Back to School With Return on Invested Capital 101
It is back-to-school week in towns and cities all over the country as hordes of students return to the classroom. In that spirit, Industry Focusis offering its own series of classes that hone in on key investing principles. For thisConsumer Goods episode, Motley Fool analysts Vincent Shen and Asit Sharma dust off the blackboard to discuss return on invested capital, or ROIC.
After introducing the concept and how it can be used to evaluate your investments, they turn to case studies for three popular companies:Buffalo Wild Wings (NASDAQ: BWLD), Whole Foods Market (NASDAQ: WFM), and Marriott International (NASDAQ: MAR) to demonstrate some of the different ways ROIC can play a role in your portfolio.
A full transcript follows the video.
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This podcast was recorded on Sep. 6, 2016.
Vincent Shen: Welcome to Industry Focus,the podcast that dives into a different sector of the stock market every day. I'm your host Vincent Shen,and it is Tuesday, Sept. 6.I hope everyone was able to enjoy their long Labor Day weekend. On the phonewith me today is Asit Sharma, our seniorconsumer retail specialist,calling in from Raleigh, North Carolina. Asit,I'm really happy to have you back, how are you?
Asit Sharma: I'm great, Vince, and I'm thrilled to be back,especially after a really relaxing long holiday weekend,doing something I love,which is chatting about consumer goods with you.
Shen: Asit,on my commute into Virginia to head to Foolheadquarters today,I felt there was this energy and tension in the air,because it happens to be the first day of schoolfor a lot of Northern Virginia. We'retalking about, in this area,hundreds of thousands of kids hopping on buses,going to school for their first day. What aboutyour home state of North Carolina? Is school in session?
Sharma: Yeah,school is back in session. Manykids went back to school last week.I have three boys, and my twooldest ones are in a charter schoolthat actually started on Aug 10. So,I definitely have dipped into that energy. Ourhousehold has been geared up inback to school. And I'll tell you,there's something about sending kids back to school thatmakes me want to learn something new. I mean,this is a great topic for today. Let's,you and I and our listeners, go back to school.
Shen: Yes. With that lead in,we have the honor ofintroducing a special back-to-school themed week for Industry Focus. Our goal this weekis to take some investing concepts,break them down together,and put them into contextwith some sector specific examples. Today, Asit -- I should call you Professor Sharma -- I'llgive you the honor of introducingthe first topic of the week. What are we discussing?
Sharma: Sure. Today, we're discussingreturn on invested capital. Youprobably hear this or see this referred to as ROIC, in articles of companies you follow on the web. I'll tell you,it can be a mystical-type concept,but today, we're going to break it down in a way thatyou can use when you invest in companies.
Shen: Absolutely. This isactually a metric that I learned a lot about when I was in school for finance and accounting. AndI did not see it as often as I would have expected,looking back on it and knowing how important it is now, actually, during my time on Wall Street. ButI think it's a really nice metric to pair withother common measures. People hear about P/E ratios, for example. But,overall, I think this is just another tool thatinvestors should have when they're evaluating a stock. There are somereally great examples with popular companies in the consumer retail sectors that we can put this into perspective for.
But,right off the bat,it's important for anybody who's not familiar with ROIC [to know]: What is it?
Sharma: ROIC isactually aprofitability ratio. Itmeasures how a company uses its own capital.I'm going to pause here,because Vince, you've been to school for finance, and I have too, but this concept ofcapital is actually sort of mysterious,so I would love if we take a moment hereto talk about what capital is.
Capital is the money a company raises in itsinitial public offerings, any follow-on stock offerings, plus money that a company may borrow in issuing bonds, taking on other types of debt, plus any profits a company makes that it chooses to reinvest in its business.
Now,if you think about all these sources of money,once those get invested into assets, thoseassets are often referred to asinvested capital. When youhear this idea ofreturn on invested capital,you can think of a profitability typereturn on money that has been invested into capital, and assets, which make a business scope.
Shen: Absolutely. On air,it's a little bit more difficult for us to break down with ROIC theactual calculations, because frankly,there are quite a few different waysto approach it.I don't think we're going to get into the nitty-gritty so much. There areplenty of sources on the different approachesof how to calculate it. But, more on the application, and how it cancome into play when you're evaluating a stock, is probably a better way for us to focus on it on air.
Sharma: Yeah. We'd like to grasp this concept at 30,000 feet,and really discuss today with our listeners how you can get an edge over other investors if you get the big picture of a company'sprofitability on these assets it's put to work.Shen: OK. We have this general idea of what ROIC is. I think the best way to reallysolidify your understanding is look at our first example,which I think is really interesting,because it involves an activist investor, a company thatI've always been following -- and frankly I'm a fan of their product offering. That'sBuffalo Wild Wings.
Thestock is down about 20% in the past year. Investors have kind of been forced toacclimate themselves to a more modest quarterly report. Same-store sales,for example, have swung fromvery impressive growth previously tonegative levels for the first two quarters of 2016. With that, this activistinvestor has been voicing its concernspublicly. Its biggest complaint,very coincidentally,has a lot to do with our back-to-school topic: return on invested capital.
Sharma: True. Thatactivist investor is calledMarcato Capital Management. They've got a 5.2% stake inBuffalo Wild Wings, which is a pretty big stake. So they can throw their weight around a little bit. They issued this letter in mid-August, with the obligatory accompanying slide deck, a hefty presentation that goes through so many things that in the hedge fund's opinion is wrong with the waymanagement is running the business. But I've read through that presentation, and they're really zeroing in on the fact that they don't thinkBuffalo Wild Wings is using its capital efficiently.
Let's back up here and look at the quick-service industry, orfast-casual industry -- related industries in general. One thing that is par for the coursewhen you have a successful restaurant businessis to start franchising your name and lettingfranchisees come and open up businesses. You canexpand more quickly,it's very profitable, because they are putting in the capital to open the stores and you're not. One greatexample of that isBurger King. Many of our listeners are familiar with Burger King as an investment. That's nearly 100% franchised. ButBuffalo Wild Wings is actually going the opposite way,against the grain andagainst the trend. They're actually buying back their ownfranchisees. Andthe hedge fund thinks this is a big mistake because, it points out,Buffalo Wild Wingsis acquiring franchisees at about 50% abovereplacement cost.
When we think of what it costs a company toopen its own restaurant versus running a franchise, which is extremely capital-light, versus going out into the market and buying back one of itsrestaurants -- if you were in that driver's seat,you would probably want to avoid option three. Because, Vince,if I approach you and say, "Hey,how is that franchise going withBuffalo Wild Wings?" And you say, "I'mmaking lots of money." If I thentry to purchase your restaurant,you're going to ask top dollar. But this is exactly what Buffalo Wild Wings doing,and the shareholders are not happy.
Shen: Absolutely. Granted,I think there are a few exceptions here and there in therestaurant industry. It is a very strong trend with thefranchising strategy.I spoke last week with Sarah Priestley aboutMcDonald's, for example, andpart of their turnaround efforts has been pushing moreinto the franchising side. But here,you bring up a really good example. IfI'm an owner of one of these franchises, and the corporate headquarterscomes to me, andI'm generating a ton of cash and I'm really happy with my sales, theperformance of my location, I know that this is more of astrategic buy for you. So,like you mentioned, I can ask for top dollar. And it seems to me likeBuffalo Wild Wings management is very willing to pay that, as well. And that's taken anegative toll on some of the company's results,specifically with their return on capital,and why Marcato Capital Management is weighing in with thisvery public airing of grievances.Sharma: There's twointeresting points related to that. One is,as you mentioned, theirreturn on invested capital has declined almost 5% from 22% to 17% over the last year. The second point, which is fascinating, is: Why wouldBuffalo Wild Wings be doing this? Why not justtake capital and build restaurants at cost,and create these new revenue streams? Marcatopoints out that Buffalo Wild Wings' management isincentivized to grow revenue and profitswithout regards to cost of capital. So,when you buy that restaurant, you're buying its revenue, too, which you can then put on your books, and that creates a bonus in management's pocket. That'spart of the reason why this hedge fund,and other investors, are fired up at the wayBuffalo Wild Wings is using its capital.
Shen: Yes. That makes a lot of sense to me. I think a lot of things in investing, and life in general, it comes down to incentives like that, frankly. And there's a very clear one if you'recompensating management based on these other metrics. I don't know. It'salmost hard to blame themfor pursuing that,and I'm sure they're happy with those bonuses, obviously.
Overall, what do you think about this strategy? Do you have concerns tied with Marcatoin terms of this having a negative long-term impact forBuffalo Wild Wings? Or,do you think this is something that can work for them. The fact is,something I noticed is that, when it comes to, for example, theirquarterly comparable-sales growth, theiroperated units tend to put up better numbers than their franchised units.
Sharma: Right. And that's thecounter-argumentthat I'm sureBuffalo Wild Wings management will make, is that we can go in andtake a restaurant that is not operating asefficiently and improve the margins. And I'm actually a fan of some balance. You mentioned McDonald's, theyactually have a fairly sustainable ratio. Right now, 80% of units are franchised, and 20% of units the company owns. They have a good mix of learning how tooperate their own units, and thenmaking money on the franchise side. IfBuffalo Wild Wings' model, which is about 50-50 now, if they sustain that and can improve things, yes, they'll show greater revenue, greater profits.
Myonly concern is thatthere's some opportunity costs there,when they're using 50%premium of their own dollarsto buy this restaurant, you wonderif they couldn't be moreprofitable. Instead of trying to go out and reacquire franchises they think they canoperate more efficiently,why not just build them and operate them yourself? Building isbetter than repurchasing at a premium. I think over the long run,I agree with you,it may not look that bad on the books, but I worry about some money that's left on the table the way they're doing it. And we'll see. It's a good dynamic conversation that going to evolve between Buffalo Wild Wings and its shareholders. Maybe they'll shift that balance. It'sgoing to be an interesting year coming up,to watch this company that we both like.
Shen: Yes. On this one hand, westarted off with this company where, I think they're getting dinged on poor management of this topic that we have for today, withreturn on invested capital.
Let's move on to another company. This time, we're talking aboutWhole Foods. I feel likethey're kind of gearing up in the opposite direction. Again, a really strong brand. They have a market leadingpresent within their niche: organic and natural foods. Thestock price has also been hurt recently. It'sactually nearly been halved since early 2015.
Admittedly, thisweakness has been driven by some of its own successover the past decade, with a lot of larger competitors being attracted to the very strong growth that isexpected and forecasted to continue among this organic/natural food segment. These biggercompetitors are more than happy toappeal to consumersin this target market withbetter prices, more convenientsince they have bigger store footprints and networks. So, Whole Foods,ultimately, their market share has been kind of squeezed. Theirrevenue growth is slowing. Margins are getting squeezed, too.But they'returning in another direction with their new strategy. I'mgoing to let you dive right into it from there, Asit.
Sharma: Awesome, that's a greatoverview of Whole Foods. And I'm sure listeners who are invested in this company are eager to know: When is the stock ever going to move? Thetruth of the matter is,the competition that the company is facing is coming from all sides: largeroperators likeCostcoandWal-Mart, smaller ones likeThe Fresh Market. It's a multiyear process to reorienthow the company does business. Of course,they're going to stick with their flagship stores. They areextremely profitable. They'll keep growing those. But they've figured out that a smaller store with a lighter footprintmight not be a bad idea.
Vince,have you had a chance to visitone of the new Whole Foods 365 stores,by any chance?
Shen: No,I have not.I think there's two of them now that are currently open,but unfortunately they're both on the West Coast,so I haven't seen them yet. Though I've been able to see a walk-through thatone of our writers, Brian Orelli provided,it's up on Fool.com,it has a lot of great photos. But unfortunately, I haven't seen it in person.
Sharma: Right,same here. I'm eager to, and hopefully I'll get to one soon. But I want to point out, forlisteners who are in the same situation,who have heard about the store but only read about it,most of the press coverage has been focused on the fact that these stores offercheaper prices,and they're meant to compete withTrader Joe's. That'swhat I've seen most often in the financial press.
But let'slook at it from management perspective. This is a company that isactually incentivized to improve return on invested capital.Whole Foods has areturn on invested capitalof about 13%, which is really goodif you're a grocery store business. Traditionally, in that industry,at the end of the day you have 1% to 2% profit margins, and you're happy. So, an ROIC of 13% is pretty darn good. These new stores have a footprint of about 30,000 square feet. Theaverage Whole Foods flagship store footprint is 47,000 square feet. They have astreamlined design,and it costs them less to build it. They also have really advanced technology, including auto-replenishment of their inventory. So,they have advanced analytics that tell themwhen they need to hit those replenish points and bring more produce back in,packaged goods, etc. So some of the human labor, in that instance,is not necessary.
But because the management team is incentivized to maintain a high ROIC, they started looking at their competition problem differently than they would have in a vacuum. After a lot of time -- and this is, I think, two years of comparable sales that have been slowing and slowing and finally went negative -- management decided, "Let's go ahead and approach the problem not from a price and competition standpoint but from a capital standpoint." You can see,if your bonus was also dependent onproducing high ROIC, you might also come to theconclusion that a lighter footprint store, a smaller store,might be the answer, versus justopening up more and more of these gigantic 50,000 square-foot stores.
Shen: Yeah,absolutely. And the beauty with the whole idea,this concept of the 365 by Whole Foods, it kind of hits thekey challenges they're being presented with from the competition. The in-house brand offers arguablymore competitive pricing, lower pricing, than their flagship stores. Then, they have this smaller footprint. The small store basically allows them to open up in more locations, opening up the number of consumers that have access to one of their store locations in general. That convenience factor, and the price factor, are going to be really important for them.
Sharma: Agreed. If we've got just a minute on this topic, I'd love to make one more point on this relationship between the customer interaction and ROIC. That is, if you fast forward, let's say 10 to 15 years, and you're in management's shoes, you have customers, like you just described, who really take to this format for convenience and price. But you have to start upgrading the stores, because after 10 years, they start to look a little stale.
Well, the cost to replenish that look,to renovate the store, to rehab the stock is a lot less when youreduce the cost of capital to begin with,when you've made the store smaller,when you've gone for light or lessexpensive materials, than it is versus thetraditional Whole Foods Market 50,000-square-foot store. This isthe power of paying attention to return on invested capital, sort of evergreen profits for your company. There areeconomic costs to everything. If you'reefficient today, you can be even more efficient down the road, and keep churning out agreat economic profit.
Shen: That is anawesome point. I was thinking about this more so from the beginning,the fact that opening these new storesis going to be less capital intensive. But 10 years down the line, taking that long-term, more Foolish outlook -- I'mreally glad you brought that up,because that is a really good point. Taking thisperspective that management is focused on with ROIC, it pays dividends down the line,obviously.
On that note, for this last topic whichI want to spend a little bit of time onbefore we have to wrap up here, is a company that,based on our conversation,seems to be a gold standardin regards to this metric, and has done really well. This is in thehospitality industry, specifically the hotel business, whichI think is really well-suited to our discussion. Obviously,when you think of building a hotel, it'svery capital intensive -- somecompanies will spend hundreds of millions, if not billions, of dollarsrenovating properties or building new ones. Butit's not as simple as that. Thecompany we're talking about isMarriott International.
Sharma: Correct.Marriott International is a brand that has its roots in the early 20th century. For those of us who of are a certain age, like myself,full disclosure here, mid-40s,I can remember whenHoliday Innwasthe brand you went to when you were on vacation. This was the early 1970s. But Marriott was the place you stayed in occasionally. It was a higher-end brand, and still is, and it's continued to polish its own brand and acquire other very respected brandsin the hotel industry.
What it's done is it's transitioned from being an owner-operator of hotels to now primarily a franchisor that also manages properties. So,they also have some property management revenue. It has a stable of luxury brands,including Ritz-Carlton and very manylimited-service brands whichall of us are familiar with, includingCourtyard and Residence Inn. I'd like to read a statement for our listeners whichhas to do with return on invested capital. This is from Marriott's CEO, Arne Sorenson. This wasin the company's quarter two press releaseissued just a few weeks ago. Sorenson says, "Ourbusiness model remainsfocused on managing orfranchising the finest hotel brandsaround the world. This asset-lightstrategy minimizes ourexposure to economic cycleseven as our brands grow their distribution."
Vince,I'll be quiet now and let you jump in,I just wanted to say that this sort of encapsulateseverything we've discussed today, this approach to thinking about your assets and trying to get a greater and greater return on them.
Shen: Absolutely. I wasreally surprisedas I was learning more about this company. It wasn't one I've followed as closely,but doing the research for the show,I was blown away to see that in their filings,the company operates over 1,000 properties, some 30,000 rooms, owns six of them. Then, itsfranchised properties, on top of that, amount to 3,000, another 420,000 or so rooms. But,you can see how the model has transitioned to where now,it's not as much owning it butmaking money from the royalties that they get from franchises, themanagement fees, theincentive fees. It's a really interestingexample. I'll let you wrap it up,but I think it's really important to quantify it,how strong the results are that they've beenable to put up with this metric for ROIC.
Sharma: Marriott is sort of quiet friend, isn't it? We know it's there, butmany of us don't spend a lot of time looking at the stock. But the stock is up 150%in the last five years,and it's no coincidence that Marriott's ROIC hasskyrocketed over the same period to 50%. That is anincredible return on invested capital. Byemploying this strategy,management understands thatthey have a smaller and smaller capital base, greater and greater revenue,that return will increase. Shareholders love it.
One last pointto wrap up today's conversation -- we'll stick with Marriott --it's important to trace how your assets may change over time. When you see you'redeveloping intangible assets, like a really great brand, then it's time toconsider whether you should still be investing in the hard assets like the hotels. And Marriott gets that. They want tolicense their name,and let other people take the capital and take the risk,and just collect those royalty checks. If you'refamiliar with the hospitality industry,you probably know the term "flag". It's what insiders use to describe the various properties. And Marriott has a reallydesirable flag because of their reservation system. If you'reout building a new hotelat the edge of a very robust metropolitan area, you want to be on Marriott's system,because you're almost guaranteedenough occupancy to be profitable. So,management leverages that by saying, "Yeah,go ahead and build it, we'lllet you have our trademark, send us a check every monthand everyone will be happy."
Shen: Alright, thank you Asit. Really great takeaway at the end there.I really like the three companies we were able to talk about intrying to put this metric into context. Otherwise,thanks again for coming on the show, and I really look forward to having you on again soon.
Sharma: Same here. And listeners, we're out of time,we can't do the pop quiz,but be ready next time we do back to school. Thanks Vince,great to chat with you.
Shen: To continue on thatwonderful theme, you can come to office hours via Twitter @MFIndustryFocus, or send us any questions or comments via email at IndustryFocus@fool.com. People on theprogram may own companies discussed on the show,and The Motley Fool may have formal recommendations for or against stocks mentions,so don't buy or sell anything based solely onwhat you hear during 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. Vincent Shen has no position in any stocks mentioned.Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Buffalo Wild Wings, Costco Wholesale, Marriott International, and Whole Foods Market. 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.