One Stock's Warning Sign for Investors

The following commentary was originally posted on FoolFunds.com, the website of Motley Fool Asset Management, LLC, on Oct. 8. With permission, we're reproducing it here in an edited form.

Focus. It's one reason certain companies succeed beyond all expectations and others limp along, misallocating shareholder capital. After all, no one is good at everything, so in order to achieve above-average success, a company must determine where it has an advantage and then use that advantage relentlessly.

On the flip side, there are individuals and organizations that don't do much well, and therefore flail about trying to do everything. This is a warning sign for investors given the risk such a strategy runs -- at best, misallocation; at worst, the permanent loss of shareholder capital.

Focus on focused firms
At Motley Fool Asset Management, one reason we're comfortable with short periods of underperformance is because we try to invest only in companies that remain focused -- regardless of the economic climate -- on what they do best. Consider, for example, the restaurant sector. Due to a confluence of events, including weakening worldwide consumer sentiment, rising commodity input costs, and even wage inflation in some markets, it has generally not been a good time to own holdings such as Yum! Brands (NYSE: YUM  ) , Chipotle Mexican Grill (NYSE: CMG  ) , and Latin American McDonald's (NYSE: MCD  ) franchisee Arcos Dorados (NYSE: ARCO  ) . In fact, Chipotle dropped sharply following claims by hedge fund manager David Einhorn that the stock is overvalued.

On the other hand, a restaurant stock that we sold not too long ago, Singapore's Breadtalk Group, has outperformed. But here's why we're happy with what we have: The aforementioned pressures on Yum! Brands, Chipotle, and Arcos Dorados will ultimately abate and their focus on opening and operating popular, profitable restaurants around the world will help them come through stronger on the other side.

Breadtalk, on the other hand, is rising likely because investors think it looks cheap, but management is showing itself to be dangerously unfocused -- the reason we sold it from our portfolio in the first place.

What diworsification looks like
Since Peter Lynch famously loathed companies that failed to master singular aspects of their business before moving on to other things, I suspect he would not have a favorable opinion of Breadtalk. This tiny organization, with just $330 million of sales, is trying to juggle seven different restaurant concepts (Breadtalk, Food Republic, Toast Box, RamenPlay, Din Tai Fung, The Icing Room, and Carl's Jr.), two different business models (franchising and owned/operated), and multiple geographic markets around the world.

Compare that to Chipotle, which waited until it had more than $1 billion of U.S. sales from owned/operated locations before it even experimented with new markets or a new concept.

Now think about the implications of those disparate strategies for each company's business. Chipotle's simple menu, singular concept, and relatively concentrated network of stores give it more bang for its marketing dollar, significant ingredient purchasing power, and loads of transferable managerial talent. These economies of scale, as business wonks would call them, are what help Chipotle deliver best-in-class operating profit margins of more than 15%.

Breadtalk, on the other hand, is just eking out an operating profit -- and that's not surprising. While a more efficient procurement process is reportedly going to be installed in 2013, think about the costs and headaches that must arise trying to source ingredients for burgers, dumplings, noodles, and baked goods. How much overhead must be associated with managing seven different marketing strategies and parallel networks of owned and franchised stores, not to mention capital management in a half-dozen or more currencies? Add in volatile food prices, the rising cost of shipping, and potential shortages looming for commodities such as pork, and it's only going to get more difficult for a small player like Breadtalk.

It gets worse
But this isn't even the worst part. No, the worst part, in my opinion, is the company's recent announcement of a $16 million real estate investment in Beijing. There's at least one thing wrong with this that makes it an enormous warning sign for Breadtalk investors: Breadtalk is not a real estate investment company.

But even if you believe Breadtalk has some competence analyzing and pricing real estate deals given the team it must have in place to find good restaurant locations, there are at least two more things wrong with this deal:

  1. Given the economic slowdown in China, it's likely that real estate prices in China are significantly overvalued at present.
  2. $16 million is almost one-third of the company cash balance -- cash that might otherwise be used to invest in restaurants, repurchase shares, or reward investors with a dividend.

This is distracting, questionable, unfocused capital allocation -- and a warning sign for investors. And why is Breadtalk making the investment? According to the release, "to build its presence in a major city where it operates its own stores in addition to benefiting from asset appreciation in the future."

Call me old-fashioned, but you know how I prefer a restaurant operator to build its presence and make money? By operating restaurants.

Editor's note: Tim Hanson is not able to engage in discussion on the boards or in the comments section below. Tim does not own shares of any companies mentioned.


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