The Value of Shake Shack

The Value of Shake Shack

Shake Shack (Ticker: SHAK) is a fine-casual restaurant chain originally based in New York City. It

started as a food cart inside Madison Square Park in 2004 by Danny Meyer. Since its beginnings in

Madison Square Park it has grown to be recognized as an international brand with 63 locations across

the globe with ambitious plans for future growth.

At the end of 2014 SHAK filed an S-1 with the SEC to initiate its public offering. At the beginning

of 2015 they raised $105 million at $21/share. Currently SHAK shares are trading at over $60/share.

This IPO will be used to help the company achieve its long term goal of expanding locations to more

than 450 restaurants globally, current short term expansion plans is to open 10 new locations next year

and management has estimated that they will continue to grow at roughly this rate into the foreseeable

future. They plan and achieving this goal through slower more calculated expansion to ensure location

profitability and survivability.

Product Offering

Shake Shack started its menu from New York-style hamburgers and later expanded to

hamburgers, hotdogs, fries and its namesake milkshakes. It later introduced local wine and bottled beer

to its menu in 2004. Its common menu offerings are most comparable with Smash Burger, In-N-Out and

Five Guys while its fine-casual feel is more reminiscent of Chipotle Mexican Grill and Panera Bread.

Much of the early growth and success of the business has been attributed to its fine-casual

concept with a burger, shake and fries focused product offering along with tailor made offerings specific

to regional preferences including wine and beer offerings. This regional variability is vital as the

company operates and plans to expand in very culturally diverse markets. Currently they have locations

in North America, Middle East, Russia, and the United Kingdom.

The fine-casual concept is a hybrid of fine dining and fast-casual format focusing on high-quality

all-natural, hormone and antibiotic-free ingredients which is similar to Chipotle Mexican Grill (Ticker:

CMG) and Panera Bread (Ticker: PNRA). They then combined this with elements of the fast food format.

All combined, customers receive high-quality food quickly at a price point between fast food and casual

dining restaurants.

Fast-Casual Industry Analysis:

The restaurant industry of America is experiencing a tectonic shift, as quick service and full

service restaurants, which had dominated the industry, are being squeezed out of the market by an

emerging new restaurant subsector, fast casual dining. Fast casual restaurants, which combines full-

service restaurants focus on healthy quality food and quick service restaurants focus on price and

convenience, is being increasingly embraced by consumers. This is reflected by the fact that Americans

are now spending more on dining out than home cooking, Americans are also eating less at traditional

quick-service and full-service restaurants, as an Americans shift toward fast casual dining. Driving by the

shift in consumer preference, the fast casual dining subsector is projected to grow at twice the speed of

the overall restaurant industry.

Consumers shunning traditional fast food:

Behind the rise of the fast casual dining is a shift in American consumer food preference toward

real and natural food over processed food. In a survey conducted in 2014, 39% of Americans

reported eating less processed food vs 10% who reported eating more compared to a few years ago.

Instead, Americans are choosing healthier food options. In the same survey, 49% of Americans reported

eating more fruits and vegetables, 26% reported eating leaner proteins, and 23% reported eating more

natural protein sources1.

Americans are choosing more active lifestyle:

A strong contributing factor to the shift toward healthier food options is that an increasing

number of Americans are choosing to pursue a more active life style. In 2014, 38% of Americans

reported exercising more vs 35% in 2004. This is contributing to the rise of fast casual restaurants as

researches have indicated a clear correlation between exercising more and choosing to eat more natural

food, as 52% of Americans reported that they incorporate natural food as part of their plans to

lose/control their weight.

Consumers are spending more on food and dining:

1 Packaged Facts, What America Eats

The other contributing factor to fast casual restaurants rise is the median household income

has stagnated at around $51,000 since the financial crisis2, and while the unemployment rate has

continued to drop from a declining labor force participation rate, the total number of wage earning

Americans remain virtually the same since the beginning of the recovery. Facing less optimal household

financial conditions, the average American household is slashing spending on entertainment and

luxuries, and instead choosing to splurge on food instead3, and fast casual restaurants with healthy but

affordable dining options have become the ideal choice.

Teens/Young adults a source for continuing growth:

In a survey of more than 1,100 young adults4, more than 45% of interviewees reported dining

out more in 2014 than last year and that fast casual styled restaurants is rising in popularity amongst the

surveyed age group. While quick service remained as the most frequently visited restaurants, overall

2 FRED Economic Data 3 Bureau of Labor Statistics Consumer Expenditure Survey 4 Source: William Blair Teen/Young Adult Survey

US Civilian Labor Force (000) 2010 2011 2012 2013 2014Labor Force 153,650 153,961 155,553 155,047 156,129

Partcipation Rate 64.3% 64.0% 63.7% 62.8% 62.9%

Working Population 98,797 98,535 99,087 97,370 98,205

Unemployed/Nonparticipating 54,853 55,426 56,466 57,677 57,924

US Household Expenditure Analysis

2013 Avg 2014 Avg YoY Ch

Income 65,029 64,432 -0.9%

Food 6,598 6,665 1.0%

Housing 17,041 17,377 2.0%

Apparel 1,706 1,674 -1.9%

Transportation 8,999 9,104 1.2%

Healthcare 3,520 3,919 11.3%

Entertainment 2,586 2,560 -1.0%

frequency has declined from the previous year. In contrast, frequency to fast casual restaurants

increased significantly, launching casual restaurants to the 2nd most frequently visited restaurants

subsector for young adults. This has become a dependable source of growth for fast casual restaurants

as casual dining becomes a part of the young American lifestyle.

Shake Shack Company Outlook

Revenue Growth

Shake Shacks unique business concept has translated in impressive revenue growth. Such high

growth is not a surprise as Shake Shack is comparatively still a small restaurant chain with a large

amount of room for future growth.

In 2010, Shake Shack had $19.5 million in revenues that grew to $119 million over the past five

years ending in 2014. Thats a compound annual growth rate, or CAGR, of 41.8%. This is in line with 2014

and 2013 revenue growth of 42.6% and 41.4% respectively year over year. This solid double digit growth

is expected to continue at 28% over the next five years. The main sources of past and future revenue

growth is and will continue to be the addition of domestic company-operated stores, domestic licensed

stores, and international licensed stores.

Domestic and international licensed locations was $6.5 million at the end of 2014 up from $1.5

million at the end of 2012 and represented 5.4% and 2.5% of revenues respectively. This is from 32

licensed locations compared to 31 company-owned and operated locations. By utilizing a blend of

franchised and company-owned locations Shake Shack is well positioned to grow without a huge

amount of capital investments.

The most important factor for future revenue growth in company-owned locations is same-store

sales. Since 2013 same-store growth has declined from $4.6 million annually to $4.3 million and is

expected to compress even further to $3.7 million in 2015 given the companys forecasted expansions

and revenue expectations. This is concerning when compared to Chipotle and Panera that are both

experiencing same-store sales growth.

Revenue growth in future will continue to come from adding locations and not from same-store

sales. Given that Shake Shack currently only has 63 locations there is tremendous amount of growth

opportunity when compared to more established competitors with thousands of locations. It is also

4,643 4,336

3,708 3,416

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3,500

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4,500

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2013 2014 2015e 2016e

Average Unit Volume

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2012 2013 2014 2015e

Store Growth

Company-operated stores Domestic Licensed stores

International Licensed stores

important that Shake Shack to grow at a sustainable pace and not to over extend themselves in the

name of growth.

Costs

Shake Shacks three main costs are Food, Labor and Occupancy. When looked at from the

perspective of company operated sales we can make a relevant comparison with Shake Shacks closest

peers.

The above graph shows the three major costs for Shake Shack for 2014 compared to Chipotle

Mexican Grill (CMG) and Panera Bread (PNRA) as a percentage of sales.

Food Shake Shack is 31.2% which is above Panera at 26.5% and below Chipotle at 34.6% which is

unsurprisingly is right between its two closest peers.

Labor Shake Shack is again in between both peers but closer to the top at 26.2% verse Panera at 26.5%

and Chipotle at 34.6%.

Occupancy Shake Shack has the highest occupancy cost by a large margin at 8.7% with Panera well

below it at 6.3% and Chipotle even lower at 5.6%.

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0%

Food and paper costs

Labor Costs

Occupancy Costs

Major Cost Comparison 2014

CMG PNRA SHAK

As a whole Shake Shacks costs are right where we would expect them to be with the exception

of occupancy costs. The occupancy costs are close enough that we dont expect them to be a significant

concern due to the year over year trend.

Year over year we can see that Shake Shacks costs have remained relatively flat with food costs

growing moderately and occupancy costs declining moderately which is a good sign considering

occupancy costs are much larger as a percentage of sales compared to peers and is reassuring that it is

coming down to be more in line with peers.

The rise in food costs is slightly concerning especially if this trend continues as it is difficult for

management to control these costs. It can increase the menu prices, but that would only further lower

its declining same-store sales.

Multiples Valuation

In order to ascertain a fair market value for Shake Shack, given the current market conditions

and Shake Shacks respective place in the market, we used a group of comparable firms. We included

fourteen firms, among them larger firms like Chipotle Mexican Grill (CMG), McDonalds (MCD), and

YUM! Brands (YUM), as well as smaller players in the industry like Chuys Holdings (CHUY), and Papa

Murphys Holdings (FRSH). Concentrating on making a list of comparable firms that wholly represented

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

Food and paper costs Labor and related expenses Occupancy and relatedexpenses

SHAK Costs YoY

2012 2013 2014

the fast-casual food services industry, we chose firms that we saw as being both qualitatively similar to

Shake Shack, in their menus and customer bases, as well as technically and quantitatively similar from

the standpoint of margins, capital structure considerations, and life cycle timelines.

On the first item of this list, we saw each of these firms as being similar in their margin profiles,

maintaining on average gross margins between low-20s and mid-30s, while seeing EBITDA margins

between the mid-teens and mid-20s. On the capital structure considerations, while we put less

emphasis on this measure, we see that Shake Shacks 3.6x total debt to EBITDA was in line with the

comparative company list average of around 2.5x. Finally, likely the most important consideration we

had outside of qualitative, business model considerations was that for the comparable firms position in

their respective life cycles. A fairly new firm, Shake Shack was only founded in 2004 and has seen total

revenues grow from $57 million in 2012 to over $118 million in fiscal year 2014 a growth of over 100%

in two years. With that in mind, we looked that both the comparable firms last twelve months total

revenue growth figures as well as the 3 year revenue compound annual growth rate (CAGR) numbers.

Though ranging, the comparable firms mostly saw mid teen, double digit growth in revenue last year

while seeing 3 year CAGRs in the low teens up to firms like Papa Murphys, Zoes, Chuys and Chipotle in

the mid-20s and higher obviously showing these firms are far from steady state growth periods.

With this in mind, we first compiled key statistics for each firm dealing with market

capitalization, net debt, enterprise value and other key figures.

Company Market Cap Net Debt TEV Sales EBITDA Net Income Total Equity

Chipotle Mexican Grill (CMG) 21,468 (758) 20,710 4,108 828 445 2,012

Buffalo Wild Wings (BWLD) 3,380 (113) 3,267 1,516 238 94 574

McDonald's (MCD) 90,990 12,917 103,907 27,441 9,612 4,758 12,853

Panera Bread Co. (PNRA) 4,927 (96) 4,831 2,529 401 179 736

Jack in the Box (JACK) 3,490 497 3,987 1,503 274 93 258

Yum! Brands (YUM) 35,040 2,766 37,806 13,279 2,781 1,051 1,613

Domino's Pizza (DPZ) 5,527 1,493 7,020 1,994 380 163 (1,219)

Noodles & Company (NDLS) 579 26 604 404 45 11 140

Zoe's Kitchen (ZOES) 652 (6) 646 172 6 (10) 121

Chuy's Holdings (CHUY) 398 5 403 245 26 12 118

Papa Murphy's Holdings (FRSH) 288 110 398 97 24 1 92

The Habit Restaurants (HABT) 425 (47) 378 175 17 (0) 117

We found five different multiples for our comparable firms: price-to-sales, to-earnings, and to-

book value, and enterprise value-to-sales and to-EBITDA, or earnings before interest, taxes, depreciation

and amortization. Calculating these multiples and then applying them to Shake Shacks own figures from

the previous twelve months, as reported on SHAKs 10-K, we found valuations of Shake Shack vastly

lower than the current market price of $62. In fact, given comparable firms current levels of price to

earnings, we found market prices for SHAK at closer to $9.50. When looking at both sales ratios though,

price to sales as well as EV to sales, we found market a price for Shake Shack around $25 per share. The

below chart illustrates this valuation technique, highlighting in red those stock prices representing

valuations below 60% of the current market price.

This multiples approach does leave us with one interesting discussion: should we use

comparable firm multiples present in the market today or multiples closer to each firms post IPO

multiples as in, the valuation multiples the market assigned these comparable firms two to three

months after their own IPO, being the time period in which SHAK currently sits? However, while this

Company Sales Earnings Book Value Sales EBITDA

Chipotle Mexican Grill (CMG) 5.2 x 48.2 x 10.7 x 5.0 x 25.0 x

Buffalo Wild Wings (BWLD) 2.2 x 35.9 x 5.9 x 2.2 x 13.7 x

McDonald's (MCD) 3.3 x 19.1 x 7.1 x 3.8 x 10.8 x

Panera Bread Co. (PNRA) 1.9 x 27.5 x 6.7 x 1.9 x 12.0 x

Jack in the Box (JACK) 2.3 x 37.7 x 13.5 x 2.7 x 14.6 x

Yum! Brands (YUM) 2.6 x 33.3 x 21.7 x 2.8 x 13.6 x

Domino's Pizza (DPZ) 2.8 x 34.0 x NM 3.5 x 18.5 x

Noodles & Company (NDLS) 1.4 x 50.8 x 4.1 x 1.5 x 13.4 x

Zoe's Kitchen (ZOES) 3.8 x NM 5.4 x 3.8 x 111.4 x

Chuy's Holdings (CHUY) 1.6 x 34.6 x 3.4 x 1.6 x 15.4 x

Papa Murphy's Holdings (FRSH) 3.0 x 240.4 x 3.1 x 4.1 x 17.0 x

The Habit Restaurants (HABT) 2.4 x NM 3.6 x 2.2 x 21.7 x

Max: 5.2 x 240.4 x 21.7 x 5.0 x 111.4 x

Mean: 2.7 x 56.2 x 7.7 x 2.9 x 23.9 x

Median: 2.5 x 35.3 x 5.9 x 2.8 x 15.0 x

Min: 1.4 x 19.1 x 3.1 x 1.5 x 10.8 x

51.35$ 41.86$ 22.70$ 47.08$ 81.61$

26.78 9.78 8.10 26.26 15.59

24.93 6.14 6.15 24.57 8.84

14.09 3.33 3.29 12.25 5.70

Price Enterprise Value

Implied Valuation

for Shake Shack:

approach may be more appropriate given SHAKs recent IPO, we knew that there would be plenty of

arguments against it as well. For instance, many of these firms went through initial public offerings years

ago, at times when interest rates may have been much higher than they are now or when the market

itself was simply valuing firms at different valuation multiples. For these reasons, we saw it more fit to

value Shake Shack with current market multiples from comparable firms, therefore hopefully arriving at

a value for shares of Shake Shack more in line with todays market conditions. Had we used multiples

from the time period of each firms respective IPO, we may have arrived at a bloated valuation given the

undue and irrational exuberance that follows a new and growing firm offering shares to the market; on

the other hand, we may have arrived at a lower valuation given the markets much higher interest rates

and therefore each firms higher cost of capital at the respective IPO periods. Simply put, we want to

find a valuation for Shake Shack that takes into account the markets outlook on the fast-casual food

services industry right now as well as the overarching interest rate environment of today. For these

reasons, we saw fit to use current market multiples to arrive at a fair and current market valuation for

the firm.

With this valuation tactic in mind we created a football field chart to visually represent that

maximum and minimum values from each valuation multiple.

As shown, the TEV/ EBITDA multiple produced the most wide-ranging valuations, due in part to

Zoes large 111x EBITDA valuation in this multiple juxtaposed with McDonalds lower multiple of only

10.8x. However, given the characteristics of the business model and the focus on sales volume, perhaps

at the expense of margins at times, we concluded that our two sales multiples were likely the most

trustworthy in a valuation of this very recently offered stock. Therefore, using a sales multiple equal to

2.7x, the average for our comparable firms, we arrive at a price per share for SHAK of $26 obviously far

from the current price of $62 but still slightly north of the IPO price of $21. This $26 price also implies an

enterprise value of just over 2.9x sales, in line with the average and median figures for the set of

comparable firms.

Key Take Away

The current share price of $62 commanded by Shake Shack seems to be more a product of

market hype than of actual valuation. This seems to be supported when looking at the current valuation

through multiples analysis. SHAK is trading at roughly 900x current earnings. We believe this is an

indicator that the company is currently overvalued.

Shake Shacks same-store sales has declined year over year from 2012 to 2014 and the trend is

expected to continue into the future. This is a concern as management continues to add additional

locations it can be expected that they will earn less than existing stores.

Management must be expecting future revenue growth to come from adding additional

locations on both the company-owned and licensed segments. They have given guidance that 2015 will

add ten company-operated locations domestically and 5 additional licensed stores international and

that this pace will continue for the foreseeable future.

Discounted Cash Flow Valuation and Pro-forma Projection

The top line projections consist of 10 new stores per year and assumptions about same store

growth. As previously stated, in the short run, there will be same-store declines. For 2015, the model

has a 10% decline in transaction volume and 5% decline in average ticket. These conservative

assumptions still put us at the high end of management guidance for 2015 (159 mm to 163 mm) at 162.2

mm. Food cost, labor costs, occupancy expense, and other operating expenses are classified as COGS.

These respective categories account for a relatively constant percentage of COGS, which allows them to

grow at the same rate as revenues. For the fast casual dining space, 30% gross margin is about average,

so we model flat gross margins are project for the entire 10 year period.

The figure above shows relatively flat margins operating margin and net income margin through

the 10 year projection period, with a slight uptick at the end. In new stores, Shake Shack typically has a

strong first year, and then faces a slump in the second year. In line with management guidance, we

project 10 new stores per year for the entire 10 year period. Accordingly, we expect the same store

second year slump to suppress margins, until they get to a more mature state late this decade. In

general, management thinks they can grow to a total of 450 stores before they cannot absorb the 10

new locations (2014 10K).

For a flexible fund account, we opened a short term investment fund, which earns 1% annually.

This fund peaks in 2015 with the additional cash from the IPO. Of the 112 mm proceeds, we allocated 36

mm to pay down the revolver, 8.8 mm for a special dividend (In line with management guidance that

they would issue a dividend for .273 for every dollar raised beyond 80 mm), with the residual going into

the newly created short term investment account. We modelled increasing Cap-ex requirements

through the rest of the decade, driven by an annual 3% increase in store construction costs, and store

refurbishments ramping up in 2020.

As one can see from the Cash Flow Statement in the Appendix, the model does not explain the

cash flows attributable to the IPO. This is an area for improvement, although this value does not have a

large impact on the overall valuation. We modelled the cost of debt to be that of the newly issued

revolver, which management states is 3.0% plus 3-month LIBOR rate. Overall we calculated WACC 4.4%

Capital Structure

D/V 0.04

E/V 0.96

D/E 0.04

Beta 0.46

Risk Free 1.92%

EMRP 5.50%

Ke 4.45%

Kd 3.3%

WACC 4.40%

Given this capital structure, we discounted the projected cash flows by the WACC. We modelled 2%

growth in perpetuity, for a target share price of $45.19. Below is a sensitivity table, which shows the

firms value is very sensitive to the WACC. A 50 basis point jump in the WACC causes a larger effect than

a 50 bps jump in growth. This effect is magnified as the growth in perpetuity gets higher.

Sensitivity Table

0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0%

2.9% 51.51 65.43 89.31 139.72 316.15 -1271.71 -213.14 -116.90

3.4% 40.55 49.30 62.67 85.58 133.96 303.27 -1220.50 -204.66

3.9% 32.86 38.80 47.20 60.03 82.02 128.45 290.96 -1171.59

4.4% 27.19 31.43 37.12 45.19 57.51 78.62 123.20 279.20

4.9% 22.84 25.99 30.05 35.52 43.27 55.10 75.37 118.17

5.4% 19.42 21.82 24.84 28.74 33.99 41.44 52.79 72.26

5.9% 16.65 18.53 20.84 23.73 27.49 32.53 39.68 50.59

6.4% 14.37 15.87 17.68 19.90 22.68 26.29 31.13 38.00

6.9% 12.47 13.69 15.13 16.87 19.00 21.68 25.14 29.80

7.4% 10.87 11.87 13.04 14.42 16.09 18.14 20.71 24.04

Residual Income Analysis

Our residual income analysis used many of the same assumptions outlined in our DCF analysis.

The main difference from the DCF is we used the required return on equity of 4.45% to establish the

proper compensation for equity holders. This creates an initial residual income that is negative, but later

becomes positive as the firms net income grows over time. Using this method we come up with a

valuation of $36.85 per share for Shake Shack.

Conclusion

In conclusion, we have utilized three different valuation techniques and have created a very

wide range for share value with the lowest multiple valuation being $3.33 from a price to earnings

multiple to a high of $45.19 from our DCF analysis. Taking into consideration the growth in the fast and

fine casual dining segment and the relative small size and tremendous future growth opportunity of

Shake Shack we feel most confident in our DCF analysis valuation of $45.19 per share. Currently SHAK is

trading at $62 per share and we therefore believe the stock is overvalued from market excitement over

their recent IPO.

2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E

Net Income 5,587 6,294 7,341 9,025 11,234 13,329 15,447 17,691 20,475 26,572

Equity 139,004 145,298 152,639 161,664 172,898 186,227 201,675 219,366 239,841 266,414

Required Return 6,182 6,462 6,788 7,190 7,689 8,282 8,969 9,756 10,666 11,848

Residual Income (595) (168) 553 1,836 3,545 5,047 6,479 7,936 9,809 14,724

1 2 3 4 5 6 7 8 9 10

Present Value (569.9) (153.9) 485.5 1,542.6 2,851.6 3,887.5 4,777.5 5,602.9 6,630.4 9,529.5

LT Growth 2%

Re 4.45%

PV of Forecast RI 34,584

PV of Terminal RI 397,192

BV of Equity 12,600

Equity Value 444,376

WASO 12,060

Value per Share 36.85$