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TAKEOVER TIME IN RESTAURANT LAND – ZOE’S KITCHEN FOR SURE, AND PERHAPS DUNKIN’ DONUTS?

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TAKEOVER TIME IN RESTAURANT LAND – ZOE’S KITCHEN FOR SURE, AND PERHAPS DUNKIN’ DONUTS?

About a year ago, two high priced acquisitions were made, namely Panera Bread and Popeye’s Chicken. We said at the time that these two deals were not harbingers of a broader trend. Panera was a strategic acquisition by a deep pocketed European buyer (JAB) . Popeye’s (PKLI) was a another franchise vehicle for the highly leveraged financial engineers at Restaurant Brands (QSR). Inexpensive capital (i.e.very low interest rates) and highly valued paper (QSR equity was trading at over 20x trailing EBITDA, with access to billions of debt) allow for some abnormal risk taking. Some have called it “misallocation of capital”.

It’s a year later, and two more highly priced deals are now on the radar screen. Zoe’s Kitchen has been bid for by Cava Grill, joined by Ron Shaich of Panera fame. ZOES is trading above the $12.75 suggested price, in the expectation that a higher bid could emerge. You can find our most recent description of Zoe’s, from our website article here:

ZOE’S KITCHEN

We are not going to comment further  on this situation, at the current time, other than to alert our readers that it is an interesting case study.

Dunkin’ Brands Group, a much larger company, has been recently touted as an acquisition target, perhaps by Coca Cola (KO), and DNKN is trading at an all time high. The latest writeup, from our website, on DNKN is provided here:

DUNKIN’BRANDS GROUP

Our attitude here is that, Coca Cola, or anyone else, would be paying an unnecessarily high price for a Company that is not the industry leader. The Dunkin’ brand has been lagging the dominant Starbucks by a large measure, clearly losing market share, and there is no reason to believe that will change in the foreseeable future. While Dunkin’ works to refresh it’s approach, Starbucks is more aggressive than ever as it works to overcome the “law of large numbers” and cope with industry headwinds such as the increasing cost of labor.

DNKN trades today at about 18x trailing twelve months EBITDA,  twenty seven times estimated earnings for 12/31/18, and it is difficult to project more than high single digit earnings growth in ’19 and beyond. If DNKN remains public, stock buybacks might take EPS growth into low low double digits, but DNKN has already leveraged its  balance sheet to about 5x trailing EBITDA, so stock buybacks won’t do too much more than cover executive options. Few investors are enthused about paying 25x forward earnings, and 18x TTM EBITDA,  for a company building earnings something like 10%. This is especially true in the case of DNKN, where a cash can be made that much of the free cash flow should be re-invested in the system. New and improved products, marketing, mobile order and pay, and other obviously lagging elements of the system are overdue to be addressed. The franchisees have been fighting the daily battle while the Company has bought back over a billion dollars worth of stock, and new highs in the stock have enriched the franchisor’s executives.

Asset light franchisors, with their supposedly free cash flow (because franchise systems have to be supported) are very desirable properties. Furthermore, Coca Cola, or another deep pocketed strategic acquirer could make the case, as Warren Buffet has often made, that one can afford to pay a fair price for a high quality asset run by proven dedicated executives, and the long term success will overcome the initial premium price. In this case, however, we don’t believe that DNKN has either a dominant industry position, nor is the management team outstanding.

Lastly, if KO or someone else is determined to get into the franchised coffee shop business, we suggest that this USA economic expansion and stock market boom is closer to its end than its beginning. A more opportune time to purchase almost anything may not be far away. We wouldn’t want to own DNKN at this valuation because the Company’s performance doesn’t support the stock price. We suggest, further,  that potential purchaser’s of DNKN would be better advised to play another day.

Roger Lipton

ZOE’S KITCHEN

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INVESTMENT CONCLUSION:

We admire the consistent job that Zoe’s 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 their bottom line margin as system wide 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.

ZOES: 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 3 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 & 40% dinner, and by channel, dine-in 53% & 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 3 franchised units, down from 9 in 2011, franchising doesn’t figure importantly in the company’s current operations). Until the last twelve 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 5 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 2 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 AUV’s 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 8 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 3, 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 3 years or more generated AUV’s 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 3 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 earler 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 ompany prudently scaled back expansion plans to consolidate past unit growth and presumably improve operating margins.

 ZOES; CURRENT DEVELOPMENTS

Per Q3’17 Quarterly Report – 10Q: https://seekingalpha.com/filing/3760371

Per Q3’17 Quarterly Conference Call:  https://seekingalpha.com/article/4123083-zoes-kitchen-zoes-q3-2017-results-earnings-call-transcript

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 5 year $50 mllion 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.

CONCLUSION: Provided at the beginning of this article

ZOE’S KITCHEN, INC. (ZOES) – TAKEN OUT AND SHOT – WHAT’S GOING ON?

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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.

 

(ZOES) ZOE’S KITCHEN, INC., REPORTS ON THURSDAY. IS THE VALUATION JUSTIFIED?

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