In defense of Shake Shack (SHAK)

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Update May 21, 2015- Bloomberg TV pointed out that, while SHAK shares have hit an all-time high today, a whopping 43% of the shares held are short, meaning investors expect the stock to go down from here.

Also, there are rumors that they will start a chicken sandwich. That was my idea that I gave to them many times in many emails. On October 8th, 2012, I wrote to Danny Meyer, “I think a breaded chicken sandwich on sesame bun would the idea for a whole new restaurant called chicken shack”. On July 16th, 2013, I wrote again, “By the way, I still think you can do chicken sandwiches and also chili”.

However, given Shake Shack’s inability to execute on a simple change in French fries, I am not so sure they can pull this one off. Expanding thier menu might be too much to ask of them now.

Is SHAK a short? Not quite yet, in my opinion, per below….

Update April 14, 2015- SHAK shares hit $60 today, which is a 30% appreciation from the closing price of the first day of trading. Told you so (see below).

March 12, 2015- By Steven E. Greer

When Shake Shack (SHAK) reported earnings yesterday, Wall Street analysts and CNBC had a field day pointing out the lack of a bottom-line profit and stagnant same-store revenue growth. While this would normally be a concern in most restaurant stocks, I do not think that it is a concern for SHAK.

Lack of same-store growth can be due to a failing business, or due to a business that is doing so well that it has max’ed out capacity to serve. With lines out the door at every SHAK, the latter is clearly the case. Therefore, investors should welcome growth from new store expansion. This is not a Kenny Rogers Fried Chicken, Krispy Kreme, or Boston Market scenario where shady accounting and too many stores created falsely impressive growth numbers.

However, the lack of a profit is a genuine concern. Since this is the first quarter of earnings after going IPO, some bizarre accounting write-offs were likely to blame (a $1.1 Million cost for the IPO process they claim, which is strange accounting indeed). It is inconceivable that each Shake Shack is losing money.

With only 66 Shake Shacks worldwide, there is plenty of room to expand into urban areas with hipsters and Millennials who like snobby “organic” food. When I made my back-of-the-envelop estimation of what SHAK is worth, 18-months before the actual IPO (which has proven to be very accurate of the actual stock price and market cap), I assumed that the number of stores would expand to only 200. If the chain expands to 200 stores, then the market cap would be around $3 Billion. The market cap is only $500 Million now, so this stock has plenty of room to grow (until the Fed raises interest rates).

My valuation method is superior to what most nitwits on the “sell side” use. A Forbes article, for example, was calling SHAK overvalued based on arbitrary meaningless “forward multiples” of revenue compared to peer group companies. The article stated, “Analysts, who see potential in Shake Shack, remain wary of the lofty valuations it fetches. It trades at an astounding 900 times forward earnings, far surpassing Chipotle’s 32 times and Habit Burger’s 144 times. It’s “a big brand with even bigger potential, but a small company,” as JPMorgan analyst John Ivankoe put it in a note last month.”.

Without boring you, this is an age-old problem in Wall Street. The sell-side analysts working at banks cannot pick stocks. They use “multiples” precisely because they are arbitrary and allow the analyst to assign stock target prices willy nilly, defying other valuations that would say that stocks are too expense. Sell-side analysts are mostly cheerleaders and hypsters, because that is what drive investment banking business.

The only long-term concern that any analyst should have with SHAK is that earnings pressures will cause a weak leadership to abandon the Danny Meyer culture of rewarding employees and providing top-quality ingredients. For me, the biggest different between Shake Shack and McDonald’s is not the food, but rather the excellent service. Mr. Meyer achieves this by offering his employees special perks, such as assistance with college textbooks and good healthcare. If some sleazoid hedge fund activist were to come along and pressure SHAK to cut costs, then the restaurant chain would fail.

Another longer-term concern is whether SHAK can expand beyond urban areas into mainstream America where people want fast drive-through food. I do not think that it can, but that problem is many years away.

A third concern I have is the competence of the CEO. They were unable to execute a simple change in fries. How will they deal with more complex problems?

But right now, there is plenty of growth in store for SHAK and the stock seem undervalued to me.