A deep dive into ZOES

Hi all,

I like restaurant concepts, especially the ones that have a local to national story behind them. I like them because they offer the promise of growth, and restaurant as a business is easy to understand compared to many other more complex businesses.

Lately, I have been scouring the SEC filings and conference calls of ZOES and I really like what I see. This long post is a summary of what I learnt, what I think of the concept, and why I think ZOES could be a big winner for my portfolio.

Anirban

Long ZOES

The business and some factoids

Zoe’s Kitchen is a fast-casual restaurant concept serving Mediterranean-inspired cuisines. Zoe’s menu offers a range of kabobs, soups, salads, and appetisers; they serve both hot and cold items. Zoe’s operates what it calls “scratch kitchens” wherein food is generally made from scratch using produce, proteins and other ingredients that are predominantly preservative- and additive-free. Vegetable is cut and prepared in the kitchen. There are no fryers or microwaves in their restaurants. This approach to simple, healthy, and tasty food is appealing to a growing number of people, and I personally think the trend towards healthy eating will continue to gain strength in the years ahead.

Zoe’s was founded in 1995 by Zoe & Marcus Cassimus in Birmingham, Alabama. As of the last report (April 2015), Zoe’s had 141 company-owned restaurants and three franchise restaurants across 16 US states. ZOES IPO’ed in April 2014, with the company selling some 6.7 million shares for $15 each. The IPO netted them $91m, and a portion of the proceeds was used to payoff a $37.5m term loan and a $2.9m line of credit; the remainder is being used to grow the chain. There have been subsequent follow up offering where existing early investor have offloaded shares.

What is the investment thesis?

Management believes there is a big market for the Mediterranean-inspired cuisine served by Zoe’s. The concept’s target audience is the affluent and educated women and their families. The concept is going after those families that have $100,000 or more in household income. Personally, I believe this is a good group to go after and this group is precisely looking for this sort of lifestyle inspired outings.

Zoe’s currently have 144 restaurants in 16 states and expects to increase store count to around 270 by December 2018. They estimate total potential of 1600 restaurants in the US. Other than the obvious opportunities via expansion, and scale will over time improve margins via supply chain improvements, leveraging of existing infrastructure & support systems (e.g, general administrative expenses grow slowly compared to restaurant base), they also have the opportunity of developing new opportunities beyond lunch, dinner, and catering. Catering accounted for 16% of the revenues in 2014, and the lunch-dinner split is 60-40. The average per customer spend is a tad under $10 ($9.98 per their 2014 annual report), so its still a smallish amount for good & tasty food.

Overall, the concept seems to be getting good traction with the company reporting positive comparable restaurant sales for 21 consecutive quarters.

A look inside Zoe’s roadmap to glory

Obviously, if the concept is able to get anywhere near its long-term goal of 1600 restaurants, the stock will be a big winner given the current market capitalisation is under $1 billion. Let’s look at some of the key drivers that might help propel Zoe’s to long-term glory.

  1. Target demographics, site selection and expansion strategy.

Zoe’s is going after the educated, affluent, middle class. Zoe’s appears to have crafted a sophisticated expansion strategy. Zoe’s employs a "hub and spoke” strategy. Hubs are identified based on total market potential and geographic spacing, while surrounding spoke markets are penetrated once hubs have reached sufficient penetration and brand awareness.
In the last conference call (Q1 15), management did note that as they start adding more stores in a relatively mature market they see these new stores getting significant traffic as there is some brand awareness out there.

Zoe’s uses sophisticated analytical tools designed to uncover key demographic and psychographic characteristics. Additional considerations include daytime population characteristics and residential density, which impact both the catering and the dine-in businesses. They follow up their analysis with “on the ground” research, focusing on customer traffic patterns, future development in the market, retail synergy and the competitive restaurant landscape.

  1. Hiring and training employees for growth.

Often times, as growth ramps up, management fails to provide adequately trained staff to new stores, which ultimately resulted in poor same store sales and brand value dissipation. Recently, we have seen that happen at The Tile Shop (TTS), a company I follow closely. Zoe’s appears to be quite methodological in its approach. Each quarter Zoe’s has about 30 new manager-in-training candidates at one of their 14 training restaurants, which are located across various geographic regions. Additionally, Zoe’s has invested in “paperless” training with use of modern technologies and proprietary digital training platforms focussed on “gamification” and “community generated content”.

In the recent conference call, they noted the following:
We decided to add a third manager to several of our high volume stores and we’ve also added to the number of training stores and the reason for both of those is that we find that it’s very important to us to make sure that we hire and train the right people for these new restaurant opening and we are building our bench so that we make sure we have people that are engrained in Zoës and the culture of Zoës and are ready to go to that next new store opening.

  1. Attractive unit economics.

Zoe’s restaurants have attractive unit level economics. A typical restaurant is 2750 square feet, with seating for 80 people, plus patio seating for an additional 30 people. The average cost for building a Zoe’s restaurant is $750,000. The company reports average unit volume (AUV), which is the average company-owned restaurant sales for all units that have been open for 52-weeks or more. Since 2009, AUVs have steadily risen from around $1.1m in 2009 to $1.5m by 2014.

I found the following discussion from the recent conference call encouraging:
We’ve been pleased with our new unit performance particularly with the class of 2014 as annualized sales for these restaurants are already exceeding our stated three year targets of $1.3 million. These restaurants further bolster our confidence in our hub-and-spoke strategy and continue to focus on existing markets while seeding new markets for the future.
This seems to suggest that the “hub & spoke” approach may likely result in the company continuing to exceed their AUV targets.

The company tracks “restaurant contribution” — defined as the restaurant sales less restaurant operating costs as a percentage of sales — and it has been around the 20% mark for sometime. Once a new unit is opened it might take sometime to stabilise sales, so at unit volume of around $1.5m, we are looking at restaurant level operating profits around $30,000/year say after the third year or so. That works out to be a 40% return on investment, which is pretty solid. Effectively, the restaurants pay for themselves in about 2.5 years, which is great. Further, since most of the restaurants are still relatively new, Zoe’s doesn’t really need to spend a whole lot on existing units, thus allowing its cash flow from operations to be channeled towards establishing new units.

Restaurant contribution is also referred to as “restuarant-level operating margin” by other concepts. I looked at the restaurant-level operating margin of well known concepts, just to get a sense of where ZOES is with respect to well established names:


----------------------------------------
Concept    Restaurant Contribution
----------------------------------------
ZOES          20% (2014)
BWLD          19.5% (2014)
CMG           27.2% (2014)
PNRA          16.5% (Q1 2015**)
---------------------------------------- 

** Calculated as bakery cafe sales less bakery cafe operating costs as % of bakery cafe sales)

Generally speaking, we expect the restaurant-level operating margin to improve as the concept scales. Early signs are encouraging. In their latest (2014) 10K, the following was reported:
As a percentage of restaurant sales, store operating expense decreased from 18.8% in 2013 to 18.6% in 2014 . The decrease in store operating expenses percentage was driven by leverage from increased sales.

Similarly, in the Q1 2015 conference call, margin improvement was noted:
Restaurant contribution margin, as a percentage of sales, improved by 140 basis points year-over-year to 21.7%.

Also, recently Zoe’s signed a new agreement with Sysco (one of the largest marketing and distributing companies specialised in food products) that should help that get better pricing on food products.

ZOES is doing well when compared with more established chains like PNRA and BWLD. Zoe’s restaurant contribution margins have been in the 20 - 22% range for a while (2009 - 2014). I would really like and I do expect that this will improve some as the concept gets bigger. For the sake of comparison, I looked at CMG’s 2006 annual report. Chipotle operated 481 restaurants by end of 2005, and that for FY 2005 reported restaurant-level operating margin of 18.5%. We will have to watch this metric closely as the concept scales.

  1. A history of strong same store sales growth.

Zoe’s has reported positive comps for 21 consecutive quarters. The comp base includes restaurants that have been open for 18 months or more. Comps can rise because of increased customer traffic and/or increase in the average customer spend. Usually, its a mix of both. Zoe’s strong comps show that the concept is gaining traction.


---------------------------------------
Quarter     Comps            Comp Base
---------------------------------------
Q1 11           10.7%               22
Q2 11            8.1%               24
Q3 11           11.9%               25
Q4 11           16.8%               27
Q1 12           14.1%               32
Q2 12           15.0%               34
Q3 12           12.5%               35
Q4 12           12.1%               40
Q1 13           10.4%               43
Q2 13            5.5%               50
Q3 13            7.7%               52
Q4 13            3.8%               55
Q1 14            5.7%               63
Q2 14            7.5%               70
Q3 14            5.9%               78
Q4 14            7.8%               81
Q1 15            7.7%               94
---------------------------------------

Management has a long-term goal of 1600 units in the US. They have been adding restaurants at a pretty fast pace, about a 30% CAGR between 2009 and 2014. In this same period, total revenues have grown at an even faster clip, about 52% CAGR, which makes sense given the comps they have been posting.

Financials

One of the rubs with Zoe’s is that the chain has consistently reported losses. Zoe’s reported losses of $10m and $3.7m for 2014 and 2013, respectively. It reported a small profit of $0.69m for Q1 2015, keeping its promise of turning a profit in 2015. However, what I ‘m really interested here is how Zoe’s can continue to fund its expansion, i.e., can Zoe’s fund its expansion from the cash generated by the business. After all, the net income line is impacted by non-cash charges such as ‘amortisation’ and ‘depreciation’ and while ‘depreciation’ is a real cost the company doesn’t really need to refresh most of its chain as the bulk of the stores are relatively new (post 2009).

So, let’s look at cash generation and cash spend of Zoe’s (all amounts in thousands).

 
------------------------------------------------------------------------------------------------------------
                                        Q1 15          Q1 14          FY14          FY13          FY12
Net cash from operating activities       $7,629        $4,024     $17,753       $10,942     $7,796         
Net cash used in investing activities    $11,362      $12,147     $40,080       $28,242     $21,282
------------------------------------------------------------------------------------------------------------

Currently, the company is dipping into the capital raised from its IPO to fund some of the growth but I would think the chain would become self sufficient probably by the mid 2016. The company is expecting to open around 31-33 restaurants, which would be similar to what they did last year. Looking at their guidance of getting to around 270 odd restaurants by Dec 2018, it looks like opening at this pace of 31-33 restaurants will get them there. So, I would expect net cash used for investing in the business to roughly stay in the ballpark of $40m, but the company should be generating a whole lot more cash from operating activities.

With a chain like this, modelling is more of an academic exercise. Zoe’s is looking expensive on traditional P/E metrics or even Enterprise Value to Earnings Before Interest Tax Depreciation and Amortisation (EV/EBITDA) metrics. E.g., here’s a rough EV/EBITDA calculation for Zoe’s:

EV = market cap + debt - cash equivalents
With stock at $40 (6/29/2015):
EV = 775m + 63.3m - 26.4m = $811m


--------------------------------------------------------------
                   Q1 15     Q1 14          FY14          FY13
--------------------------------------------------------------
EBITDA             5.6m      -4.6m          4.7m          8.4m
Adj EBITDA         6.8m       3.8m           16m         10.9m
--------------------------------------------------------------

TTM EBITDA = $14.9m
Adjusted TTM EBITDA = $19m

EV/(Adjusted EBITDA) = 42.6
EV/EBITDA = 54

As a comparison, I looked up EV/EBITDA for CMG. CMG’s current EV/EBITDA is around 20. It was 24 (Dec 11), 16 (Dec 12), 25 (Dec 13), and 25 (Dec 14). One thing to note though is Zoe’s EBITDA is growing at a rapid clip. It was up some 70% in Q1 15 over Q1 14.

Zoe’s management had said that they intend to turn a profit in 2015. They did report positive eps in Q1 15. What about the remainder of 2015? We can look at the guidance provided by the company and come up with some estimates. My calculations below, assuming the top end of the company’s guidance, seem to suggest that the company would more or less breakeven this year.


(all amounts in thousands)
Sales: $223,000
Restaurant-level operating margin (@20.5%): $45,715
G&A expenses: $24,700
D & A (@6%): $13,380
Pre-opening costs: $2,600
Interest expense, net: $3,000
Net income: $1,262 (after incorporating 38% tax)


We can model Zoe’s further out, say 5-years out based on projected AUV and EBITDA growth. But, I think overall this is an investment based on the trend towards healthy eating and the lifestyle choices of the demographics targeted by the company. The investment is also about management’s ability to maintain the pace of same store sales, their ability to grow catering, and their ability to expand successfully using the hub & spoke method they have used so far. If things keep going the way they have been for the past several quarters, then this will likely grow into its valuation and some and will be worth a fair amount more than it is today. This is a business where I wouldn’t put a lot on one go. A little bit to start with is fine, and that’s what I have done. I will add when I see further proof of solid execution.

44 Likes

One opened near me in Plymoth Meeting PA.

I have only gone once. It was not crowded, but not empty. The food was very good and the service was better.

It was more expensive than my other choices for lunch out. I have not yet been back, but I only go out for lunch once every other month or so.

I just wonder if the mediterranean food concept will stick, like Mexican has for CMG. People seem addicted to CMG. I like those addictive type stocks, including SBUX. I wonder if they track return visits (does CMG?).

Karen

2 Likes

Thanks Anirban for all the details on Zoes Kitchen. Appears to be a very interesting possibility. One question: Any thoughts on the leadership, Anirban? I looked up management and it appears there is some chronic turn over. The CFO just left (rather suddenly) last month. One analyst that I came across mentioned his concern with management turnover too.

Also FWIW, Karen, I just emailed my friend in Birmingham Alabama where Zoes was founded and asked her if she liked it. She came right back with the comment that she and her friends loved it and go all the time and have gone there for years. A great alternative to Chipotle and Panera. She said food is fresh, service great, and the founding family lived near her but she didn’t think they were running the company any more.

I’ve put this on my watch list.

Thx. J.

4 Likes

Thanks Anirban for all the details on Zoes Kitchen. Appears to be a very interesting possibility. One question: Any thoughts on the leadership, Anirban? I looked up management and it appears there is some chronic turn over. The CFO just left (rather suddenly) last month. One analyst that I came across mentioned his concern with management turnover too.

Their CEO Kevin Miles has been with Zoe’s for a while. Kevin has been CEO for about 4.5 years and he was a VP at Zoe’s immediately prior for a little less than 2 years. The CFO might have left for other opportunities … not sure, but I 'm quite okay with Kevin’s stewardship of the company.

Also, Kevin seems to stick around for a while. He was VP at Baja Fresh for 6 years, and Director of Operations at La Madeleine (not sure what this was) for about 7 years.

I have seen the guy give interviews and he comes across as genuinely interested and motivated. He was on Cramer’s show not too long ago promoting Zoe’s.

Overall, though, I think the business has done well and expanded greatly under his leadership. If Zoe’s succeeds and become a mini Chipotle he will eventually be lauded as a great CEO, but you never know.

So far, looks good to me.

Anirban

2 Likes

Anirban - I missed the boat on CMG which will forever piss me off as I had spotted it and meant to take a position. Anyhow - I agree with you on Zoes and recently took a position myself. I also bought into Grubhub with their recent tanking.
Ant

Thanks, Anirban, for the color on Zoes management. I’m reassured now that you’ve commented.

It appears Kevin has a nice varied background in Quick Serve: We used to really like Baja Fresh when they opened their (first?)shop near Cal Tech in Pasadena, then it seemed to slide down hill a bit. Later we were sorry when Baja closed all of their locations here in Ohio in 2009. I don’t think Baja is public yet but it’s one to watch–don’t know if they can compete with Chip Mex Grill or even Qdoba though. La Madeleine is a nice chain with lots of shops around Wash DC among other places. ‘The ladies’ (my girls, sisters, cousins, etc. and I)like to eat there when in DC, so maybe CEO Kevin picked up some ideas from it.

Fool on!
J.

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