It has been a tough year to be an investor in the retail sector, with the group underperforming the S&P 500 substantially, down 2% year to date. Fortunately, investors in Shake Shack Inc. (SHAK, Financial) were rewarded with significant outperformance after a brutal 2022, but the stock has since given up over half of its year-to-date gains and has slid back below its 200-day moving average as it gets ready to report third-quarter results next month. On a positive note, the stock's valuation has improved from being priced for near perfection earlier this year after its sharp correction and the company appeared quite upbeat about its full-year results, raising its margin outlook and being optimistic about its upcoming and current limited time offers (Bourbon Bacon Burger, Avocado Bacon Burger and Hot Chicken).
Unfortunately, these limited-time offers will have to combat plunging industry-wide traffic and a clear 180-degree turn in consumer behavior. This is based on quick-service restaurant traffic on track for three consecutive monthly declines on a year-over-year basis, and with Darden Restaurants (DRI, Financial) calling out early signs of check management, also a negative development. In this analysis, I will look at Shake Shack's valuation, industry-wide trends and whether the stock is worthy of investment after its recent correction.
Recent results
Shake Shack released its second-quarter results in early August, reporting revenue of $271.8 million (up 18% year over year), system-wide sales of $426.3 million (up 21% year over year) and shack-level operating profit of $54.9 million. These were all meaningful improvements from the year-ago period, driven by same-store sales of 3%, and with this momentum carrying into July, when the company reported a 150-basis point acceleration to 4.5% comparable restaurant sales. That said, these results still translated to a 1% traffic decline and average weekly sales may have improved to around $77,000, but this was to be expected and a little lower than my expectations given the benefit of more drive-thrus in the system (which carry much higher construction costs) and high single-digit pricing. Plus, the quarter benefited from a highly successful limited-time offer (White Truffle Burgers), which carried a higher average check, and while adjusted Ebitda was up meaningfully to $37.1 million (up 61% year over year), this included around $4 in stock-based compensation ($33.2 million non-adjusted for SBC) and was up against easy comps after a tough second-quarter 2022 because of margin compression.
Source: Author's chart compiled from Shake Shack quarterly revenue and company filings.
Digging into the results a little closer, the one highlight was that margins improved materially year over year, up 240 basis points to 21%. Menu price increases, labor efficiency, lower marketing expenses and the benefit of sales leverage that offset commodity, utility and wage inflation helped to deliver this beat. And the company noted that it continues to see benefits from its in-store kiosks that are rolled out across most of the system, and these kiosks continue to drive higher sales and help profitability because of being the highest-margin channel. In addition, Shake Shack shared it generated its highest quarterly Ebitda dollars on record at $37.1 million, though it is important to note that while this was a quarterly record, adjusted Ebitda margins of 13.6% were still down substantially from peak levels (second-quarter 2016: 21.4%).
Finally, as for development and labor, Shake Shack opened 23 new locations across its system (10 company-operated and 13 licensed) and plans to open 75 total restaurants this year, pushing its store count above 500. However, while the company shared that it is seeing improvements in labor with its lowest turnover in two years and waste and packaging reduction are improving profitability, it is seeing much higher build costs, with average build costs of $2.6 million, up 30% on a three-year basis. In fact, several of its class of 2023 restaurants have come in significantly over budget. While the company is confident it can reduce overall build costs by 10% to improve its returns with a reduced store footprint, success on this front remains to be seen and costs are still well above 2019, 2020 and 2021 class returns. In summary, the headline results may have been impressive, but I would argue the second-quarter results were mixed overall, with traffic still down year over year, build costs up sharply year over year and same-store sales of 3% being the minimum one would hope for given the high single-digit menu pricing that Shake Shack carried in the period.
Source: Author's chart compiled from Shake Shack's filings
Commodity inflation
Looking at industry-wide trends, the restaurant space has finally started to get some help from a commodity inflation standpoint after a rough 2022, but some brands have benefited more than others. For example, while brands that skew higher toward pork, chicken and avocado have benefited due to deflation in these items, beef costs have remained quite sticky, with beef and veal costs up nearly 16% in August and 21% in September, leading the commodity basket for year-over-year increases. This is not ideal for Shake Shack from a margin standpoint, and this could be why the company's next limited-time offering is focusing on chicken, avocado and acon to push some guests away from higher-cost beef into higher-margin categories. In addition, although the company has reduced labor hours year over year with better scheduling and the benefit of kiosks, wage inflation is not going away, and two key markets will see outsized wage inflation next year with California raising its minimum wage to $20 and New York raising wages further, with a planned increase to $17 in 2026 (New York City, Long Island and Westchester County) and $16 by 2026 in the rest of the state. These two markets combined make up nearly one-third of Shake Shack's system, so this could be a headwind from a margin standpoint.
The other negative for Shake Shack though is that while it has improved margins in its most recent quarter and is aiming for 19.0% plus margins this year, its margins are still miles below 2017 levels (approximately 28%) and this is with the benefit of consistent high single-digit menu price increases. And although this has been absorbed by guests with no pushback to date, I do not see high single-digit pricing as sustainable, especially when we have already seen a negative shift in consumer behavior as wallets get tighter and credit has been tapped (record credit card debt in Canada and the U.S.). So while the company may continue to drive sales across its system with 10%-plus unit growth per year, its bottom line could remain pressured given where traffic has headed. The second quarter could mark peak margins over the next two years ahead of some normalization from now on.
Worsening traffic and a weaker average consumer
Digging into this a little closer, we can see that industry-wide traffic has worsened materially since the time of Shake Shack's upbeat second-quarter call (early August), with data from OpenTable showing that seated diner growth has continued to slide on a year-over-year basis. While this does not directly correlate to quick-service restaurant traffic, data suggests that quick-service traffic worsened considerably in August and September, with the segment seeing two consecutive monthly declines in traffic for the first time in two years. Meanwhile, October is off to an even worse start, which could suggest that consumers are finally starting to feel the pinch. So while Shake Shack may have a busy line-up planned to drive sales in regard to its limited-time offers in the second half of the year, I am less optimistic about its ability to buck this trend, especially when traffic was still down 1% in what was its best quarter of the year.
Source: Seated Diners Growth - OpenTable
The other point worth noting is that while some quick-service brands can be thought of as trade-down beneficiaries, like Burger King, McDonald's (MCD, Financial), Wendy's (WEN, Financial) and Popeyes, because of their lower average tickets, Shake Shack is hardly a trade-down beneficiary, with burgers that can come in above $12 for premium items and closer to $9 depending on the market for burgers. And given that the company's margins have been helped over past quarters by its guests trading up to premium items, it is not clear whether these new limited-time offers will be as successful when consumers may reduce visit frequency or trading down on the menu from a premium offering to a basic offering if they are maintaining frequency. The result? We could see less sales leverage, which could negatively impact margins in this seasonally weaker part of the year. Hence, given this dynamic of much weaker traffic that has continued to decelerate into the fourth quarter, I think there's a higher probability of a miss in sales and earnings when traffic for quick-service and fast casual looks the worst in has in years, excluding pandemic-related closures.
Valuation
Based on roughly 42.4 million shares and a share price of $55, Shake Shack trades at a market cap of around $2.33 billion and an enterprise value of $2.78 billion, making it one of the smaller capitalization quick-service names in the restaurant industry. This is especially true among the burger category, behind behemoths like McDonald's, Wendy's and Restaurant Brands International (QSR, Financial). And despite a less non-franchised model (270 out of 471 restaurants are company-owned) versus its larger peers, the company continues to trade at a premium valuation, sitting at 19 times 2024 enterprise value/Ebitda estimates and 130 times 2024 earnings estimates (41 cents), a rich multiple relative to Restaurant Brands at 15 times 2024 EV/Ebitda estimates and 18.6 times earnings estimates ($3.50), respectively. And while some premium is justified given its higher growth rates, the company has seen a steady decline in margins over the past several years even with the benefit of optimization initiatives. So while it may be one of the better growth stories in the restaurant space, it is hard to argue there is any margin of safety even after the stock's 30% correction.
Source: FASTGRAPHS.com
Using what I believe to be a more conservative multiple of 20 times EV/Ebitda to account for its growth, but adjusting for the high-rate environment and continued macro headwinds and using 2024 estimates, I see a fair value for the stock of $61.80, pointing to a 12% upside from current levels. However, for mid-cap growth stocks, I am looking for a minimum 25% discount to fair value to ensure an adequate margin of safety and ideally closer to 30% for names that are not generating consistent free cash flow. And even if we use the low end of this discount range (25%), Shake Shack's ideal buy zone comes in at $46.40 or lower. So although the stock may be down sharply from its highs and oversold heading into earnings next month, I see more attractive bets elsewhere in the market currently from a valuation standpoint, and I would need a deeper pullback to become more interested in the stock.
Summary
Shake Shack made some progress in the second quarter from a margin standpoint and has taken its restaurant-level margin guidance higher to 19.6% at the midpoint, a significant improvement from 2022 levels. That said, these margins are still well below peak margins of pre-pandemic margins of 28% and second-quarter margins benefited from highly successful limited-time offers and strong seasonality, with the third and fourth quarters typically being softer, and there being clear evidence of a steep pullback in quick-service/fast-casual restaurant traffic. Hence, although Shake Shack might find a way to beat estimates if its Avocado Bacon, Hot Chicken and the Shackmeister Burger outperform expectations, it is tough to be optimistic about its commentary on the fourth quarter and fiscal 2024 when traffic has nose-dived since the company's last quarterly call.
Assuming the stock was down 45% from its highs and trading at less than 15 times 2024 EV/Ebitda estimates, there might be reason to brush off the risks of a miss on sales and earnings and rush in to buy this dip. However, this is hardly the case, with Shake Shack continuing to trade at one of the higher multiples sector-wide in a more promotional environment and ahead of further wage inflation next year, with the possibility of outsized inflation in its California restaurants (minimum wage rising to $20 in April). And while the second-quarter results were better than I expected, I think we could see some pressure on margins and sales going forward and a less impressive back half of the year than some investors might have hoped for. In summary, if I wanted to go long the stock and add a high-growth name to my portfolio in the restaurant space, I would be waiting for a dip closer to $46 to start new positions.
