When we look at "Food Away from Home" numbers in the CPI, we see prices continue to accelerate. The market still remains bullish on the Quick-Service Restaurant industry as people trade down their outdoor dining but, not all companies are created equal.
We've identified the Shake Shack as one of those companies that are failing and worth looking at for a swing short
Failing on Profitability, Returns and Balance Sheet
Shake Shack came public with positive profitability, back in 2014. Since then, the company doesn’t seem to have done very much on driving profitability. Their gross profit margin and pretax margin are not well below the industry average.
Gross margins have seen significant compression over the years. Compared to previous years, the inflationary pressure hasn’t take much of a toll, because of price increases but then have paid for this with decreasing sales.
Wage increases are bound to hit their pretax margins and they are also looking at increasing their store count (which will include drive throughs).
Unfortunately, that’s not where the story ends. The company is also failing free cash flows and return metrics. As a value investor, this wouldn’t pass the sniff test at all.
The company does have a cash balance of $337million as of the last quarter but, it also has long term debt (bonds) of $250million that mature in 2028. They’ve invested $687million in Capex to generate $62million in EBIT over the last 9 years. That’s a 9% return over the last 9 years.
Update from our community: Our community member on Discord (grizzly090) added some views since he's also in the restaurant business.
"since I still own a small restaurant chain. Beef patties are quoted up next year by 5-10% across the industry...so while commodities are easing generally, the patty is still a headwind. Also, everyone I know is pulling back growth because development costs are +20-30% across the industry. The commercial construction market seems likely to weaken but as is hasn't meaningfully so it's a capex drain. We are slowing growth on our burger chain which has good numbers just b/c fighting too many headwinds. Point is just that headwinds abound"
All of the above are just more headwinds for margins and expansion programs.
Management Goals and Growth Strategy
Management is incentivized to receive short-term performance -based cash bonuses for:
50% by hitting total quarterly revenue vs. budget
50% by hitting quarter adjusted EBITDA vs. budget
This is not comforting because they don’t have the incentive to grow profitability as such. “Adjusted EBITDA” can be manipulated and it’s clear that the management is fine with failing on Return on Investment metrics, as long as they can hit their budgeted numbers at the top line.
They’ve discussed accelerating their growth strategy, as mentioned above, at a time when the US is about to enter a recession. Part of this growth acceleration is perhaps also to meet their quarterly sales target which is part of their incentive but, it completely ignores profits, free cash flow and return.
Our view at Traderade is that we are entering a recession in 2023, if we're not already in one in many ways. More importantly, you've heard our thesis of the Fed destroying demand to curb inflation and the fact that the consumer isn't so strong anymore.
Outdoor dining remains a luxury, and while QSRs may do better, Shake Shack is on the higher end of the price scale. In fact, even international stores are under pressure because Shake Shack is slightly above average in terms of pricing
Wall Street still has very positive outlooks on Sales and EPS growth, which I think are far to optimistic even after the downward revisions in earnings.
Not surprisingly, rating have moved over to a hold for the company. However, I think this has more to do with the outlook of the Macro environment instead of the inherent problems with the company itself. This is why the Street still has an average target price of $53.72 on this company.
The company has a decent menu selection and their food is quite good.
Outlook for the Restaurant Industry is still positive
It’s a favorite stock for trading and we often see short covering driving prices higher.
This is a tricky one to short because of all the short covering and the price has already come down quite a bit from cycle highs. Nevertheless, over the next 3-6 months, the company still has further downside potential.
Entry: Potential entry would be at $48 level with a stop loss of 5%.
Exit: Potential Exit just above $38 which would mark the June 2022 lows. Second price target would bet $30 which would mark the Covid lows.
Disclaimer: This is not investment advice. We have no position in this stock but, we may initiate a position 72 hours after the publication of this article or upon hitting the entry price target.
Source: All data and charts from FactSet. Price chart from TradingView