Zoe’s Kitchen, Inc. (ZOES) – Taken Out and Shot – What’s Going On?
ZOES is an interesting case study, since coming public in April of 2014. This is a well run company, with (what I call) “adequate” store level economics, serving an appealing new niche in “fast casual” dining space. After consolidating a relatively few franchised stores, ZOES has become a company operated (184 unit) chain, expanding steadily at a 20%+ rate, with a long “runway” for ultimate national growth. Brought public by a prestigious group of underwriters, the analysts (almost entirely within the underwriting firms) and money managers looking for predictable growth vehicles embraced ZOES, taking the stock to a high of $45/share, trading until yesterday mostly in the high 30s. The long term promise has been enhanced by steady growth in traffic and comps, above the “model” volume at new stores (especially by the class of 2014), and steady expansion of “store level margins”, which virtually every restaurant company has adopted to describe “store level EBITDA”.
As we have described in previous articles, “STORE LEVEL EBITDA” or “profit margin”, or “profit” at the store level, or “cash on cash” return at the store level”, do not finish the equation in terms of a restaurant company’s net after tax cash on cash returns or profit.
Virtually all restaurant companies describe their operations this way, using “non-GAAP” descriptions, all very legal and typical these days. We are only focusing on ZOES because reality is apparently setting today regarding its valuation in the marketplace.
Using calendar 2015 as a base, ZOES spent $700,000 on new stores, plus $75,000 of pre-opening expenses. Their average volume, systemwide was $1,552,000. Their average EBITDA at store level (“margin” or “profit” as everyone calls it) was 21.1% of sales. Similarly their “cash on cash” return at the store level, excluding the pre-opening expenses, was 46.8%. These are impressive sounding numbers, obviously enough, combined with their long runway of growth to 1600 stores, to drive a very high valuation of their equity. However: Pre-Opening Expenses are Part of the Original “Investment”, Depreciation is Not Free Cash Flow, Corporate G&A is required, & Taxes Have to be Paid. If pre-opening expenses are included, the cash on cash return comes down to 42.3% at the store level, still a very good number. Taking it a step further, depreciation was 5.7%, so the more appropriate “profit” at the store level was 15.4% of sales. The “cash on cash” return on the investment (including pre-opening) comes down to 30.8%. Next comes Corporate G&A, which in this case was 11.2% of sales, and this number is not coming down much any time soon. Subtracting the 11.2% from the 15.4% (after depreciation) leaves 4.2% pretax. The cash on cash return comes down to 8.4%. Lastly, taxes have to be paid, and at a 35% rate the after-tax GAAP earnings become 2.7% of sales. The “cash on cash” return comes down to 5.5%. It should be pointed out: These numbers are based on historical average store sales of $1.5M. The new store “model” is $1.1M in new markets, $1.3M in established markets, so it takes a number of years for new stores to generate these obviously mediocre returns. These calculations are not “pie in the sky”. The old estimate (yesterday) of $0.25/share or about $5M after taxes for 2017, would amount to 1.4% of $340M estimated sales. (Estimates have today been revised downward to $0.19/share or under 1.1% of sales).
Of course, the stock market discounts the future, and the expectation is that volumes will grow, and the returns will improve well beyond current levels. G&A leverage could help by 4 or 5 points, which would help a lot, and store level margins could improve substantially.
Now we get to the generalized stock market lesson. It takes “everything in gear” for a retailer or restaurant chain to maintain a high valuation, say 30-40x expected earnings. The concept should be “defensible” (i.e.competitively strong), demonstrated store level economics should be compelling, new stores have to be opening at encouraging volumes (ideally, above the chain average), comps and traffic have to be positive, store level margins would be improving, corporate G&A would be leveraging, etc. If any of these parameters are not in place, it will be almost impossible for the stock market valuation to discount the future at a high level. While ZOES has not had (what we consider) extraordinary store level margins, the appealing niche in fast casual dining, combined with meeting most of the other parameters, has resulted in a sky high valuation, well over 100 times next twelve month earnings. Even today, trading around $30/share, down $7.00 on the day, ZOES is trading at over 100x the old Bloomberg consensus of $.25/sh. for 2017 and over 150x the new estimate of $0./19.
Lastly, the specifics regarding ZOES, and the reason for today’s disillusionment in the marketplace: They barely met the Street earnings estimate, which disappointed at least a few followers. Importantly, comps moderated to only 4%, 3.1 points of which was price, 0.9% attributed to “traffic and mix” (the definition of which is a little confusing). Even more important, the guidance for Q3 and Q4 was for further moderation of comps, apparently running at even lower (perhaps 2-3 %) single digit right now. Store level margins are not expected to improve, since labor costs continuing upward, and commodity expenses (recently lower) will help less. There will be no G&A leverage this year. New stores are opening “on plan”, as opposed to the class of 2014 which opened strongly as they came public (amazing how that happens). There are lots of positives here, including qualified and competent management, a strong balance sheet, a still appealing niche with lots of growth likely.
Rather than describe further all the details of ZOES’ results, and outlook, I suggest you read the conference call transcript from last evening. If you can’t access it quickly, email us and we will forward a copy to you.
Suffice to say, in our opinion, reality has set in, the bloom is off the rose (or should be) and the stock, over time, will move toward a more appropriate valuation. Lots of strange things happen in a zero interest rate environment, there is a large short position in ZOES stock (which supports the price during a downswing), and the very long term prospect is far from dismal. What ZOES is worth, and its potential reward vs. the risk, is up to debate. For our money, we wouldn’t embrace the long side. For the record, we have no position at the current time, but that could change without notice.