An Inside Look at the New Whole Foods Market Concept: 365 By Whole Foods

As more and more people have adopted a healthier diet, natural and organic specialty grocery stores like Whole Foods Market (WFM) are finding that competition is catching on to the trend. What was once labeled a small, hippie niche of the food market is now going mainstream. Products from companies like Annie’s, once able to set stores like Whole Foods apart, can now be found almost anywhere. As a result, WFM is finding that it can retain its loyal customer base that is willing to pay a little more for higher quality ingredient standards, locally sourced products, and a wonderful in-store experience, but it is getting harder to find new customers. Many people are perfectly happy with their traditional stores and not very eager to pay any more than they have to for groceries. The result is that WFM remains a profit-generating machine, but sales per store have plateaued. The stock has also reversed course, currently trading for $28 per share, down about 50% over the last 18 months.

The company continues to open new flagship stores across the country, as there continues to be a significant amount of demand for the original concept. But in order to try and expand their reach across even more customer types, WFM has created the “365 By Whole Foods” store to grow alongside the core store brand. The country’s third “365” store recently opened in Bellevue, WA, not too far from my home in Seattle and I decided to go check it out. The company has said the goal was a smaller store with fewer SKUs, focusing on cheaper items (lots of generic store branded items) and lots of automation in order to keep development and operating costs low (which further allows them to be more aggressive on price). Here are some photos of what I found:

This location actually an anchor store in Bellevue Square mall, occupying what used to be a JC Penney. During mall hours, you can access the store directly via escalator.
This location is actually an anchor store in Bellevue Square Mall, occupying what used to be a JC Penney. During mall hours, you can access the store directly via escalator.

 

Modern design interior but not a lot of fancy fixtures. Probably costs a lot less to build out than a flagship WFM store.
Modern design interior but not a lot of fancy fixtures. Probably costs a lot less to build out than a flagship WFM store.

 

Rather than run their own in-store restaurant, 365 locations will partner with local chefs to bring in fast casual dining options.
Rather than run their own in-store restaurant, 365 locations will partner with local chefs to bring in fast casual dining options.

 

Same goes for the coffee counter... outsourced to a local Seattle company.
Same goes for the coffee counter… outsourced to a local Seattle company.

 

With the goal of lowering costs, digital signage was very prevalent, including all of the pricing labels. You need less staff if you don't need humans updating prices all the time.
With the goal of lowering costs, digital signage was very prevalent, including all of the pricing labels. You need less staff if you don’t need humans updating prices all the time.

 

Automation is a trend. Here is a do-it-yourself tea kiosk.
Automation is a trend. Here is a do-it-yourself tea kiosk.

 

Weigh your own produce. Saves time at checkout and you don't get any surprises  on cost.
Weigh your own produce. Saves time at checkout and you don’t get any surprises on cost.

 

Whole Foods is known for their prepared foods and it is a huge money-maker for them (more than 10% of sales). Again, rather than not knowing how much your container will cost (priced by weight at regular WFM stores), now there is flat rate pricing.
Whole Foods is known for their prepared foods and it is a huge money-maker for them (more than 10% of sales). Rather than not knowing how much your container will cost (priced by weight at regular WFM stores), at 365 there is flat rate pricing.

 

WFM will sell some fast casual meals itself. Order and pay at the kiosk and it is sent to the kitchen for preparation.
WFM will sell some fast casual meals itself. Make your selections and pay at the kiosk and your order is sent to the kitchen for preparation.

 

I picked up my tacos at the back of the store when they were ready (computer monitors show your order's progress).
I picked up my tacos at the back of the store when they were ready (computer monitors show your order’s progress).

 

Craft beer is as hot in the Pacific Northwest as anywhere. No shortage of local brews to choose form.
Craft beer is as hot in the Pacific Northwest as anywhere. No shortage of local brews to choose from.

 

Interesting idea here; digital signage promoting the products on the aisles of the end caps. WFM makes money on advertising as well as actual sales. Smart.
Interesting idea here; digital signage promoting the products on the aisle end caps. WFM makes money on advertising as well as actual sales. Smart.

 

Overall, I was very impressed with the 365 store. Will it cannibalize regular WFM stores? Probably some, if they are close by. Will some people be attracted to the prices which skew to the lower end and are competitive with places like Target or Safeway? I think so. Will WFM see a strong return on investment on this store format? I certainly think so. The big question is how many stores like this the market can support and what others do in response. I am not sure anyone can pinpoint those answers at this point, but good for them for trying to address a clear hole in their store offering.

In the meantime, WFM stock is extremely attractive at $28 per share, in my view. At 7x EV/EBITDA and a history of opening stores that trounce the competition in terms of sales per square foot and profitability, I suspect WFM’s future remains bright and that the business will continue to be a cash cow. The stock price today does not really reflect such a viewpoint, hence my optimism.

Full Disclosure: Long shares of WFM at the time of writing, but positions may change at any time.

Ackman Investment in Chipotle At 3x Sales Is Far From A Bargain

I have written previously about how I do not find shares of Chipotle Mexican Grill (CMG) very compelling in the 400’s and recently we learned that Pershing Square’s Bill Ackman has taken a near 10% stake in the company. This move seems odd to me for a couple of reasons. First, the restaurant business is pretty straightforward, so it is unlikely Ackman engaging with CMG’s board is going to result in a dramatic strategic shift or business model pivot. I guess they could start franchising units, but that’s hardly a bombshell idea.

Second, and even more importantly from an investing standpoint, is the price Ackman is paying for a restaurant chain. At roughly 3 times this year’s projected sales of $4 billion, investors in CMG at current prices are not getting a very good deal. Before the company’s health-related issues, CMG was earnings a very impressive 21% EBITDA margin. The owned unit restaurant industry (as opposed to franchising-based) typically fetch about 8 times EBITDA in the public markets. Some quick math tells us CMG should trade around 1.7 times annual revenue. And that is before operating expenses increase due to new food safety procedures that CMG has now implemented. As a result, it is quite possible that the “new normal” for CMG is an EBITDA margin of less than 20%.

Many fans of Chipotle would likely argue that the company should trade at a premium valuation to the industry due to below-average build-out costs, above-average unit economics, and a reasonably loyal customer base. Okay, fine. Let’s give CMG a 50% premium and say it is worth 12 times EBITDA instead of 8 times (too high in my mind, but at least the case can be made). Even at the company’s old margin levels, investors would value CMG stock at 2.5 times annual sales, or about 15% below current levels.

It is really hard to see how Ackman sees this investment playing out, or how he thinks he can really move the needle by speaking with management. Customers are going to have to come back in droves to justify CMG shares trading at $500 or $600 per share. I love their food, but color me skeptical.

Full Disclosure: No position in CMG at the time of writing, but positions may change at any time

Leading Tech Companies All Chasing The Same “Next Big Things”

I miss the old days of tech investing. Times were simpler. Companies were more focused. There were one or two companies that tended to be dominant within a certain fragment of the industry. Google was search and online advertising. Amazon was e-commerce. Intel was chips. eBay was marketplace. Microsoft was operating systems and productivity software. Cisco was networking. Apple was high-end devices. Facebook was social networking. Netflix was movies. You get the picture. Oh how times have changed.

The tech landscape now has led us down a different path. Each of these companies has been extremely successful in conquering their home turf. They are all wildly profitable and have more money than they know what to do with. So they repurchase shares and pay dividends and buy startups to add talent and new technology. And after they do all of that they still have billions of dollars extra sitting around. What to do?

It appears the answer now is to become a tech conglomerate. Heck, if we took over one area of the marketplace, why not shoot for the stars? Why not be everything to everybody? So now when we talk about the leading tech companies (Apple, Facebook, Google, Amazon, Microsoft) the future looks far less predictable.

In the old world Tesla would be the de facto electric self-driving car play. But Google is building cars. So is Apple.

In the old world Oculus would have been the virtual/augmented reality play. But in the new world Facebook acquires them and then Microsoft and Apple and Google all start working on the same thing.

In the old world Netflix would be the benchmark for streaming video. Nobody would argue that households looking to get rid of their $100/month cable bills would substitute them with a half dozen individual services that cost $10-$20 per month. The expensive cable bundle is no worse than a bundle of Netflix, Amazon Prime Video, Hulu, HBO Now, YouTube Red, and CBS All Access. And as if there are not enough competitors vying for your TV dollars, it was recently reported that Apple has decided it has identified the next big thing; producing original TV content. Are you kidding me?

I understand that self-driving cars and streaming over-the-top video and virtual reality could all very well be huge markets over the long term. But everyone can’t be a winner. Do you really think GM and Ford lack the ability to produce self-driving, electric cars? Are the Big Three auto makers going to be replaced by Apple, Google, and Tesla a decade from now? Are we really going to cancel our Comcast service and pay the same amount of money for less content by buying subscriptions to 6 or 8 streaming services?

The leading tech companies got to where they are today by being laser-focused on creating or improving upon one big tech trend. Becoming indispensable in that arena has made them billions of dollars and created a ton of shareholder wealth. They did not win out after a long, brutal battle with the other tech titans at the time.

The biggest risk to Apple, for example, is that the innovation they are focused on revolves solely around virtual reality, electric cars, and streaming TV and movies. That is not how Apple became Apple. And it is not the secret for them to stay at the top. The same goes for Google and Microsoft and Facebook. As long as these companies are battling against each other, as opposed to paving their own way to the future, I am afraid that those of us hoping for the next big thing to come out of the mega tech stalwarts may be disappointed. To truly develop a market-leading position you have to try something new and do so long before everyone else. Nobody is likely to catch Amazon in the public cloud computing space (although Google and Microsoft are trying, of course). They are years ahead because they saw the trend before anyone else and went all-in to the number one.

Chipotle Identifies The Next Big Thing in Fast Casual Food: Burgers, Fries, & Shakes?

Is there a bubble in fast casual restaurants in the United States? More specifically, is the burger chain craze starting to look a little frothy? Chipotle (CMG) announced this week that it is launching Tasty Made in Ohio, a new chain focused on burgers, fries, and shakes. They must see burgers as being an underpenetrated market that they can exploit with their simplified, customizable fast casual concept (he writes sarcastically). In reality, the burger space is getting very crowded, very quickly. For those chains with grand expansion plans I would be careful. For the commercial real estate developers who continue to build higher end, mixed use buildings with the expectation that they can quickly secure leases with fast casual chains due to their ever-growing desire to blanket the country, I would be careful. I don’t know when we will reach oversaturation in the fast food/fast casual restaurant segment, but we will. The population is simply not growing fast enough (less than 1% per year) to support high sales volumes and profit margins at all of these locations.

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This move by Chipotle is a bit odd considering the competition. In contrast, the company’s ShopHouse Kitchen Asian concept has far less competition (Noodles & Company and that’s about it in terms of national chains) and only 15 locations nationwide. Given that Chipotle has over 2,000 U.S. burrito restaurants, coupled with the insane growth in the burger space right now, it is bizarre that they feel this is the ideal time to launch the Tasty Made brand. Not to mention that the company also has a pizza concept called Pizzeria Locale with less than 10 locations open or under construction.

Ironically, Chipotle’s relentless focus on simplicity in its restaurant operations does not seem to be spilling over to the company’s growth plans at the corporate level. With average unit volumes down 20% at the namesake brand, the company has a lot of work to do. The competition is intense already and adding new concepts in crowded sectors of the market seems like a questionable decision at this point in time. The high valuation on the stock right now is already a red flag, but now investors might start to question management’s game plan.

It will be interesting to see how this all plays out. So what do you think? Is fast casual growing too fast? Are we approaching “peak burger?”

Full Disclosure: No position in CMG at the time of writing, but positions may change at any time

Consumer Trust Far From Only Issue Hampering Recovery At Chipotle Mexican Grill

The “we can do no wrong since we already got people sick” trading patterns in shares of Chipotle Mexican Grill (CMG) are continuing unabated after the company reported second quarter earnings that showed a tepid traffic recovery. As you can see from the chart below, Chipotle stock has been hanging in the 400’s this year despite a slower than expected return of the company’s loyal customer base. It seems like the stock only treads water or rises even as the business is clearly struggling. Today is no exception, with shares jumping to 5% to $440 each despite a 23.6% decline in same store sales for the second quarter.

cmg

Despite the headwinds facing the company, investors continue to assign the stock a premium earnings multiple. The stock currently trades for roughly 3 times peak sales ($4.5 billion of revenue was booked in 2015), 30 times peak earnings ($15 per share in 2015) and over 13 times peak EBITDA (2015 EBITDA was ~$925M). Essentially, investors are willing to pretend that nothing has happened and recouping all of the sales and profit losses is a foregone conclusion.

I would not be so quick to discount Chipotle’s challenges. There are factors that could easily result in the company never reaching its former level of annual sales per unit ($2.5 million). First, consider that CMG continues to open new units at an aggressive pace (about 225 new locations per year). With more than 2,100 locations nationwide, continuing to open a new one every 39 hours will surely result in store cannibalization. In fact, during the second quarter same-store sales improved versus the first quarter (-23.6% vs -29.7%) but sales per unit actually declined further ($2.07 million vs $2.23 million). As more and more locations are opened, it will be harder for CMG to get that metric back up to $2.5 million.

Second, the sheer volume of new fast casual restaurants being opened (both new concepts as well as the expansion of existing ones) means that Chipotle faces more competition than it ever has. Customers who stopped eating there during the safety scare may have simply found other nearby options that they enjoy just as much. Humans are creatures of habit and if you give them a reason to break their habits (by getting people sick), it is entirely possible that their dining frequency will never return to the previous level, even after they feel safe to eat Chipotle’s food again.

All of this could spell trouble for Chipotle investors. The company’s simple business model and astounding unit economics allowed it to generate store-level profit margins of 27%, an nearly unheard-of level in the industry. The stock’s sky-high multiple reflected an expectation that CMG could see its units average $2.5 million of sales annually along with 27% margins ($675,000 of store-level profit per year). If they can not get back to those levels in 2017 or 2018, investors could very well be overpaying for the stock today. For comparison, right now store-level margins are running at 15.5% due largely to expense deleveraging from lower sales.

So what happens if the “new normal” for Chipotle is $2.25 million of annual sales per store and 20% store margins? Well, the math comes out to per-unit profit of $450,000 per year, or a decline of 33% from last year. That would mean that CMG would need 3,000 locations to get back to its prior peak level of profitability. At the current rate of new store openings, they would reach that size sometime in mid-2020. Paying three times revenue for a restaurant stock is high enough already, but without regaining their former financial glory investors might very well be left with a bad taste in their mouths.

Full Disclosure: No position in CMG at the time of writing, but positions may change at any time

U.S. Stock Market Post-Brexit: The Beat Goes On

Friday’s somewhat surprising Brexit vote (given that the polls showed both sides neck in neck, I cannot agree with the media that a 52-48 vote was a “shock”) reminds me a lot of the financial market turmoil that was brought on by Greece’s tumult several years ago. The fear was always about a European contagion rather than a huge impact from the main event. As I reminded people back then, Greece is roughly the size of Ohio and therefore we could extrapolate its ultimate impact on the rest of the world to have its limits. The U.K. is definitely larger in population than Greece (about the size of California and Texas combined), but it remains a small sliver of the globe.

As was the case then, the Brexit vote is going to have its biggest impact locally as the U.K. tries to figure out exactly what it means and how to tread slowly in order to minimize economic disruption. Companies doing business in Europe will have to contemplate their next steps, but by and large it should be business as usual for most players in the region. The stock market reaction has been interesting because one can point to obvious losers where substantial market devaluations seem warranted (U.K. banks, for instance), but also many that seem to be painted with the guilt by association brush. Anheuser Busch InBev (based in Belgium) and Shire (based in Ireland) each fell by 5-10% on Friday despite the fact that sales of beer and pharmaceuticals should be unaffected (in fact, perhaps alcohol consumption in the region sees a tick upwards in coming months). Those types of investment scenarios might be ripe for picking.

Other areas are worth watching too. U.S. commercial and investment banks are actually very healthy these days after taking dramatic capital raising measures post-housing crisis. If one was looking for a chance to buy well-run firms such as JP Morgan or Goldman Sachs on sale, the current drops might look quite appealing. For those brave souls who want to scour the U.K. for riskier options (not a task I plan on undertaking, simply due to my lack of knowledge of the region), there will not be a shortage of opportunities to ponder. After all, British Telecom has lost 25% of its value over the last two days, despite operating a business traditionally seen as fairly defensive in nature. A bank it is not.

With the U.S. market only down about 6% from its all-time high, I think it is too early to be either overly worried or overly eager to gobble up stock bargains. Consider that the crash of 1987 was a 500 point decline that equated to 23% of the market’s value. Friday’s 600 point drop was a little more than 3%.

Microsoft/LinkedIn: Maybe The Folks In Redmond Will Finally Get An Acquisition Right, But Don’t Hold Your Breath

I am often asked why some companies trade for sky-high valuations even when a majority agree that the price does not make a lot of sense. In part, the answer is that there are always people who perceive value differently and will overpay for companies. The saying goes that something is only worth what someone else is willing to pay for it. That might be true in many instances (in the short term especially), but many stock market investors would argue that a company’s worth is actually tied to its future free cash flow. And that is what makes a market.

If you had to pick a tech company that has a miserable history with acquisitions, it would be Microsoft (MSFT). Just in the last nine years MSFT has paid $6.3 billion for online advertising firm aQuantive, $7.6 billion for Nokia’s phone business, and $8.5 billion for Skype. That is more than $22 billion for three companies that have all struggled under Microsoft’s ownership. The most logical from a strategic perspective, Skype, seems to be a flop. With its huge installed based of Windows, Outlook, and Office users, Microsoft had a huge opportunity to build and integrate the world’s most dominant audio and video corporate communications platform. Oh well.

Today Microsoft announced they are paying more than $26 billion for corporate social network LinkedIn (LNKD), a 50% premium to last week’s closing stock price. Will this deal finally be the one that gives MSFT deal credibility? The odds seem long. Product synergies seem sparse and even industry pundits are using odd justifications for the deal. One tech commentator thought this was a boon for Microsoft’s Azure cloud business because LinkedIn is big and growing quickly, and therefore would give MSFT a lot more data flowing through its cloud infrastructure. So LinkedIn doesn’t use Azure now but it is a smart deal because the tie-up will force them to use Azure in the future? Yikes.

If I was a Microsoft shareholder I would be most concerned with the $26 billion all-cash price tag (to be funded entirely with debt). In 2015 LinkedIn had free cash flow of $300 million. Subtract non-cash stock based compensation of $510 million and you can see that LNKD is not “profitable” really, non-GAAP accounting aside. EBITDA in 2015 was about $270 million, so the deal price equates to a trailing EV/EBITDA multiple of roughly 90 times. Even if one believes the strategic rationale for the deal is sound, making it worthwhile from a financial standpoint is another story.

While it totally makes sense that Microsoft feels its relevancy fading, and thus wants to make a splash and try to get “cooler” in the world of tech, there are plenty of obstacles in front of them. It will be tough task to make this move one that we look back at in a few years and say “Wow, that LinkedIn deal really paid off.” So even with a new CEO, maybe MSFT has not changed all that much at all. Time will tell.

Full Disclosure: No position in any of the companies mentioned at the time of writing, but positions may change at any time

Will People Continue To Buy Clothes In Stores?

It is always interesting to me when Wall Street takes a few select situations and uses them to make dramatic conclusions about how the world will change forever. If you have read much about consumer spending in recent months you might come to a few conclusions, such as:

  1. Millennials are the only consumer group that brands should care about because they now outnumber baby boomers
  2. Millennials don’t spend money on clothes
  3. Instead Millennials spend money on travel, eating out, live experiences, and consumer electronics

I want to focus on where consumers are spending money because I think the idea that retail shopping is dead due in large part to a de-emphasis on clothing and accessory purchases is presenting excellent investment opportunities right now. Many leading department store chains as well as specialty retailers focused on apparel and accessories have been crushed in the public markets. They are trading at equity valuations that imply their businesses are in permanent decline due to a combination of shopper preference changes and increasing market share for online-only retailers. Even though the bricks and mortar companies have spent billions of dollars building out their online capabilities to complement their store networks, investors largely do not believe these investments will show solid returns.

First, I find it odd that investors do not want anything to do with the apparel and accessories category right now. Are we going to somehow stop wearing clothes? If not, are there technological advances in the space so great that wearing clothes will no longer result in them wearing out and needing to be replaced? The view that there is an irreversible trend toward spending materially less on clothing and related products appears suspect to me.

If you agree, then it makes sense to continue down the road and examine other supposed reasons why retail is supposedly “uninvestible” today. For instance, I hear many people point to the fact that Amazon is going to surpass Macy’s in clothing sales in the United States. Even if this is true, should we conclude that Macy’s is therefore doomed? If I think about it, it seems logical that Amazon will surpass many retailers in various categories. After all, Amazon allows any company to list their products on their site. Conversely, Macy’s has a limit to how many items they can sell, as both their stores and distribution centers have finite capacity. Isn’t this therefore an apples and oranges comparison? Honestly, I would be concerned if Amazon could not sell more clothing than Macy’s given their vastly different business models.

Macy’s stock has dropped from $73 to $33 per share in the last 12 months, bringing its equity value down to $10 billion. To give you a sense as to how negative investors view the company’s prospects, it has been widely reported that the Macy’s flagship store in New York’s Herald Square (which they own) is worth at least $3 billion. Add two more valuable stores in Chicago and San Francisco and there might be $6 or $7 billion of real estate value in just three of Macy’s 800+ store base across the country. This discrepancy tells me two things; 1) there is a large margin of safety in Macy’s stock, and 2) investors don’t think very much of the company’s retail business despite more than $25 billion in (very profitable) annual sales. Another interesting fact is that Macy’s stock currently yields 4.5%, which is higher than the yield on Macy’s corporate bonds that mature in 2023 (about 4.1%). Typically investors accept lower income payouts on equities in return for more capital appreciation potential. And in case you were wondering, Macy’s is more than adequately covering the dividend with free cash flow.

There are many other examples of retail stocks that I believe are being mispriced today. Some have inherent real estate value due to owned stores vs leased stores. Others have high dividend yields that actually point to undervalued stocks rather than distressed operations. Others have no dividend or owned real estate, but instead have real growth opportunities ahead of them and simultaneously are trading on public markets as if they are shrinking in size. Because the opportunities vary in shape and size, I recently began buying a basket of five names that I find particularly attractive as a way to spread the risk around (retail will always be an extremely competitive business) but make a macro bet on the apparel space continuing to operate quite profitably. There are many values to be found if you, like me, believe that clothing and accessories is a retail category that will remain in style for decades to come.

Full Disclosure: Long Macy’s and many other retailers at the time of writing, but positions may change at any time

Chesapeake and SandRidge Alum Tom Ward Just Admitted How Bad The Energy Exploration Business Model Really Is

Those of you who follow the energy exploration and production industry probably know Tom Ward very well. He co-founded Chesapeake Energy with the late Aubrey McClendon in 1989 and later left to start SandRidge Energy in 2006. With Chesapeake struggling mightily these days (there were whispers of a bankruptcy filing earlier this year and shares trade below $4, down from an all-time high of $74 back in 2008) and SandRidge having filed bankruptcy just this month (Ward was fired as CEO in 2013), Ward’s two companies are wonderful examples of how the need to grow via debt financing can cripple energy exploration firms. Undeterred, Ward founded Tapstone Energy in 2013 as act number three.  Tapstone’s web site reads “Tapstone Energy: A Tom Ward Company.” I’m sorry, but given Ward’s track record that’s quite humorous.

I just saw Tom on CNBC discussing the current state of the domestic energy market and one of his comments was very instructive for energy investors. He said the industry’s “dirty little secret is that you cannot spend within cash flow and grow production.”  This comment was following his assertion that lack of access to capital was the real hindrance to the industry right now because banks “want you to spend within cash flow.”

I guess banks only want to lend money to energy companies that can operate at free cash flow break-even at a minimum. This is very logical of course, as it means that the profits from the oil and gas sold can cover the interest payments due to the banks. I find it amusing that Ward is in a way criticizing the banks for being so strict so as to want to ensure they can be repaid.

But the “dirty little secret” comment is most important in my view. What Ward is saying is that energy exploration companies cannot grow their production without borrowing money to do so. Put another way, this means that drilling for oil and gas does not generate any free cash flow (after all, if it did there would be excess cash to drill more wells and thus grow production). In financial speak, maintenance capex (the amount of reinvestment requires to maintain a steady level of output) eats up every dollar of operating profit.

This is crucial for investors because stock values reflect the present value of future free cash flow. If free cash flow is never above zero, there is no profit left for equity holders after creditors are repaid. From a strictly textbook definition, that would mean that all of the common stocks are worth zero.

I wish I had heard this comment many years ago, as it might have allowed me to realize a lot sooner just how bad of a business model most independent energy producers are employing. What is amazing is how many people continue to want to invest aggressively in the sector.

Despite Strong Fundamentals, Restaurant Stocks Struggle To Deliver

There is a long list of things to like about the restaurant sector from an investment perspective. Secular trends such as dual-income households have led many families away from frequent home-cooked meals around the dinner table. The busier we are, the more likely we will rely on restaurants of all shapes and sizes. Add in low gas prices and one would think restaurant stocks would be among the stock market’s best performing groups. And yet it has been quite the opposite lately.

I have always liked to invest in the sector, not only for the reasons above but also because it is relatively easy to understand and analyze. Chains often try to differentiate themselves, but the general recipe is the same for most. Suffice it to say I am finding so many bargains in the sector lately it is difficult to choose which ones should make the cut in a portfolio. Valuations are about as low as I have seen them since I began investing more than 20 years ago.

So why are these stocks having so much trouble with both secular and cyclical tailwinds? I think a big issue has been a very strong market appetite for well-known restaurant IPOs. Consider that there are more than 50 publicly traded restaurant stocks in the United States, and more than 20 of them have IPO’d since 2010. Just as these companies are having to compete for customers, they are also competing for investors’ capital. Given that restaurants are a small subset of the consumer sector, there is a finite amount of investment dollars being allocated to the group. With more and more options boarding the public market train, many are simply being discarded.

And despite low gas prices and a propensity to eat out or carry out meals, there are operational challenges all of these chains are facing. The biggest in my view is simply the sheer number of new locations being opened by restaurant chains generally. The number of food options these days can often be overwhelming. At some point it is reasonable to assume the U.S. is going to be facing an overbuilt restaurant sector, at which point many will start to see material declines foot traffic, sales, and profits.

That said, I firmly believe that there are many attractive investment opportunities within the restaurant space. Within the small cap arena there are many companies that offer a compelling business model and meager valuation. A great example is Kona Grill (KONA), a sit-down concept that will deliver over 20% unit growth in 2016 and end the year with 45 locations across the country. The company averages $4.5 million in annual unit revenue and 17-18% unit level profit margins, with a build-out cost of $3 million per location.

At the current $11 share price, which is down a stunning 50% from its 52-week high, the stock trades at a total market value ($127 million) below its $135 million replacement cost (note: replacement cost is how much money it would take to replicate the company’s assets if you started from scratch today). Throw in a long runway of future expansion potential and you have a very attractive long-term investment that Wall Street is completely ignoring. And there are many other bargains out there to be found if you look closely.

Kona Grill (KONA) – 2-Year Chart

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Full Disclosure: Long shares of Kona Grill at the time of writing, but positions may change at any time