Zoe's Kitchen Gets Punished for Underperforming the Restaurant Industry

Mediterranean cuisine chain Zoe's Kitchen (ZOES) reported a dismal start to 2018. Its restaurants had started to show signs of life at the end of last year, as has the restaurant industry overall -- comparable sales actually ticked higher by 0.6% the last three months, with April showing a 1.5% gain. There was no such luck at Zoe's.

First, the numbers

Data source: Zoe's Kitchen quarterly earnings. YOY = year over year. 

While revenue showed double-digit growth once again, that was because of the 40 new restaurants not in operation a year ago. Total store count at the end of the quarter was 254.

In spite of higher revenue, profitability fell dramatically. That's a function of the important comparable-store sales metric, which is driven by foot traffic and size of customer bills. The 0.3% gain that was notched at the end of 2017 was more than erased by a 4.4% drop in traffic, partially offset by a 2.1% increase in customer bills. Restaurant contribution, which measures the profit margin of individual locations, fell to an average of 16.2% compared with 19.9% a year ago. In short, Zoe's is underperforming its peers in a big way. Shares were trading nearly 30% lower as of this writing.

What next?

"Weather and calendar shifts aside, trends softened sequentially from the fourth quarter of 2017 primarily due to decelerating dine-in traffic," said CEO Kevin Miles about the quarter. "Early results in the second quarter have not shown significant improvement, necessitating a downward revision to our annual guidance."

What was the cause of the big slowdown if it wasn't weather or differences in when the Easter holiday lands? There were some hints in management's comments about slowing down new store development and reallocating toward marketing efforts. That sounds like existing stores have been neglected. It could also be discounting activity at competing chains. Overexpansion within its home markets in the Southeast could also be to blame (Zoe's is still mostly a regional chain).

Image source: Zoe's Kitchen.

At any rate, management revised its guidance for 2018 downward. Revenue is expected to be $345 million to $352 million (compared to $358 million to $368 million before). Comparable-store sales should be down 2% to 4%, and restaurant contribution margin should be 16% to 17%. Expected new store openings for 2018 was left unchanged at 25. It's likely that contracts to start construction are already finalized and can't be backed out of, so perhaps the slowdown in new development will come next year.

Unfortunately, cash is a finite resource for Zoe's, and its use of it may have been ill-advised. The company has a new digital and catering strategy as well as a revamped menu, so all the pieces are there for a rebound. But business taking an unexpected turn for the worse just as the rest of the restaurant sector is improving is not a feel-good story. Management may need to revisit its plans to revitalize its business.