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3 Takeaways From Shake Shack's Earnings

By James Sullivan - Mar 17, 2016 at 1:54PM

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Store-level performance, domestic growth, and international licensing agreements leave this Fool bullish on his favorite burger chain.

Shake Shack (SHAK -2.82%) reported fourth-quarter and FY 2015 earnings on March 7. Operating results at the restaurant level are excellent, the number of company-owned Shacks is likely to increase faster than guidance suggests, and the pace of international expansion needs to seriously ramp up.

Source: Shake Shack.

Shacks are cooking up great results
When looking at restaurant stocks, it's easy to get caught up in the high-level numbers for the company as a whole. Earnings, revenue, and margins get the headlines on CNBC, but these numbers are affected by capital investments, new locations, and other factors that don't necessarily reflect the day-to-day operation of the restaurants. I'm more interested in knowing how well the stores themselves are performing. 

Average weekly sales for domestic company-operated Shacks are the envy of the industry. Last quarter the number came in at $89,000, which was up 4.7% from the year-ago period. In 2014, Chik-fil-A did weekly sales of just under $60,000 per unit, and Chipotle Mexican Grill generated average sales of $47,500. Shake Shack may have a tough time significantly growing the store count while increasing average sales as well. Management expects the new domestic company-operated stores opened in 2016 to generate weekly sales of around $63,000, which is impressive but a bit off the existing pace.

Individual Shack's continue to become more efficiently run as the company grows. Shack-level operating profit margins for the quarter came in at 28.2% of Shack sales, compared with 22.3% for the year-ago period. The full-year results are nearly as impressive. The company reported an increase from 24% in FY 2014 to 28.9% in FY 2015.

Increased revenue, mostly from new stores, but also from higher prices, new products, and more customers, is one part of the equation for success. Continually improving operations so that more of that revenue is turned into operating profit is the second part. Shake Shack is delivering on both fronts.

Domestic store growth
Shake Shack has grown from 31 domestic company-operated stores at the end of FY2014 to 44 at the end of FY 2015. These locations are revenue and profit machines, and management has the long-term goal of getting to at least 450. This might take awhile, but not as long as many are expecting. 

When management issued guidance for FY2015 at the end of FY2014, it had plans for 10 new locations. Thirteen were actually opened, including one location that was expected to be included in FY 2016 but began serving up burgers and shakes, ahead of schedule, on Dec. 30. The company is guiding for 13 new locations in FY2016, and based on the outlooks from previous years, this will probably prove to be a conservative estimate.

CEO Randy Garutti opening first Arizona location. Source: Shake Shack.

The majority of the locations are expected to be opened in the second half of the year. Seeing six or seven new openings in the first and second quarters combined would be a great sign for shareholders. Growing from 44 locations to 450 at 15 Shacks a year would take around 27 years. Management has a long-term focus, but getting to 450 won't take nearly three decades. The growth rate for new domestic company-operated locations continues to increase. It's just a question of by how much and how soon.

Licensees are supposed to be cheap and fast
For FY 2015, Shake Shack generated only 3.9% of revenue from licensing and added eight international licensed locations.The company guided for six new international licensed Shacks in FY 2016 and one licensed location inside a new Las Vegas arena. Growth should ramp up in the coming years -- Shake Shack's partner in South Korea has plans to open 25 locations by 2025 -- but I'd like to see new locations popping up at a faster pace. The benefit of working with partners such as SPC, which runs over 6,000 stores globally, is rapid growth with little capital outlay. Right now the company is opening domestic stores at a faster pace than all of its international partners combined.

Source: Shake Shack.

One hopes that this is a transition period where partnerships are put into place, quality controls are established, and the success of initial locations is monitored. We should begin to see in FY 2017 guidance whether international expansion is turning out to be a worthy endeavor. Right now, contributing less than 4% of revenue, licensed locations aren't critical to the company.

If Shake Shack continues to find great partners, opens in new markets, and speeds up the rate of openings in existing markets, this revenue could become a material part of the investment thesis. Because of the nature of licensing fees -- payments made drop almost entirely to the bottom line -- success here could end up having an outsized effect on net income growth.

Concluding thoughts
An investment in Shake Shack is not for the faint of heart. It's hard to justify a buy using conventional valuation metric. However, the products are great, the stores are whirring, and expansion might be happening faster than management is letting on. I plan on holding my shares for the long term while this story plays out and will consider picking up some more if they go on sale.

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