Shake Shack's 'Hype' Is Well Founded: It's A Long-Term Home Run

| About: Shake Shack (SHAK)

Summary

The market over-reacted to Shake Shack’s headline comps guidance, creating a buying opportunity.

Shake Shack is following Starbucks’ strategy in many material respects that will make it “best in class” in the healthy/premium QSR space in the next 60 months.

Fears about the company’s ability to grow and maintain existing quality are well over-stated. The company’s “tent pole” strategy will allow rapid, but quality, growth.

Shack shows a willingness to innovate and take on other QSRs.

Once Shack has completed building out its brand nationally, there is enormous long-term potential if management adopts an “asset light” strategy and re-franchises its company-owned restaurant venues.

The market reacted sharply negative to Shake Shack's (NYSE:SHAK) earnings guidance during its 2015Q4 earnings call. But those who sold or shorted likely only read the headlines.

Shake Shack's comps were 17.1% in 2015Q3; they were at 11.0% in 2015Q4; essentially, Shake Shack is at veritable capacity at its existing stores. The company's growth will come not from increases in comps, but from building out the brand.

Building out the Shake Shack brand is a long-term project, of course. But the company's strategy to do so is well-considered and represents a value-building play for long-term investors.

Shake Shack plans to build out using a "tent-pole" strategy, whereby Shake Shack opens a high-profile, restaurant in a highly trafficked area in a new city as a big event, with local earned media. Then, when the "tent-pole" inaugural local restaurant has developed a loyal base of local customers, other locations in the local market will be built out to develop greater local market share and deeper penetration. (Currently, the plan is to do 1/3 of new restaurants as "tent-poles" while adding 2/3 of new restaurants to existing cities and regions, according to the conference call.)

This is similar to the strategy that Starbucks (NASDAQ:SBUX) used during it's early expansion outside its Seattle base, although Starbucks first sought mastery of a market before going elsewhere.

When Starbucks opened its first outlet in New York City in 1994, for example, headlines included "Starbucks Coffee Chain Hopes to Turn Big Apple Into Bean Town"; "Coffee Retailer Ready To Roast N.Y."; "Starbucks Brews Up Storm in Big Apple." The Starbucks CEO was quoted as saying, "We had to have crowd control at the door," at the time. He quickly followed up with a commitment to open an even wider Starbucks footprint in New York City.

While Shake Shack has already earned a loyal following among customers at its original flagship location in New York City's Madison Square Park in Manhattan, it has also had great success at new locations in Brooklyn and in Queens. Now, as Shake Shack moves to build other "tent pole" locations in other cities, three things will happen:

First, there will be substantial and rapid earnings growth in the new local tent pole location. Public curiosity will drive near capacity traffic in the first several weeks in high-traffic venues and customer loyalty will likely keep customers returning. (An opening at a Shake Shack venue in Tokyo inspired people to camp out overnight so that 400 customers were lined up at 9:00AM.)

Second, new stores opened in other venues around the tent pole location (what I call "tent spike" locations; that is, those locations that are built around the local flagship tent pole location) will allow for economies of scale in things like the local market basket of food costs, regional management and oversight costs, and employee training.

Finally, the tent spike locations will more thoroughly penetrate the regional QSR market in lower-cost venues, so that average regional store profits will increase.

Even beyond the expansion of the brand revenues from additional restaurants, Shake Shack has three other buried intangibles.

Among other things, Shack wants to create a dining "experience", akin to that which a customer enjoys at (once again) Starbucks or some of the remodeled, upper scale McDonald's (NYSE:MCD). But Shack is putting money behind the concept of a QSR dining experience, by boosting employee salaries to obtain and retain the very best employees and by serving wine, beer, and even chocolate to its diners.

Shack's recent "Chicken Shack", launched just several weeks ago as a regular menu item (at most, but not at all, locations), shows a willingness to experiment and go head-to-head (here with Chick-fil-A) with market leaders in the QSR space. Shack already serves up a better-tasting gourmet frankfurter.

The company is well on its way to providing the "experience" of its ambitions so that it is not "just another QSR."

By far, though, the most substantial upside potential for Shake Shack lies in the even longer term: once the brand is built out, the company can adopt an "asset light" strategy and re-franchise its company-owned venues to franchisees. (The company could probably do that with some of its New York City locations even now to obtain capital for additional brand expansion.)

I would advise long-term investors to go long on Shake Shack and put it in your pension/retirement account. Pension fund managers should be stocking up on the growth potential at the discounted price.

The"hype" around Shake Shack is grounded in tremendous upside potential and, I believe, already undervalued restaurant locations, assuming they were re-franchised.

Shack promises healthy, wholesome food that is an alternative to the other former leading quick-growth healthy QSR dining option, Chipotle (NYSE:CMG) , and will gain much of the lost market share of Chipotle in those venues where the two brands compete head-to-head. (Chipotle, in my view, carries far more risk than Shack as an investment in the QSR space. Among other things, Chipotle has far more ingredients in its supply chain, so many that last year's outbreak of E-Coli could not even be traced to its source.)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The views expressed are the opinions of the writer and do not represent, and should not be considered to be, investment advice. Before making any investment decision you should consult your own business, legal, tax, and financial advisors.