The burger market within the restaurant industry is the largest dine-out segment in the US with more than $70 billion in yearly sales. It is estimated to be twice the size of the next largest category, the pizza market, and has proven to be successful around the globe as well, with an estimated global market size of more than $135 billion. We expect overall “burger demand” to continue to increase at a GDP-like pace and generally ebb and flow with the broader economic cycle, as consumers trade-up in good times and trade-down in troubled times. Concept proliferation by new entrants may offer an incremental tailwind to the overall market size, while lower prices at the gas pump have already offered a shot in the arm for operators, albeit arguably a temporary one.
The burger industry is largely dependent of the price of its key ingredient, beef. 2015 will mark the fifth consecutive yearly decline in commercial beef production in the US, and the lowest amount of beef produced since 1993, but beef prices are hovering at all-time highs. We don’t expect food input costs for producers to alleviate anytime soon, and pressures to increase the minimum wage could also prove to be stiff headwinds. Offsetting increased labor cost inflation may represent the greatest obstacle to margin expansion in the restaurant space in coming years. New burger concepts will look to the leveraging of operating costs as the number of restaurants under operation advance, as price hikes may not be welcomed wholeheartedly by price-conscious consumers, especially at Five Guys and Shake Shack (SHAK), the high end of the fast-casual burger market. Mature chains may have to look elsewhere to offset higher costs, and it’s no surprise that headcount reductions and robotics have become primary areas of interest for established players.
The overall burger market continues to be saturated, and the fast-casual space within it is no exception. New chains seem to be popping up every day, and each thinks it has a slightly differentiated concept. A few of these chains have recently taken their success public, but the vast majority of them remain off the market for investors. Privately-held companies such as Five Guys, Smashburger, and Fatburger have hundreds of restaurants throughout the US and across the globe, convoluting the fast-casual burger space. Red Robin’s (RRGB) recent fast-casual development Red Robin Burger Works is also attempting to gobble up market share. Without a doubt, these new entrants have taken a bite out of the traditional fast-food burger joints, namely McDonald’s (MCD) and Burger King (QSR)—share that may never return.
Habit Restaurants (HABT) and Shake Shack are two of the highest-profile, publicly-traded fast-casual burger restaurants, and both have grown substantially since their IPOs during the past 12 months. As it relates to their investment candidacy, we have to mention front-and-center that one potential pitfall of “getting in early” on these young, high-growth entities is the risk of paying too much for shares; all too often these kinds of companies trade at extremely high earnings multiples out of the gates, far before their business models have been proven on a large or “stable enough” scale to warrant the price tag. Historical respective comparable store sales growth is shown for each in the table below.
Source: The respective companies
Of course, it is also not guaranteed that every new burger concept entrepreneurs dream up will be a long-term survivor. Very few, for example, have experienced a weak economy, and we’d expect many to face tremendous pressure in the event consumer discretionary spending tapers off in more troubling times. Management teams may not sacrifice restaurant unit growth plans, which could heighten credit risks and increase default risks in a down economy. Those that succeed may not be open to scooping up weakened entities that tried to grow-too-fast to capture share within the fast-casual segment. A lot still has to “play out,” in our view. In this piece, let’s take a closer look at how the major public burger companies performed in the calendar second quarter of 2015 and shed some light on their fortunes, which appear to be bright, in spite of a sluggish economy and incremental cost threats.
Habit Restaurants’ Strong Cash Flow
Habit Restaurants went public in November 2014 and reported its 46th consecutive quarter of sales growth in the second quarter of 2015 with a growth rate of 36.7% on a year-over-year basis. The company opened four new restaurants in the period, and now has 118 locations in five states. Company-wide comparable restaurant sales in the quarter increased 8.9% in the quarter thanks to a 3.8% improvement in transactions and a 5.1% increase in average transaction amount. Adjusted EBITDA grew over 53% to $7.6 million in the second quarter, and adjusted EBITDA margin advanced by ~1.4 percentage points to 13.3%. Adjusted net income per share more than doubled to $0.09 from the year-ago period.
Habit Restaurants is executing well through its growth stages, and its net cash position at the end of the second quarter was nearly $50 million. Free cash flow through the first half of the year was ~$4.6 million, and management is confident that its cash on hand and expected cash flows will be sufficient to fund its capital needs for the next several years. With free cash flow generation like this, we like its chances relative to many of the new, still-private start-ups. As long as its coffers remain flush, Habit will continue to be formidable rival to anything that is thrown at it.
For the full year 2015, Habit is expecting revenue between $225 and $227 million, driven by the opening of 26 to 28 company-owned restaurants and 3 to 5 franchised restaurants and comparable restaurant sales growth of approximately 5%. Restaurant contribution margin is expected to be in the range of 21%-21.5%. The company raised its guidance for all three of these metrics in its second quarter results, a sign that management is making rational assumptions and is subsequently executing well.
Habit is doing a whole lot of things right, but shares sold off following the second-quarter announcement on fears of cost inflation. Though this may not have been fair, investors should be cognizant that the social pressure to increase the minimum wage to levels closely mirroring entry-level, college-graduate positions has never been greater in the US. Cities across the country, including Los Angeles, San Francisco, and Seattle have already moved to $15 per hour, and New York will do so by the end of 2018. Once $15 is achieved, $20 may very well be next. Consumers can only pay so much for a burger and fries to offset the increased costs, posing a serious threat to upstart fast-casual business models.
Shake Shack’s Earnings Leverage
Shake Shack hit the ground running after its IPO in early 2015. The firm reported outstanding growth in the second quarter of 2015, with its top line growing nearly 75% to $48.5 million on a year-over-year basis. The company opened three new domestic company-operated restaurants and two international licensed restaurants in the quarter. Same-store sales grew ~13% on a year-over-year basis.
Adjusted EBITDA more than doubled from the second quarter of 2015 to $11.2 million, and adjusted EBITDA margin expanded by ~6 percentage points to 23.1% thanks in part to lower-than-anticipated food costs and the leveraging of labor and other operating expenses on increased sales. Shake Shack’s adjusted EBITDA margin is materially higher than that of Habit’s in part because of its higher burger price points. Adjusted net income per share advanced to $0.09 from $0.03 in the second quarter of 2014.
Shake Shack continues to be in great financial shape following its IPO. The company has nearly no debt on its balance sheet as of the end of the second quarter, and it has a cash position of nearly $65 million. Through the first half of 2015, the firm generated free cash flow of ~$0.7 million. While this is not necessarily a substantial amount of cash generation, the notion that the company is able to fund growth through existing cash from operations is promising.
For the full year 2015, Shake Shack expects total revenue to be between $171 million and $174 million, driven by the opening of 12 domestic company-owned restaurants and five international licensed restaurants and comparable restaurant sales growth in the mid to high-single digits. The guidance for each of these metrics was raised following the firm’s second quarter, a sign of better than originally expected growth taking place across its operations.
As with peer Habit, however, shares may face pressure should expectations of cost inflation overwhelm optimism surrounding future growth potential.
Can Red Robin Keep Up?
Red Robin is more of a full-service restaurant than Habit and Shake Shack, and its growth reflects the fact that it is a more mature entity and one that is not necessarily perceived to be of the fast-casual variety. However, this is not stopping the company from attempting to get its share of the fast-casual burger market with Red Robin Burger Works, where it is focused on getting its same products to consumers, but in less than 5 minutes.
Red Robin reported total revenue, which includes company-owned restaurant revenue and franchise royalties, of $293 million in the second quarter of 2015, or growth of 14.4% on a year-over-year basis. The company opened four new restaurants in the quarter, and comparable restaurant revenue increased nearly 3% compared to the year-ago period. Adjusted EBITDA increased ~ 20% to $35 million in the period, and adjusted EBITDA margin expanded by ~0.5 percentage points to nearly 12% from the second quarter of 2014. Adjusted earnings per diluted share grew ~15% to $0.78 in the quarter on a year-over-year basis.
As of the end of the second quarter of 2015, Red Robin had a net debt position of ~$122 million. Through the first half of the year, the company generated nearly $3 million in free cash flow. Though cash flow generation has been less than spectacular in recent years, especially for an entity of its size (relative to Habit and Shake Shack), we can’t disagree with its decision to pay down its debt with available cash. We’ve also been encouraged by Red Robin’s recent revitalization, and we attribute it to the consumer willing to pay up for a better burger. Management noted in its second-quarter press release that it has “now outperformed the casual dining industry in reported comparable sales for the last four years and outpaced them on traffic by over 200 basis points during the second quarter.”
For the full year 2015, Red Robin is expecting total revenue growth near 12%, driven by the opening of 20 new Red Robin restaurants and three to five Red Robin Burger Works and comparable restaurant sales increasing 3%. Restaurant-level operating margin is expected to be over 22% for the year. Capital expenditures are expected to be significantly higher in 2015 compared to previous years due to the remodeling or relocating of ~150 restaurants in accordance with the company’s Brand Transformation Initiative. We like the initiative as it should help the company’s full service restaurants fight the fast-casual craze.
Wrapping Things Up
Habit and Shake Shack will continue to trade at extremely high earnings multiples, and we aren’t ready to jump into unproven businesses at such levels, especially in the elite Best Ideas Newsletter portfolio. Nevertheless, we can’t deny that there is tremendous growth potential present, and both entities look like long-term survivors. These two could very well become the McDonald’s and Burger King of burger fast-casual, the preferred choice for millennials.
Red Robin is a more established entity and does not trade at astronomical multiples like its speculative peers, but its shares continue to trade ahead of our fair value estimate of $71 per share. In fact, shares of most participants in the restaurant space are benefiting from expectations that consumers will inevitably experience increased discretionary income once gas prices come to reflect the significant decline in crude oil pricing as of late (unplanned refinery maintenance and pipeline failures have been keeping gasoline prices somewhat elevated). McDonald’s and Yum! Brands (YUM) trade at 21+ times and 24+ times current-year earnings, respectively.
Though we are fans of the cash generation at Habit and the strong margins at Shake Shack, the fast-casual burger market itself is relatively young, and many might say, consumers got along just fine without it. Both of these entities have a degree of geographic risk, as they are somewhat concentrated near the areas in which they were founded. The risk of them truly becoming “national” firms is still large, which may prevent them from “growing” into their earnings multiples. In any case, investors in Habit and Shake Shack should expect shares to be highly volatile in coming years.
As it relates to the fast-casual burger space, we’re content with being consumers instead of investors at this point in time. During the month of August, the Best Ideas Newsletter portfolio just notched an all-time high and its largest degree of outperformance yet.