Is the Worst Over for Zoe’s Kitchen?

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With a concentration of restaurants in the south, Zoe's Kitchen's (NYSE: ZOES) third quarter was hit hard by Hurricanes Harvey and Irma -- reducing revenue by $1.1 million and contributing to a 0.5% decline in comparable-restaurant sales. Despite the unattractive headline numbers, there are several signs that comps could be on the verge of a recovery.

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Here are three reasons to believe that this fast-casual Mediterranean restaurant chain may finally be turning around.

Comps were better than they looked

Zoe's 0.5% comps decrease broke down into a 2.3% decrease in traffic and a 1.8% increase in the average ticket size. Even with hurricanes affecting about one-third of Zoe's stores, the company easily outperformed restaurant industry averages, which included a 2.2% comps decrease and a 4% fall in traffic. According to Black Box Intelligence, that marked the second worst quarter for restaurants in over five years. In that context, I find Zoe's results impressive, especially given that its comps results had recently been underperforming these industry averages.

Also, although comps declined year-over-year, they actually showed significant sequential improvement. You can see that the rate of downward trend decelerated in the second quarter, and the sharp upturn recently indicates that this metric may have already bottomed out.

Lastly, and most importantly, the company says that the hurricanes alone were responsible for a negative impact of 0.9% on comps. Put another way, excluding the effects of the storms, Zoe's believes comps would have actually increased 0.4% for the quarter. Perhaps that shouldn't be too surprising, given that on the previous conference call, CEO Kevin Miles noted that the company had seen positive comps during the early weeks of the third quarter.

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What's driving the improvement? The company's recent menu revamp has performed better than expected, with some of the new products cracking Zoe's top 10 list of items ordered.

Digital investments are showing good early returns

In the early third quarter, Zoe's launched a redesigned website and a mobile app that includes online ordering for its growing catering business. Since then, the company says its online sales comps are showing "strong sequential gains versus the first half of the year."

The digital investments are part of Zoe's larger efforts to use data to improve customer loyalty. And though it's still early, it appears those investments are beginning to pay off. Within two months of launching the new website and app, the company grew enrollment in its loyalty program by 20%. Being able to tailor digital offers to different types of customers who already eat at Zoe's will give the company another way to shore up its flagging traffic numbers, and it expects to ramp up these marketing efforts in the last part of the year.

Reducing store growth next year will help, too

Management now plans to open only 25 new restaurants next year, down from its prior guidance of 25 to 30 stores. That will work out to roughly 10.3% annual store growth in 2018, a significant pullback from the 20%-plus growth in recent years. That's of some concern, given that most investors would love to see the chain keep expanding quickly to fuel revenue and earnings growth. But with all the uncertainty around comps right now, it's understandable that Zoe's is pumping the brakes.

However, the good news is that Zoe's more moderate store growth should improve the company's cash flow and margins next year. By reducing new store builds, capital expenditures should come down to the point that Zoe's won't need to take on any additional debt in 2018. If comps can get back to positive levels, CFO Sunil Doshi thinks the company's cash flow could hit a big inflection point:

[W]ith the development plan lower and just kind of thinking through the business, yes, we do see kind of a range where, on a low single-digit comp, we can be kind of breaking even to slightly free cash flow positive next year.

In addition, the company should also start seeing some relief in its restaurant contribution margins, which have been under pressure lately from higher labor costs. New restaurants generally report lower margins during their first couple years of operation, so having a mix of more mature stores and fewer new ones in 2018 should help -- though Doshi called it a "modest benefit."

While Zoe's continues to trade within a few bucks of its all-time lows, comps appear to be firming up. And the company's initial success with its digital initiatives bodes well as the company looks ahead to what it hopes will be a better year in spite of slower expansion.

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Andy Gould owns shares of Zoe's Kitchen. Andy Gould has the following options: Short Jan. 2018 $30 puts on Zoe's Kitchen and long Jan. 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.