[UNLOCKED] Why Hedgeye's Howard Penney Is Still Bearish On Shake Shack

Editor's Note: Below is a recent institutional research note on Shake Shack (SHAK) written by Restaurants analysts Howard Penney and Shayne Laidlaw. To access our institutional research email sales@hedgeye.com.

Since Penney went bearish on Shake Shack in May 2015, the stock has nearly halved. "The centerpiece of our short SHAK thesis is the company’s growth strategy of planting flags around the world," they write. Apparently, things aren't going so hot. Here's an update.

The centerpiece of our short SHAK thesis is the company’s growth strategy of planting flags around the world. In my 20 years as a restaurant analyst, I cannot name one company that has successfully deployed this strategy. Not surprisingly, the SHAK 10-K gave us a glimpse into how hard it is to execute this strategy on a consistent basis around the world.

The key to long term success is to deliver a consistent product to the consumer time and time again. As you can imagine, it takes time to build a supply chain that allows for new unit growth and the ability to deliver a consistent product with long-term sustainable results. Given SHAK is just now developing its international infrastructure; it’s not surprising the global supply chain is less than developed. It’s hard to imagine the company is replicating a consistent product in all of its global markets. 

First, domestically, SHAK has a limited number of suppliers for their major ingredients, including beef patties, potato buns, custard, Portobello mushrooms and cheese sauce. At this point, we will remind you that it was issues with the supply chain that caused the downfall of Chipotle. According to SHAK’s 2015 10-K, there is significant concentration to its US supplier base:

• The company purchased all of its ground beef patties from five suppliers (approximately 76% come from one supplier.) 
• All of the potato buns are purchase directly from one supplier
• Custard base from one supplier
• “Shroom Burgers” from two suppliers, with approximately 67% of the Shroom Burgers supplied by one supplier;
• ShackSauce from two suppliers, with approximately 92% of ShackSauce supplied by one supplier.

Internationally, they are having a different issue. Getting products with the right specification into the global market place is a challenge for the company. The international licensed Shacks import the proprietary ingredients from the United States and the European Union. Here are some of the issues the company talked about in the recently filed 10-K:

• “For example, our proprietary blend of beef patties and/or raw materials for beef patties originate from the United States and the EU as well as Australia. In addition, our potato buns are exclusively from the United States, and other key items such as crinkle cut fries and American cheese originate within the United States or the EU. While we have established secondary supply solutions for some of these ingredients, we have not acquired secondary supplies for all of them.”
• “Due to the long lead time and general volatility in the supply chain…we have had past and ongoing issues ensuring that timely and adequate supplies reach our Middle East Shacks.”
• “In the Middle East, our licensee, Alshaya Trading Company W.L.L. ("Alshaya"), delegates the supply function to its own third-party logistics providers in each country in which Alshaya operates, with which we have limited and restricted communication, preventing us from exercising control or instruction over such entities.”
• “The recent sanctions enacted by the Russian Federation on many imported ingredients from the United States, the EU and Australia have affected our Russian licensee's ability to import such ingredients to our Russian Shacks.”
• “We have given our licensee in Russia approval to utilize alternative ingredients not affected by the sanctions, but there is a risk that these substitute ingredients may be inferior in taste and quality or come from suppliers that have not been vetted for food safety and quality assurance.”
• “Our U.K. Shacks face challenges in obtaining potato buns and custard, which originate from our U.S. suppliers. While these ingredients have no trade restrictions, they must be shipped from the United States, which poses an ongoing risk of delay in supply deliveries.”
• “Our Turkish Shacks currently import many key ingredients from both the EU and the United States. As is common in many developing markets, regulations are always subject to change which could potentially give rise to import risks should current importation legislation change. We are currently working on local Turkish alternatives to alleviate these risks in the future.”

Along with continued new unit growth in the existing markets the company will be opening up new markets internationally, further complicating the problem. Internationally, SHAK opened their first unit in Oman in February 2016 and will open up in South Korea later this year as well. How is it that a company the size of SHAK has the ability to execute a global growth strategy and supply customers with the product they believe they are getting?

The supply chain warnings in the 10-K are something that should not be looked at lightly. As we have seen from other growth restaurant companies, supply chain issues can be very disruptive to the consumer perception of the brand and profitability.