On January 9, 2018, Zoe's Kitchen, Inc. (ZOES) presented at the annual ICR conference, one of the largest investment conferences in the country. During the two day event in Orlando, FL, Zoe's presented alongside more than two dozen other industry names, including bellwethers such as Darden Restaurants (DRI), Ruth's Hospitality Group (RUTH), and Shake Shack, Inc. (SHAK).
Although Zoe's reaffirmed expectations for some important operating metrics going into 2018, the company failed to address in a meaningful way how it would solve 2018's biggest challenge: increasing store traffic in order to flip comparable restaurant sales from negative to positive. But before we get to that, let's take a look at what Zoe's did share with investors.
An Ugly Start
Dave and Busters kicked off day one of the conference by lowering its full-year revenue and earnings guidance, setting a sober tone that helped to send the entire sector into red for the day.
Zoe's Key Operating Metrics Expectations for 2018
Zoe's, presenting on a more subdued day two, did not offer any new earnings guidance, but CEO Kevin Miles and CFO Sunil Doshi did discuss expectations for 2018 for several important operating metrics. The pair also reiterated strategic priorities for the year and guessed at the potential impacts of tax reform in a fireside chat format that lasted about 25 minutes.
Expectations for Key Operating Metrics in 2018
When asked about price increases for 2018, Doshi cited the company's historical four-year average increase of about 1.5% per year as a baseline for 2018, but also noted that the exit run rate coming out of 2017 was a little higher than that. He concluded by pointing out that the company had the "wind at our back" headed into 2018 and so would wait until the back half of the year to make a decision on any increases above that baseline level.
It's interesting to note that although Doshi was careful to refer to the third quarter reported number, he nonetheless spoke of having the wind at the company's back going into 2018, implying a strong, in-line price increase occurred in 4Q as well.
Management's decision to hold the line on price increases will have a big impact on comparable restaurant sales, a statistic that refers to year-over-year sales comparisons for restaurants open for 18 fiscal months or longer. It's one of the most important pieces of operating data reported each quarter and can move the stock. Because it is comprised of two parts, price and volume/mix, if management holds one part constant, the other part must drive the remainder of the increase.
Restaurant Contribution Margin
During the fireside chat, Doshi twice cited the store level efficiency benefits from reduced new store openings, presumably making that reduction the single most important positive factor in maintaining or growing 2018 restaurant contribution margins. Restaurant contribution margin is measured as restaurant sales less operating expenses and is used by investors to understand the per unit economics of the business.
In previous periods when the company was opening new stores at a faster rate, comparable restaurant sales needed to increase at a rate of between 2% and 4% in order to keep restaurant contribution margins steady. As a result of slower new store openings, Doshi pointed out that comparable restaurant sales can be at the lower end of that range while maintaining restaurant contribution margin. The comparable restaurant sales guidance currently in effect covers only 2017 (at -2% to -2.5%), so guidance provided when the company reports earnings in February will hold the key to understanding 2018 restaurant contribution margins.
Discussing traditional cost inputs, Doshi said he believes inflation will run "a couple percent", with produce potentially being a little higher and dairy being deflationary. He also reiterated a point made in the third quarter that the company was about 12 to 18 months away from being big enough to hedge poultry inputs, which comprise about 13% to 14% of the food basket, by buying forward.
The company has typically experienced a 2-3% annual increase in wage rates. Doshi said he sees 2018 falling in line with that, albeit a bit higher on the low end with expectations set at 2.5% to 3% (consistent with 3Q 2017 guidance).
From a corporate perspective, Doshi sees the likelihood of non-cash benefit resulting from an initial revaluation of the company's net deferred tax liability. More importantly, on a recurring basis, Doshi hinted at formally lowering guidance for the company's all in pro forma statutory rate of 38%. He pointed out that the rate should come down as the federal component is reduced from 35% to 21%.
As to whether or not tax reform would help the revenue line by putting more money in the consumer's pocket and driving increased sales, the company offered up what might be my favorite answer of the entire interview.
Doshi twice offered that it "remains to be seen" whether or not tax reform would spur top-line growth at Zoe's by putting more money in consumer pockets.
The moderator, Bob Derrington of Telsey Advisory Group, circled back and again asked: "… could [tax reform] possibly add a little bit of juice to your top line?". This time Miles replied by saying "We think so" but quickly hedged with "obviously to be determined, right?", before adding that "[consumers] don't know what's going to come back in the tax return".
Fair enough. But then the pivot to "no" began: "I don't think that drives a whole lot of extra sales for us just because of the overall economics of our consumer", referring to the impact of things like gasoline prices and tax refunds on the more affluent and educated Zoe's customer.
So there you have it, from "it remains to be seen", to 'yes', to 'maybe', to 'no' all in quick succession. Listen for yourself here, with Doshi answering at 11:39 and Miles answering at 13:04.
The big news in 2017 for Zoe's was the slowdown in new store openings announced in 2Q 2017. The company used the ICR conference as a chance largely to reaffirm its 2017 change in strategy going into 2018. The company expects to open 25 to 30 new stores in 2018, all within existing markets and specifically with a heavy focus on Florida.
Downside Risk Remains Strong for 2018
On August 17, 2017, Zoe's reset investor expectations away from fast growth and towards moderate growth accompanied by a focus on improved operating results. Considerable shareholder turnover followed over the next several months as growth investors exited the stock.
Meeting or exceeding the key operating metric expectations outlined above will be critical to attracting new shareholders who trust management to deliver consistent earnings improvements.
Many of those improvements, however, will depend on things that lie far outside of the company's control, such as moderate commodity and wage inflation. As an added challenge, same-store sales will need to jump from 2017's negative levels into positive territory driven mostly by a turnaround in traffic.
The other lever at the company's disposal to influence comparable restaurant sales, prices increases, will be maintained at a moderate level by management as we learned earlier. But why can't management increase prices is comparable restaurant sales start to lag? Because a price increase over a certain amount could be counterproductive as the higher revenue from each customer visit is offset by reduced traffic from cost-sensitive customers. For the 40 weeks ended October 2, 2017, the company increased prices by 1.4% on top of 2016's increase of 2.7%. The company operates in the very competitive quick service segment and has little pricing power.
That leaves strategic initiatives to drive the required increase in store traffic. Neither of the two major strategic initiatives, menu innovation and digital marketing, discussed at the conference as being top priorities for 2018 are new, though. Some initiatives falling under those priorities have been kicking around since at least Q4 2016, with the company citing its snack box rollout (Q1 2017) and investment in digital for several quarters in a row.
The success of these initiatives is critical to driving store traffic, which in turn drives the transaction volume needed to flip comparable restaurant revenue growth from negative to positive. Without that positive comparable restaurant sales growth, Zoe's will not be able to generate positive free cash flow, often a vital characteristic required by the new type of investors Zoe's will need to attract to support the stock price.
Just how important are comparable restaurant sales to positive free cash flow? In Q3 of 2017, Doshi stated: "… we do see kind of a range where on a low single-digit comp we could be kind of breakeven to slightly free cash flow positive next year. But again, it's just - the comp will be the sensitive factor there but if it's on a low-single digit type scenario we can model that."
Combining this with some other information provided during that quarter and during the conference, the challenge becomes apparent. With management having guided to keeping prices increases level at, let's estimate based on Doshi's earlier response, 1.5%, the company clearly needs a positive volume/mix increase from improved traffic in order to generate positive free cash flow. Given 2017's volume/mix statistic of -4.0%, this presents quite a challenge in light of the company's plan to carry forward the same strategic initiatives as last year.
If the company fails to generate the comparable restaurant sales growth needed to generate positive free cash flow, it would be the eighth year in a row for Zoe's with negative free cash as the table below shows:
Without the growth narrative to explain away the negative cash flow, it's unclear whether or not investors would continue to hold the stock.
Going long on Zoe's is a bet that the rapid and speculative run up in the stock price since the Buffalo Wild Wing's (NASDAQ:BWLD) sale announcement on November 28, 2017, spurred industry consolidation talk is sustainable.
However, without the rapid top-line growth needed to convince investors it's a growth story, Zoe's now needs to focus on improving operating results in order to attract and maintain a new group of shareholders.
For long investors, betting on improved earnings is also a bet that commodity and wage inflation will stay moderate and that the company's year old strategic initiatives will finally begin to bear real fruit. That's a lot that needs to go right and a lot that could go wrong.
Disclosure: I am/we are short ZOES.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.