Delivery and the Future of the Restaurant Industry

On this episode ofMarket Foolery, Chris Hill and David Kretzmann turn their attention to the latest news from the casual dining segment: Jack in the Box(NASDAQ: JACK)wants to spin off Qdoba; Red Robin(NASDAQ: RRGB) turned in an earnings beat; and McDonald's(NYSE: MCD) has added a number of big cities to its delivery pilot program. The team also looks atTarget(NYSE: TGT)and the big box retailer's prospects in e-commerce, small-format stores, and more.

A full transcript follows the video.

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This video was recorded on May 17, 2017.

Chris Hill: It's Wednesday, May 17th. Welcome to Market Foolery. I'm Chris Hill. Joining me in studio today, from Rule Breakers and Supernova, David Kretzmann. Happy Wednesday!

David Kretzmann: Good to see you, Chris.

Hill: Good tosee you. It's a happy Wednesday for fans ofcertain NBA franchises.

Kretzmann: Our franchises. It was agood night last night.

Hill: Ifyou're a Celtics fan,it was a good night. If you're aSacramento Kings fan,good news out of the NBA draft lottery. Here'shoping our respective teams don't screw it up.

Kretzmann: So far, so good.

Hill: I've made this comment before --one of the things I love about opening day for baseball,one of the things I love about the draft,particularly for the NBA and the NFL, is kind of like investing, hope. Hope springs eternal when it's opening day in baseball and the same for NBA and NFL drafts.

Kretzmann: A wholeopen field of possibilities.

Hill: Yes,before ultimately --

Kretzmann: Thedisappointment continues.

Hill: Really kicks in.

Kretzmann: Although,your Celtics have done pretty well.

Hill: They'redoing alright. We have some restaurantearnings we're going to get to, but let's start withTarget. Their first quarter profitscame in higher than expected, I would say significantly higher than expected. Same-store sales fell a little bit. It wasn't too bad. Management,I love this quote,pleased with Target'sperformance in light of "avery choppy environment." God, that's putting it mildly when you think about retail over the last 6 to 12 months.

Kretzmann: Yeah,it has not been an easy time for retailers or restaurants. Definitely a lot of changes anddisruptions happening forcompanies in thosespaces. Comps were still down 1.3% for the quarter, but Wall Street wasexpecting it to fall closer to 4%, so thisreally is a case of,it wasn't as bad as we thought, so we won't punish the stock.

Hill: And Ron Grossmade this comment on Motley Fool Money last week, we werelooking at, particularly last week, whenyou looked at some of the big general retailers,Macy's, Kohl's,J.C. Penney,that sort of thing, andthe results were so bad across the board. And Ron made the point that, some of these aregoing out of business. This is capitalism,not everybody gets a trophy. Andit's unfortunate for the people who are going to lose their jobs, butsome of these aren't going to survive. I feel like Target is in a position wherethey can be one of the survivors.I haven't looked too closely at what they're doing in terms of e-commerce lately. But it does seem like they've put up good enough numbers often enough that they're in better shape in general.

Kretzmann: Yeah. I think they're better-managed. Theydon't break out what percentage digital makes up of their overall sales, but for this quarter, digital sales were up 22%. It seems like,pretty consistently over the past year or two, their digital saleshave been going between 20% to 30% clip. That'snice to see. It's probably still apretty small portion of overall revenue. They'realso investing $7 billionover the next three yearsinto technology, improving their supply chain. They'reremodeling a bunch of stores, they're launching a small format concept where they'll have about 100 of those locations rolled outover the next three years or so. So, they're being moreproactive than a lot of retailers, which are justtaking the bad news as it comesand not really changing a whole lotin any meaningful way.

AndTarget is still in pretty solid financial shape. They generated almost $5 billion in free cash flow over the last year. So they'renot going anywhere. Theirdividend and share repurchases will be able to continue.I wouldn't be surprised if Target orWal-Martbuys someone likeWayfairor something,because I think this e-commerce battleis really going to heat up. And thesecompanies are only going to be able to do so much internally, as far as ramping up that e-commerce strategy. So I think, you'll see more and more companies, likePetSmartrecently buying,I forget what the name of it was, but it was the largest e-commerce acquisition ever. It might have been Essentially anonline pet food business. PetSmart spent several billion dollarsacquiring them within the past month.I think it's inevitable that you will seeWal-Mart, Target, and some of these other retailers that, despite the troubles, are still generating a lot of cash, and they have cash they can put to work buying some of those pure play online retailers.

Hill: I think the smaller footprint locations are going to be interesting to watch.I don't know if they've gone public with where the locations --I would be curious toactually walk through one of those and see how it differs fromthe big Target that's a few miles from Fool HQ, and seewhat they're doing differently, because like you said, done correctly, thatcould be something that they look to grow even more.

Kretzmann: Yeah, they'reexpecting to build 30 of them this year.I haven't looked into this too much,I would assume it's a similar strategy to whatWhole Foodsis doing with its small 365 concept, whereessentially you're able to get the storescloser to consumers.I think, especially for younger consumers, for the millennials, they valueconvenience more than anything else, andgetting those smaller stores with the key,essential, top selling itemscloser to consumers, that could be a good way to go.

Hill:Red Robin Gourmet Burgers first quarter, I know they loweredguidance coming into this report. But give themcredit for crushing the lower guidance.

Kretzmann: It worked.

Hill: It did work. Stock up 17% this morning. This is a company you knowbetter than I do. How goodwas this quarter?

Kretzmann: The quarter itself was OK. Kind of a similar case toTarget, where it wasn't as bad as Wall Street was expecting. And their guidance is promising. And I thinkthis is a company that --

Hill: Guidance for the rest of the year?

Kretzmann: Yeah. Theyraised their guidance a bit withearnings per share. They're expecting earnings per share to come in about $3 this year, which is close to their peak earnings in 2015. So essentially, they're saying things are improving. Theyespecially expect things to improvetoward the second half of the year. This is a company that's beenproactive despite all the differentheadlines that have been going on in the restaurant industry over the past couple years. They're reallyputting a lot of effort into their digital efforts,online ordering, take out, things like that. I thinkWall Street recognizes that and is rewarding them for that. A lot of other restaurants, I think, are being left behind.

Selim Bassoul, who is the CEO ofMiddleby, Tom Gardner, co-founder and CEO of The Foolrecently interviewed Selim Bassoul, and Selim Bassoulessentially said the restaurants who are going to stick around arethe ones who are going to emulate Domino's, the pizzacompanies that have mastered andintegrated that digital, online ordering into their entire operations. Those are the restaurants that willbe able to stick around and thrive. And we've seen that with Panera, and I know we'll talka bit more about that. But I think Wall Street recognizes that Red Robin is putting out the effort there. One of the interestinginitiatives here,one of these things is a centralized call center for to-go orders, which juststreamlines that whole to-goordering process. 10% of theircorporate-owned stores offercurbside pickup, so essentially, you just drive to the store and they'llbring out your food for you. That will be rolled out in about 25%of their locations this summer. So just,different things like that. They're beingmore innovative than most casual dining chains.

Hill: Also,one of the things they talked about forthe conference call at Red Robin wasprices ticking up a little bit,and it was one of those things where I looked at that and thought,I think, if you are a shareholder, andcertainly if you're the CEO of the company, you're reallylooking to do that even a little bit more. They raisedprices something like 1.2%. That's the sort of thing where, that'sbetter than lowering prices, it's better than discounting. We'll get to discounting atrestaurants in a second. But if you can bump that up a little more,if you can do that a couple quarters a year,then it starts to have a meaningfulimpact on your gross margins.

Kretzmann: Yeah, and that offsets thetraffic losses that a lot of restaurants,especially casual diners,have been seeing. Giventhe initiatives that they're doing, I thinkcustomers right now value conveniencealmost more than anything else. They like being able to order online or call in acustomized order. And when they do that, theytypically order more stuff, too. So it bringsyourself to the customer. Then,ideally, as you get more peoplegoing through those stores,even if it's virtually, the volume of sales that those stores generate goes up,and your margins really improve. So I think Red Robin is positioning itselfin a good place if they can keep that traffic going.

Hill:Jack in the Boxsecond quarter profits came in higher thanexpected, which is fine. That's always nice. ButI think what's really pushing the stock up 5% to 6% today is the news thatJack in the Box has hired Morgan Stanleyto help explore thepotential sale of Qdoba.Jack in the Box is the parent company of QdobaMexican Eats.I think they have, and I'm ballparking here, roughlythree times as many Jack in the Box burger places as they doQdoba Mexican restaurants. There area couple things I don't understand about this.

Kretzmann: Me too.

Hill: [laughs] I was hoping you were going to have all the answers.

Kretzmann: I wish.

Hill: Lenny Comma, the CEO atJack in the Box, when he talked about hiringMorgan Stanley, he said of Qdobarelative to Jack in the Box,they have two different business models. Really? Because they're both restaurants.I understand that they're two different foods. How are they two different business models?

Kretzmann: That'sa very good question. Yeah,I don't understand the logic there. They have a very loose definition of business model,because yeah, you're selling food.Jack in the Box is more your traditionalquick serve restaurant, or fast foodrestaurant. Qdoba is more the fast-casualrestaurant that emulatesChipotle. But at the end of the day, they're both selling food,customers are paying for the food the same way. So I don't see them being different business models as a very goodreason to justify looking to spin it out.

Hill: Ifyou go back three or four years, thestory with Jack in the Box, in terms of whatever theirquarterly earnings report was,basically went like this: same store salesat the burger places up 2% to 4%. Samestore sales at Qdoba up double digits, anywhere from 10% to, in some cases, closing in on 20% same store sales growth.Qdoba was really carrying the water for this company for a long time.I guess I question the timing of this in part because, yes,same store sales at Qdobafor this quarter and the last couple,not doing as well as Jack in the Box. But wasn't the time for this move a year ago, when Chipotle was on the ropes? If you'reJack in the Box and you're thinking, "OK,what's the maximum value we can get from spinning this off?"I feel like it was a year ago whenChipotle same store sales were falling through the floor.

Kretzmann: Yeah. In theCEO comments you mentioned, he said it's become more apparent to them that Jack in the Box'svaluation is impacted by having twodifferent business models, andthat's just a head-scratcher to me. That implies that Qdoba is bringing down Jack in the Box's value, becausethey have struggled in the past year. Buta lot of restaurants, fastcasual in particular, have struggled. But Qdoba's same store sales grew 6% in 2014, almost 10% in 2015. Then, they only grew 1.4% in 2016, and they actually dropped in this most recent quarter. Butthat isn't out of the ordinary forvirtually any restaurant that isn't Domino's. So this really seems like a case where they'reditching it atprobably the worst possible time.I just don't understand the logic here. And in general, with a spin off like this, whereI don't think the business models are all that different, I thinkhaving this kind of diversification isactually a good thing over time because they'll have one concept that does well in certain quarters, like Jack in the Box now, you'llhave some that do better like Qdoba a few years ago. It's like Chipotle being spun out ofMcDonald'sworkedso well for McDonald's, so let's do the same thing and spin out Qdoba. I have a hard time seeingthe logic here, because the implication that Qdoba is pulling down the valuation of the overall business, it's like,a couple years ago, it was probably propping up the valuation whenthings were going really well. Now,suddenly that things aren't rosy for Qdoba,which isn't a Qdoba-centric problem,this is an industry problem, just makes no sense to have that be the main logic for looking to spin it out. The timing, I think, is really questionable.

Hill: And we touched on discounting before. When you look at Qdoba's results, the companytalked about how they have been doing some discounting. ButI think that goes right in line withwhat you were saying. When you look at restaurants in general over the last 12 months,it's not like Qdoba is the only one out there doingdiscounting trying to get people in the door. So,I don't know, it seems like they are ...I don't want to call it a panic move, because I don't have a good enough sense of this CEO and this management team toattribute that. So I'm not calling it a panic move. Butit really does seem like they are not going to get the value out of this spin off that they would have gotten if they had done this, oreven contemplated doing it, 12 to 18 months ago.

Kretzmann: Yeah, this really feels more like selling at the bottom. It'sprobably not quite panic mode, but yeah,if you were interested in spinning it off, the time to do it is when things are doing well. ToMcDonald's credit,Chipotle wasknocking it out of the park, theirgrowth was phenomenal, theirnumbers were phenomenal. So McDonald's probably maximized their value, to an extent, withChipotle. AlthoughI don't know if anyone atMcDonald's really thinks that was the best decision,given how Chipotle hassucceeded. I think,if anything, if I was Jack in the Box, I would first see,maybe we should shift the management or the strategy withQdoba, reevaluate thatbefore you jump to spinning it off or selling it as a solution. I thinkthis kind of diversification makes sense. You seerestaurants going out of their way todevelop new concepts now,whether it'sBuffalo Wild Wings, Chipotle,virtually every restaurant you can identify,even Red Robin,they have a fast-casual concept they'redeveloping. So, this seems to be bucking the trend at a bad time, andthe strategy doesn't make a whole lot of sense to me.

Hill: I'm glad you mentioned McDonald's, becausethey're in the newsnot because ofearnings but because of the delivery thatthey have been testing in a few locations in Florida. They are nowrolling out delivery in Los Angeles, Chicago,Phoenix, and Columbus, Ohio. They'redoing it through Uber's UberEATS service. I'm curious how you view delivery, and I think to the point you made about Selim Bassoul at Middleby and his comments -- for those unfamiliar with Middleby, they aremainly in the oven business, so chances are,if you've gone out to eat in the United States in 2017, chances are your food was prepared in a Middleby oven. I think he's definitely onto something. I mean,this is an industry he knows very well, soI'm not going to disagree with him abouthow crucial delivery is going to be. From yourstandpoint,David, I'm curiousif you have a thought on what the betterstrategy is? In the case of McDonald's, they'repartnering with UberEATS. You see some places that are opting to build out thisdelivery network on their own.GrubHubis essentially a business built on going torestaurants and saying, "Don'tworry about delivery, we'll do it for you." Andcertainly, that stock is having a monster 2017. So do you see any particular strategy, onebeing better than any other? Ordo you just look at it and say, lookdelivery is important, how you execute is up to you but you'dbetter have a strategy?

Kretzmann: There was someinteresting discussion on this in Red Robin's conference call. Up to this point,Red Robin has used three of those third-party delivery providers. So they'renot doing it on their own.

Hill: Threeseparate ones?

Kretzmann: Threeseparate ones and about 138 locations. The CEO said, seamless isnot exactly how I would describe ourexperience with those third-party providers,because integrating those third-partyproviders with their payment system, their ordering system,it's a little clunky. They said the delivery times have often beennot as promised, whichdisappoints the customers, andobviously that's not great for Red Robin's brand. So it seems like right now at Red Robin,they basically said, "We'reopen to other alternatives, becauseclearly what we're doing now with these third-party providers isn'tworking as effectively as we would like." AndI contrast that with Panera,which I think is a great example of a company that went from zero delivery and now they're going all in on their own in-house delivery. I really think that's the model that will reward these companies over the long-term the most. You look at howDomino's, which is crushing it quarter afterquarterdespite the restaurant slow down,I think a huge part of that is because theydeveloped their own point of sale system,essentially their own internal system, to manage payments and orders, their ownproprietary system. Panera has started to do the same thing.

And that just makes it a seamless experience for customers, wherever you arein the country or the city. You don't have to order through a separate delivery company, youdon't have to change your payment information,especially, have a loyalty program likePanera, which has 25 million members, itmakes it so much easier as a consumer whenyou have that consistent experience wherever you are,and I think it makes it a much stickier experience, too, wheneverything is done through the company. And that raises repeat orders, which is,at the end of the day, what these restaurants need to bump up their margins and volumes. So I think most companies probably won't go that route initially, because that's the tougher route,because you do have to reinvent yourself,especially if you're a casual dinerlike Red Robin or more of the fast-casualcompany like Panera. So I think, initially, you're seeing a lot of companies going with these third-party providers. But at the end of the day, to maintain full control over the brand, the experience, and ideally building a loyalty program, which,as we've seen withStarbucksand Paneraand Domino's that's beena huge factor in theirongoing success, despite the restaurant slow down. I think keeping it in house isinitially the harder move, but it's the one that makes the most sense. But it will be interesting to see how it shakes out. I'll leave it at that.

Hill: As you said,it's definitely the harder move. It also seems like if you do it right, it's the much more rewarding move.

Kretzmann: Yeah. Ifyou can pull it off. And it really doesrequire a reinvention. It can't just be a tack-on item to the business. That is one concern I have withChipotle and some of the other companies that are justrelying on these third-party providers.I just don't see that being a consistent experience. Theeconomics of it don't really make a whole lot of sense for the company. Unlessyou have it going through your own internal system, whereyou can really promote additional offers or something, you don't want the third-partydelivery orders to just be replacing peoplegoing into the store. Wheredelivery gets very profitable is if people say, "I'llbuy the salad and the breadsticks inaddition to the pizza." That's where you really get additional volume and your margins bump up. But ifsomeone is just buying the same thing they would have gottenif they walked into the store, that's going to cost,because these companies have to pay the third-party providers, who need a cut of that transaction. That'ssome of the headwinds thatRed Robin has run into. They mentioned, theeconomics of delivery are not that great,on top of everything elsewith the consistency of the experience, whichhave not been very consistent. So I likecompanies like Panera,even though they're few and far between that aredeciding to go all in and keep it in house.

Hill: David Kretzmann,thanks for being here!

Kretzmann: Thanks for having me!

Hill: Asalways, people on the program may have interests in the stocks theytalk about, and The Motley Fool may have formal recommendationsfor or against, sodon't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! We'llsee you tomorrow!

John Mackey, CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Chris Hill owns shares of Chipotle Mexican Grill, Starbucks, and Whole Foods Market. David Kretzmann owns shares of Buffalo Wild Wings, Chipotle Mexican Grill, Domino's Pizza, Middleby, Panera Bread, Red Robin Gourmet Burgers, Starbucks, Wayfair, and Whole Foods Market. The Motley Fool owns shares of and recommends Buffalo Wild Wings, Chipotle Mexican Grill, Middleby, Starbucks, Wayfair, and Whole Foods Market. The Motley Fool owns shares of Panera Bread. The Motley Fool has a disclosure policy.