Shake Shack’s Valuation Doesn’t Make Sense (NYSE:SHAK)

Founded in 2001, Shake Shack (NYSE:SHAK) operates and licenses restaurants in the United States as well as other countries. Since the company’s IPO in early 2015, Shake Shack’s stock has appreciated well at a CAGR of around 10.3%. The stock has rallied by over 100% in the past year as Shake Shack’s growth story has continued, and the company has been able to slowly improve its profitability.

Good Revenue Growth Continues

Shake Shack has been an incredibly fast-growing company in the restaurant industry, achieving an impressive revenue CAGR of 30.3% from 2012 to current revenues as of Q1/2024. The company is guiding for a 2024 growth of 12% to 15%, expecting to open 40 company-owned and 40 licensed restaurants in the year.

The growth takes up capital – in 2023, Shake Shack spent $146.2 million in capital expenditures compared to depreciation of $91.2 million. As the company’s operational cash flows are very thin, Shake Shack has had to use equity to finance the growth, growing outstanding shares from 30.1 million diluted in 2014 into 44.4 million diluted after Q1/2024. The dilution has slowed down in recent years, but outstanding shares are still slowly increasing.

Reported Q1 Results & Outlook

Shake Shack reported the company’s Q1 results on the 2nd of May. The company saw revenues increase by 14.7% year-over-year, hitting very close to the consensus estimate. The EPS came in at $0.13, three cents above analysts’ expectations. The stock reacted neutrally, closing the day at +1.6%.

With the report, Shake Shack mostly reiterated the 2024 guidance, tweaking expected revenues, Shack-level operating margin, SG&A, equity-based compensation, and the adjusted tax rate very slightly. The Q2 guidance shows revenue expectations of $308.9 million to $314.3 million, representing a year-over-year growth of 14.6% with the middle point of the guidance. The report came in very near expectations; the neutral stock reaction seems justified.

Shake Shack’s Profitability Should, And Needs To, Increase

In recent years, Shake Shack’s profitability has been bad, as the company’s operating earnings hover near breakeven and even being negative during the Covid pandemic. Prior to the pandemic, Shake Shack was able to sustain quite good margins, reaching a level of 10.7% in 2015. Currently, the trailing operating margin stands at 1.4% or at 3.0% excluding pre-opening costs, with the Q1 results showing a good year-over-year improvement.

The company is clearly focusing on leveraging profitability. The Shack-level operating margin is guided at a range of 20.2% to 21.0% for 2024 compared to 19.8% in 2023. The Shack-level margin doesn’t account for SG&A, depreciation, and pre-opening costs, though – the high-seeming margin isn’t a fair margin to evaluate the company’s total profitability; the 2024 outlook still expects very thin total profitability. Improvements are being made in the supply chain to increase margins, which should position Shake Shack for growth in profitability. Growth should eventually also raise margins as Shack-level income outscales SG&A and other managerial costs. Additionally, in the brick-and-mortar business as for Shake Shack too as told in the Q1 earnings call, store traffic takes time to pick up, making restaurant growth temporarily pressure Shake Shack’s margins.

Still, the current profitability is weak, and I expect that clear improvements in the bottom line should take multiple years to realize. Shake Shack’s management relates a part of the weakness to current inflationary pressures in paper and food, but I wouldn’t expect too good improvements in the COGS in the near-term, and longer-term effects’ scale is unknown. Currently, some profitability improvements are happening, but the speed isn’t very fast.

The Valuation Doesn’t Make Sense

While the company’s growth story has been impressive, the current valuation doesn’t seem to make sense. The forward adjusted EV/EBITDA multiple stands at 27.4, near the post-IPO average. The multiple seems high, and as Shake Shack adjusts for multiple non-recurring costs in the adjusted EBITDA along with the large amount of depreciation, the EV/EBITDA doesn’t seem to provide a good expected return.

To further evaluate the valuation, I constructed a discounted cash flow model. In the DCF model, I estimate the revenue growth to continue well with a 2024 growth of 14%, 2025 growth of 16%, and 2026 growth of 15% that gradually slows down into a perpetual growth of 3%. The revenue estimates represent a CAGR of 11.7% from 2023 to 2033. For the EBIT margin, I estimate a gradual increase into 8.0%, representing a good amount of operating leverage from growth and well-executed cost initiatives. As Shake Shack’s growth slows down, I estimate the growth investments to slow down improving the cash flow conversion.

With the mentioned estimates, the DCF model estimates Shake Shack’s fair value at $31.11, around 71% below the stock price at the time of writing – the current valuation seems to be grossly overvaluing the business. While Shake Shack has incredible earnings growth potential, the earnings growth doesn’t make the valuation justifiable with my expectations. Even with higher profitability and growth than I anticipate, the stock doesn’t seem to be easily worth its current price.

A weighted average cost of capital of 11.95% is used in the DCF model. The used WACC is derived from a capital asset pricing model:

In the most recent reported quarter, Shake Shack had $0.5 million in interest expenses. With the company’s current amount of interest-bearing debt, Shake Shack’s annualized interest rate only comes up to 0.83%. The interest rate is abnormally low, but I use the estimate in my CAPM regardless coupled with a long-term debt-to-equity ratio estimate of 10%.

For the risk-free rate on the cost of equity side, I use the United States’ 10-year bond yield of 4.51%. The equity risk premium of 4.60% is Professor Aswath Damodaran’s latest estimate for the United States, updated on the 5th of January. Yahoo Finance estimates Shake Shack’s beta at a figure of 1.81. Finally, I add a small liquidity premium of 0.25%, creating a cost of equity of 13.09% and a WACC of 11.95%.

Takeaway

While Shake Shack has grown incredibly well increasing the chain’s presence, investors are looking at a bleak earnings yield. The Q1 results showed continued revenue growth and margin expansion, but the margin expansion is slow at the moment. The company’s currently very thin profitability seems to take time to increase into a good level, and while some eventual margin leverage is very probable, the current valuation doesn’t seem to price the stock with reasonable expectations. My DCF model estimates a very high amount of downside for the stock, and as such, I have a sell rating for the stock for the time being.