When Shake Shack stock ballooned to over $90 per share following its IPO last year, I was worried for the people with no real financial literacy that were inevitably drawn to the bright lights of an IPO in an easy-to-understand industry that enjoyed an emerging brand name. Many of the Shake Stock stock IPO (or shortly thereafter) investors were purchasing stock for the first time, and were excited to get in near the ground floor on a business primed for 10+ years of very high earnings growth.
The problem is that anytime casual investors collectively get really excited about something, it almost always signals that the asset you’re considering is going to be overpriced. There’s nothing quite like an IPO for a corporation with a scalable business model that creates a period of maximum investor excitement. Often times, you’re best off waiting a year or two to assess the stock, as the decline in investor excitement is a good opportunity to reassess whether the stock price has come down to a reasonable value.
On May 22nd, 2015, Shake Shack stock (SHAK) hit a price of $92.86. At the time, Shake Stock stock was posting profits of $0.35 per share. This is yet another entry in a long line of examples that involve investors getting hyped up about a stock to such a degree that the price becomes so high that most of the future earnings growth has already been captured by the stock price years in advance. That’s exactly what happened when Shake Shack stock’s P/E ratio hit 265 last year.
Now, the earnings have grown, the sentiment has cooled and brought the price down, and it’s a good time to re-evaluate. What’s Shake Shack stock worth?
Before we analyze the corporation, we need to figure out the capital structure. Right now, there are over sixteen million shares of Class A Shake Shack stock, which are the “regular shares” that trade on the exchange. There are also over 21 million Class B shares of Shake Shack stock, which are non-registered shares and can’t be traded on a public exchange like the NYSE). These are the shares that were created for the investors that purchased Shake Shack stock before the IPO as well as Danny Meyer and other members of the management team when the corporation was not yet publicly traded.
The economic interest of both shares are identical; if you want the right to sell your shares on a public exchange, you must first complete the step of converting your B shares into A shares. These aren’t rights that affect the size of the shareholder base, but rather, have to do with different transferability rights.
Eventually, all B shares will be converted into A shares (unless a member of the management team or an initial investor truly treats it as a passive holding that is never sold, and passed down from generation to generation.) To capture the economic heart of the matter, we can assume that Shake Shack exists as if there are 37.50 million shares outstanding. And it is adding about a million shares through an additional offering this year, so the measuring base for calculating per share profits at Shake Shack ought to be 38,500,000 shares (which are currently a mixture of A and B shares).
The balance sheet itself is an extraordinary shape. Shake Shock only carries $300,000 in debt. It has $69,800,000 in the bank. The net cash surplus is $69.5 million. This is an extraordinary position of financial strength for a corporation that only has 75 burger joints.
Shake Shack is expected to earn $18,000,000 in profits this year. Divided against the 38,500,000 shares, Shake Shack stock ought to represent $0.4765 in profits this year. The stock currently trades at $37 per share. That’s a valuation of 77x earnings.
Even though that is a far better deal than the investor that paid 265x earnings got, it is still above the point at which I would consider it a prudent investment even as Shake Shack is expected to grow profits substantially in the next few years.
The same store sales growth remains in the high single digits, and the 75 location base can lead to rapidly increased earnings as Shake Shack adds more locations up east and expands out west. The problem, from the perspective of a potential investor, is that 77x earnings continues already price in much of Shake Shack’s future growth.
The top analyst estimates call for $1.10 per share profits five years from now. That would be an impressive feat–an increase in profits of 134% over five years. But there is a catch: To even make money on that growth, the stock would need to trade at a valuation over 34.3x earnings. If you want to get a return of even 1% on your Shake Shack investment, then you would some combination of the following: more than 134% profit per share growth over the next five years and/or a 2021 valuation that is above 34.3x earnings. That’s not something you want to rely on.
And, presumably, people that purchase Shake Shack stock want at least 10% annual returns over the next five years. Well, if the $1.10 per share estimate holds, then the price of the stock needs to go up to $61.50. That’s a valuation of 55x earnings. It could happen, but it’s not stacking the odds in your favor–you need profits to more than double, and the valuation to remain quite extended.
P/E compression takes all the fun out of growth stock investing. It always happens eventually, even though many investors try to ignore that fact during the early stages of a corporation’s publicly traded life. But that P/E ratio of 20 seems to eventually exert some gravitational pull on nearly every company eventually, and that is what makes investing in these types of corporations so difficult to pull off with regular success. If it is eventually inevitably that Shake Shack’s stock will compress in value from 77x earnings to 20x earnings over the long term, then you need a whole lot of earnings per share growth in the meantime to still experience capital appreciation even amidst such substantial P/E compression.
My view? Given Shake Shack’s incredibly strong financial position, and relatively small size in the restaurant sector, I would consider it a good deal around 35x earnings and a margin-of-safety type investment once you get near 25x earnings. Shake Shack would need to come down to the teens range before I’d consider it an investment that loses its speculative flavor created by the high current valuation of 77x earnings. The $20-$29 range is my gray area where I wouldn’t actually do it, but I also wouldn’t analyze it as an objectively unreasonable decision for others to make because higher than expected earnings growth could cure some valuation issues (at the current price, it would require extremely high earnings per share growth for the price to be justified).
There is also the fact that the burger industry is intensely competitive. The quality of Shake Shack burgers, custards, and fries does seem to be winning a loyal following. But the restaurant industry is subject to extreme shifts in fashionability. There was a time when Red Robin was the next big burger joint, and now, it receives hardly any press coverage. It’s a very hard industry to make money reliably because there are so many entrenched operatives and new entrepreneurs entering the market. You can’t really project success out decades in advance–there is a lot to learn from the fact that McDonald’s is the only publicly traded restaurant chain that has made its shareholders post-IPO real money over a multiple generations timeframe.
I do admire Shake Shack management. The financial position is incredibly strong, and the deliberate rollout of new locations does suggest a prudence that is often missing when a corporation becomes popular (the only other fast food/restaurant company that has been as shareholder-friendly with its growth that I’ve ever studied is Chipotle Mexican Grill (CMG)). The basically debt-free balance sheet and nearly $70 million in the bank will permit Shake Shack to self-fund its growth without heavy shareholder dilution along the way.
Still, the price must be rational. I think you have a high probability of success buying Shake Shack at 25x earnings, a fair shot around 35x earnings, and it’s a gray area for me to analyze in the 35-45x earnings range (if growth is high, it can work out; but even low double-digit growth for five years could make that valuation prove too high). At 77x earnings, you’re still not being compensated for the long-term risk that is inherent in the restaurant sector. The compression is too great. The stock has gotten a lot more reasonable in the past year, but there is still way too high of a portion of future earnings being already captured in the price of the stock.
Originally posted 2016-04-15 17:59:38.