Mike Khouw on $SHAK: When Options Prices Tell You a Stock is Likely to Fall

by CC August 19, 2015 1:43 pm • Education

On this past Friday’s Options Action on CNBC, our friend Mike Khouw, President, and Chief Strategist of Optimize Advisors and Dan had a quick discussion on the launch of options trading on shares of Shake Shack (SHAK) that day:

Mike of course had a lot more to say, and he has kindly allowed us to re-post his further thoughts. Some cool stuff about reversal conversions on hard to borrow stocks here:


When Options Prices Tell You a Stock is Likely to Fall

By Mike Khouw

If you like burgers and milkshakes, chances are you’ve heard of Shake Shack. Started by well known chef and restaurateur Danny Meyer and run by Randy Garutti, the company describes itself as a “modern day ‘roadside’ burger stand”. In addition to their “all-natural” burgers and hot dogs (no hormones or antibiotics) they also serve frozen custard, shakes, and importantly beer and wine. A couple decades ago it might have seemed daunting to enter a business dominated by McDonalds, Burger King, Wendys, Jack in the Box and the like. It is clear though that information moves much more quickly now. When Shake Shack opened their store on South Lamar in Austin, TX, there was a long, long line on the first day.

In some respects the world is going through a late 1950’s/1960’s type of renaissance. The post-war era transformed the economy and the nation as many returning GIs went to college and migrated to cities. Now, companies that seemed invulnerable due to their size and scale, such as McDonalds, are viewed as outdated monoliths as some consumers are no longer satisfied with fast food, but also want good food. Combine that with modern day viral marketing and maybe a hot dog stand in Union Square can be transformed into a business valued at two billion dollars in just over a decade.

Of course Shake Shack didn’t create the trend, it was riding one that had been started earlier by other burger joints that focused on better burgers, rather than speed, cost and advertising such as Five Guys, In-n-Out and Fatburger. They aren’t the only new arrival either, the Denver based Smashburger has joined the fray and already has 300 stores ($SHAK has 71), and in foodie-culture towns such as Austin, where Shake Shack opened to much success, they are challenging Austin’s already successful answer to In-n-Out, P. Terry’s.

Comparing a Shackburger with a glass of wine to Big Mac value meal and one begins to see why investors might get excited. I can tell you which I’d rather have.

Investors gobbled up the limited float with as much enthusiasm as they eat the burgers imagining that Shake Shack may be to burgers what Starbucks is to coffee, and that they may one day become as ubiquitous. Looking more closely at SHAK as an investment opportunity, however, means we need to take a look at their financial statements, and for owners of the stock that may be about as appealing as looking at the nutritional information from their menu. By the way a single burger and fries (no cheese) will be 360 and 420 calories respectively; lets assume that’s the minimum. A double SmokeShack burger, cheese fries and a Shake would be 910, 560 and between 640-990 calories respectively or up to 2,460 calories, essentially my entire daily recommended caloric intake assuming I am moderately active.

Here are some other statistics you might find interesting.

  • Enterprise Value of Shake Shack ~ 2.1 billion USD, of McDonald’s 103.4 billion.
  • Number of locations added over the most recently reported quarter. Shake Shack – 5 locations added for a total of 71. McDonald’s – 78 locations added for a total of 36,368
  • Revenues per location (here SHAK shines over MCD). Shake Shack – >$4.3 million USD annualized McDonald’s – >$2.4 million USD. In both cases company owned locations have higher revenues than franchise averages (>5m and >2.7m respectively)

These latter numbers are not particularly surprising. SHAK’s menu items are substantially higher priced than MCD’s, and SHAK has the advantage of beer and wine sales, a de minimis number of McDonald’s sell alcohol. In any case the current valuation of SHAK is ~ 30 million per store and they added 5 locations in the past quarter. The current valuation of McDonald’s is 2.85 million per store and they added 78 locations last quarter. Hmm.

Options markets have been highly skeptical of SHAK stock since they first became available for trading, and this is largely due to the limited float. Last Friday for example, if one bought the January 2017 47.5 calls on the offer or “ask” price, and sold the January 2017 47.5 puts on the bid price, one would have executed that trade for a .10 credit. Given the large bid/ask spread it’s entirely possible that one could have gotten an even larger credit. If you are long the 47.5 calls, and the stock is above that level one would exercise the calls and be long the stock at the strike price, or 47.50 in this case. Because one collected a dime credit to do the trade, the net purchase price would be 47.40, substantially lower than the level at which the stock was trading ($5). If the stock finished below the $47.50 strike price, the calls would be out of the money, but the puts you sold would be assigned, and you would purchase the stock at 47.50, again net of the dime credit the effective purchase price would be 47.40. Effectively entering into this trade would be a commitment to purchase the shares at 47.40 in January of 2017.

Why would it be possible to get long the stock synthetically at such a discount to where it is currently trading? Because the limited float made the stock “hard to borrow”, and those that would short the stock have to pay to borrow the shares. In other words the demand to borrow stock to short is high, and the availability of stock to short is very low. So what happens when the supply of stock available to sell increases? It’s simple economics, and the options markets suggest that the price of the shares may fall.

So what is the takeaway here? If you are inclined to purchase the stock, the valuation is a bit heady here, and perhaps you should wait until the supply and demand for those that would sell the stock has normalized.