Breaking Down Future Prospects for Chipotle and National Beverage Corp.

By Markets Fool.com

Shares ofChipotle Mexican Grill (NYSE: CMG)enjoyed a small boost following the disclosure of Bill Ackman's $1.2 billion stake in the fast casual chain earlier this month. But the stock has since continued its downward slide, perhaps indicative of the ongoing challenges that the company will have to address before diners return to its restaurants with their previous enthusiasm.

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In this episode ofIndustry Focus: Consumer Goods, Motley Fool analysts Vincent Shen and Sarah Priestley take a look at the biggest problems Chipotle faces today and what Ackman may push to turn the company around.

The pair also take some time to look at an Industry Focusnewcomer that has beenenjoying incredible growth due to the exploding popularity of sparkling water -- National Beverage Corp(NASDAQ: FIZZ). Learn about the company's key brand, LaCroix, and its future prospects as competition increases from industry giants like Pepsi (NYSE: PEP) and Coca-Cola (NYSE: KO).

A full transcript follows the video.

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This podcast was recorded on Sept. 13, 2016.

Vincent Shen: This episode of Industry Focus is brought to you by Rocket Mortgage byQuicken Loans. Rocket Mortgagebrings the mortgage process into the 21st century with a fast,easy, and completely online process. Check out Rocket Mortgage today at QuickenLoans.com/fool.

Hey, Fools! Welcome to the latest episode of Industry Focus, the podcast that dives intoa different sector of the stock market each day. It is Tuesday,September 13th, so today we will be talking about developmentsin the consumer and retail sectors. I am your host, Vincent Shen, and joining me in studio today is the one and only Sarah Priestley. How are you?

Sarah Priestley: That wasa very nice introduction, thank you.

Shen: Thank you.I was really thinking about that before the show. How are you doing, Sarah? This is our second show together,your fourth podcast overall?

Priestley:It is.I'm still a newbie.I'm definitely still in that bracket.

Shen: Are you feeling the newbie jitters?

Priestley:It'sgetting less and less each time, but, yes, they're still there.

Shen: OK. So, today, we'retalking about two companies and some recent news. One's on earnings,and one is on a big-name hedge fund owner activist investor getting to it. So the first one isNational Beverage Corp We havevetalked about the beverage industry in the past, usually focusing, frankly, onCoca-Cola andPepsi,the two leading names. But in this case, FIZZ is their ticker, they're the No. 4 player,and I don't think I've covered them in my time on Industry Focus. They have seen some growth,especially in the really prominent categories,in this case, sparkling water,that I think they deserve a little attention from us. They havea really interesting CEO who has a huge ownership stake in the company.I'm going to let you take it away from there,Sarah. I think the best thing we can doright off the bat is to touch on their most recent earnings,to put into context some of the incredible growththat the company has seen.

Priestley:Yes,you're exactly right.National Beverage Corp and their big brand, LaCroix, don't quitehave the same brand recognition that Pepsi and Coca-Cola enjoy, but they are in a boom period. Togive you some idea, in the past 12 months, theirshare price has hiked 85%,which is pretty huge. So thereason for this is that they've pivotedmostly toward sparkling water. If you look, in 2015, in the U.S.,Americans drank 12.4 gallons less soda than they did in 2005. That'sequivalent to two sodas per week less,which I think is a significant drop. Andconsumers are pivoting away from thatand toward sparkling water. Between 2010 and 2014,domestically produced sparkling waterincreased by 58%,and last year, on its own,it increased 26%. So, Americans are loving sparkling water, andthat's having a direct impact on National Beverage Corp and its big brand, LaCroix.

Shen:So, [National Beverage Corp] breaks out their most powerful growth segmentas their Power+ brands. I thinksome of these are very regional.I'd actually not heard of all of these, andI've only actually tried two of the brands in FIZZ's portfolio. The Power+ brands include LaCroix, Shasta Sparkling Water, Rip It Energy Drinks, Everfresh juices, and Mr. Pure juices.

Again,these aren't necessarily the huge national namesthat you might recognize, but in terms of thisspecific sparkling water niche,LaCroix and National Beverage isdefinitely leading the charge. I think theirbiggest competition right now comes fromNestleand the Perrier brand, for example. But,at the same time, Coca-Cola and Pepsiare not sitting on their hands, they see the big opportunity here,and they have actually released products to competepretty recently. In April,Pepsi joined the fray with Aquafina Sparkling, which,in my opinion, bucks the competition. There'sactually 10 calories in the water,and there's a little bit of sugar,whereas a lot of the competition doesn't have any, so that really surprised me.I'm curious how that ends up going for them. Also,Coke has some skin in the game. They launched in 2015 theirSmartwater Sparkling, which is obviously an evolution of itspopular bottled water brand.

Just tojump to the CEO real quick,because he's a really interesting guy --they don't do earnings calls, which depending on your view, I typically likethat transparency, that extra color, with each quarter. Their press releases can be quite the read, in my opinion.

Priestley:They arecertainly entertaining. The CEO, a majority share owner, he owns 70% of the shares, is Nick Caporella. He seems like a really interesting character. He built this business up, he bought LaCroix, which isone of their biggest brands right now, in 1995?

Shen: 1996, I think.

Priestley:Yeah. So, he foresaw this trendaway from soda toward more healthy drinks, so he's obviously very entrepreneurial. He loves the phrase "indeterminable growth." If anybody has read any of their shareholder letters or looked atsome of their quarterly reports, it'sscattered through there.So,he really sees this as being exponential growth potential with LaCroix.

Shen: Yeah,and it seems some of the stats you mentioned earlier in the show -- obviously, this niche does seem to have a really solid runway of growth ahead of it,but otherwise, I'm partially concerned for the fact that I think this is a $2.5 billion market cap company sales-wise. Coca-Cola does 50 times its sales. And we all know how powerful,especially in the beverage industry, very competitive,the distribution models can be, the advertising budgets,things along those lines.

So for this company,obviously, leading the charge in this niche. Butother parts of its business,like it's more traditional soda business, the brands arestruggling a little bit more, getting stale. But obviously, the CEO is pivotingas much as he can to these Power+ brands. But,what do you think, in terms of the next five years as Coke and Pepsi really rev their engines to take over this space? Do you think this is a space LaCroix can hold on to?

Priestley:To a degree.I think they've attracted a lot of millennials. We tend to refer to millennials as a bighomogeneous group. But, they are doing very well. They have 20 different flavors, and this gives them the cache of scarcity, because not every store stocks every flavor, so youhave to go on a treasure hunt for it,and they have a huge social media following.

We were looking before we came in on anInstagram site specifically just for one flavor of LaCroix. So, they clearly have quite the following. Andthey don't do television advertising, they only work on social media. So far, that's worked very well for them, because it's opposite big business, which a lot of young people are moving toward. I think thatYelpas a start-up, they included LaCroix in their office fridge,GrubHubhad a "LaCroix Luau" at one of their happy hours. So,you can see it has quite the following,but, yes, you're exactly right. As soon as the Coca-Cola andPepsi media machines start going,you're going to have some sizable competition. And if you look at San Pellegrinofrom Nestle, they'reexpanding their flavors, too, so that'sgoing to be increasingly pressurizing.

Shen: OK, so, overall, like we mentioned earlier, this is the No. 4 player.I think it's a really interesting company, andwe haven't had an opportunity in the past to cover it,it was really interesting to do some of the research, readsome of those press releases and annual reports. The takeaway is,if you want to try some of these brands we mentioned,the stores they typically get carried in are likeWhole FoodsorFresh Market. Sarah actuallydrove around last night trying to find some LaCroix to try. But there's actually quite a few Fools hereat headquarters with boxes next to their desks. So,the followers they have do seem to be loyal. Those are the placesif you're curious about the draw that some of these flavors have,they have hilarious Instagram feeds, go check it out.

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Next story, we mentionedan activist investor,a guy who runs a hedge fund, pretty notable. Hisrecent disclosure of his investmentin the companyChiptole led to quite a nice bounce in the shares. Obviously,Chipotle has been struggling in the past year with their food-borne illness outbreaks. The stock is down, I think, over 40%. Some of their comps,especially for the first quarter of the year,if you look back in January, they're comfortable store sales were down like 36%. Really hit very hard by the poor media and the bad visual aspect in terms of, every day, in the press, you hear about these new outbreakshappening on the West Coast and the Northeast. But,Ackman has had some historyin the restaurant industry and some very successful investments. What do you think?

Priestley:I think this is a great move from himright now and the fact that it's much more in his wheel house than what he's been doing morerecently. I think it's very well publicized aboutPershing Square not performingas it should in the past two years. And last year, it lost 20%. This year, it's down 14%. If you look at Ackman's investments in things likeHerbalife, that's much moreaway from what he previously done in terms of these turnarounds. He hasformerly invested inMcDonald's,and he was also involved in theWendy'sspinoff ofTim Hortons,and in both of those investments he doubled his return. This, to me, sounds likea very natural progression for him.I think investors should take this as a nod of goodwill,even though there are a lot of analysts that are being very bearish on this stock right now.

Shen: Yeah,for Chipotle in particular. For a little more detail,Bill Ackman and his fund Pershing Squarehas taken a 9.9% stakeand Chipotle. I think the value of that is around $1.2 billion. Overall,right now, there's not much information aboutwhat he might push. Inthe filing, it basically has,we have the quote somewhere,but the idea is, he's going to open up somelines of communication with with the board, with management to look at, maybe,the composition of the board, andother operational efficiencies they might be able to squeeze out.

But,in addition towhat we mentioned at the outset, in terms of some of the food safety scares, a lot of other issues right now plaguing Chipotle that are stacking on top of it, making it hard. They have Chiptopia right now in the summer totry and boost traffic, and they'reprobably going to turn that intoa more permanent loyalty program,we can talk about that later. But I wanted to mentionsome of the other issues, too,and how they play into the business overall.

Priestley:Yeah. As you mentioned, in quarter one, their comps were downquite significantly. But in the last quarter, where weexpected to see some sort of improvement, their comps were down 24%, revenue was down 17%. Andthat's to be expected to some degree,but this is a very lagging recovery.

Andother things that are affecting them more recently,Mark Crumpacker, who wasin charge of cleaning up the crisis, he was the exec put into the role, he was put onadministrative leave in July because of a very well publicized cocaine bust, which could not be foreseen,it was very unexpected. The other thing is employee lawsuits,people are alleging thatChipotle underpaid its staffby misclassifying them and making them work extra hours. There's nine lawsuits across six states. And there's a lot of workers involved. And you weretelling me before we came in at this is all part of a bigger issue for Chipotle, becausethey recently announced that they have 130% staff turnover.

Shen: Yeah. So, with the class action lawsuitamong the employees, this basically comes down to an issue ofthem working overtime and not getting paid for it. Chipotle, in terms of their headquarters,core company management hasargued that this is not their doing, maybe some rogue managers. But,overall, Chipotle is unique in that it doesn't have franchises,it operates all of its stores. I don't think it's that easyfor them to wipe their hands of thisand blame somebody down the line.

At the same time,the latest news was that 10,000Chipotle employees have signed on to be part of the class action. The company, overall, has around 60,000 employees. So,that's a pretty sizable portion.I don't think this is a concern they can just make go away. It'sgoing to impact them for sure,in terms of their ongoing recovery.

Priestley:I think the bigger problem for that --sorry to interrupt you --is around this "Food with Integrity" issue.I think the marketing needs complete overhauling,because it does not resonate with people anymore.I think this, the exec being put onadministrative leave, and obviously the whole food borne illness thing,directly goes against everything that Chipotle has previously stood for. AndI think it's starting to make people second guess everything that they formerly believedfrom the marketing. So, for me, the biggest thing that whoever, Ackman of whoever, becomes in charge of this turnaround, Steve Ells, theyneed to start addressing that identity issue.

Shen: It's funny. Earlier in the summer, we did a lifecycle episode, and wefocused on Chipotle, how that burritocomes to be, from the farm where the ingredients come from to theprocesses they've implemented to improve the food safetyaspect, and how that ends up in front of youas your burrito bowl, for example.

And we touched on the fact that thecompany talks a lot about food with integrity,how they have these initiatives and place to help local growers and suppliers. But, in the end,some of the feedback that we've gotten on the episode was the fact that it's hard to take that at face valuewhen they've had some of these issues,not only just on the food safety side but now with employees. It doesrequire for Steve Ells and the rest of management to think about how they'regoing to reposition the company in terms of the marketing and its image socustomers have that feeling again. I remember,before the scare, going to Chipotle, and it being something that diners reallylook forward to, and seeing those long lunch lines,and the fact that they were able to get through those so quickly.

But otherwise,what do you think might be some changes that Ackman pushes? Youmentioned some of his other restaurant investments. I think thatsome of the success he saw with those was really strong management teams. WithBurger King, for example,they got bought out by3G Capital, which has madequite a name for itself,turning around some big companies. They were involved in theAnheuser-BuschInbevdeal, they wereinvolved in theKraft Heinzdeal. Very strong leadership there in terms of cutting costs andimproving operations. In this case,I guess it really depends, do you believe in Chipotle'smanagement being able to do that, what do you think Ackman might suggest?

Priestley:I think there has been for a long time, the suggestion that they shake up the board. It's a nine person board, andthe average tenure is crazy. It's like 20-plus years. There'sa lot of criticism that there aren't diverse opinions there,so I think he may suggest a shake-up of the board. I wouldn't be surprised about that at all. Andit's something that a lot of investors have been pushing for.

I think he may also suggested move to franchisees, whichI know that Chipotle is tryingmore recently, but they aren't enjoying that process, so we'llsee how that goes down. And then,generally,constructive operational improvements, likenew restaurant formats,kind of a general shake-up, a substantive loyalty program, which you alluded to earlier. And then,the other thing, which I think is more important,is trying to get them to focus. If youlook at a lot of things that they're doing, there's a bit of a scatter approach,especially with their seed concepts. They have Tasty Made, which is a new burger chain,ShopHouse Kitchen, and Pizzeria Locale.

Shen: Yeah. Tasty Madeis actually a prettyrecent announcement. I think I've seen some bears orcritics argue that they haven't really done much with ShopHouse,in terms of growing those concepts, and Pizzeria Locale. So,to start another one in the midst ofthe fact that they're reporting comps still down 20%-plus,is this really the right time to be thinking aboutthese side pet projects?

Priestley:Absolutely. Andthey reiterated in their last quarterly earnings callthat they want to grow Chipotle by 256 stores this year. So, they'reexpanding rapidlyin their core competency,and they're looking to go into other things.I think they really need to take stock and find out what's workingand what obviously isn't working for thembefore they go and proceed with anything else.

Shen: Yep. So,wrapping up here, I think with the news,there's a small bumpwith the disclosure of Bill Ackman's10% holding. At the same time, here at the Fool,taking more of that long-term view,something to keep in mind is that Chipotleis going to be coming up soon on somepretty favorable comparisons for them,because their hardest-hit quartersare ahead of them over the next year.

Evenpsychologically, I think, for some investors, to see that comps are up again, revenue is up again, I think Ackman's timing is pretty good, if you're going to take a 10% stake. At the same time, it's not a 0.5% stake, and theactivist investor tries to get heavily involved in the company -- 10%is respectable. I think he can have somepretty positive contributionsbased on his prior experience in this industry. But, again, in terms of just that stake, and the long-term view, I think there is,in the next couple years, some momentum that Chipotle can buildif they can get through these issueson the food safety side and with employees,and other bad press, and get back to,I think their core efficiency is theirrestaurant operating margins, getting those back up to par,being able to deliver those, in the past, I think, as they scale,that really benefits them. Any other takeaways that you can think of?

Priestley:No,I think you hit every point on the head there. They have obviously been struggling. And I think this is just more of a minor market move that people shouldn'tinclude in their long-term thesis.

Shen: OK. So that is all from us today. You cancontinue the conversation with Industry Focus viaTwitter @MFIndustryFocus, orsend us any questions or comments via email at industryfocus@fool.com. Peopleon the program may own companies discussed on the show,and The Motley Fool may have formal recommendations for oragainst stocks mentioned, so don't buy or sell anythingbased solely on what you hear on the program. Thanks for listening and Fool on!

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Sarah Priestleyhas no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill, PepsiCo, and Whole Foods Market. The Motley Fool recommends Anheuser-Busch InBev NV, Coca-Cola, Nestle, and Yelp. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.