Wall Street appears to be losing patience with Shake Shack.
Engaged Capital, a hedge fund based in Newport Beach, Calif., has apparently taken a 6.6% stake in Shake Shack and has been talking with the company for months, even proposing a trio of board members, according to the Wall Street Journal. That news sent Shake Shack’s shares soaring 8% on Monday.
Engaged has a history with the restaurant industry, having taken on Del Frisco’s and Jamba in the past, both of which ended up selling to privately held companies. The board members the activist is apparently proposing for Shake Shack includes Kevin Reddy, the former CEO of Noodles & Co.
The issue, apparently, is profitability. According to the Journal, the activist wants Shake Shack to rethink much of real estate, store design, labor and supply chain planning to improve its profitability.
Shake Shack, like many growth chains, has invested heavily in opening new restaurants and the company has traditionally spent more to open a new location than many other brands. Raymond James analyst Brian Vaccaro, for instance, in a note on Monday said that Shake Shack historically spent about twice as much to open a new location than many other concepts. Company executives said earlier this month that they are working on “new and tighter prototypes” to cut costs on new builds.
“We’re working on our next generation of designs with an aim to execute on additional cost-saving measures,” CEO Randy Garutti said, according to a transcript on the financial services site Sentieo/AlphaSense. “We’re going to optimize the size of the Shack box.”
At the same time, Shake Shack has not quite lived up to some of its early hype, in part because that early hype was badly overdone, but also because of the pandemic as well as the curse that infects so many other fast-casual burger chains.
Shake Shack went public in 2015 in one of the most anticipated restaurant industry IPOs of all time and, at least in the short term, it did not disappoint. It opened at $21 per share, after investors bid it up in the days before the IPO, and then it soared well past $80 per share as Wall Street bet that it would be the burger version of Chipotle Mexican Grill.
But investors soon realized that they were badly overpaying for the stock and it came back to earth. (Similarly, incidentally, another fast-casual chain went public two years earlier, helping to ignite the fast-casual bubble of 2013 to 2015, only to disappoint investors when it did not, in fact, become the “next Chipotle;” that concept was Reddy’s Noodles & Co.)
At least part of the reason for Shake Shack’s early excitement was its extraordinary popularity in New York City, where its unit volumes exceeded $7 million. But, by building a lot more locations outside of New York, those volumes have come down and so has the extraordinary per-unit profitability those early units generated.
Shake Shack’s average unit volumes systemwide were $3.8 million last year, according to data from Restaurant Business sister company Technomic. That’s down 17% over the past five years. That’s more than twice the unit volumes of Five Guys ($1.6 million) and $1.7 million more than the unit volumes of Yum Brands-owned Habit Burger.
The expense of building and running those locations, however, may be keeping the per-store profitability down—Shake Shack expects store margins to range from 19% to 20% this year, which as Vacaro noted is stronger than average for many of the chain’s rivals. And construction costs have soared since the pandemic. The cost of opening a new location is up 20% since 2019 and Shake Shack is opening a lot more complex locations with drive-thrus these days.
But it’s also worth noting that much of Shake Shack’s problem may hearken back to those New York locations. Shake Shack’s earlier, stronger locations are in urban areas that have been slower to come back than suburban restaurants with drive-thrus. “New York City has been something of an anchor around their neck,” the restaurant consultant John Gordon said.
That has kept sales down and prevented some of the profitability activists want out of a Shake Shack. But as sales have returned, profits are coming back.
The company generated adjusted EBITDA, or earnings before interest, taxes, depreciation and amortization, of $82 million in 2019. That plunged to $23 million in 2020. It only got back up to $70 million last year. That profitability appears to be improving. The company is expected to generate adjusted EBITDA of $115 million this year. It started 2023 with its best restaurant profitability in the post-COVID era.
Shake Shack’s stock, perhaps predictably, rose 59% before news of Engaged Capital’s interest in the company became public over the weekend.
Said Gordon: “It wouldn’t have been my choice” of an activist target.