3 Ugly Truths and 2 Silver Linings from Zoe's Kitchen's Q2 Earnings

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The last year has not been kind to Zoe's Kitchen (NYSE: ZOES) shareholders, with the stock down more than 50% over the past 12 months. Even with the low expectations baked into the second quarter earnings report, the actual results did little to ease concerns that the Mediterranean fast-casual chain's best days might be behind it.

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Comparable restaurant sales growth and restaurant-level margins continued their downward slide, and the company also announced that it's planning to slow its rate of future store openings. But as bad as these results were, some nuggets from the conference call pointed to the potential for better days ahead.

The worst comps since IPO

There's no sugarcoating Zoe's awful comps performance. After its first-ever comparable restaurant sales decline as a public company in the first quarter, the latest numbers were even worse, down 3.8%. For a company that was sailing along with comps growth in the 4% to 8% range for several consecutive years, Zoe's decline has been steep and swift. The company was able to raise prices 1.2%, but that only partially offset a stunning 5% decline in customer traffic. 

While the industry at large is also struggling as fewer customers dine out, Zoe's traffic problems have generally been worse than average. However, the company still reiterated its full-year comps guidance of down 3% to flat, a wide range that indicates management isn't banking on a recovery anytime soon. Or are they?

Silver lining No. 1: On the conference call, CEO Kevin Miles said that in the early weeks of the third quarter, comps had actually turned positive. The company believes this is the result of the menu revamp Zoe's rolled out near the end of the previous period. Customers can now enjoy a new line of bowls, pita sandwiches, and sauces. While it's too early to know whether this uptick in sales is sustainable, the company noted that it had seen improvements in both the average ticket as well as traffic. Zoe's will also launch a new ordering app and loyalty program this quarter that may help increase its repeat and to-go business.

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Margins are moving the wrong way, too

From 2012 through 2016, Zoe's restaurant contribution margin (as a percent of restaurant sales) generally held steady in the 20% to 21% range. However, a combination of factors -- primarily higher labor costs and a significant number of newer, less-efficient restaurants with lower average sales -- is pushing margin significantly lower.

After falling by 2.1 percentage points earlier this year, Zoe's restaurant contribution margin decreased by 2.6 percentage points in the second quarter to 19%. The company reaffirmed its prior guidance for full-year contribution margin of 18.3% to 19%

There's not much relief in sight beyond 2017 either. In previous presentations, management has stated that as new stores mature, Zoe's margins will rebound over time, citing the end of 2020 as the year margins should stabilize -- that's the point when 60% to 70% of the company's restaurants would become mature (their third full year of operation), which generally results in meeting higher targets for sales and profitability.

Store growth will slow dramatically next year

As a reaction to the weak customer traffic management is seeing -- and perhaps also to the cannibalization that's occurring as Zoe's continues to aggressively build new stores in existing markets -- the company plans to slow its rate of expansion next year.

The company will still open the 38 to 40 units it planned for 2017 -- which represents 19% annual store growth at the midpoint. However, next year, Zoe's will open 25 to 30 new restaurants. Assuming 28 new stores, this represents just 11.5% annual store growth. That's a big hit to an investment thesis that relies on substantial expansion as a tailwind for sales and earnings, especially when Zoe's is so early in its stated growth ambitions. Zoe's has repeatedly pointed to the potential for 1,600 restaurants in the U.S. and was targeting the 400 store mark by 2020. But at this rate, the company would end 2018 with roughly 271 stores, making that goal look out of reach.

Is dialing back on new store growth the smart move?

With comps and margins faring poorly, Zoe's announcement about slowing its rate of expansion is not exactly a surprise. Additionally, the company has had to rely on debt to fund its new store expansion in 2017 -- with the company saying it borrowed $10 million so far with plans to end the year with $15 million to $20 million in debt.

Silver lining No. 2: With the company slated to open fewer stores next year, CFO Sunil Doshi stated that capital expenditures in 2018 will come down to a level that's much more in line with operating cash flow, greatly reducing -- or eliminating -- the need for additional debt. Lower store growth also means fewer new locations dragging on margins. Just keep in mind Zoe's won't see that benefit to store-level margin until 2018.

In a very challenging sales environment, I think Zoe's is making the right move here by dialing back on some of its more ambitious goals. But like most restaurants in growth mode, I wouldn't expect much of a comeback for the stock until the company's comps can show signs of life once again.

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Andy Gould owns shares of Zoe's Kitchen, and has the following options: short January 2018 $30 puts on Zoe's Kitchen and long January 2018 $30 calls on Zoe's Kitchen. The Motley Fool owns shares of and recommends Zoe's Kitchen. The Motley Fool has a disclosure policy.