Zoe's Kitchen and Yum China Attract Buyers in 2 Very Different Markets

Fast casual dining has been all the rage since Chipotle exploded onto the scene, but even that surging popularity wasn't enough to support all of the new restaurant openings since the financial crisis. Zoe's Kitchen (NYSE: ZOES) is just one of many chains struggling over the past few years with overexpansion, but a $250 million buyout has entered the picture.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and Motley Fool contributor Nicholas Rossolillo discuss the Cava Group's offer and plans for Mediterranean, fast-casual domination. Meanwhile, rumors are buzzing that Yum China (NYSE: YUMC) could soon become the largest consumer buyout in China's history.

A full transcript follows the video.

10 stocks we like better than Zoe's KitchenWhen investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has quadrupled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Zoe's Kitchen wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of August 6, 2018

This video was recorded on Aug. 21, 2018.

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. It's Tuesday, August 21st. It's been a deal-heavy month across the consumer and retail space. We're going to take a closer look at two of those deals, one announced and one still in the works, both of them in the restaurant industry. It's my pleasure to welcome a brand-new guest to Industry Focus today, Mr. Nicholas Rossolillo, who's joining us via Skype from Spokane, Washington. Nick has been a Fool.com contributor for over three years. Great to have you with us, man!

Nicholas Rossolillo: Hey! Thank you, Vince!

Shen: This is your first time on Industry Focus. I think a quick intro is in order, so our audience has a better sense of who they're listening to. Can you tell us a little bit about yourself, your investing journey?

Rossolillo: Sure. My investing journey. I was a weird kid growing up. I worked all through high school, pushing the lawn mower around the neighborhood, I washed dishes, bussed tables, and I saved all that money. My parents told me I should probably open up a brokerage account. As a happy graduation gift to myself, I walked into a local brokerage firm with a check in hand, and I left with a job. That's how I got into investing, and here I am today.

Shen: Awesome! I'm curious, what was your first stock purchase?

Rossolillo: My first individual stock purchase was Visa, shortly after they debuted back in 2007, I believe it was.

Shen: Oh, wow! Good choice!

Rossolillo: Yeah, it didn't work out too bad.

Shen: Again, very pleased to welcome you to Industry Focus. I want to get the discussion started. As I mentioned previously, it's been a deal-heavy stretch in consumer and retail. Even just yesterday morning, PepsiCo announced the acquisition of Israel-based SodaStream for $3.2 billion, in their hopes of pushing further into healthy beverage offerings. SodaStream reported second quarter results on August 1st. Stock jumped 26% following that report. The $144 per share offer from PepsiCo adds an additional 11% premium to last Friday's close. Overall, the rally and end result for a lot of SodaStream shareholders must be pretty sweet, as the stock was trading at less than $60 per share at this time last year and not even one-tenth of the buyout price that PepsiCo offered in early 2016. Chris Hill covered the deal yesterday on Market Foolery. Check out his discussion, as they go into a lot more detail than we have time to do here.

For today, we have restaurant-specific deals in mind. The first one, announced last Friday, was for Zoe's Kitchen, the Mediterranean-inspired fast-casual chain. This isn't a really big deal, $250 million, but the Zoe's Kitchen journey since its 2014 initial public offering, has been a bumpy one. It serves as a very appropriate case study that's representative of the ups and downs that a lot of restaurant chains have experienced in the past several years.

Before we dive into the Zoe's story specifically, I want you to hop in here, Nick, and paint the backdrop for us. There's a lot of forces at play coming together to influence the direction of not just restaurants but a lot of other consumer-facing industries. Can you tell us a little bit about that?

Rossolillo: Consumer goods in general, specifically of the discretionary nature, like restaurants, a lot of it has to do with technology. New technology like video streaming is keeping people at home. Lots of new options in the entertainment space. Also, changing consumer trends has affected restaurants. Lots of consumers are focusing on healthier options, higher-quality options, more variety -- and of course, all of that without sacrificing convenience. There's been this push for things like digital ordering options, new delivery options, both from restaurants themselves and also third-party delivery. Think Uber Eats. Then, in light of all these changing trends, the restaurant industry hasn't helped itself much, either. Since 2008, post-financial crisis, the number of restaurants in America has really, really exploded. The fast-casual segment -- higher-quality food but still in a quick setting -- has really blown up.

What's happened, though, is they've over-expanded. Specifically starting in late 2015, early 2016, that became apparent as all these new locations started to cannibalize foot traffic from one another. We've had, for over two years now, same-store sales growth has declined. That leveled off this year. But a lot of that's been because of price hikes on the menu. Foot traffic growth continues to be elusive so far this year, according to industry group TDn2K.

Shen: And that's across the restaurant industry.

Rossolillo: Yeah, across the whole restaurant industry. Foot traffic down 2% still this year. Then you add in other things, like heavy discounting that comes into play when you have your foot traffic down at your restaurant. Wages are on the rise; food costs are on the rise. Really difficult environment for restaurants, the last couple of years.

Shen: Absolutely. You mentioned a lot of different forces coming into play there. Listeners, you'll get a sense of how that all plays into the Zoe's story as we get into more detail here.

A private equity firm, Brentwood Associates, they acquired a large stake in Zoe's back in 2007, when the chain operated less than 20 restaurants. By April 2014, when the stock debuted at $15 per share, Zoe's had expanded to over 110 locations. With that IPO, shares popped 65% on their first day of trading. Not too long after that, by mid-2016 -- about two years later -- the stock had nearly tripled from the IPO price to about $40 per share. At that time, Zoe's was still expanding to new markets. It was quickly approaching 200 restaurants. Management envisioned doubling the store base to 400 locations by 2020, with an ultimate goal of as many as 1,600 total locations.

But as quickly as the stock rallied, it was, again, another two years later -- 2018 now -- we have shares trading below $9. The current buyout price that was offered was just $12.75 per share. That's still good for a 33% premium over the last closing price before the deal announcement.

Nick, you've been following Zoe's for quite a few years. I'm curious what your take is, in terms of what happened and why the stark reversal, in terms of the restaurant's outlook in just that two years' time.

Rossolillo: Right. A couple of things at play. Zoe's is expanding. Management has delivered on that initiative. They're up to 261 locations. That was per the announcement that they last made on Friday. A lot more stores than they had a few years ago, when they debuted as a public company.

But a lot of those new locations, Zoe's has kept in its home market. At 261 restaurants, it's still a pretty small chain. They're also a regional chain. Most of their locations are in the southeast quadrant of the United States, with just a handful outside of that area. As far west as they've made it is a few restaurants in Arizona, a few in Colorado. Rather than go nationwide with the concept, management chose to keep it in the Southeast. There's been some dispute over whether that has been a good idea, as maybe they've started to step on ...

Shen: Each other's toes, in terms of the store locations?

Rossolillo: Yeah, on these locations' toes. They're stealing sales from themselves, essentially.

Shen: What do you think about the rapid expansion pace? In just four or five years, they've essentially doubled their store base multiple times. With that, I know that management has spoken before, when they initially started running into weaker results, how the newer restaurants needed more time to develop their business, get their feet beneath them, so they could see strong results. But that doesn't seem to have panned out, right?

Rossolillo: No, not yet. Again, going back to this last report from Friday, Zoe's is still posting negative same-store growth, down 2.4% so far in 2018 compared with last year. That's on top of the 2% decline in 2017. Yeah, the existing stores are not doing well. In addition to that, management also said that they've identified 30 underperforming restaurants in the quarter that they're basically going to write off as a loss. They're never going to get their investment back in those locations. The company took a $16.3 million impairment charge in the second quarter.

Shen: Again, that speaks to the struggle we're seeing here across the restaurant industry, with the overexpansion here. The growth that Zoe's was seeing initially was really strong. It surprises me still how quickly results turned for the worse here. At the end of fiscal 2016, Zoe's reported its 28th consecutive quarter of comparable-store sales growth. Those comps had been slowing from high single-digit levels earlier in that year to below 1%. But then, from 2017 on, five out of six quarters have been negative for the comps. And this isn't a situation like Chipotle, where there's this obvious roadblock or catalyst for the decline in results. It was really these broad industry headwinds coming to play.

In terms of the stock itself, the decline that we've seen, that tends to happen when a stock rallies on really hot growth expectations. At its peak, Zoe's' stock was trading at over 350x earnings, plus very thin profitability. Next up, we're going to take a closer look at the acquisition, the buyers, and then the outlook for the new entity.

Alright, let's move on to the deal now. We have a little bit of this backdrop, this context for Zoe's, where it's come from since its IPO in 2014. After just over four years as a publicly traded company, it's being taken private again.

At first glance, it's an odd situation, because Cava Group, the buyer, is a smaller chain with only 66 restaurants to Zoe's 261. I'm a huge fan of Cava, which has over 15 locations around D.C. alone. You'll catch a lot of Fools grabbing a bite to eat there. It's really the buyers, I think, that make this such an interesting transaction. Can you tell us a little bit about the story there?

Rossolillo: Yeah. Cava Group came in with an offer of $12.75 per share for Zoe's to take the company private again. That values the company at $250 million, below the debut IPO price that you mentioned earlier for Zoe's investors. For long-term investors, probably not a lot to be happy about here. However, given the report on Friday and seeing that Zoe's numbers continue to deteriorate, things may have been about ready to get worse before they got better. This could be some short-term reprieve for investors in the company, with this buyout press release.

It's also interesting, just this morning, several institutional investors have come out and actually said that they think that this $12.75 per share price is too low. Part of this deal is that another suitor can come in within the next month and offer a higher bid for Zoe's. It'll be interesting to see if someone else does come in and say, "Hey, we actually think this company is worth more. There's more potential than this $12.75 share price that's been offered so far."

Shen: I'll add to that, this go-shop period for Zoe's, it's about a 35-day period where they can basically go out and seek other buyers and potentially higher bids for the company. An interesting development, in terms of this deal. But on the other side of that, in terms of this deal value and who might be really happy about that, we have, on Cava's side, its CEO, Brett Schulman, he's going to take the reins for the combined company. They did not have the funds to come up and make this deal by themselves.

They're also getting a big equity infusion from Ron Shaich, who's taking the chairman position. If that name sounds familiar, it's because Shaich was the man essentially behind Panera Bread, former CEO. That company was bought out last year. Since then, he's formed this fund, Act III Holdings. They're focused on finding these niche opportunities in the restaurant industry and consumer-facing industries. When it comes to the restaurant fast-casual space, Mediterranean cuisine definitely seems like a ripe niche opportunity for them to jump on. You've managed to combine, here, two of the most popular names in this space, between Zoe's and Cava. I think having Shaich's guidance is going to be a major positive for Cava going forward, given his experience growing fast-casual businesses.

You mentioned previously, when we were prepping for the show, investors not being too pleased with the buyout price since Cava is coming in at the absolute lowest point, essentially, in Zoe's trading history. On the flip side, the value there, you definitely see that for Shaich and Cava. At least from what I've seen -- and I was talking with some Fools about this, too -- the number of candidates that we could think of putting in a better offer, a better bid for Zoe's, it's very slim. It would essentially be a tuck-in. Not exactly a lot of other restaurant chains in this Mediterranean niche that can really do this. It would have to be a completely new addition, essentially, for a bigger chain. Again, the prospects for that, I think it's great to have the option. I'm curious to see whether any bids actually materialize.

Rossolillo: That's the golden question right now. Who can do it?

Shen: Exactly. Final point, Nick, I'll ask you this -- if this deal goes through in its current form, what do you think is next for Cava and Zoe's? I know it will be a private entity, outside of the public market's view. I'm curious what you think some of the levers are that Shaich and Schulman might pull to bring Zoe's chain specifically back to growth. What can they do?

Rossolillo: Shaich obviously has a lot of experience in growing a national brand, a successful fast-casual brand. That's probably going to be a point of emphasis for Cava and Zoe's. Between the two, a little over 300 total locations but still only in 24 states total. Still lots of room for growth across the country. Then, obviously, shoring up those existing Zoe's locations that are confounding investors with those quarterly losses going on two years now. That's probably going to be the two areas of focus, is taking the brand national, getting more exposure out there to consumers, and then figuring out what's wrong with the actual business itself right now, that consumers are headed for other pastures.

Shen: Last thing I'll mention, which is covered in the release, is that, at least at this point in time, Cava has mentioned that they do intend to keep Zoe's as a distinct, separate chain, maintaining that brand name, since it does have, at this point, the bigger base and probably larger recognition. We will follow up on this deal once that go-shop period ends and see if things close in their current form.

We're running short on time, and I want to make sure we have at least a few minutes left to talk about our second deal. This one is still running in the rumor mill. It's in the early discussion stages. The target is Yum China. Asit Sharma and I touched on the strong results that Yum China has been delivering since it was spun off from Yum! Brands in late 2016. This is the largest restaurant company in China, with about 8,200 stores split between its KFC and Pizza Hut banners, as well as some small restaurant concepts.

Yum China would make for a much larger deal. Its current market cap is around $13.5 billion. That explains why the rumored buyers at this point include a full posse of companies or firms. They include China Investment Corp, which is a sovereign wealth fund; Hillhouse Capital, which is a private investment firm, pretty notable as an early backer of Tencent and JD.com; Primavera Capital, which already has a minority stake in Yum China; and then some additional private equity players.

This is another company, Nick, that you've been following since inception. On one hand, you have KFC, which enjoys leading market share among chain restaurants and a management team that ultimately envisions 20,000 locations as their end goal for the Chinese market. On the other hand, Pizza Hut continues to struggle -- weak comps, declining profits. Even KFC is losing some of its allure among certain demographics in China. What do you think are the most pressing issues, and also the big opportunities for Yum China right now?

Rossolillo: Yeah, pressing issues. China's a different animal from the U.S. market. Obviously, China's middle class is still growing and developing. Ultimately, this is not so much a story of declining same-store sales like Zoe's is, but more of, how many locations the company can actually grow. You mentioned KFC, doing well; Pizza Hut, not so much. The company also has access to the Taco Bell brand. It only has three so far, all of which are in Shanghai. There's a lot of different routes they can go to get to that 20,000 total stores in China that they ultimately foresee having. That's really the issue with Yum China.

Of course, Pizza Hut has been a drag. That's caused some weakness in share prices as of late as it underperforms.

Shen: It's a higher-end chain there, right?

Rossolillo: It's a higher-end chain in China, yeah. It's marketed as an upscale dining experience, if you can believe that, over there. The other thing that's happening is, same as here in the U.S. -- I think actually the U.S. is maybe echoing what's already been happening in China, as far as the digital movement, also the delivery movement. Most of the world's food delivery sales actually occur in China, and it's not slowing down. It's still growing by double digits. KFC, for example, well, 13% of sales were delivery last quarter. That number is still growing by double digits every quarter. That's the other thing that's been happening. As the company's trying to work in more delivery, that's a way for them to control their profit margins as they grow this massive new store base over the coming years. But, again, weakness in some of the brands has caused some weakness in share prices, and thus the private investor interest now in the company.

Shen: I'll add that, it's an interesting aspect of the operating environment for Yum China and the competing restaurant chains in that region, in that delivery is really big, but also, the technological capabilities and the infrastructure at the restaurants -- mobile pay is extremely common there. It's far more common than it is in the U.S. Kiosk ordering, things along those lines, are not as foreign to consumers there. To them, it's a perk and it's something they expect to see in a lot of their dining experiences.

Something that blew me away, I think Asit and I talked about this last year, is the loyalty programs that these two major chains have within Yum China, KFC and Pizza Hut. They boast together at this point over 150 million members. It's just a massive base for the company to work off of as they try and improve their operations, rebuild the Pizza Hut brand and the positioning of where that goes. Taco Bell, three stores, not even really a blip on the radar at this point. But if they can manage to grow that out, definitely a big part of their growth vision and the strategy.

Last point before we sign off -- if the potential buyers that we've talked about, all these private equity firms, the sovereign fund, if they manage to come together and make a deal happen for Yum China, I'm curious what you think they bring to the table specifically that can help Yum going forward, in terms of righting the ship for certain brands, or just growing KFC, or whatever it may be. What do you think?

Rossolillo: More than anything, it's probably just access to capital. This is more than double the number of restaurants the company currently has that it wants to build out in the years ahead. That costs money. So probably quick, easy access to capital to make that happen is the biggest thing they bring to the table. Outside of that, part of the reason for Yum China spinning off from its former parent Yum! Brands back in 2016 was so that it had more flexibility to control its menu to adapt to the unique market that is China versus the market here in the U.S. All of that has already happened, and the company has shown the value in doing that. Probably just the access to the capital, is what would be the compelling reason for the company to go private.

Shen: Well, and that second point, I think that's interesting. I've seen some reporting that there is some blowback from consumers in China regarding what are generally seen as these American brands. With that in mind, having a sovereign fund, for example, like CIC, buy in, adds, potentially, an air of legitimacy, and supports what can be a very nationalistic or patriotic consumer. Asit discussed that previously in his coverage of the company, and how that can add that additional vetting for the brand, and restore its popularity with KFC or Pizza Hut, whatever the chain may be within the country, being something else that, for example, a consortium like this, can help bring to the table with a lot of these investors based in the Asia region.

Alright, that's all the time we have today. We will be following up on both these stories, with Zoe's, as the go-shop period ends, where that goes; and then the Yum China story, whether a deal is announced or not. Ultimately, with Yum China, the company is playing in a market with incredible growth potential before it even begins to approach the saturation and penetration of regions like North America and Europe.

Nick, it was a pleasure having you on the show. Thanks for being here, man!

Rossolillo: Hey! Thank you, Vince!

Shen: Thank you, everyone, for tuning in! People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!

Nicholas Rossolillo owns shares of Tencent Holdings, Yum China Holdings, Inc., and Zoe's Kitchen. Vincent Shen owns shares of Tencent Holdings. The Motley Fool owns shares of and recommends JD.com, Tencent Holdings, and Zoe's Kitchen. The Motley Fool owns shares of SodaStream and Visa. The Motley Fool has a disclosure policy.