Why Fred’s Inc. Bit the Dust

In this episode of MarketFoolery, host Chris Hill talks with fool.com's Dan Kline about some business news. Fred's Inc.'s (FRED) years-long descent ended in bankruptcy today, and the stock is plummeting. Dan explains how the brick-and-mortar retail landscape is shifting, not dying. NFL season means Pizza Hut ads, which, it turns out, means Pizza Hut sales. Is Pizza Hut finally getting out of the shadow of its siblings, KFC and Taco Bell? Starbucks (SBUX 1.59%) announced plans for its largest location to date: a massive new Roastery in Chicago. Find out how the Roastery/Reserve stores fit into Starbuck's long-term plan, and what it means that the Roastery initiative seems to have been shelved under CEO Kevin Johnson. 

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This video was recorded on Sept. 9, 2019.

Chris Hill: It's Monday, September 9th. Welcome to MarketFoolery! I'm Chris Hill. Joining me in studio, safe from Florida, is Dan Kline.

Dan Kline: [laughs] There was no storm. We did all the prep, we got everything ready -- batteries, water. Some of that stuff's going to the Bahamas now. But, yeah, we missed the storm. I'm happy about that!

Hill: Good! We've got a couple of big restaurant chains that are making headlines. We have a couple of highlights from FinCon, the big event last week, including an announcement from The Motley Fool, which I will share in a little bit. But we're going to start with retail. 

Not good news for discount retail chain Fred's. Shares of Fred's down 40% this morning. Closing all of its stores, filing Chapter 11. For those unfamiliar with Fred's, it operates in 15 states across the southeast United States. This is a story that we've seen play out over the last couple of years with Sports Authority with Toys R Us. Now it's hitting Fred's.

Kline: Fred's is in an interesting position because they've been sort of an under-the-radar Sears. For the last three years, every time I have to write a "these companies are closing stores," they were probably on the list. And they did the "Let's get smaller, and that will somehow make us profitable." What they weren't doing is the concurrent "Why are we losing business?" They didn't make major changes. They didn't revamp their offering. And they actually had something that has worked for other people. They're a discounter. Dollar General does really well. Costco does really well. There's lots of room to succeed there. And Fred's just slowly slid into irrelevance. And as you get smaller, people think of you less often. You become less of a news story. And there was no profitable business model for them.

Hill: It's interesting, you mentioned Sears, we've been talking about Sears going out of business for much of the past decade. Really, Fred's is the more typical example that we see with bricks and mortar retailers, which is, when the end comes, it tends to come quickly. You go back to February of this year, Fred's had more than 550 locations open. Now they're going to be closing every single one of them. 

Kline: The problem is, if there's no one to backstop your losses -- and Sears had that to a point in Eddie Lampert, the former CEO, the chairman who now sort of runs the place. His hedge fund had assets. The second you have an inability to get merchandise -- Toys R Us, we've talked about, went out of business because they had too much leveraged buyout debt. But the reason they closed when they closed is, they couldn't secure funding to get the goods they needed for the holiday season. At that point, even if you have enough money to stay open for three more months, but there's nothing on the shelves, what are you going to do? Fred's got to the point where, they don't have a digital strategy, so anybody that might have, you know, "We'll take 30% of the company, we'll give you a lifeline," or, "Make us the first secured debtor, we'll give you the money you need," there was no reason to do that because it's much like the story with Sears. I look at Sears and say, "There is no business there." I feel the same way about JCPenney. There is no turnaround possible, so why prolong the inevitable? Sears is now more or less a private company, so they can do what they want. JCPenney is -- if you're the CEO, you're not going to be like, "OK, let's just cash out now." So, the reality is, they're going to drag it out to the bitter end. And Fred's tried to, but when you can't pay the bills, it's over.

Hill: When you add up the announced closings this year of bricks and mortar retail and the actual closings, you're looking at more than 7,000 stores. We still have a few months left in the year. We're already ahead of pace in 2018. 2017, I believe there were somewhere in the neighborhood of 8,000 store closures. 

Kline: We'll probably break the record. The interesting piece about this -- I feel bad, I don't remember the survey I'm citing, I wrote about it last week on fool.com -- the amount of store openings is actually running ahead of the amount of store closures in every category, including department stores. It's close with department stores. But in most cases, the openings are strategic. It's a TJ Maxx, a Marshalls, a Ross going in the right places. It's Warby Parker, Casper Mattress. In a lot of places, it's much smaller-footprint stores. So, you might lose the Nordstrom at your mall. We just lost the Nordstrom at my mall. You might pick up two CBD stores, one of those places that does Botox injections, and, I don't know, an Untuckit. And all those together are 15,000 square feet, and you lost an 80,000 square feet department store. It's a really interesting transition we're going through.

Hill: I'm glad you mentioned Warby Parker. They're a great example of, to your point, one of the things we've seen over the last few years, which are these niche retail brands that were created online, and then they said, "You know what? We want to raise the flag a little bit," and one way to do that is with some key locations.

Kline: It demonstrates proof of concept. Dylan Lewis and I did a show about Peloton. Peloton opens stores or kiosks in, I'll call them the A-malls, the top-tier mall in your area. Are you going to buy a $2,500 exercise bike without sitting on it? I have no idea what a Casper mattress costs, but it's a lot. Are you going to buy one without laying on it? I don't think you will. So, it facilitates the process. It's not about making sales in that mall store.

Hill: Just in case you were actually curious, I'm not buying it $2,500 exercise bike, period, no matter how comfortable the seat is.

Kline: [laughs] Chris built his own exercise bike.

Hill: The NFL season kicked off this weekend, which is good news for shareholders of Yum! Brands (YUM 0.71%), the parent company of KFC, Taco Bell and Pizza Hut. We are now in year two of Pizza Hut being the official pizza of the NFL. For a bunch of years, it had been Papa John's. I think most people who listen are aware of the debacle that happened with Papa John's. This seems like -- on the surface, anyway -- Pizza Hut is finally starting to gain some traction in terms of sales.

Kline: I think it really shows you -- Pizza Hut sales lag the other Yum! brands, KFC and Taco Bell, but they've trended upwards after a long time of being flat or toward negative at least some quarters. When you watched football yesterday -- I watched, conservatively, maybe two and a half game sets, so, half of the 01:00 o'clock, the 04:00 o'clock and the night game. Pizza Hut was all over the telecasts. I think it's showing you that proximity matters. If you're going to order crummy delivery pizza --

Hill: [laughs] How dare you?

Kline: I did a show on Papa John's; these are barely passable pizzas. Pizza Hut... it's not even like pizza. It's unique, somehow it's fried, but it's baked... But, you're sitting in front of the TV, and it's really easy to order Pizza Hut. And six commercials remind you. Pizza Hut, Pizza Hut. And all the ads were is, "Hey, we're the place that has pizza in our name." That's pretty much the commercial. I didn't think that would work. But the NFL has moved past its own controversies. I don't think there's any taint to the NFL brand. This has actually been a home run for Pizza Hut. I stand corrected, because I said it was a terrible idea when it happened.

Hill: You mentioned Yum! Brands, we have seen this story play out quarter after quarter with Yum! Brands, which is essentially, "Results from KFC and Taco Bell were pretty good, and they were weighed down by Pizza Hut." And despite that, over the past year, shares of Yum! Brands are up more than 30%. Imagine Yum! Brands where all three franchises are growing sales in a meaningful way.

Kline: I think they bounced back from a strategic mistake with Pizza Hut. If you remember, a few years ago, they announced they had sriracha and honey garlic, and they were competing with like Blaze Pizzas, the places where you go in, they make you an incredibly customized pizza in three minutes, and it's really good. They tried to turn Pizza Hut into that, which is kind of like sometimes the missteps McDonald's has made with very expensive burgers. Nobody's going to Pizza Hut because they want gourmet pizza. It didn't work. And now they're back to, like, "We've got the pizza with the most cheese stuffed in the crust!" And that's the lane for Pizza Hut -- it's stuffing things in the crust.

Hill: In November, Starbucks is set to open its largest location in the world. It is a four-story Roastery in Chicago, more than 40,000 square feet. In addition to coffee, it's going to serve pizza and cocktails. It'll be hard to miss if you're in Chicago because it's right there on Michigan Avenue. We almost talked about this story on Motley Fool Money last Friday. As happens often on Motley Fool Money, some stories get cut, and this was one of them. I'm curious what you think this. I'm a longtime Starbucks shareholder. I'll share my thoughts in a moment. You tell me what you think about this.

Kline: I am a giant Starbucks fan and I flew out to Seattle a couple of years ago -- not entirely to go to the Roastery, but that was one of the things I did when I was out there. And I was absolutely knocked out by the experience. I am an almost-every-day, sometimes twice-a-day Starbucks customer. When you go to the Roastery, you can have a traditional Starbucks quick serve, in-and-out experience; or, you can sit down and have a wine-steward-like barista experience where you describe what you're looking for. I did a flight of cold brews.

They had the $20 whiskey-aged short-term -- it's a very different experience. So I'm gung ho on the Roasteries. I'm not so gung ho on the fact that this is the last Roastery planned. Howard Schultz had planned this whole strategy where the Roasteries would be matched by Reserve stores. I wasn't a big fan of those except in big cities. But, Reserve bars, put in more popular stores. Where I live in downtown West Palm Beach, there is a store that does really great business until like 06:00 o'clock at night, where they added a Reserve bar, which is more exclusive coffees, higher-end experiences. Again, it's like a wine steward experience. They would extend their day at a higher price point. And I felt like that was the growth story for Starbucks. I mean, yes, there's China; but how many more can we have in the U.S.? I've been in Vegas hotels that there were four in the hotel. So I am not entirely sure there's a lot of growth. And I thought premium was a way to extend your relationship with your existing customer. And that will work in the Roastery cities, where they will have a core of locals that wants to spend time there. They are an absolute tourist destination. This is the Willy Wonka of coffee experiences.

Hill: You mentioned some of the big cities. You look at New York, Tokyo, Shanghai, Milan. I mean, they've got a few of these going on. As a shareholder, though, I remember when the first one got announced, and Howard Schultz was out there talking about this. And I thought, "OK, this is something he's clearly very passionate about. If this is something he wants to do, he has certainly earned the right to do that." As a shareholder, I thought then and continue to think now, "This is a nice thing that doesn't really move the needle in a demonstrable way."

Kline: I think that's true of the six Roasteries. When the idea was 20% of all U.S. stores would get a Reserve bar, which would sell beans produced at the Roasteries, and the upper-end experience, that made a lot of sense to me. It was either taking existing real estate that's underused -- some stores are bigger than they need to be -- or, in certain locations where there are stores going out of business next to them, making favorable deals to expand their space with a product that's going to increase their sales per square foot. You would have had to be very judicious, but they have the research. They know which Manhattan Starbucks is the one where people need to walk through and pick their coffee up on the way to work that should have a limited menu and which one is the neighborhood one that still has people in it at 10:00 o'clock. You're not going to go on a date to a regular Starbucks. Neither one of us are going to go on a date; we're married. But if you were going to take your wife, you probably wouldn't be like, "Let's get a latte for $6." But if it was an experience with premium desserts, and a whole tended coffee, tea, someone who's really paying attention to you, and it cost you $30, that's a pretty cheap night under those circumstances.

Hill: As you said, this was the plan under Howard Schultz. Kevin Johnson has been the CEO since April 2017. I wouldn't assume that pumping the brakes on this plan is set in stone. I say that because, look, we're just over two years into Kevin Johnson being the CEO; the stock has, in that time, more than doubled what the S&P 500 does. I think if you're a shareholder, Kevin Johnson's doing a good job. It's the sort of thing where it wouldn't shock me at all if a year, 18 months from now, they decided to roll a couple of more of these out.

Kline: I do think that's possible. I think Howard Schultz left the company partially because his role had been leading this initiative, the Roasteries and creating of a new brand for Starbucks. And I think Kevin Johnson went to him -- and this happens at all companies -- and said, "Hey, I like this! Great idea! But, let's focus on efficiency, making our stores work better, making our customer experience." If you read the Starbucks earning call transcripts, or listen to them, the vast majority of time is spent improving the customer experience. Their Tryer Center, which is their test store in Seattle, actually has store employees who work out in the field spending part of their week explaining the pain points and working to make that -- Kevin Johnson's done a brilliant job with that. That said, I don't think for a brand this size, to keep rolling out some tests of this or to put one more Roastery each year on the docket, I don't think that's that big of an investment, and they should have kept moving forward with it.

Hill: Do you have a trip planned to Chicago?

Kline: [laughs] I don't have a trip planned to Chicago, but I'm actually going to be in Seattle in November, and I have scheduled some meetings that will take place at the Roastery. 

Hill: Nice. Before we wrap up, last Thursday, I got the chance to talk with Robert Farrington at FinCon. I've gotten a couple of questions from people saying, "Hey,, why were you guys there? Why was The Motley Fool there?" We were there with Soapbox. You may ask, "What is Soapbox?" And that is a question we got over and over and over at the booth that we had, with the fabulous logo, that's red, "Soapbox Financial Network," and then underneath, "a Motley Fool company." So, what is Soapbox? At The Motley Fool, as we've talked about before, our mission is to make the world smarter, happier and richer. Part of that is trying to bring the best financial content to everyone out there. There are some amazing bloggers out there. Soapbox is a new venture from The Motley Fool, announced last week. Also announced its first acquisition, the very popular financial blog Budgets Are Sexy.

Kline: J. Money, now a Fool.

Hill: Exactly, the one and only J. Money, who I got the chance to meet in person. Just a fabulous guy. Anyway, more news to come from Soapbox. Going to be looking to work with freelance writers and bloggers. You can go to soapbox.com for more information. I was hanging out at the booth. You were actually leading a breakout session. What was the topic, and how did it go?

Kline: I went to FinCon for the first time last year. FinCon is a collection of people who produce financial content, from baby bloggers, early stage freelance writers, to rock stars like Chris Hill here or J. Money, who are celebrities in that world. It's this really fun gathering. What I wanted to do is, one of our goals at The Fool broadly is to help people do things better. I'm a freelance writer. That's essentially what my main role is. I've done some onboarding of writers here. I've seen some of the applications. I led a session on what freelancers are doing wrong. I see the same mistakes over and over. A cover letter that has nothing to do with the job. A cover letter that actually tells me that what your dream is, is a different job. So, I got up and -- the awesome part of it is, being part of The Motley Fool, you have an instant credibility. They sort of know you've made it. So, I had, I don't know, 300 people in the room, tons of questions. Really exciting. I hope to go back next year!

Hill: That's great!

Kline: And I hope to see some of you there!

Hill: Dan Kline, always great talking to you! Get home safe!

Kline: 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 MarketFoolery! The show is mixed by Austin Morgan. I'm Chris Hill. Thanks for listening! We'll see you tomorrow!