What Burned Zoe's Kitchen Most May Be How It Handled Its Financials

In this segment from the Motley Fool Money podcast, host Chris Hill and senior Motley Fool analysts David Kretzmann, Jason Moser, and Aaron Bush go through a long menu of problems for fast-casual operator Zoe's Kitchen (ZOES), and an equally long menu of potential cures that management is lobbing them.

The Mediterranean-style restaurant chain has overused debt to fuel its growth -- and now it looks like it expanded too fast. The Fools consider where Zoe's goes from here. They also pivot to another fast-casual player that appears to be recovering from its problems, and that could do so in part because it didn't go into debt to expand: Chipotle Mexican Grill (CMG 0.53%). The Mexican chain is adding some drive-thrus...but in an unusual way.

A full transcript follows the video.

This video was recorded on May 25, 2018.

Chris Hill: Zoe's Kitchen has more than 200 locations across America, and that number may be going down soon. Shares of Zoe's Kitchen fell more than 35% on Friday after a first quarter report that, David, it was just a train wreck. They lost money, they cut guidance.

David Kretzmann: Yeah, this was a really ugly quarter. Same-store sales were down 2.3%. Margins are being pressured, expenses are going up. And I get the feeling here that management is just throwing a lot of stuff against the wall at this point and hoping, praying, that something sticks. They're reducing their future store opening plans, they're looking at letting some existing leases expire with their current locations. They're increasing the amount of money they're spending on marketing, they're looking at franchising. And the board of directors even formed a committee to consider strategic alternatives.

So, presumably looking to sell the company or find some sort of saving grace. Zoe's has really backed themselves into a corner here. For a long time, they've relied on debt to open new locations. At this point, they only have a few million dollars of cash on the balance sheet, over $45 million in debt, and they're still generating negative free cash flow. They need to find something quick to turn this ship around.

Jason Moser: This is sounding more like Zoe's Kitchenette.

Hill: I've never been to one of these. This is fast casual Mediterranean cuisine. It seems like something I would like. I should probably go soon, because, I mean ...

Aaron Bush: [laughs]

Hill: When you hear about a restaurant stock dropping this much in a single day, absent any other news, my mind immediately goes to some sort of outbreak of some sort. So, I guess the good news is, this is not an outbreak of some sort. The bad news is, they are mismanaging this business to the point where it can drop this much in a single day.

Kretzmann: And I think the other challenge for Zoe's is that the restaurant category as a whole has actually been improving so far this year. When you're generating such poor results when the rest of the restaurant landscape is improving, that's just extra cause for concern.

Bush: The yellow flag investors should have seen coming years ago at this point was the fact that they couldn't fund expansion out of their operations, out of their cash flows, and they had to rely on debt. That's really risky, because when they're going from a regional to a national play, a lot of companies don't make that leap. So, if you end up struggling while doing that, and you have a ton of debt, and you can't really fund out of your operations, you're in a really tough spot to maneuver. So, I'm not surprised by all of this.

Moser: Recent troubles notwithstanding, that's something that Chipotle did very well early on. When they needed to make that leap, they had the balance sheet and the business model that enabled them to do it without having any real obligations hanging out there. And even today, I mean, still, a pristine balance sheet, plenty of cash flows. If they can rebrand and create more interest, I think there's still a chance for them to grow.

Kretzmann: Yeah. Whenever you're looking at smaller restaurants that are potentially trying to expand nationally, I think the primary thing you want to look for is, is this company capable of expanding out of the cash they're generating from the business, as Aaron and Jason highlighted. If not, if you're relying on debt or issuing stock to fund that expansion, that really dramatically increases the amount of risk you're taking as an investor.

Hill: I'm glad you mentioned Chipotle, Jason. Last year, executives at Chipotle said that they were going to be testing a drive-thru concept. And they've begun to do that in a few locations. But it's not drive-thru in the sense that you can pull up to the window and order. It's something they're calling mobile drive-thru pick up. You actually have to order ahead of time, then go and pick it up. Any time I've been in a Chipotle, it's been a pretty fast experience. Why wouldn't they just go for straight drive-thru?

Moser: Baby steps, Chris, baby steps. You have to try something and iterate. I think one of the problems, maybe, with Chipotle right now is, that entire restaurant model has been built without any consideration to a drive-thru. Even when I think about some of the Chipotles in our area that I visit, I don't know where you would put a drive-thru. I think Starbucks ran into that position or that situation, as well. Part of it is trying to figure out the actual logistics. I have a feeling, if you throw a drive-thru in a restaurant, it's going to bring some traffic in, and that's really what Chipotle needs right now.

Kretzmann: I think this actually makes sense for Chipotle. A traditional drive-thru, I think, would be very clunky with Chipotle, because they don't have a Big Mac or 7-Layer Burrito. You have to really build your own each time you go to the store, and order that way. So, I think the traditional drive-thru would just get clunky and held up if you're rolling that out to Chipotle, because they don't have any predefined menu items.

But, this mobile drive-thru, I think, is interesting, because it's really just pushing people to use the app or the online experience. That's just a way to increase the volume or the throughput going through the restaurants. So, for Chipotle, I think this actually makes sense.

Moser: You know who's mastered the drive-thru? I'll tell you, our Chick-fil-A by our house, oh my God. They have two windows for two lines, and that line will continually back up out of the parking lot. So, then, they get two employees from the store that are out there on, like, iPads with payment swipes. They're taking orders by hand to keep the traffic moving, and it works. It's unbelievable how they have that down. But, man, it's a nice problem to have, I guess. They can't keep the customers away.