the city (Union Square Coffee, Gramercy Tavern and Maialino). The origin of the company was not to create a successful chain, but was born as an urban planning project to revitalize an area of Madison Square Garden that was in decline. The original idea was to set up a cart selling Hot Dogs, but the success was such that there were queues during the summer months of that year and the following three.

In response to this success, the New York City Council rewarded Shake Shake with a license to open a kiosk in the same location. In this way, they expanded their repertoire of products to become widely acclaimed by food critics, the press, the pride of New Yorkers and a tourist destination for visitors.

Throughout all these years the quality of its products has been widely recognized, with numerous awards and recognitions. This has been possible due to the hard work of Danny Meyer, who had the goal of merging the best of fast food with the best of an upscale place, that is, to break the myth that fast food is junk food.

This is the beginning of a successful path, which has led him to currently have more than 300 establishments spread across 30 U.S. states and more than 15 countries. But, you know the good thing? its capacity to grow is immense.

Shake has been listed on the New York Stock Exchange since January 2015 under the ticker SHAK. To date its CAGR has been 12% per year, quite an interesting return, but just in its infancy.

Key Ratios

• Shake Shack's revenues had grown at an impressive 40% CAGR from 2012 to 2019, a year in which the pandemic has reduced its revenues by 12%.

• Their operating margins in 2012 were 8.2% and are declining year over year to 4.5% in 2019. These margins, I believe, will even continue to decline year over year until the business achieves maturity in the US.

• Profits have grown from 4 million in 2012, to 20 million in 2019, showing losses only the year it goes public, 2015, and in 2020.

• It has not distributed dividends and does not intend to do so; its cash flows are intended to finance growth by opening new restaurants.

• It has sold shares year after year since its IPO in 2015 to finance its growth and possibly at its high price.

• Its ROICs are quite irregular and will possibly remain so for a few years, so this ratio is not indicative of quality at this time.

• It has never had high levels of debt, except until a few months ago, when it raised 250 M at 0% rate through convertible notes maturing in 2028.

Industry

The restaurant industry has been the most damaged globally during the pandemic. Thousands of hours closed, employees laid off, unpayable rents, closures and a lot of money lost during these long months. Fortunately, it seems that the worst is over and the numbers are similar to those before the pandemic or even better.

Restaurants are currently facing a huge increase in demand as vaccinated Americans go out to eat. As we see in the graph above, growth between February and May is up more than 20%, already the highest in history. The savings accumulated by the population during the confinements and the liquidity injections driven by the Government, augur that this demand will continue to increase in the coming months.

Before the pandemic, the U.S. had about 12.3 million people working in the sector, by the end of 2020 that number had dropped to 10 million, and now stands at around 11 million. This may pose a short-term problem for many restaurants due to the inability to meet the growing demand, but in the long term, it will most likely be possible to fill all the positions required by that demand.

Shake has been no stranger to this phenomenon. At the end of 2009 it had 7,603 employees and by the end of 2020 it was down to 7,429. It is possible that in this first half of the year they have surpassed the figures of the end of 2,019, since restaurants in airports and stadiums have been gradually opening, as well as new shakes. But the fact that it has reduced its workforce does not mean that it has problems hiring, since the conditions for its employees are among the best in the industry (training, private insurance, above-average salaries, growth, equality...).

What is important from these last two paragraphs are two things: 1) The restaurant industry will continue to grow and Shake will benefit, 2) If there continues to be a labor shortage, wages in the industry will increase, Shake will have to pay more to keep its employees, its costs will increase and therefore it is very important that it has power pricing to counteract this effect.

Another feature of the industry that has been accelerated in the pandemic has been that of digitization. Many restaurants have survived thanks to this, as for months 100% of their sales were by home delivery or pick-up on the premises.

This trend, will slow down in the future, people will return to restaurants, as the experience of eating out is very different to that of ordering in. What is possible to achieve is a hybrid, restaurants (especially fast food restaurants) that are unable to provide more service because of their capacity, will find in digitalization a way to increase their SSS. As we can see in the graph below, people are returning to restaurants and reducing door-to-door sales.

Finally, the most notable characteristic of this industry is the high level of competition and fragmentation. You can compete on taste, price, service, location, quality or restaurant design. There are national, regional or independent restaurant chains. Competitors with much more experience and financial capacity to offer products as tasty or healthy as Shake's and to carry out large marketing campaigns.

If Shake wants to keep its piece of the pie and even expand, it needs to be able to maintain the values it was founded on and not let its moat collapse.

Business

Before getting to know Shake Shack's business, I think it is interesting to know its somewhat complex structure. Shake Shack belongs to the holding company SSE Holding. They are the sole manager, operating and controlling all their businesses, of which Shake Shack is the only business. They file consolidated financial statements themselves and report to other members who have interests in the holding company.

Why this business figure? Well, it has a number of tax advantages, which may favor them, but also some limitations, since they have to give part of their cash flow to the members of the Holding Company, which may limit their ability to grow without issuing debt or shares.

In addition, we are obligated to make payments to certain members of SSE Holdings under the Tax Receivable Agreement. As of December 30, 2020, such obligations totaled $233.0 million.The payments that we are required to make will generally reduce the amount of overall cash flow that might have otherwise been available to us or to SSE Holdings, but we expect the cash tax savings we will realize from the utilization of the related deferred tax assets to fund the required payments. - 10K 2020

Many of you will already be familiar with and may even have tried Shake Shack's famous burgers, so I don't think I'm going to tell you anything new. Shake sells beef and chicken burgers, hot dogs, fries, drinks and different types of shakes. The main characteristic and what Shake is known for is the great taste of their burgers, unlike other fast food chains.

All their products are characterized by their high quality and excellent taste, in addition to using 100% natural proteins, without hormones or antibiotics. The animals used in their recipes are raised in an excellent way and without mistreatment of any kind. Another of the characteristics they seek is that the food is not only excellent in taste, but also nutritious. To this end, for example, they have eliminated artificial elements from their pickle sauce.

This environmental awareness extends not only to the food, but also to all packaging, which is made of organic and 100% recyclable material. Their excellence and commitment to the customer is part of their culture.

In order to have these excellent products, they have allied with a concentrated chain of suppliers, allowing them to have an excellent relationship among them, identify problems that may arise more quickly, modify some characteristics of their products...

• Their meat suppliers are located in the USA for national and international supply and in the UK for international supply. They currently have 7 beef hamburger producers, one of them supplying 44% of the hamburgers and one supplier of chicken hamburgers.

• Their buns come from a single supplier, Martin's Famous.

• Two suppliers for its milkshakes.

• Potatoes from two suppliers.

• Sauces from two suppliers.

This concentration has the advantages described above, but it can also lead to problems that damage the operation of the business. A problem at one of your main suppliers' factories could lead to supply constraints. Internationally, the search for foreign suppliers is fundamental, above all to avoid transportation costs, customs, international taxes, duties, taxes, avoid delays... something that the management mentions in one of their last call transcript that is something they will have time to worry about.

As with its suppliers, to reach every Shake in the US and control the entire process, it has established a highly concentrated distribution relationship, with a single distributor, which has 20 logistics centers across the country, allowing it to deliver fresh products to each restaurant on a daily basis.

SALES BY BUSINESS AND REGION

Shake Shack has two different formats to reach consumers:

1. Own restaurants: 97% of total sales, 183 own restaurants out of a total of 311. This is the format used mainly to expand nationally, all of them in the US (48 in New York and New Jersey) and, as we have seen, they account for almost all the income despite being only 58% of the restaurants. Their characteristics:

• Control: By running them themselves they can spread their famous culture throughout all new restaurants.

• Costs: Each new restaurant costs between 1.5 and 2 million. These costs, as they move away from New York (where their headquarters are located) lose scale and are more expensive, as they have to move trainers for new openings, pay for hotels, planes, per diems... That is why I believe that operating margins, as they expand, will decrease until the business is mature in the country, that is, until existing restaurants outnumber new ones to be opened.

• Design: All Shake's have a design reminiscent of the original Madison Square Garden, but with details characteristic of its current location, fostering an atmosphere that invites you to sit down and have a good time in the restaurant.

• Rental: Their restaurants are all leases with very long term contracts, some are dated through 2038. It would be very interesting if they also acquired some property as an investment, since most of their restaurants are located in the busiest areas of the cities and could be revalued over the years, strengthening the fixed asset part of their balance sheet.

• Quality: Since the main characteristic of Shake is the quality of their burgers, but obviously I have not been able to be in each one of them, I have researched on google the opinions of people.

  My conclusions are that the people's perception in their own restaurants is excellent throughout the country, always having a rating higher than 4 out of 5. In licensed restaurants, those that are in airports or sports stadiums, the quality drops in some of them, even failing, which shows that the absence of control can affect the quality.

  

• Licensed Restaurants: They account for 128 of the 311 restaurants and only 3% of revenues.

  In the U.S. they have 22 of the 205 total. They are mainly used in airports and stadiums, since for regulatory reasons they are not allowed to open on property.

  To expand internationally, they have chosen the formula of licensed restaurants for all Shake Shack restaurants. Unlike franchises, licensing agreements allow licensees greater control. In this way, they allow local restaurant groups to exploit the brand under a series of pre-established agreements. According to the board, these hospitality groups have much more experience in those geographic areas and know the local consumer much better, so they can provide a much more satisfactory experience than they would have been able to do on their own.

  This has allowed them to offer products such as some kind of milkshake or dessert made with local produce, which they would not otherwise have known about. Characteristics:

  • Control: Every license has some pre-established conditions that must be met. But if you don't run your own restaurants, how do you transmit your famous culture? Are your suppliers, customers, distributors and above all, workers as happy as in your own restaurants? Why don't you expand with franchises that allow you more control? Why don't you go slower and combine with your own restaurants? When your biggest competitive advantage is culture, it's strange that you would allow loss of control at the expense of expansion.

  • Revenue: Shake Shack earns a percentage of sales made by international restaurants, territory fees and opening fees. Shake does not provide how much that percentage is, but it is only 3% of total revenue despite being 128 of the 311 total restaurants.

  • Marketing: This ''free`` expansion also allows you to make yourself known internationally with low advertising costs, as licensees incur them, word of mouth works excellently and above all, social networks, consumers love to share their experience in Shake, and that is achieved by the high quality of your products.

  • Low cost and high margins: The costs of opening a new restaurant, salaries, utilities, food... are assumed by the licensee, therefore Shake does not incur costs in the expansion and also everything it earns is practically profit.

  • Market testing: Through this licensing format, they can penetrate ''free of charge'' in markets unknown to them and test whether or not they are accepted by consumers. Thanks to this format, they entered Russia, stayed for several years, and ended up closing all their restaurants in 2019, although this decision was more political than economic.

  • Quality: In the same way I did with owned restaurants, I did research on international licenses. The conclusion is that satisfaction is full, with virtually all reviews exceeding 4 out of 5. It may help answer my doubt about whether the loss of control could affect the quality of the products, it seems not.

  

Future

Shake's growth will be driven primarily by 4 factors, in addition to the industry's own post-pandemic growth as people return to restaurants.

• New US restaurants: This will be the main driver of growth over the next few years. The idea is to create at least 45-50 new restaurants per year until 2022. This figure is likely to increase from that year onwards with the generation of cash flow from the growth itself.

  In the middle of the pandemic, 20 new restaurants have been opened in the US.

  As I show in the following image, the growth possibilities are immense, since many cities do not have any Shake to date.

  This growth will have a direct impact on revenues, as the company's own restaurants account for 97% of total revenues. It will also have a direct impact on costs, which are higher the further away from New York.

  

• New licenses : So far, international expansion has been particularly important in China and Asian countries. Proof of this is the agreement with Maxim Caterers to open in southern China up to 55 Shakes until 2030.

  In Europe, they only have restaurants in London, so the opportunities are immense, but it seems that for the moment this is not the immediate growth target.

  As we commented in the previous point, this growth is at the cost of the graduates, which favors obtaining 0 cost revenue, all margin, making themselves known abroad and knowing how to operate in new cultures.

• Same Shak Sales (SSS): This metric will experience the slowest growth in the coming years. The reason for this is that Shake Shak restaurants tend to be crowded with long lines, so SSS growth will depend on the following:

  

• Digitization: The pandemic accelerated this process. To address bottlenecks and to be able to serve all those customers who want to eat at a Shake. To this end, the company is investing its capex in improving all its digital services. This will allow them to get to know their customers better, provide an order-and-collect and home delivery service.

  In addition, it has reached agreements with numerous delivery companies for the latter, such as Uber Eats, Doordash, Postmates or Caviar.

The increase in other operating expenses for fiscal 2020 was primarily due to higher delivery expense as a result of digital growth - 10K 2020

• Pricing power: Not only to increase its sales per store, but also to compensate for salary increases, raw materials, rents... it is necessary for Shake to raise its menu prices. Does it have the capacity to do so? From what I have researched on the net, they have already done so on several occasions, without impacting a decrease in clientele.

With these wage increases came a spike in Shack's prices of about 1.8 percent, which the chain first announced during its last conference call in November. Some items, such as French fries and classic frozen custard shakes, have not gone up in price at all. www.eater.com - 2017

The product, to date, has resonated with guests. But there have been some concerns about consistency in the supply chain, in addition to trying to align costs. In the first quarter, Shake Shack saw a 140 basis point increase in paper and food costs to 29.5 percent of total revenue, which promoted a 1-2 percent price on some menu items, including Chick'n Bites. They went from an initial promotional price of $4.39 to $4.99. - www.qsrmagazine.com - 2020

• New Restaurant Formats: In order to meet demand, Shake has launched two new types of restaurant formats this year, which will allow people to not have to wait for a location, as the idea is to order and pick up.

  These formats are the walk-up and drive-thru windows, where they combine traditional restaurant and drive-thru window pick-up. The other format is the drive-thru, where the only option is pick-up, with no restaurant service.

  But...don't you lose the essence of premium service?

  

Moat

Shake's competitive advantages are two, but they are advantages to which they have to pay close attention in order to remain sustainable over time, since in the face of any unforeseen event, they could vanish. For this reason, I consider them certainly vulnerable or narrow moats, especially in such a highly competitive context as the restaurant industry. I am talking about brand and culture.

• Brand: When we think of Shake Shack, the first thing that comes to mind is quality, flavor, exquisiteness. If we feel like trying a good burger, we know that we will not be disappointed. The choice is based more on quality than on price.

  It is true that there are many small hamburger restaurants that make premium burgers and perhaps of higher quality, but Shake is always an alternative that we have in mind. In addition, for the millions of tourists who are traveling outside their circle of restaurant knowledge, when it comes to eating a good burger, Shake Shack will always be one of the first choices, much simpler and safer than looking for other unknown alternatives.

  Proof of this is that it has become a tourist attraction for people traveling to New York, and this is not easy for a restaurant. This also allows the company to obtain free advertising for the loyalty of its fans on social networks, a very important cost saving that other chains do not have.

Shake Shack has become a New York City institution, a vibrant and authentic community gathering place delivering an exceptional experience to our loyal guests. This gives us tremendous media and brand power - Annual Report 2020

Shake Shack grew up alongside social media and we believe we have benefited from our close relationship with passionate fans who want to engage with us and share their real-time experiences. We're proud to be recognized by media and influencers alike, garnering attention around the world - Annual Report 2020

To the above, we must add the numerous awards and recognitions it has achieved over the years: Restaurant Business 2020 Pacesetter Award, Restaurant Business's Top 500 Chains, mentioned in Casual's Top 100 Movers and Shakers, finalist in 2019 Shorty Awards' Best in Food & Beverage Sites and Apps, Nation's Restaurant News's 2018 Top 10 Fastest Growing Chains.

But why do I say it's a vulnerable moat? Well, because competition lurks and is starting to take action. We are talking about giants like Mcdonalds, Wendys or KFC among others. These chains are starting to raise prices and improve their products.

These giants are used to offering menus at very competitive prices, but the increase in meat costs (20% in 2021), salaries, utilities... has forced these chains to increase prices to be profitable. It makes much more sense to pass on these price increases with quality products than with low-quality products, to which consumers may be reluctant. Although it will not be easy to change the consumer's mentality from that of a fast-food restaurant to that of a restaurant with good products.

• Culture: Danny Meyer, the founder of Shake Shack continually refers to culture as its main competitive advantage. He believes that extraordinary customer, supplier and employee treatment will have an impact on business results, and as a consequence, on shareholders. I recommend this TED talk to learn a little more about its founder and this moat.

We have already discussed suppliers and customers throughout this thesis, but not employees.

The conditions are better than those established by the agreements, with a minimum wage above the legal minimum wage, medical, dental and vision insurance, pension plans, employee discounts, dining vouchers, discounts at gyms, tax benefit programs... In short, decent conditions for a sector as abusive as the hospitality industry.

We believe that culture is the single most important factor in our success. To maintain this, we take care of our teams first and foremost, and this allows us to take care of our guests, our community, our suppliers and our investors. - Danny Meyer

Before reviewing Shake Shack, I didn't consider culture as a moat, but after reading about it, I've come to realize that it may be the most important moat of all. As an example, two quotes from two business management geniuses.

Culture is not the most important thing in the world. It's the only thing...It is the thing that drives the business - Jim Sinegal, Costco founder

Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will decline. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as "widening the moat. - Warren Buffett, 2005 Letter to Shareholders

There are many great, smart and capable CEOs, but it is these small, day-to-day details (instilled by culture) that provide ownership, identity, motivation and sharing of common goals among employees.

To address this moat, your traditional peers should uproot themselves from their outdated management systems, which as we know, are often not employee-centric. This doesn't happen overnight, and Shake could get years of head start.

If Shake manages to maintain this moat over time, it will undoubtedly redound to its bottom line over the years. We will see over time if this continues to be the case for licensed Shake.

Management

Throughout the thesis, we have already discussed the management a bit. Its culture, its continuous reinvestment in the business, the search for new formats to be more profitable, the low debt, the ability to generate cash flow... but we will try to go a little deeper.

Skin in the game

Danny Meyer, with 4.8% of the outstanding shares, owns a significant number of shares that make him fully aligned with the company's interests. In addition, many of the managers own a good number of shares.

On the other hand, salaries, although very competitive, are not exorbitant. In addition, there are performance bonuses both in the short and long term.

Share buybacks and dividend

To date, the company is very focused on its growth, so it has declared that it will not distribute a dividend, nor is it planning to do so in the short term.

As the company is growing, and doing so at a rate above what its cash flow allows, the company has needed to dilute shares over the years and it is foreseeable that it may do so for some more years until it is able to grow with its own resources.

Balance Sheet, Debt and Capex

Through 2021, Shake Shack has grown with virtually no debt. Thanks to having negative working capital, its debt needs are only required to continue building restaurants. It has enough cash to deal with any unforeseen events, with 415 M in cash.

In the first quarter of 2021, they have issued 250M convertible notes maturing in 2028 at 0%. In the words of CEO Randy Garutti, this is a fantastic opportunity that will allow them to do great things in the future.

That gives us an extraordinary opportunity and it should go forward at a high rate, it's a very small dilution opportunity. I mean, it's a fantastic financial transaction for the company, rarely seen in our world. - Randy Garutti (free translation) - Call Transcript

Regarding capex, it's practically all growth, destined to new openings and digitalization of the company. In the future, it will also be destined to repairs, web maintenance... in other words, little capex needs for the company's operation.

Acquisitions

None, all the company's growth is organic and through new restaurants.

Valuation

Shake Shack's valuation reflects the euphoric state of growth companies currently in the market, exorbitant multiples that can turn a good business into a bad investment, to paraphrase Buffett.

It is currently trading at approximately EV/EBITDA x 35 estimated for 2022 and PER x 270 estimated also for 2022. I refer to 2022, because earnings will be more normalized than in 2021, but these are still very demanding multiples.

Some analysts may take as a reference to value Shake its EV/Revenue, which would be somewhat more conservative at x4 in 2022. Given that it is a growth company, it may be understandable, but given my very conservative investment style, it doesn't do much for me.

I prefer to wait to see if something happens to the company that makes its price correct, and if at that moment I consider that the price is adequate, it is very possible that I could be interested in acquiring it, for the time being, I will wait and see how the business evolves.

Conclusion

Company with a lot of growth ahead, with just over 330 restaurants at present. Peers like Mcdonalds have 39k in the world, Dominos Pizza 19k, Wendy's 6700 or Five Guys 1.5k. Carrying out an international expansion through licensing. I prefer to analyze calmly how their competitive advantages evolve outside the US. For the moment, it seems to be doing well.

Its competitive advantages, if maintained, are very important. But I am concerned that if it grows too much it could lose its image of quality fast food and become just another fast food. Its culture, at the US level seems quite stable, at the international level it needs more time.

Financially, with 415M in cash, and a debt of 250M (convertible notes) with 0% interest and maturity in 2028, its situation, for the moment, is calm. We will see how it evolves over the years, if their ambition to grow very fast makes them continue to request other types of debt, we will have to be alert.

Unaffordable multiples regardless of their future growth. Although I like the business and how it is developing, I prefer to continue to wait, because there is a downside scenario quite possible at these prices.

In short, it seems to me a very good business, which is going to grow, with very solid values and a management that knows the sector well. But I would like to wait a little longer to see if the business evolves as it has done so far, if the management is not in a hurry to grow and if its competitive advantages are sustained. This wait may cause me to miss the train, but I don't mind, I prefer a significant margin of safety before deciding to invest.

DISCLAIMER: This analysis is in no way a recommendation to buy or sell, each person must do their own research.