Shake Shack’s latest deal with Engaged Capital may be a setback for shareholders

Business: Shake Shack owns, operates and licenses Shake Shack restaurants offering hamburgers, chicken, hot dogs, fries, shakes, sundaes, beer, wine and other products. The company was originally founded in 2001 by Danny Meyer’s Union Square Hospitality Group. The company has restaurants in every region of the United States and licensed locations in the Middle East, Asia and the United Kingdom.

Stock Value: $2.76B ($65.40 per share)

Ownership percentage: 6.6%

Average price: no

Comment from the activist: Engaged Capital was founded by Glenn W. Welling, former CEO and Managing Director of Relational Investors. Engaged is an experienced and successful small-cap investor and makes investments with an investment horizon of two to five years. His style is to hold management and boards accountable behind closed doors.

Shake Shack signed a partnership agreement with Engaged. As part of the deal, the restaurant chain appointed former Domino’s Pizza CFO Jeffrey D. Lawrence to its board and agreed to work with Engaged to appoint an additional mutually agreed-upon independent director with experience in restaurant operations to the Shake Shack board. .

Shake Shack is an iconic fast-casual restaurant founded by culinary visionary Danny Meyer. Through Union Square Hospitality Group, Meyer founded and operated some of the world’s most critically acclaimed gourmet restaurants for many years. Over the past 20 years, he and his team have developed Shake Shack, one of the nation’s largest casual hamburger chain restaurants. They took Shake Shack public in 2015 with 63 restaurants and expanded to 436 restaurants within eight years.

Many of the senior management came from Union Square Hospitality Group and the fine dining industry. Perhaps that’s because CEO Randy Garutti has a long history with Meyer, having been the general manager at New York’s Union Square Café and Tabla. The problem is that the same skill set required to build a brand and run high-end, gourmet restaurants is not the same skill set required to run and expand a quick-service restaurant. In fact, some might say it’s quite the opposite skill set. Accordingly, restaurant margins at Shake Shack have declined 790 basis points since 2018, and corporate return on equity is down more than 30% today from zero. As a public company, Shake Shack has significantly underperformed both the market and its peers.

The good news is that the hard part—creating an iconic brand—is already done. Not many people can do that. The easy part – expanding an already strong and growing brand – has been done by countless people, many of whom could do it again. This means getting a board focused on assembling a management team with experience in operating and expanding quick-service or fast-casual restaurants and holding that team accountable when they fail.

To that end, Engaged announced that it has identified three new director candidates and is seeking to retain the company’s operations consulting firm. One of those candidates, Kevin Reddy, has extensive experience managing and growing restaurant chains like Chipotle. Another candidate is a co-founder of Engaged and another is an experienced consultant and advisor. Only four of the 11 directors can be elected this year because the board is in disarray. This, as we see in a public company, is only a visible part of the problems faced by those engaged in this campaign because it is bad for the corporate governance structure.

Meyer controls less than 9% of the company’s stock, but he has special rights over corporate actions that far exceed his economic ownership, including (i) the ability to appoint five directors; (ii) the ability to appoint 50% of the members of each committee of the board; (iii) hiring or firing the CEO; and (iv) increase or decrease the board size. In other words, this is Meyer’s company, and only he can make significant changes.

As a result, it’s a crusade for Engaged. Engaged had the option of going to a proxy fight and having shareholders replace three current directors, including the CEO, with new directors. While that wouldn’t give Engaged or the new board the power to overturn anything Meyer and his current directors want, it would send a strong message to them that shareholders expect change. Instead, Engaged settled on a director who was not one of the three they proposed, and there was a second director to be agreed that would not be one of the firm’s proposed three directors.

This is a definite win for the company as there are very few directors on such a board. This allows Engaged to claim a win, but the firm is still relying on Meyer’s decisions and missed a valuable opportunity to send a message to management. It doesn’t effectively change anything, and it doesn’t empower Engaged to implement the changes it has so deftly identified to create shareholder value. Identifying problems is one thing and having a way to solve them is quite another. The road here is completely controlled by the management.

Ken Squire is the founder and president of 13D Monitor, an institutional shareholder activism research service, and the founder and portfolio manager of 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments.