Roger Lipton: Zoe's 'Admirable' but Stock Is Overpriced
Roger is an investment professional with decades of experience specializing in chain restaurants and retailers, as well as macro-economic monetary developments. He turns his background, as restaurant operator and board member of growing brands, into strategic counsel for operators and perspective for investors.
An archive of his past articles can be found at RogerLipton.com.
We admire the consistent job that Zoe's Kitchen (NYSE: ZOES) management has done in establishing a fast-casual concept that is “leading edge” in terms of healthy (at the same time, tasty) cuisine. The concept is now well established in multiple markets and management is moving appropriately in a generally unforgiving environment. Operating margins, while not at the top of its peer group (e.g.Shake Shack), and down from their previous level and long term targets, are still generating an attractive return on capital at the store level. While the company has, until recently, steadily leveraged its bottom line margin as systemwide units and comps grew, with better absorption of G&A, this progress has stalled. The previous growth objective of 20% unit growth, with earnings growth on the order of 25%, is now unrealistic in the short term, and only time will tell when unit growth and /or margin improvement will return. Unfortunately, increasing competition is not likely to abate, rents only go up, and labor cost pressures continue. Recent partial relief has come from commodity costs but that has apparently run its course. From a valuation standpoint, investors have rarely been willing to pay more in terms of P/E multiple, even for the very best situated companies, than twice the long term growth rate. There have been exceptions (e.g. Amazon, Tesla, AOL, Chipotle in its heyday), but invariably valuations come down to earth over time. This has recently been the case with ZOES since earnings expectations have been revised downward.The latest analyst consensus (per Bloomberg) for earnings in ’18 shows no earnings at all, basically breakeven, but it is anybody’s guess at this point. With ZOES at $14.00/share as this is written, at 50x earnings estimates, the earnings would have to be $0.28/share or $5.6M after taxes. Since that magnitude of earnings power is unrealistic over the next year or two, at least, we have to conclude that, even with ZOES down over 65% from its historical high, investors still have an unusually long wait before the fundamentals catch up with the current stock price.
Company Overview (2016 10-K)
Zoe’s Kitchen, Inc. (ZOES), headquartered in Plano, Texas, is a steadily growing, fast-casual concept, offering a wholesome Mediterranean-style menu. Menu items are made from scratch daily from fresh, simple ingredients and served in only three modes: raw, grilled or baked. Per the company’s January 2017 ICR presentation the sales breakdown by customer base was 78% female, 22% male, by daypart (excluding catering), 60% lunch and 40% dinner, and by channel, dine-in 53% and off-premise 47% (about a third of which was catering). The average ticket was $14 at lunch, $16 at dinner and >$200 for catering.
Revenues are generated by the current 235 company-operated stores, as of 10/2/17, with three additional franchised units. Sales in calendar 2017 are expected to be about $314M, up in the six years from $50.2M in 2011. (Note: with only three franchised units, down from nine in 2011, franchising doesn’t figure importantly in the company’s current operations). Until the last 12 months, the company’s restaurant-level EBITDA grew at the same pace as sales, from about $10.4M to $55.2M in 2016, with the margins at a relatively steady 20% – 21%. Consolidated EBIT and EBITDA operating margins have been substantially lower and somewhat erratic, not unusual for an early stage growth company with irregular costs incurred on a relatively small revenue base. In the five years ending 2016, before the “slippage” in 2017, the company’s consolidated EBIT margin fluctuated between -2.8% and +3.4% with EBITDA between +3.3% and +9.5%. Reconciliation of the foregoing EBITDA measures with the company’s reported “adjusted” EBITDA metric is available in company releases and presentations. The principal difference between the two measures is that the company’s adjusted EBITDA excludes pre-opening expense and miscellaneous non-recurring expenses.
In 2016 10-K, management disclosed that company restaurants generated AUVs of $1.541M, up from $1.3M in 2011, driven by 28 consecutive quarters of positive comps (averaging about 9%). Comps have been negative in 2017, as shown in the table above. As of 12/31/2016, the most recent Zoe’s units averaged about 2,750 square feet and typically required an initial cash outlay of about $750K, net of landlord allowances (all units are leased) plus pre-opening expense of $75K. The company expansion strategy continues to designate a “hub” market in each territory for initial penetration and subsequently building out adjacent markets (“spokes”). Employing this “hub and spoke” strategy the company has taken the concept’s beyond its core Texas roots. It currently has units in 20 states, having expanded throughout the South, moving up the Eastern seaboard and into the Midwest, and management has noted in the past that its top 20 units are located in eight different states. According to the model provided early in 2017: In year one, units are expected to generate sales of $1.3M, and store level EBITDA margins of 10%-12%, at which levels the cash-on-cash return ranges from 16%-19%. By year three, sales are expected to reach $1.5M with EBITDA margin of 18%, driving cash on cash return to ~30%. Results have obviously been disappointing during 2017, and, to our knowledge, the previous model has not been updated. Back in '16, when there was still a great deal of sales momentum, management pointed out that: as of ‘16Q3, the 96 units open three years or more generated AUVs of $1.7M, EBITDA margins of 23% and cash on cash returns of about 47% (assuming initial cash investment of $825K). The company noted that 54% of its fleet is less than three years old (about 110 stores), which should drive substantial incremental revenues and profitability as they mature in accordance with the trajectory of its store model. While we have no doubt that the older stores are generating volumes above system averages, the results in '17 imply that the stores perhaps two to three years old, entering the comp base after eighteen months, are not growing as fast at that stage as earlier openings.
The company (as presented at the ICR Conference in January '17) has the ability to more than double the store count, to 400 units by 2020, which combined with 2% – 4% comps and fixed cost leverage (primarily G&A), will drive adjusted EBITDA at a pace of 20% or more. Longer term, management believes the chain potential is 1,600 units. While growth plans for 2018 have been adjusted downward, there has been no indication of modifying the longer term plan.
As to the balance sheet, the ratios of debt to EBITDA and lease adjusted debt to EBITDAR were 1.3X and 4.1X, respectively at the end of '16, which was in line with peers with less than 20% franchised units (1.8X and 3.7X). In 2016 cash from operations was $26.1M, which net of $45.8M capex left FCF of a negative $19.8M, or -7.2% of revenues. Since earlier comp sales and profit targets have not been met, even with up to $75M of total borrowing power, rather than go heavily into debt, the company prudently scaled back expansion plans to consolidate past unit growth and presumably improve operating margins.
ZOES reported another lackluster quarter, penalized not only by the competitive conditions within the restaurant industry and the overall economy, but the effect of two storms. Harvey and Irma cost the company about $1.1M of revenues, representing a negative effect of 0.9% on the comp, swinging the final comp result into negative territory. With 11 new restaurants opened during the quarter, those inefficiencies along with generally higher wage costs reduced the restaurant level EBITDA to 18.8% of sales. Other elements of the income statement included Cost of Sales lower by 140 bp (bucking industry wide higher commodity prices) to 29.5%, Labor higher by 110 bp to 30.1%, Store Operating Expenses 70 bp higher to 21.6%, G&A 50 bp higher to 9.9%, Depreciation 60 bp higher to 5.8% (higher investment in new stores?). Income From Operations was down 150 bp to only 1.6%, which was virtually wiped out by interest expenses of 1.4%. That “interest expense” of $1.1M primarily represents “cash expense related to build-to-suit leases.” While the bottom line EPS at zero looks better than the year earlier loss of $0.02, that loss in Q3’16 was a result of a tax provision that wiped out income before taxes. This year’s income from operations, at $1.256M was down from $2.053M in Q3’16.
The company lowered guidance for Q4’17 as follows: Comp sales are expected to be -2.0 to -2.5, revised from flat to -3.0. Revenues will be $6M lower at the high end, the new range being $314-$316M. Restaurant EBITDA Contribution Margin will be 18.3-18.5%, instead of 18.3-19.0%. Openings expected for the year will remain at 38-40.
Other than revising calendar 2018 openings to about 25 units, new guidance was not provided for next year. The Company has entered into a new five-year $50 million credit facility, which can, under certain conditions, be expanded to $75M. $12.5M has been drawn to refinance a previous line.
On the positive side, the sales trend during Q3 was improved over the first half of '17. Credit was given to initiatives including menu innovation (the largest menu rollout in eight years), technology improvements, more delivery and improved marketing. Snack boxes, which were rolled out in Q1’17 are addressing the consumers’ need for convenience. An improved website and mobile app was launched in Q3, and online sales comps have shown strong sequential improvement. Marketing plans are apparently being stepped up to leverage the greater customer data base, while the company is also concentrating on speed of service and order accuracy. Third-party delivery has apparently been working well, and still improving in terms of the message and the execution. Catering is another area of ongoing emphasis, with 60 restaurants leading the way.
There were questions on the call relating to the apparently higher level of coupons distributed through social media, and the company responded that this was “targeted” to increase trial of new products. Fourth quarter trends were discussed, a little confusing to this listener, but are apparently expected to improve late in the quarter, with easier comps to lap, more marketing and more delivery capability. It seems clear that the marketing spend in the future will be higher than in the past, not 2% or 3% of sales, but more than the sub-1% of the past. When questioned, management indicated that ZOES could be cash flow positive in ’18, if there is a low single digit comp. Obviously, a lower comp would require tapping the credit line, unless the opening schedule is further reduced.
The company is obviously doing all it can to build sales. On the expense side, commodity costs will be favorable for all of '17, “stable” in '18, so perhaps no more help from that area. Wage rates were up 2.4% in Q3, from 2.0% in Q2. There was no indication that this pressure will ease any time soon. Store operating expenses, up 70 bp in Q3 was a result of higher marketing spend and an increase in occupancy costs, once again with no indication of relief. The best hope for store level margin improvement seems to be the likelihood of less drag from the inefficiencies of new openings, the number of which is being reduced for the time being.