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Does Zoe's Kitchen's Expansion Strategy Still Make Sense?

At the Jefferies 2017 Consumer Conference in June, Zoe's Kitchen (NYSE: ZOES) management continued to sound relatively upbeat about its aggressive expansion efforts, noting there are no plans to slow the pace of store openings at least through the remainder of 2017. With the company currently suffering from negative comparable-restaurant sales growth, however, this strategy is beginning to look more questionable after Zoe's noted that adding stores in existing markets is leading to cannibalization of stores, not to mention eroding margins.

Don't expect a comps turnaround soon

Zoe's comparable-restaurant sales began slowing significantly in the second half of 2016 before turning negative in the first quarter of 2017. The 3.3% comps decline in Q1 was Zoe's first negative quarter since the company's IPO.

Image source: Zoe's Kitchen. 

At the Jefferies conference, CEO Kevin Miles admitted that there's a lot more competition for Zoe's customers' these days -- not just from chains, but from smaller restaurants as well that focus on healthier, grilled fare with fresh fruits and vegetables. In terms of what is having the biggest impacts on Zoe's comps, Miles said that its restaurants are concentrated in parts of the country (Texas, in particular) that have witnessed the most dramatic slowdowns in consumer traffic.

Unfortunately, the trend isn't improving much into the second quarter. According to Black Box Intelligence, in April, the restaurant industry saw average comps declines of 1%, with traffic declines of 3.3%. For May, industry comps fell an average of 1.1%, with traffic declines of 3%. And as the saying goes, everything's bigger in Texas, which averaged far worse comps and traffic declines in June of 2.4% and 4.3%, respectively.

Full speed ahead anyway?

On the company's first-quarter conference call, Zoe's lowered its full-year comps growth guidance to between flat and negative 3%. But in spite of its comps struggles, the company hasn't dialed back at all on its store growth plans for 2017.

Zoe's still plans to open between 38 and 40 locations this year, utilizing a "hub and spoke" strategy that will put most of its new units in locations that are relatively near at least one existing store. Many of those stores will be opened in Texas, home to around one-quarter of Zoe's current locations. Specifically, the company recently announced plans to double its number of locations in the Houston area, where it already operates 15 restaurants. Another area of emphasis will be Dallas, which is at 25 stores and counting.

This will present yet another challenge since the company says cannibalization of sales -- as it adds stores to established markets -- has been one of the top three factors causing a drag on comps. While Miles says that this cannibalization is intentional as they seek to build the long-term business potential of a given market, I'm not sure investors will see this move as positive, given the potential to drag comps down even further in the short term.

New stores will be keeping margins lower for years

Compounding the store growth issue is the fact that newly opened restaurants will suppress Zoe's margins for the foreseeable future. In their first year of operation, new restaurants -- due to lower average sales and higher labor costs -- tend to post store-level EBITDA margins of just 10% to 12%, and it's generally not until a restaurant's third full year that it's able to meet Zoe's target of at least 18% store-level margin.

While new stores as a percentage of Zoe's total base will naturally drift lower over time, the company estimates it will take until the end of 2020 for 60% to 70% of its stores to become mature, the point at which restaurant-level margins should stabilize.

Can Zoe's overcome these hurdles? Possibly, but it will take time, and the market is notoriously short-term-focused in nature. With no seemingly easy path back to comps growth, and the company not regularly posting positive earnings yet, the additional headwinds created by keeping the pedal to the metal on new store growth might cause even patient investors to look for a smoother ride elsewhere.

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Andy Gould owns shares of Zoe's Kitchen, and has the following options: short January 2018 $30 puts on Zoe's Kitchen and long January 2018 $30 calls on Zoe's Kitchen. The Motley Fool owns shares of and recommends Zoe's Kitchen. The Motley Fool has a disclosure policy.