Shake Shack: Margin Movement Is A Concern

Recommendation

Shake Shack (NYSE:SHAK) performance was in line with expectations; however, the company's guidance for strong first quarter has given me reason to be optimistic about the remainder of FY23. While SHAK's 1Q sales guidance was raised, comments from stores indicated the company was actually tracking toward the lower end of its 16-18% target margin range, which could be explained by the significant impact of recent store openings. Here we reach my primary challenge: margins. I believe that many investors are looking to FY23 as a turning point in the company's performance due to cost deflation, the easing of impacts from store openings in 4Q22, and possible price increases, but management has not provided any explicit guidance on margin for the coming year. I'm concerned that the consensus will revise their projections upward to account for a much larger margin inflection than SHAK will be able to achieve. This would lead to unnecessary fluctuations in the stock market. That's especially true considering that food and packaging inflation are both expected to inflate in FY23.

Despite this, I have a few minor worries about the SSS's (same-shack sales) waning lackluster performance. This trend has shown no strong signs of turning around as of yet. What worries me is that management is prioritizing store expansion at the expense of considering how profitable individual stores are. Therefore, until there are signs of SSS improvement and also clearer visibility for margin movement going forward, I advise holding off on purchases.

Latest earnings highlights

SHAK's 4Q22 SSS was 5.1%, with the increase coming from a 6% contribution from check and a 0.9% reduction from traffic, and the result being 4Q AWS of $76K. Despite some noise from Omicron laps, January's SSS was noticeably stronger at 17%, and the $72K AWS during the month benefited from large unit openings in the fourth quarter. As a result, the 1Q23 sales guidance has moved up from $240.25M to $245.75M, with SSS in the high single digits. Digital momentum has also been building, with the introduction of kiosks at company-owned locations scheduled for the end of FY23. In the short term, however, SSS will continue to be driven by successful menu innovation and increased pricing.

Margin

It's encouraging to hear that management is making improvements to the company's bottom line by, among other things, investing in the training of new employees and optimizing existing teams in order to increase digital capability and labor efficiencies. With the advent of kiosks, workers will be freed up to focus on other tasks besides taking orders, which will increase productivity. A further interesting point is that new packaging that is currently being tested and the potential for passing more costs onto delivery guests are expected to increase off-premise profitability.

Although lower COGS were partially offset by higher labor, the overall restaurant level margin of 18.8% was generally consistent with management's previous commentary. However, I anticipate some margin headwinds this quarter, primarily as a result of actions taken in 4Q22. As an example, the recent spate of openings in 4Q22 should cause some inefficiencies in 1Q, with January typically trending at the low to middle points of the restaurant level margin guide. However, SHAK stands to gain from slower price increases for both packaging materials and some raw materials. Overall, to increase my confidence in the stock, I need to see an enhancement in margins throughout the year due to the following factors: the rebound of in-Shack footfall, which has a favorable impact on margins; the stabilization of off-premise demand; and the mitigation of difficulties resulting from inefficiencies in new units.

Guidance

The new guidance for 1Q23 are as follows: $240.25–$245.75 million in revenue, high single-digit percentage growth in comparable sales, 6–7 new company-owned stores, and 16%–18% unit level margin. Pre-opening expenses are now anticipated to be between $17 and $19 million, but the rest of the FY23 guide is unchanged. In addition, 40 new company stores are still anticipated by management for FY23, and they now believe that build costs may be roughly flat compared to FY22.

Summary

The challenge remains with margins as management has not provided explicit guidance for FY23, which could lead to unnecessary stock market fluctuations if consensus projections are revised upward to account for a larger margin inflection than SHAK can achieve. Additionally, the lackluster performance of SSS and management's prioritization of store expansion over individual store profitability are also one of my concerns. To gain confidence in the stock, an improvement in margins throughout the year is needed, which could be achieved through the rebound of in-Shack footfall, stabilization of off-premise demand, and mitigation of difficulties resulting from inefficiencies in new units. Therefore, I recommend to hold off on purchases until there are signs of SSS improvement and clearer visibility for margin movement going forward.