Zoe’s Kitchen is a South Eastern US focused restaurant concept with 186 locations that serve “Mediterranean-inspired” food. Zoe’s IPOed in 2014 and benefited from pitching its fast casual positioning to the investment community. Investors, still eagerly looking for the next Chipotle, along with a richly valued market for growth names, rewarded ZOES with huge growth multiples in excess of 30x forward EBITDA, a significant premium to even what CMG traded at (15 to 25x EBITDA) in its early stages of growth after its IPO.
Most mature, company owned, restaurant companies trade at around 8 to 10x EBITDA, with some growth concepts trading between 12x and 20x, depending on the strength of the concept and the attractiveness of its growth runway. The more expensive names must maintain strong financial performance to maintain premium multiples. ZOES most recent results highlight a major negative inflection in its key performance indicators, one of the sharpest shifts in trend we’ve seen (absent unusual events such as Chipotle’s e-coli scare). We believe ZOES, despite a -20% move post earnings, is in the early stages of its negative re-rating process, as the company still trades at 23.5x 2016E EBITDA and over 200 P/E, despite now producing 1. Negative comparable transactions, and 2. Declining new store unit economics which appear to be trending below management’s targets.
Some investors believe ZOES is secularly well positioned due to both its fast casual positioning along with serving food that is healthier than most restaurants. We believe “fast casual” is a label primarily used to extract high valuations from investors rather than something inherently appealing to the consumer. While Zoe’s Mediterranean food and healthy positioning makes it more unique among the chain restaurant landscape, it is a positioning that also carries risks that potentially limits its appeal. Risks include: 1. higher menu prices and average check compared to most fast casual and fast food concepts, and 2. a unique taste profile relative to most mainstream concepts which typically focus around popular American food groups. The company touts that 70% of its customers have household incomes of over $100,000; however, this also highlights the risk that the concept may only cater to this niche demographic. The company has stated goals of growing to over 1600 locations, a level of penetration that only concepts with broad and mainstream appeal have achieved.
Zoe’s Kitchen operates a 2,800 square foot box with an average unit volume around $1.55mm annually and new unit investment of around $0.75 mm. The company targets new stores to achieve around a $1.23mm AUV in year one, maturing to a $1.37mm AUV by year 3 at 18% restaurant level margins and around a 30% cash on cash return. The 30% cash on cash returns that restaurant management teams tout do not include expenses from maintenance capex, remodels, closing underperforming locations, corporate G&A, regional manager costs and other regional infrastructure costs. Ultimately the company level ROIC will be far lower. A 30% cash on cash return is solid but unexceptional, and we would consider this the minimum level of new store profitability to justify growth. Other mediocre concepts such as Noodles and Co, Potbelly, and even mature concepts like Red Robin, all target around a 30% cash on cash return for new restaurants, while exceptional concepts such as Chipotle have achieved in excess of 70%.
From 2014 to 2015, ZOES new store productivity seemed to exceed their stated targets. I estimate 2014’s class of new restaurants were tracking towards a $1.4mm year one AUV, suggesting a 1.5mm year 3 AUV and around 40% cash on cash returns. In Q2 2016, new unit profitability slowed sharply towards what I estimate to be around a $1.2mm year 1 AUV number, slightly below management’s targets. While roughly 1/3 of this year’s new stores are in new markets which open at lower volumes, this only partially explains the slowdown.
Sharp slowdown in financial performance
From 2010 to 2012, Zoe’s Kitchen generated exceptional financial performance with double digit comp sales in each of these years. We attribute much of this period of growth to brand repositioning initiatives around starting around in 2009/2010, including new menu items, restaurant remodels, and service improvements. We believe this history of strong comp growth has contributed to the market’s perception of Zoe’s as a strong, secular grower. However, we believe after several years of benefit, the company’s historical repositioning has run its course, as evidenced by the recent slowdown in performance.
From 2014 to 2015, ZOES maintained a premium valuation on strong MSD to HSD comps, LSD comp transaction growth, and strong new unit economics. These key metrics have all deteriorated sharply in Q2 2016. The company no longer discloses comparable transactions growth, instead choosing to disclose comparable transactions + check mix, a more favorable looking metric. This metric decelerated sequentially by 510 basis points on a one year and 680 basis points on a two year basis, one of the sharpest slowdowns we’ve seen. Management commentary suggests the slowdown continued throughout the quarter, which would suggest the company is currently running at negative LSD comparable transactions.
Management pinned the blame for the slowdown on macro factors including increased industry discounting and election rhetoric. While we acknowledge more difficult industry conditions this year, we note most industry data points and public company reports suggest a moderate slowdown in Q2 2016, nothing close to the levels reported by ZOES. At the very least, ZOE’s vulnerability to industry cyclicality should dispel investor notions of this being a secular growth story, deserving of 20+ forward EBITDA multiples. Furthermore, we note that many of the industry headwinds are not expected to abate in the foreseeable future. These headwinds include increased industry promotions, QSR share gains, increased fast casual concept unit growth, increased competition from grocery and delivered food concepts, and elevated labor inflation.
Other financial metrics have been concerning as well. Over the past year and a half, the company has deleveraged restaurant operating expenses and corporate G&A, despite strong comp growth and opening new restaurants almost entirely in existing markets during this period. We note that opening new restaurants in existing markets is financially advantageous, as existing markets tend to produce higher volumes due to greater brand awareness, along with a more favorable cost structure, due to leveraging existing market infrastructure and purchasing agreements. We believe the deleverage of these line items despite strong comp growth raises warning signs around potentially weaker than expected new store performance, or indicates that comp growth may be juiced in part by expensive investments in initiatives such as those supporting catering growth. Furthermore, with many existing markets already showing moderate saturation, we expect go-forward unit growth to be more evenly spread out among new and existing markets, further pressuring company financials.
Consensus 2017 estimates which assume modest operating margin expansion, now appear aggressive and is at odds with the company's reported financial performance and observable business drivers. We note that 1H 2016 reported adjusted EBITDA margins declined by 20bps, despite numerous tailwinds, many of them which look to no longer repeat, or potentially reverse. We note the following tailwinds to 1H 2016 margins:
·Extremely favorable commodities deflation: +150bps to 1H cost of goods sold.
·Elevated pricing, averaging 2.6% in 1H.
·Moderate labor inflation, averaging 2.7%.
·Strong 6.2% comp store sales.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise do not hold a material investment in the issuer's securities.