Costco's Bold Plan to Re-Coop Rotisserie Chicken Losses

In this week's episode of Industry Focus: Consumer Goods, host Shannon Jones and Motley Fool contributor Dan Kline review some recent news in the CG space. First, the reverse merger between Chanticleer Holdings (BURG) -- best known for its burger joints and Hooters restaurants -- and Sonnet Biotherapeutics. Find out what the heck is going on here, what's going to happen to both companies, and why investors should probably steer clear of Sonnet (at least for now). Then find out why Costco (COST -0.12%) is taking chicken farming into its own hands, what this move means for the big-box retailer, what it could mean for retailers in general, and more.

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This video was recorded on Oct. 15, 2019.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every single day. It's Tuesday, October the 15th, and we're talking Consumer Goods. I'm your host, Shannon Jones, and I'm joined by Foolish contributor Dan Kline via Skype. How's it going, Dan?

Dan Kline: Oh, not so bad. In honor of the show today, given that we're not doing video, I am in full uniform of the company we're about to be talking about. 

Jones: Missed opportunities.

Kline: Sadly, I am not. That would be a missed opportunity -- a missed opportunity to ridicule me, most likely.

Jones: To ridicule, yes, for sure. I'm excited for today's show. This is a very fun show for both of the stories we're going to be diving into. I want to dive into the first. I don't know how to adequately cue this up, other than to go right in. Charlotte-based Chanticleer Holdings, ticker BURG, operate and run out of my hometown. They own and operate franchises, specifically your fast-casual full-service restaurants, primarily burgers. They made some very spicy headlines this week, and not for their food. Let me read a few of these headlines here. The first: "Hooters Operator Trades Tank Tops for Test Tubes." Thank you, Bloomberg, for that! "Hooters Operator is Getting into the Drug Business." And my personal favorite: "On the Menu at Hooters: Chicken, Cleavage and Cancer Drugs." [laughs] Dan, help us unpack what in the world is going on here. 

Kline: These headlines are having fun, but they're sort of getting it wrong. Chanticleer Holdings, the company that owns Hooters, a restaurant famous for its somewhat scantily clad but still PG waitresses, sells wings, sells burgers, kind of a sports bar -- they are being purchased by a tiny, and I mean $8.3 million in sales, medical company that's developing cancer drugs. This isn't a case where you're all of a sudden going to have scientists selling burgers, or the two companies are going to interact, you'll be able to get your cancer treatment and some wings. That's not what's happening here. This is what's called a reverse merger. It is a backdoor strategy for a private company to buy a public company and then become a public company. You know a lot more about medical companies than I do, but generally, they're in the investment stage, they're creating their drugs. If they manage to get something approved and have something that's successful, they could scale very, very quickly. This gives them a way to raise capital, but it also is a way to go public without facing the traditional scrutiny. And in their case, they don't have anything to scrutinize. They're a relative handful of people. They will be spinning the restaurants back out, so it won't be a bunch of scientists running a restaurant company.

Jones: And thank goodness for that!

Kline: [laughs] I don't know, they can't do worse than many of the restaurant chains that are out there.

Jones: Maybe do better than some of the biotechs out there as well. But, Chanticleer Holdings, this is not the first time that they've dipped their toes into other industries. Matter of fact, back in 2018, during the mass of cryptocurrency craze, they were diving into blockchain, specifically related to their restaurants and how they manage loyalty programs. So, it's not completely out of the question. But, Chanticleer Holdings -- I've seen some stories that have said this is the parent company of Hooters. It's not that. They do own and operate some Hooters restaurants, but they're primarily focused in fast casual burger joints. 

You talked a little bit about the company Sonnet Biotherapeutics. Just taking a look -- I won't dive into this, because this is a consumer goods show, not the healthcare show, which you can check out on Wednesdays -- for this company, you're exactly right. This is an early stage company. They don't have any approved products on the market. As a matter of fact, they're actually pretty early stage. They're just starting testing in humans for their lead product, which is trying to find something to help with some of the side effects related to chemo. But they've got some really interesting products in their very small pipeline. I think what's interesting to me, though, Dan, with biotechs that go the route of reverse mergers, obviously, when you do a reverse merger as opposed to an IPO, you're looking for basically an easier, shorter path to getting onto the public markets, you're looking for some liquidity, probably going to be raising some capital, which a lot of these biotechs need. But with a traditional IPO, there tends to be a lot more scrutiny. You've got investment bankers, you've got lawyers, you've got analysts covering the stock, trying to better understand it, its weaknesses, its strengths. With a reverse merger, though, you don't get that as an investor. On the biotech front, for me, obviously, I want to be able to dig into the financials and the pipeline and the science. It doesn't necessarily happen with that with a reverse merger.

Kline: Yeah, this is a real red flag as an investor. Now, if you already own shares, well, they're going to spin off the restaurants, so you're kind of getting a little something extra. But when you're looking at this as like, "Wow, should I get in? Is this a good way for me to get a piece of this potentially blockbuster company?" The reality is, we don't know anything about this company. As you know, because you talk about it on mostly Wednesday shows, the path to getting a drug to market, even a drug that proves successful in doing what it's supposed to do, there's then the whole marketing campaign of it, and those are very expensive. There's very big companies you're fighting with. This, for the company, is a way to avoid privately raising money. It's probably easier to publicly raise money. They're becoming public without having to have, really, anything. Again, $8.3 million in sales. That's a very small company. They don't have anything happening. And it could be years until they do. We don't really know. So, as an investor, this is something you wait on. Until they start to have to report so, three months in, you'll get a quarterly report, and you'll see, what exactly is this weird mishmash of a company that owns fast food burger chains and some Hooters restaurants and a cancer thing, until they spin everything off? As you start to see that picture, this might prove to be an early buying opportunity; but, just because a company is in a space that has the potential for profits doesn't mean you should invest. If you want to send me money for my rideshare company that also offers made-to-order tacos, feel free to do so. But just because you're in a couple of areas that could make money doesn't mean you're going to make your investors money.

Jones: Absolutely, very well said. This will be one we'll certainly have to keep an eye on. Hey, we may even cover it on the Industry Focus: Healthcare show. 

Alright, Costco, ticker COST, is taking matters into its own hands, aiming to control the entire supply chain of its... get this -- rotisserie chickens. Yes, those addictive Costco rotisserie chickens that I'm sure all of our listeners -- if you haven't tried it, you should. Before you wonder, wow, why are we talking about Costco's rotisserie chickens? Let me give you some context. 

Costco sold 91 million of these birds last year. That's double the number that they sold a decade earlier. They even have their own cult following, Dan. There is a Facebook page dedicated to Costco's rotisserie chickens.

Kline: [laughs] Of course there is!

Jones: It has like 16,000 followers. But, Dan, it's not just that these are good and addictive , they're also cheap. They only cost $4.99. Dan, there's more than meets the eye as to why Costco would want to go fully vertical and control this particular supply chain. Why is that?

Kline: This is part of a bigger story. Costco is competing with Walmart, Target, Kroger, a couple of other people for audience. One of the things they think is a differentiator is being able to sell their rotisserie chicken at $4.99. Other places are $5.99. I know at my Whole Foods, they're like $8.99 or something like that. So, this is an area where they've identified that they're willing to lose money. In 2015, they estimated that they lost $30 million or $40 million gross margins keeping the price at $4.99. In order to do that long-term, even if they are losing money, they need to take as many people out of the process as possible and essentially the middleman. And to do that, they've opened a $450 million poultry farm in Nebraska. It sounds silly. Frankly, I feel like they could go to $5.99, it wouldn't be that big of a deal, but they don't agree. 

This is going to be something you see more and more retailers do. If there is a product that is important to them, that they need to sell at a certain price point, they are going to more directly manage that process, down to perhaps going into business themselves, which is what's happening here.

Jones: Exactly. Even in terms of the placement, where this rotisserie chicken is in the stores, is strategic. They put it at the back of the store so that you purposely have to walk past everything else, in the hopes that this chicken is not the only thing that you walk out of the store with. But that's not all. They're even investing in high-efficiency ovens, and even containers made with less plastic, just to show you how important this rotisserie chicken is to them. 

When you look across the board, this is probably the first big move of a retailer like this, getting into meat production. We have seen Walmart, Kroger, Albertsons attempt to supply their own milk, opening their own milk processing plants. Milk is another one of those low-margin commodities that we do see become very susceptible to price swings. For milk, we have seen it on the decline. Not so much for chicken, though. It sounds like Americans are actually eating more chicken, Dan. 

Kline: Chicken is growing in popularity, and part of the reason chicken was an area Costco had to go into is, the five biggest chicken producers -- Tyson, Pilgrim's Pride, Sanderson Farms, Purdue, and Koch Foods -- they control 60% of the entire supply of chickens. That gives them a fair amount of leverage. In a normal case, a Costco, a Walmart, a Target can go to a vendor and say, "If you would like to keep the shelf space you have, you need to figure out how to keep the cost the same year to year, or lower it by $0.02 per unit," or whatever the number is. They're often very aggressive goals aimed at keeping margins, which are somewhat thin, at least existing, and generally keeping costs down for consumers. In this case, Costco maybe can't go to the chicken providers because they have other places to sell them that might pay more. This is a case where they have to produce their own. They want to meet their standards. They want a uniform rotisserie chicken. They don't want them too big, too small. 

I also think this is going to be something you see more and more often. Milk is a great example. We're about to experience a global pork shortage, something we've talked about on this show before, because there's a Chinese pork flu that's constraining supply. If you're a company that sells, I don't know, baby back ribs, you might need to open a farm. This is a test case where Costco could do more and more. And their goal isn't so much to get you to buy more. They make 75% of their money from memberships, not from purchases. The goal is for you to be so enticed by those chickens that you couldn't possibly think about giving up your Costco membership, because then you wouldn't have access to a cheap dinner and a pretty tasty chicken.

Jones: I think one thing to watch with Costco, though, is that, they've always been a company known for being very socially conscious. That's been something that has drawn a lot of investors, even here at The Fool, to this company. But, Dan, the chicken industry is not necessarily known for being environmentally friendly, even from an employee friendly perspective. It'll be interesting to see what practices they put in place to try to keep that reputation as an industry leader when it comes to social consciousness.

Kline: As a company, opening up a farm puts you out to certain risks. Are you raising them humanely? How are they being fed? How are they being treated? There's definitely some exposure here for Costco. But some of this, it just has to happen. The other problem, the other thing that constrains supply of chickens, is how many chicken wings we all eat. It used to be most profitable to sell a whole chicken. Now, it's generally more profitable to cut that chicken into pieces. This is probably something Costco was forced to do. I'd like to assume, because they've always been a very publicly conscious company -- they pay good wages, they treat people well -- that they will take that same model into their farm and they will be aware that in general, animal welfare is a very hot button issue. You don't want to see stories headlined, "You're Not Going to Believe What Costco Does to Make Your $4.99 Chicken," that talks about atrocities on a farm. I'm pretty sure that's not going to happen.

Jones: Yeah, I can agree with you there. I think Costco will protect its image and its brand, very much so. But there's a lot to watch with this story. Again, it's not just about the chickens. Costco is known for protecting its margins, and it likes to keep them thin on purpose. It also gives it a lot of leverage with its suppliers as well. A lot to watch here. Dan, I have to know, have you tried Costco rotisserie chicken before?

Kline: I have. I can honestly say it's fine. It's a meal, if you're in Costco and don't feel like cooking. I would prefer Whole Foods' in general. I also think that maybe, if I'm in a Costco, there's so many tempting things I want to cook -- where else can you go and get fresh crab legs inexpensively? Or a whole bunch of shrimp that you can run home and cook? I'm a dedicated Costco fan, but I would rate their rotisserie chicken as maybe third or fourth of all the places I could go get a rotisserie chicken. 

That said, it's absolutely one I would eat. For me personally, the difference of $4.99 to $7.99 or even $9.99, when that's going to be the basis of dinner for my three-person family ... fortunately, I'm in a position where those dollar figures don't matter that much to me.

Jones: Yes. I'll go ahead and say it -- I'm going to say Walmart has the better rotisserie chicken. Don't at me on Twitter. I've tried it. I've tried Whole Foods. I don't know what Walmart does to those chickens. I probably don't want to know. But I can tell you, they're pretty darn good. 

But, for Dan and I, that'll do it for this week's Industry Focus: Consumer Goods show! We want to thank you so much for tuning in! As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For Dan Kline, I'm Shannon Jones. Thanks for listening and Fool on!