Delivery and the Future of the Restaurant Industry

On this episode of Market Foolery, Chris Hill and David Kretzmann turn their attention to the latest news from the casual dining segment: Jack in the Box (JACK -0.70%) wants to spin off Qdoba; Red Robin (RRGB 6.15%) turned in an earnings beat; and McDonald's (MCD -0.42%) has added a number of big cities to its delivery pilot program. The team also looks at Target (TGT -0.54%) and the big box retailer's prospects in e-commerce, small-format stores, and more.

A full transcript follows the video.

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 to see you. It's a happy Wednesday for fans of certain NBA franchises.

Kretzmann: Our franchises. It was a good night last night.

Hill: If you're a Celtics fan, it was a good night. If you're a Sacramento Kings fan, good news out of the NBA draft lottery. Here's hoping 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 whole open field of possibilities.

Hill: Yes, before ultimately --

Kretzmann: The disappointment continues.

Hill: Really kicks in.

Kretzmann: Although, your Celtics have done pretty well.

Hill: They're doing alright. We have some restaurant earnings we're going to get to, but let's start with Target. Their first quarter profits came 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's performance in light of "a very 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 and disruptions happening for companies in those spaces. Comps were still down 1.3% for the quarter, but Wall Street was expecting it to fall closer to 4%, so this really is a case of, it wasn't as bad as we thought, so we won't punish the stock.

Hill: And Ron Gross made this comment on Motley Fool Money last week, we were looking at, particularly last week, when you looked at some of the big general retailers, Macy's, Kohl's, J.C. Penney, that sort of thing, and the results were so bad across the board. And Ron made the point that, some of these are going out of business. This is capitalism, not everybody gets a trophy. And it's unfortunate for the people who are going to lose their jobs, but some of these aren't going to survive. I feel like Target is in a position where they 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. They don'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 sales have been going between 20% to 30% clip. That's nice to see. It's probably still a pretty small portion of overall revenue. They're also investing $7 billion over the next three years into technology, improving their supply chain. They're remodeling a bunch of stores, they're launching a small format concept where they'll have about 100 of those locations rolled out over the next three years or so. So, they're being more proactive than a lot of retailers, which are just taking the bad news as it comes and not really changing a whole lot in any meaningful way.

And Target is still in pretty solid financial shape. They generated almost $5 billion in free cash flow over the last year. So they're not going anywhere. Their dividend and share repurchases will be able to continue. I wouldn't be surprised if Target or Wal-Mart buys someone like Wayfair or something, because I think this e-commerce battle is really going to heat up. And these companies 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, like PetSmart recently buying, I forget what the name of it was, but it was the largest e-commerce acquisition ever. It might have been Chewy.com. Essentially an online pet food business. PetSmart spent several billion dollars acquiring them within the past month. I think it's inevitable that you will see Wal-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 to actually walk through one of those and see how it differs from the big Target that's a few miles from Fool HQ, and see what they're doing differently, because like you said, done correctly, that could be something that they look to grow even more.

Kretzmann: Yeah, they're expecting to build 30 of them this year. I haven't looked into this too much, I would assume it's a similar strategy to what Whole Foods is doing with its small 365 concept, where essentially you're able to get the stores closer to consumers. I think, especially for younger consumers, for the millennials, they value convenience more than anything else, and getting those smaller stores with the key, essential, top selling items closer to consumers, that could be a good way to go.

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

Kretzmann: It worked.

Hill: It did work. Stock up 17% this morning. This is a company you know better than I do. How good was this quarter?

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

Hill: Guidance for the rest of the year?

Kretzmann: Yeah. They raised their guidance a bit with earnings 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. They especially expect things to improve toward the second half of the year. This is a company that's been proactive despite all the different headlines that have been going on in the restaurant industry over the past couple years. They're really putting a lot of effort into their digital efforts, online ordering, take out, things like that. I think Wall 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 of Middleby, Tom Gardner, co-founder and CEO of The Fool recently interviewed Selim Bassoul, and Selim Bassoul essentially said the restaurants who are going to stick around are the ones who are going to emulate Domino's, the pizza companies that have mastered and integrated that digital, online ordering into their entire operations. Those are the restaurants that will be able to stick around and thrive. And we've seen that with Panera, and I know we'll talk a bit more about that. But I think Wall Street recognizes that Red Robin is putting out the effort there. One of the interesting initiatives here, one of these things is a centralized call center for to-go orders, which just streamlines that whole to-go ordering process. 10% of their corporate-owned stores offer curbside pickup, so essentially, you just drive to the store and they'll bring 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 being more innovative than most casual dining chains.

Hill: Also, one of the things they talked about for the conference call at Red Robin was prices 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, and certainly if you're the CEO of the company, you're really looking to do that even a little bit more. They raised prices something like 1.2%. That's the sort of thing where, that's better than lowering prices, it's better than discounting. We'll get to discounting at restaurants 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 meaningful impact on your gross margins.

Kretzmann: Yeah, and that offsets the traffic losses that a lot of restaurants, especially casual diners, have been seeing. Given the initiatives that they're doing, I think customers right now value convenience almost more than anything else. They like being able to order online or call in a customized order. And when they do that, they typically order more stuff, too. So it brings yourself to the customer. Then, ideally, as you get more people going 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 itself in a good place if they can keep that traffic going.

Hill: Jack in the Box second quarter profits came in higher than expected, which is fine. That's always nice. But I think what's really pushing the stock up 5% to 6% today is the news that Jack in the Box has hired Morgan Stanley to help explore the potential sale of Qdoba. Jack in the Box is the parent company of Qdoba Mexican Eats. I think they have, and I'm ballparking here, roughly three times as many Jack in the Box burger places as they do Qdoba Mexican restaurants. There are a 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 at Jack in the Box, when he talked about hiring Morgan Stanley, he said of Qdoba relative 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's a 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 traditional quick serve restaurant, or fast food restaurant. Qdoba is more the fast-casual restaurant that emulates Chipotle. 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 good reason to justify looking to spin it out.

Hill: If you go back three or four years, the story with Jack in the Box, in terms of whatever their quarterly earnings report was, basically went like this: same store sales at the burger places up 2% to 4%. Same store 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 Qdoba for 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're Jack 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 when Chipotle same store sales were falling through the floor.

Kretzmann: Yeah. In the CEO comments you mentioned, he said it's become more apparent to them that Jack in the Box's valuation is impacted by having two different business models, and that's just a head-scratcher to me. That implies that Qdoba is bringing down Jack in the Box's value, because they have struggled in the past year. But a lot of restaurants, fast casual 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. But that isn't out of the ordinary for virtually any restaurant that isn't Domino's. So this really seems like a case where they're ditching it at probably the worst possible time. I just don't understand the logic here. And in general, with a spin off like this, where I don't think the business models are all that different, I think having this kind of diversification is actually a good thing over time because they'll have one concept that does well in certain quarters, like Jack in the Box now, you'll have some that do better like Qdoba a few years ago. It's like Chipotle being spun out of McDonald's worked so well for McDonald's, so let's do the same thing and spin out Qdoba. I have a hard time seeing the 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 when things 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 company talked about how they have been doing some discounting. But I think that goes right in line with what 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 doing discounting 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 to attribute that. So I'm not calling it a panic move. But it 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, or even contemplated doing it, 12 to 18 months ago.

Kretzmann: Yeah, this really feels more like selling at the bottom. It's probably 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. To McDonald's credit, Chipotle was knocking it out of the park, their growth was phenomenal, their numbers were phenomenal. So McDonald's probably maximized their value, to an extent, with Chipotle. Although I don't know if anyone at McDonald's really thinks that was the best decision, given how Chipotle has succeeded. I think, if anything, if I was Jack in the Box, I would first see, maybe we should shift the management or the strategy with Qdoba, reevaluate that before you jump to spinning it off or selling it as a solution. I think this kind of diversification makes sense. You see restaurants going out of their way to develop new concepts now, whether it's Buffalo Wild Wings, Chipotle, virtually every restaurant you can identify, even Red Robin, they have a fast-casual concept they're developing. So, this seems to be bucking the trend at a bad time, and the strategy doesn't make a whole lot of sense to me.

Hill: I'm glad you mentioned McDonald's, because they're in the news not because of earnings but because of the delivery that they have been testing in a few locations in Florida. They are now rolling out delivery in Los Angeles, Chicago, Phoenix, and Columbus, Ohio. They're doing 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 are mainly 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, so I'm not going to disagree with him about how crucial delivery is going to be. From your standpoint, David, I'm curious if you have a thought on what the better strategy is? In the case of McDonald's, they're partnering with UberEATS. You see some places that are opting to build out this delivery network on their own. GrubHub is essentially a business built on going to restaurants and saying, "Don't worry about delivery, we'll do it for you." And certainly, that stock is having a monster 2017. So do you see any particular strategy, one being better than any other? Or do you just look at it and say, look delivery is important, how you execute is up to you but you'd better have a strategy?

Kretzmann: There was some interesting 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're not doing it on their own.

Hill: Three separate ones?

Kretzmann: Three separate ones and about 138 locations. The CEO said, seamless is not exactly how I would describe our experience with those third-party providers, because integrating those third-party providers with their payment system, their ordering system, it's a little clunky. They said the delivery times have often been not as promised, which disappoints the customers, and obviously that's not great for Red Robin's brand. So it seems like right now at Red Robin, they basically said, "We're open to other alternatives, because clearly what we're doing now with these third-party providers isn't working as effectively as we would like." And I 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 how Domino's, which is crushing it quarter after quarter despite the restaurant slow down, I think a huge part of that is because they developed their own point of sale system, essentially their own internal system, to manage payments and orders, their own proprietary system. Panera has started to do the same thing. 

And that just makes it a seamless experience for customers, wherever you are in the country or the city. You don't have to order through a separate delivery company, you don't have to change your payment information, especially, have a loyalty program like Panera, which has 25 million members, it makes it so much easier as a consumer when you have that consistent experience wherever you are, and I think it makes it a much stickier experience, too, when everything 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 diner like Red Robin or more of the fast-casual company 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 with Starbucks and Panera and Domino's that's been a huge factor in their ongoing success, despite the restaurant slow down. I think keeping it in house is initially 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. If you can pull it off. And it really does require a reinvention. It can't just be a tack-on item to the business. That is one concern I have with Chipotle and some of the other companies that are just relying on these third-party providers. I just don't see that being a consistent experience. The economics of it don't really make a whole lot of sense for the company. Unless you have it going through your own internal system, where you can really promote additional offers or something, you don't want the third-party delivery orders to just be replacing people going into the store. Where delivery gets very profitable is if people say, "I'll buy the salad and the breadsticks in addition to the pizza." That's where you really get additional volume and your margins bump up. But if someone is just buying the same thing they would have gotten if 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's some of the headwinds that Red Robin has run into. They mentioned, the economics of delivery are not that great, on top of everything else with the consistency of the experience, which have not been very consistent. So I like companies like Panera, even though they're few and far between that are deciding to go all in and keep it in house.

Hill: David Kretzmann, thanks for being here!

Kretzmann: Thanks for having me!

Hill: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don'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'll see you tomorrow!