Good Investing Talks - How to find the best retail & restaurant stocks, John Zolidis?

Episode Date: September 20, 2022

John Zolidis is an expert on retail and restaurant stock. I had the please to interview him on different opportunities in his universe.

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And now, enjoy the video. The audience of Good Investing Talk, it's great to have you back. Today I'm having an American who has an firm that's named Latin, Kuwaitis Capital, and he lives in Paris. It's great to have you here, John. Thanks for having me. You have an interesting background in investing and today we are mostly focusing on your like core expertise. It's restaurants and the retail industry, which you're covering from the

value investing perspective. What has brought you to this kind of setup and why are you in Paris as American? Okay. So just a little bit of background about me. I was actually born in Germany, which you probably didn't know, and grew up in a small town in Wisconsin, attended some university in England. I lived in the Czech Republic, and then I married a French girl, so that eventually brought me to Paris. So I've always been pretty internationally oriented as far as my interests from a cultural and kind of lifestyle standpoint. Looking back at investing and value investing, Originally, I was a philosophy PhD student, which is probably also now what you normally hear, moved to New York to pursue PhD in philosophy, but quickly found that was an untenable career

choice and went directly into finance. From there, I started an equity research, and over time, I've graduated towards the value-investing species with a focus on the consumer, particularly retail and restaurants. So I'm following some U.S. companies, some Canadian companies, some Chinese companies, and I try to get on the road quite a bit to see the businesses, meet with the management teams, as well as do my modeling, et cetera, from here and talking to clients with clients in the U.S., UK, Australia, different places around the world. So why did you decide to go for retail and restaurants as your focus of analysis? Well, retail was a little bit of an accident.

So when I got my first job as an analyst, which is that a firm called Sedodian company, they kind of just gave me a retail business to analyze a small retailer called piercing pagoda, which sold jewelry and kiosks, now part of Zale Corp. But it turns out that that was a really good area for me because it combined kind of, if you will, left brain and right brain approach. I was a little bit more on the qualitative side in terms of my thinking and how I approach life in general versus a pure analytic sort of person. So combining those two things happen to be pretty appropriate to my way of thinking and

something that I found interesting and enjoyed. For the restaurants, that came out of a more technical approach that I developed to looking at retailers, which was focused on unit level economics. So over probably 15 years, maybe longer, I've developed an approach to breaking retailers down into their component parts and analyzing them at the unit level. And I have an entire approach that uses this as a basis for forecasting. And what I discovered is I'm kind of agnostic about what is sold in the box. And so it can be any kind of retailer. And realistically, restaurants have the same financial structure of a corporate headquarters,

some expenses that can be leveraged. And then the engine of economic value creation is the individual box. And so I've been able to take that retail discipline, which I did. developed and apply to this other area. It also works in different things, for example, fitness gyms, anything where there's a lot of individual units that can be analyzed for their return properties. The US consumer plays a super important role to understand the dynamics in retail and restaurants. So how do you keep up to date on the US consumer?

What are key metrics here you are tracking? What can you share with us? When I look at the U.S. consumer, the number one thing that we look at is first on is employment. And so generally the idea is that if consumers are employed, they're going to keep spending. And as you know, U.S. consumer spending is two-thirds of the economy domestically in the U.S. Within, aside from that, the next things we look at are access to capital. So we look to see if borrowing costs are going up or down, if banks' willingness to lend is changing. We look at the expense trends that the consumer might have.

That's obviously a very important topic today. We look at oil prices and gas prices in particular, which historically have been volatile. And then we look at the housing market, as that's a big big. driver of consumer activity. We look at the stock market that can impact the higher income consumers' spending activities. And then consumer confidence, I find that a little bit more of a lagging indicator. I actually think retail sales are a better measurement of consumer confidence than is consumer confidence, as it stated. And one other thing that can affect the consumer that we pay attention to is the media. So we look at it.

look in particular for political news can be disruptive and change what consumers are doing from a behavior standpoint. But realistically, the main thing is employment, followed by some expenses. And then beyond that, we'll look at some psychographic trends and secular trends that are causing consumers to change what they're doing or their behavior or their values. But those are a few of the things that we start with. Also, I spend my time I try to talk to a lot of different companies. I'm talking to companies every week, consumer companies. And so when I speak with them, I ask them what they are hearing from their consumers,

what kind of behavior is going on, what concerns there are. Some of the businesses that I follow, namely Walmart, specifically conduct their own consumer confidence surveys. and frequently they are willing to share some details that they get there. And so all of these things kind of come together to create a mosaic, if you will, for a view of how the consumer is feeling right now. And then, of course, you know, as investors, we're looking into the future. So we're thinking about how the consumer might be changing six, nine, 18 months into the

future and what the implications might be for the financial results of the companies that we follow. Why are you a bit skeptical with the consumer conference? measures? I don't think they're that great. So there are two consumer confidence measures that people look at. There's the University of Michigan and then there's the conference board. And oftentimes what you'll find in the media is they will cite consumer confidence from those two sources to either be positive or negative about things that are going to happen

in the future with the economy. But what happens in my view is that those surveys capture short-term sentiment changes in the consumer, but that doesn't necessarily correlate with what they actually do with their financial, with their money. So they may feel uncertain but continue to spend as if nothing had really changed. And so that's why I think retail sales is a better measurement. So when you see retail sales go down, that tells you the consumer is pulling back. And they don't necessarily line up with the surveys.

Where do you see changes happening in the like consumer taste preferences in the restaurants and retail spaces? What big trends or what micro trends shape the space? Well, right now, everything is still the after effects of COVID. Those are the biggest identifiable secular shifts in behavior. So, for example, you also have some demographic shifts. So you have consumers moving from urban areas to suburban or rural areas. We might call that rural revitalization. You have more interest in health and well-being because there was a very strong correlation

between negative outcomes with COVID and personal health scenarios. So there's a kind of an amplified interest in remaining healthy and activities around that. There has been some change in travel. These kind of continue to develop. So initially, no one travel. And now there's an explosion of travel demand. But there are also people that are still avoiding airplanes and airports. And so they're buying RVs or traveling domestically within the U.S. and their automobiles.

those are a few of the trends and then from a secular standpoint right now we are more of an economic standpoint you have a divergence in spending based on income group so the lower quintile income group in particular is under a lot of pressure based on inflationary changes and so that income group is is pulling back from discretionary spending other higher income groups seem to kind of be continuing in the same vein as before and absorbing the higher costs. So we're paying attention to that as well. And, you know, there's still some question about whether you'll get what's called reversion in some of these categories that it's seen as significant pickup in sales. For example, the sporting goods category is still significantly higher

than it was pre-COVID from a sales productivity standpoint. Is that going to revert back to the pre-levels or is that going to stay at a higher levels of sales and consumer demand because of secular change? So these are some of the debates that are out there and some of them people lean one way or another. Stock prices may be reflecting one dominant view. We may or may not have that view and then we're looking for data points to support whichever outcome we think is going to happen. Being a few years into this kind of research field, are there any spaces or taste preferences where you are still surprised that they are that stable? Well, there's a lot of debate about change and adaption.

So two examples, as I mentioned sporting goods, right? Another example, I saw this company called Tractor Supply, and they sell to what's called the the hobby farmer. So you have to kind of, this might be a little bit challenging to get your mind around. Even I grew up in a rural area and I didn't really understand what this was, which is they're talking about people who have a couple of acres. They may grow of some crops, but it's not their kind of, they're not, it's not professional farmers. It's people who maybe have a few horses and have chickens. I know it sounds kind of unusual, but this group of these homesteaders have,

there's been an influx of people into this lifestyle, which is also very independent and self-sufficient. It tends to be, obviously it's more rural, but they were less impacted by COVID and social distancing because they were already distanced before all of this happened. And so the sales in these categories have gone up quite considerably. there's also a strong correlation with this group of individuals and pet ownership. So pet ownership went up a lot during the pandemic. A lot of people adopted dogs because, you know, they felt lonely. They needed companionship. And so these pets continue to be around. And so pet sales are still elevated relative to the pandemic. So there's some question, you know, does that tail off over time? Is this a permanent shift? Are these changes going to last for a long time?

You know, did. And then you had also in the U.S. complicating it, the distribution of all these funds and you had a pent-up period where people didn't spend money. And then now they, over the last year, 18 months, have gone out and spent on things that they didn't buy during the pandemic. Is that the new level of spending or has that been elevated and is somehow, you know, ethereal and it's going to tail off? A different example, just to add one more. more to the mix is the beauty category. So during the pandemic, you know, there was still some need to wear makeup, maybe a little bit less, but you still wanted to look good, I guess, on your Zoom call, and the self-care component of beauty also continue to do well as part of the health and wellness focus. But one category that did not sell so well during the pandemic was fragrances. So you don't really need to smell that. good on your Zoom call. But now that the economy has opened up again, there's been a big resurgence of fragrance sales. And so the beauty business is seeing more people spend on a kind

of feel good, treat yourself. You only live once sort of approach. In addition, they're spending on fragrances, which tend to be a high price tag and a very high margin. And so you're seeing, for example, Ulta Beauty just reported fantastic sales, perhaps the highest quarterly sales and profit in the company's history, on the back of this surge in spending in this category. So in my mind, the question is, is this a one-time makeup, of makeup, not to use a pun there, but one-time recovery of past spending that didn't happen, or is this a new higher level of spending that's going to be sustained? Two interesting questions.

You have this also interesting state that you're living in Europe and you have this focus on the U.S. It's quite interesting to use these two lenses because there are some concepts, for instance, Walmart, they did try to expand to Germany. They failed. So are there any concepts that are quite unique to the U.S. market and that won't transfer to other geographies that easily? So the biggest thing when understanding the two markets from consumer standpoint, in my opinion, is dependence on the automobile. So the outside of a few select large urban markets in the U.S., literally everyone is driving. And this goes up and down the income spectrum.

Sometimes my clients would think that lower income consumers in rural areas didn't have cars. But having grown up in a rural area myself, I know that you can't get to. your job if you don't have a car. People don't live close to wherever their employment might have been. So it's really a necessity. You just can't function as a family without a car. And so the retail approach for consumers in the U.S. almost always involves access via a vehicle. And when we look at Europe, I just don't think that is the same. I think people are much more concentrated. You have better public transportation. You have fewer stores that are built on the periphery of towns. You have longer geographies that weren't originally designed around automobiles.

And so it's just not as convenient to build all of these inexpensive, cheap boxes on the exterior population centers because people in cities wouldn't go to them. Europe. So with that as a backdrop, for example, one of the sectors I follow is called the dollar stores. Now, some of them sell things only at $1, but many of them sell things at prices higher than that. And the idea is just that they are inexpensive sellers of consumables to consumers in a low-maintenance, inexpensively constructed store, typically either in rural markets or in urban markets. So they're situated where they don't have to compete with Walmart

or they are close to where their customer lives. And so I don't think that that concept, would translate as well to most European markets. There was a company, I believe, went private in the UK called Poundland, which is a very cheeky change from dollar store. And I don't think that there is anything of that nature that I'm aware of in France. Another thing that's happening right now in the U.S., which is worth mentioning and in the same theme, is drive-thrus for food and restaurant concepts. And so Starbucks, for example, is transforming its storebays from the sit-down cafes that originally made it so successful and popular into a drive-thru format. It's trying to put more of its stores into drive-thrus, and that's driven by two factors.

technology. So you can use your app to order in advance and you can customize on the app and you get all of your loyalty program, et cetera, data through the app, which enables more convenience of staying in your car and getting the product correctly made for you when you arrive. Chipotle is also shifting from its more sit-down-oriented store-form. format to a drive-through format. There's a small company that just went public called Dutch Brothers, which sells coffee-like drinks, let's say, all drive-through, 100% drive-through format. And I just, you know, people don't live in their cars in the same way in Europe. At least that's my perception from Paris.

How unique are the markets in the US compared to Europe? Europe. Like if you compare to German and the French market, it's apples and bananas you're comparing. But like, for instance, if you compare Omaha to California or to New York, how unique are these markets or is it like easily to roll out to 400 million consumers in the US? So that's a great question. And the answer is there are regional differences. And it might depend a little bit on the category. So for example, you know, I followed footlo. for a long time, and Foot Locker has about a third of its stores here in Europe. And so they would tell me that the market in Italy is very different from the market in Germany.

So what the Italian consumer wants to buy could be completely different shoes than what the German consumer is buying. In the U.S., I don't think there is as broad of a chain. You do have kind of urban versus suburban. So you have certain customer groups that live in downtown areas. areas that may be buying specific kinds of shoes that don't also sell in suburban markets. That's a fashion comment for the restaurants. There are some concepts that just work in all markets.

Like, you know, Starbucks seems to be not only working in all markets in the U.S., but they have 33,000 stores worldwide, although they do adapt. They're not all selling the same product in every store. But the concept seems to translate quite well. You can have differences in regional competition. You can have some influences in some southern states. You might get a different Hispanic population, which if you're a food retailer,

you need to have specific products that cater to that customers' interests and needs. And those can be actually different because you have sometimes different groups of immigrants from South and Central America that have different tastes, so a food retailer might have to adapt to those kind of things. But in general, I think it's a fair bet to say that it's relatively homogenous and concepts that work in some places will work in other places from a consumer standpoint. What I've seen happen is that the expense structure can be different. And so in particular, if you start in California and then move to the Midwest, they may not really

understand who the customer is or the density of the stores, like how close together you can put them might have to be different. And I've seen rent, changes in rents and customer taste happen. So it's subtle. It can exist. You can have problems, but it's not nearly as different as what you're describing between going to France and Germany, for example. Thinking a bit about the infrastructure retailer runs in. You mentioned the cheap boxes already, which are part of this retail game or this restaurant game. This cheap boxes depend on cheap energy to run, I think, because they're usually, maybe it's more a read question you don't cover, but I'm interested in this coming from this European external shock. with energy prices. So you need cheap fuels to get to the store and the store has to be cooled

and to be warmed in winter. It has also like high energy costs and it's not like the highest billing quality if it's a cheap box or am I wrong here? So there's a couple of things to dig into there. So first, as I'm sure you know, energy costs at the consumer level are much higher in Europe than they are in the US. Just as an example, filling up my Jeep tank here in France was costing me 100 euros and then filling up the tank I had rented over the summer and a giant SUV for seven people cost me only $70 in the U.S. And I'm pretty sure the tank in the U.S. was much larger than the one in Europe. I mean, I think most people are aware of that, but it's kind of, that was just my own personal example recently. The, when I

I talk about the cheap box. So, yes, you need the low gas prices so the customer can continue to get to the store. I think that's important. But it's the buildout of the box that had tend to be inexpensive and then drove a very attractive financial model. Because, for example, in the dollar stores, they would spend, I would say less than $250,000 to build the entire store. And these are probably 8,000 square foot stores. So in meters, that's like 80 meters squared.

So the 800 meters squared. And so the build out cost is very low. Like you couldn't build, you know, much for that kind of price. But then you have very fast turnover of consumables with low inventory. So you're generating a lot of cash through a box with not much initial buildout. What's happening right now is that the cost to build all these stores is going up. So it costs for steel is going up, costs for labor is going up, supply chain costs are going up. So the economics for some of these concepts is less attractive.

I think building costs in general tend to be more expensive in Europe. In the UK, you can't get five-year leases as easily, for example, as you can in the U.S., they tend to have 20-year leases. So you're signing up for a much longer commitment there. I think the build-out costs and the regulations here in Europe tend to be longer and more onerous and more expensive. And so there's a little bit higher of a risk threshold to get stores into these markets. But theoretically, you would also have less competition as a result of that.

Who owns the stores or the land? Like, for instance, in Europe, it's quite fascinating that Aldi and Liddle, as they expanded. They always bought the land and built the stores on them. So now they have like premium land in some of the core cities in Europe. Okay, so that's going to depend on a retail by retail basis. In general, most public companies rent their or lease their properties, and they tend to be owned by all kinds of different investors. Sometimes they'll do build-de-suit and they do sale lease back. In contrast, the big box retailers, Walmart, Target, Home Depot, and Lowe's, for example, they all own their real estate. And I believe

Costco as well. And a lot of times investors forget about that. They forget about the real estate value of those, of that significant investment. So your return on invested capital is going to be much lower because you're expending a much higher capital amount to acquire the box. But on a risk adjusted basis and on an expense structure basis, you could argue this is much more attractive because you're not exposed to higher rents, and you have an asset underlying the business. So I think when you're analyzing these kind of companies, you need to take into account the capital structure

of the business's balance sheet, but also that approach that they use from a real estate perspective. And another comparison I often was surprised when I saw it was the comparison of square meters available for malls and shopping concepts in Europe and the US, it's still that the US has so much square meters and malls available. So I haven't looked at that recently, but if what you're alluding to is the report

that there's some enormously larger square meters per capita in the US versus the rest of the world, yeah, we're, you know, I'm aware of that. Like so Canada, which is maybe more similar from just a psychographic demographic perspective to the U.S., they have much less retail square footage per capita. So in general, in Canada, you'll see higher sales productivity and higher rents because there's less space available.

The U.S., it's widely believed, has been significantly overbuilt from a, especially the mall's standpoint. Now, the last time I really looked at this was maybe 10 years ago, And at that point, everyone was focused on the fact that Amazon was a much more convenient and better solution and that all of these malls didn't really have a reason to exist. And since then, a lot of, like the weakest malls have disappeared or been converted into other space. And there's a lot of what I guess call zombie malls where they just, you know, I guess they still exist, but they're not really that. visit well visited by the population. There's generally what's considered to be what's called an A mall and they're around 300 of these in the U.S. And you can be an A mall by being surrounded

by a very high income demographic or you can be an A mall by being surrounded by a very dense population. So the sales productivity in the malls tends to be really, really good. And these malls continue to do quite well, despite the general shift or the share shift to online shopping. Another thing when you think about the infrastructure and the stores is the inventory they have. And then through the last years, we had this problems with inventories and this volatility that companies had to order a lot. And they now have two big inventories. Like, do you think there's something structurally changing in the future, especially as a lot of the production happens in China for the US or yeah so it's a good question

the companies are trying to address this supply chain volatility many of them have been caught and part of that with too much goods and part of that is not understanding the extent to which business was distorted by transfer payments in stimulus checks in a post-pandemic recovery where consumers also had pent up spending ability from, you know, being stuck inside. So this augmented or inflated demand at the time, retailers didn't have enough goods. So then it was taking too much longer because of ripple effects of COVID impacting production in the Far East and also the ability to get product off of the ports and there weren't even enough truckers.

I mean, it was, there was, there was an issue at every moment in the supply chain, um, getting the product into the stores. So as a result, retailers ordered more and they ordered earlier. And so then when demand slowed down because of inflation, eating into discretionary spending ability and fewer, uh, stimulus checks, they were left with too many goods. And so that's what you saw particularly at Target and Walmart. Other retailers have also faced that. But it has been concentrated in retailers that service the lower income consumer.

And I believe that these retailers will work through the inventory, kind of the history of like inventory bubbles within retailers suggest that they, if they take the strong actions to clear those goods out, that margins will return to some normal level at some point in the future. Usually you want to buy retailer when they have real problems around inventory because it's a fixable issue. But the second part of your question, just to continue, is if things are going to change in the future.

And I think that's an interesting question because there's also a heightened political tension, if we put it in those terms, between the use. U.S. and some of its trading partners. And there's a kind of a movement to use this as an excuse to try to bring the supply chain closer to home. One element of getting products from the Fort Far East is that this has been a deflationary influence over 20, 25 years. And so it's helped the government to keep interest rates low over this very long time period. So if we're at the end of that multi-decade cycle of offshoring production to lower cost countries, and we're now bringing that product or that production back, that's going to make it more difficult to bring down inflation, in my opinion.

Now, this might be a little bit above my level of qualification to talk about, but I think that's within some of the considerations that companies are using when they think about if they want to change their supply chains kind of on a permanent basis to be closer to home. And for now, I think most retailers are going to stick with their Far East suppliers, but that could change. Yeah, there's a general topic also of the question, if there's enough labor. cheap labor to keep the costs so low because in Europe, I think in Germany, the next five years or 10 years, 30 million people will retire. So there's a question to find enough laborers. And also in China, if you think of like there are one billion in habitants or 1.2, 1.4 depends on who you quote. And there are only 10 million childs. So it's our children every year born.

So it's an interesting question to also think about this consequence. It's definitely not positive to have a shrinking population or an aging population. The U.S. has historically benefited from immigration. So even though perhaps, I don't have the numbers on this, but perhaps the higher income more educated population has fewer children, but the overall population of the U.S. has been augmented through. through emigration. And many European countries don't have that same kind of component boosting up their demographics and the younger worker base that they need to be paying in taxes and producing things so that, you know, other people can retire and the economy can continue to grow.

So those demographic influences are important. I think that's important from an investment standpoint also to know that there are enough, there's enough demand to create, you know, GDP growth in the market. But now let's circle back to the restaurant and the retail sector. If you think about the sector and companies, you've studied what could go wrong in the sector? Like, how and why do companies fail or be a really bad investment? Okay, there's a lot there's a lot there to approach. you know, the most obvious one is change in in competition, right?

And so failure to invest and stay up to date with what's happening with the consumer. So, I mean, the biggest killer of retail businesses over the last 15 years has been Amazon. So you had businesses that were late to understand that the consumer was shifting to shop online. They didn't invest in having their own solution from an Omni Channel standpoint. and they may have been selling product produced by others. So they didn't own the product from a vertical supply chain standpoint. And so they just got priced out. And they had nothing really that they were bringing to the table.

You can have from an investment standpoint businesses that, yeah. So investing in the business, I think, is one of the most important things to look at. So another good example that maybe isn't discussed as much anymore is Sears Kmart. So if we compare Sears Kmart to Walmart and Target, Sears Kmart has gone bankrupt and is disappearing and there's only a few of them left. But it used to be one of the biggest retailers in the United States before Eddie Lampert acquired it and combined the two and then basically used it to sell off assets and, you know, and, you know, benefit from that while he ran the company into the ground. So that's an example of their just deferred maintenance. They didn't

keep the stores up to date. They didn't invest in a true e-commerce solution, and they were just run over by the competition between Walmart Target and Amazon, amongst others. In the third, fashion space, you can always get the fashion wrong. And so that's a big risk on any of these either teen-based retailers or even if you wanted to look at Lou Lemon or Nike or Adidas, if they were to be on the wrong side of fashion for too long, you would lose sales and market share and you would definitely not do well owning the stock during that period. That's pretty hard. There's not that many companies that can consistently deliver attractive assortments that their customer wants and anticipate where their customer is going on a season in, season out basis on

over many years and in different markets. Blue Lemon has been incredibly good at it. And Nike is also, I think, one of the most exceptional companies in the world. Other things that's up. Retailers are, you know, expanding too fast, bad execution. There's a host of ways you can get killed owning retail stocks. What could go wrong with restaurants? So restaurants are a little bit more volatile because they tend to, well, first of all, they're more economic, they're more cyclical, right? So, you know, historically, you save money by eating at home. So in a time, that things get more difficult for the consumer, restaurant stocks just underperform. And we've seen that so far this year. They're also exposed to commodity price pressures more. So beef costs,

wheat costs, chicken, corn, all these commodity costs are up dramatically, partially because of what's happening in the U.S., but also what's happening in Ukraine. And that is impacting the margins that these businesses report. So that hasn't been great for them. There's also consumer trends within restaurants and food. There are certain things that people want to eat. They move away from. You can have temporary situations like you may recall the Chipotle E. coli outbreak,

which crushed the sales in business for some time. It turned out to be a wonderful buying opportunity because they were able to bounce back and then bring in really excellent management since then. But if you're not anticipating that, you can certainly get hurt. And then there's changes in, as I mentioned, consumer behavior. So you mentioned Cheesecake Factory earlier. I think that that concept tends to appeal to an older customer. And it needs to be reinvented to appeal to the millennials and the Gen Zs. And if they can't find a way to translate that concept to that younger customer, I think it's going to be challenging for them to remain relevant over the long term.

So there's all these different things that are happening. Brinker International, which operates Chili's as a lower income consumer. They seem to be under pressure because their business was typically driven by promotions and now due to the commodity price pressures and labor price pressures, they feel that they can't really offer the same level of promotions and obtain reasonable margins. So they're trying to pull back on promotional activity within their stores, don't know if that's going to work. And then lastly, I'll mention this before I turn it back over to you.

Right now in the U.S., there is a coordinated increase of prices at revenue. restaurants in a way that I have never seen before. So, for example, Cheesecake Factory, which I spoke to last week, is raising its prices about 7.5% compared to last year. Chipotle's average price in the second half of the year will be 13% higher than last year, which in turn was 10% higher than the year before. Both companies say that prices at grocery stores have gone up even more, and so therefore on a relative basis they're still providing value to the consumer and it's going to be fine and okay and the customer is not going to push back. But my feeling is that if you raise your prices too much, and the consumer starts to no longer believe that your product

offering presents a value, it will be very, very difficult to get that perception back. And so I think these businesses or the industry in general is running this risk right now and I don't think that this is going my personal sense is that this is not going to turn out well it's definitely a challenge with this kind of high price races but we will see how it plays out in the future if you think about restaurants there's this this I would call it a bit holy grail for investors the idea of franchises because you just license out your brand or you constantly concept and you earn royalties from it. But with this, it also goes hand in hand with the question, how you can keep up quality with your concept and give this kind of like good or superior restaurant experience.

What is your experience around this franchise concepts and also the general questions, how restaurants, if they scale, how they could execute on a high level and still offer a lot of value for the customers? Okay. So I've just, I recently just did a lot of work around franchising and looking at different concepts. And I looked at it from a financial standpoint, more than an operational standpoint. So let me talk a little bit about the financial perspective first. And then I'll address the meat of your question, which is more around the operational execution side of it. You know, first off, yes, you're absolutely right that being a franchising, is a very attractive business model, right? So you get your franchisee to put their capital into the business, and you take a royalty off of the revenues. And in a inflationary environment, I think this is a very interesting sector to be looking at, because as the franchisor, you benefit from inflation. that is the price is going up because you're taking a royalty off the top line, but you don't own the labor. Like your franchisee partner has the labor cost that they have to deal with or so the commodity cost.

So the franchisor theoretically can benefit from this, you know, within reason without being exposed to the downside. Now, my personal experience owning some of the franchise stocks I own, they've done okay. I wouldn't say they've been doing amazing. in 2022. But that's point number one. Point number two, the return on invested capital, when you look at it, does count for the franchisee. So you want to see that your franchisee partner is able to generate attractive cash flows

at their box because that's your engine of growth there. You need your franchisee to be generating good returns in cash so they can open up more stores. And that's what creates incremental value for you as the parent company. And then to get to your question around operations, that, I mean, that's a little bit trickier. I don't know if I have a good answer for you. I think the reality is that if you're going to be a franchisor, you need to have a team. You need quality inspectors. You need to have guys out there in the field. You need to bring in your franchisees on a fairly regular basis so that everybody is on the same page in terms of how the stores need to look, the standards, the products. And those, that is actually,

there is a, you know, serious execution risk. If you try to move too fast, you sign up the wrong people as franchisees. So most of the big public companies I've dealt with, I've never really seen a problem from that perspective, but I imagine that there are problems for sure. And it's a good question how they manage it. But I think the answer is with lots of people and inspections and meetings. Do you notice a movie about the founders of McDonald's? I saw one movie about it recently. I don't remember.

Yes. Remember the name, but the whole topic was about like two founders who did develop the concept, but had problems in scaling it and one guy who just saw the concept and copied it and then was successful with McDonald's rolling it out and constructing McDonald's in a way. It's quite interesting to understand this dynamics and also a question that came up for me from this.

Is it like if you have a successful restaurant concept or a successful store concept, how helpful is it to have an owner operator in this space? Especially if you think about scaling it and running it like running from 10 scores to like 50, 100 scores, stores, not scores. I mean, look, it's a really effective business model. And you can franchise so many different kinds of things.

So I think you initially might think of stores or restaurants as a concept, you know, like a subway sandwich shop is a something that you can get into as a franchisee with a relatively low initial outlay of cash. And a lot of times the parent will actually finance, help finance that initial outlay of cash to get you in there and open up the store because they believe that the concept will be successful. But, you know, I've seen battery and light bulb stores franchised.

I've seen real estate flipping businesses franchised. eyeglass businesses, really any kind of thing that can be run on a local basis can be franchised. And it's a very effective way to expand or scale, as you put it, quite quickly. If you have enough infrastructure and you can monitor your franchisees, yeah, I think it's really attractive both as a public investor and in the private, private space as well. I often heard when I talk to people in e-commerce and retail, retail is a quote they give me often. So how much love to detail is needed to run a restaurant or a retail business successfully? It depends on the concept. I think with restaurants, you know, cleanliness is very

important. So you need to have a clean store. The kitchen needs to be clean. You've got health inspections. You have a much higher standard. And the consumer isn't going to come back if they feel that the place that they're eating is not safe or clean, et cetera. That's not true at all in some retail concepts. And actually a funny thing that people may not be aware of is that in the discount store space, having a cluttered, messy store actually conveys value, which is to say, if you clean your store up too much, the consumer will actually perceive your prices are higher. So in a way, there's an ironic benefit of being messy and disorganized if you're a value, you know, if you're trying to present to the value. Now, on the other hand, if you're Nordstrom or you're

selling to a luxury customer like you obviously can't get away with that so so that's my answer is it depends on the concept but you know it's important to know who your customer is and maintain store standards that are appropriate for for for that person how like coming back to this in your way of analyzing companies how do you look at consumer feedback for instance Google reviews or yelp reviews are they helpful to you or are just like often biased at the moment because i've heard about some like Italian restaurant chains where everyone pays everyone out like to review the other store badly, that their store looks good and stuff like this. Well, that's very unethical.

So it's a good question. So I have spent too much time looking at reviews. But what I find is that it's not that helpful. So if I use Lulu Lemon as an example, again, you may recall several years. years ago, there was a debacle where they had some manufacturing issues for some of their pants, which caused the pants to, well, VC through. And the founder went on and made the comment that certain customers should not be wearing the pants because they were not appropriately sized, and that's why the pants were see-through, because they were being stretched over a too

grade of an area. So as you can imagine, this was a terrible thing, and I'm putting it very politely here. And the sales went down, the customers were irate, et cetera. So at that time, I spent a lot time reading through the Google reviews, and everyone was time talking about this. But what I've come to to believe is that the online reviews are a forum for people who like to complain. So you have a bias to be complaining on those forums. Like it's if you go on there to complain. So it just, if you as an analyst try to look at the Google reviews and try to understand them, it's going to, I think it will be misleading.

It's not a good, it's not a good measurement. you can't get a quantitative view of the business based on that. It might still be worth looking at now and then to just make sure that a company is executing properly, but the noise level is very high. Like coming back to the idea of retail is detail. Like how much detail do you need for your, like retail analysis is detail. How much detail do you need for your analysis and how much do you like say it's more looking at the bigger picture? You definitely need to understand, you know, how I find how the concept fits within the context of the competitive set.

And so I'm doing a little bit less of it now that I'm mostly based over here in Europe. But when I was in New York, I spent one minimum of one day. every month driving to stores. And so I would drive all around to stores in New Jersey, Connecticut, Long Island, upstate New York, and visit stores. In addition, every business trip I went on, I would allocate a half day or more to visit stores in local markets. So I visited stores in Nashville, in Seattle, in San Francisco, in Denver, in Wisconsin, in Chicago, in Georgia, Florida, all over the whole country. And the purpose of that was to review the store standards, see how the execution is at the store, take a look at inventory levels and promotional activity,

and then also to view the stores relative to the competition. And so I think when you're trying to understand, you know, why is a concept working or not working, you do need to have a grasp of that qualitative component. Like, why is that business different? How is a position relative to the competition? Giving you an example, there's a retailer that I really like that's reporting earnings tonight. Actually, it's called Five Below. The ticker is Five. There's also a Russian food retailer with the name Five, not to be confused with this company. And what Five sells are originally was $5 and less, but it sells discretionary items aimed at a kind of teenage to audience in a kind of a happy but cheaply constructed store. And where does this business

fit within the context of its competitive set? So if you are a college student, and you want to buy some kind of decorations for your dorm room, your options might be Walmart and Target, where you know you're going to get cheapest, you know, a good price, but no teenager wants to shop in that environment. Or you could have a business like an urban outfitters or a hot topic where they have really cool things, but you're paying a significant premium to get those items.

Five below is selling fun, exciting product aim for you at a value. And so what I found is that this concept, the value plus the psychographic target of its customer, they didn't really have competition for their model, what they were doing. And so they were providing solution. and the stores have been very, very successful. They also are very good as merchants and building assortments and taking on top of trends. And the stock has been a fantastic performer.

So I think that's maybe the best example I can give you of why it is important or how I would take into account kind of these qualitative or observational type details when I'm analyzing these businesses. Like what importance do you pay to your own gut feeling or your own taste when analyzing restaurants and retail shops or are you trying to be more like a kind of sociologist in this way or how you're balancing between both views? So another good question. I mean, I think that you need to make sure you don't confuse your taste with the customer's taste. So whatever I might want to do or eat could be completely irrelevant to what many, many other people want to do or eat or buy.

So you have to be able to kind of separate your own personal aesthetic or taste from your analysis. So I think that's important. You know, there's certain clothing that I would never wear, but there are millions of things. people who would wear that clothing. And so that, you know, whether I like it or not is irrelevant. Good point. You mentioned this approach of the unit level approach or figuring out the unit economics. Can you maybe walk us a bit through this approach? You're taking? It's a little bit technical, but let me see if I can kind of talk about it in a way without referencing specific spreadsheets, but maybe I can give you some slides that you can put on

the talk to kind of overlay when I'm discussing it. I do have some presentations that go over. Anyway, so the idea is that you can isolate the sales profit. and capital captured in cohorts of stores or restaurants or individual stores and restaurants depending on how many they are. And when you're looking at a income statement for a restaurant or retail company, the first component is to separate out the expenses that aren't directly attributable to the stores. So I try to estimate, sometimes they break this out for you, but if not, I estimate how much are the corporate overhead costs? What's the GNA? And in the case of retailers, I tend to remove distribution and transportation expenses. And so then get to what is the store

level margin. And so you can calculate what you think the cash flow per unit is. And then based on talking to the company, looking through the filings, presentations, you estimate the capital that's involved in each store, and you calculate return of asset capital that way. That's the kind of the first level. Then you take that and you can do a peer group analysis where you compare what you think the box level return is to many other concepts. And then that tells you, is this a good concept or not? Because sometimes what happens is companies go public with tons of unit growth and Wall

Street wants to assign a large multiple to the stock because of it. hey, look, they can keep opening up these stores forever. But then when you do the actual analysis, you find out that the return metrics on the business are actually not attractive at all. They're just, so tons of stores with mediocre returns is not something you want to invest in. Certainly don't want to pay a high multiple for it. And then the second piece is to do a trend analysis. So we look at, on a linear basis, are the return metrics of the box?

getting better or getting worse. And we try to understand what are the factors behind that? Sales productivity is increasing. Expenses are rising faster than sales. Our rents for the store is changing over time. And we generally want to own companies that have a rising return on invested capital. We want to avoid those that have deteriorating return on invested capital. We also look at cohorts of boxes. So we might say, okay, the company's average store, are excellent, but the stores they open over the last 12 months, if we isolate these, we can see that their returns are much, much worse, and we try to find out the reason for that. And what I would call that is return on incremental invested capital.

And so the kind of the best scenario from an investment standpoint is something where incremental invested capital is higher than the base capital. Let's just repeat that. So every incremental dollar or euro or pound that a company is putting into its business is generating a higher return than the existing business. When that happens, it means operating margins will be going up. Overall return of asset capital for the company will increase. Growth rate will normally accelerate. It correlates with all of these things.

And you get a higher multiple for the stock because you get upward revisions to earnings relative to analysts estimate. And, of course, the opposite is true if you have a deteriorating return on incremental investment capital. Let me give you two examples. When Chipotle went public, it wasn't that well known, but they had some stores in New York City where I was living at the time. And I noticed that people were willing to wait in line out the door to get to Chipotle. Well, there must be 100 places to get lunch on every block in New York City. So I surmise that people must really believe there is a superior product there or they wouldn't wait in line like that. It's hot.

They're wearing suits. Back in the day, people had to wear suits. And when the company went public and started opening up stores, the new store, like people, the brand, knowledge of the brand was actually growing faster than the brand was growing. itself. So over a five-year period, each set of stores it opened opened at incrementally higher revenue levels. And so this was a very virtuous scenario for the stock because the company was consistently beating analyst estimates. Margins were rising. Growth was accelerating. and that just makes the stock do extremely well. The opposite of the case is at ShakeShack.

Shake Shakeshack went public with a small number of stores only located in the highest volume markets in America. So Times Square, Madison Square, New York City, Los Angeles, downtown Chicago. and they've been growing from those locations into suburban locations, smaller towns, etc. And so each incremental store year that they've opened has been a weaker set of store metrics with lower revenues on a per box basis, lower margins, and a reduced return of invested capital. And so that is a scenario that you want to avoid. So to kind of tie this together from an analysis and approach standpoint, that's really the essence of the unit level approach is to find these trends and then understand the implications for this value of the company's stock based on following and understanding what's going on beneath the surface. And that's what I do. That's what I spend most of my day doing. If you do this, how important is also like the integration of digital services and online services for the existing retailers and restaurants, like what are good examples also, like the companies really made it to integrate digital into their services?

So the answer is it's super important, but it also depends. So in the case of the dollar stores, not so important because it's a $12. average ticket and the customer is buying by average ticket I mean that's the average size of the items number of items that they're buying in the store you know it's not something you're going to have shipped to you it's a convenience driven purchase at the last minute and so what their job is to do is to get this product to the consumer at the lowest possible price so they can save money and buy it close to neat. But excluding that in some other cases, the answer is it's super important. And I generally attribute the revenues produced on the internet or e-commerce to the

store, which may have been what you were kind of getting to. And so I'll give you an example. During the pandemic, two companies, Target and Dick's sporting goods, had been investing in same-day fulfillment for years. And because of the pandemic, people wanted to get product without interacting with others, which is to say, either have it changed. ship to them, but another option is buying it and getting it actually delivered to you in the parking lot. Walmart's also been developing something like this. They have what's called drive-through grocery. And you can find this in Europe too. But Walmart actually knocked out a wall onto its stores. They created a staging area with refrigerators and then integrated their grocery inventory into the app so the consumer could go on their app, you know, order what they wanted and then

drive up and never get out of the car and Walmart would come out and put the product directly into the trunk and they don't have to transact or whatever and they just continue driving to get home. The challenge for Walmart is it's extremely difficult to make money on this transaction because previously, if you think about it, the customer was doing the fulfillment, right? They walked through the store and picked all the merchandise. And now you have extra labor because you need someone to walk through the store, pick up all those goods, stage it in the fridge, time it correctly, and get it out into the store. But if we switch to companies that have higher margin products like Dick Sporting Goods or Target, the economics are

different. And they were able to finally provide a, a real response that Amazon couldn't match because even though Amazon's getting a lot of things shipped to you same day, there are some inconveniences associated with getting products shipped to your home. You have an extra cart and you've got to get rid of. What if it's the wrong size? You have to send it back. That's not always so easy. When you buy something online and you pick it up in the parking lot on the same day,

you can immediately verify that it is what you ordered. You can try it on right there in the parking lot if it's apparel and then exchange it right at that moment without having to drive to the post office. And then the customer would typically come in and get add-ons potentially when they got less concerned about COVID. And all of these capabilities were enabled by this multiple years of investment in technology

and knowing where their inventory was at integrating their apps into what's in the store, and then having the store employees be able to fill those orders. Just as a last addendum target, which also operates franchised Starbucks in nearly all of its stores, is trying to integrate its online ordering so that when you arrive at the store, you can also have your custom-made Starbucks coffee beverage. brought out to you at exactly the same moment. Now, think about the logistical challenge of doing that, right? So picking a bunch of diapers and laundry detergent and apparel or whatever and putting that

in the bag, that's one thing. But to get the coffee beverage just the way you want it so it's still hot at the moment that you arrive is another level of precision. And that's amazing. It's definitely something that Amazon can't do for you. and it eliminates the need to do a second shopping trip or a second trip if you're that customer. So technology and Omni Channel, these things are super important. They're definitely table stakes and companies that can execute well are definitely winning.

Digitization is definitely a super interesting topic. But for the end of our great interview, I want to discuss two names in more details. It's Luckin Coffee and Lulu Lemon. Let's start with Lucky and Coffee. You've recommended it as an investment, but it was a fraud. Like, what happened there? Hey, Tillman here. I'm sure you're curious about the answer to this question.

But this answer is exclusive to the members of my community Good Investing Plus. Good Investing Plus is a place where we help each other to get better as investor day by day. If you are an ambitious, long-term-oriented investor that likes to share, please apply for Good Investing Plus. Just go to good minusinvesting.net slash plus. You can also find this link into show notes. I'm waiting for your application. And without further ado, let's go back to the conversation. So if anyone wants to discuss more details and lacking coffee, the person can reach out to you.

your details below. I will link your website below. And now let's take a look at Lulu Lemon. I think it's a bit more known name. But it's not like, I honestly had no, personally I had no touch points with them. So maybe you can tell a bit about a background, especially for the European listeners,

who hasn't had that many touch points with them. What do they do besides recommending that some of their yoga pants shouldn't be wet by everyone or worn by everyone that was past that that was asked um the i believe they do have some stores in germany i'm not sure how many i'm not sure if there's one in stuttgart i have to to go to it today i've already planned it okay okay excellent okay well good visit the store which this is important um uh so essentially they understood that um women uh were looking for very high quality athletic apparel to wear in their activities. And the alternative, which was the Nike product or Adidas or some of these other athletic

brands, I think at the time was more produced with a mass customer in mind. so it's a premium product, but not ultra-premium. So Lulu Lemon came in with very high-quality, well-designed, fashionable product, and really captured the consumer's interest. They also at the stores tried to integrate themselves into the local community, and they aligned their brand with a lot of things. that women in particular felt very strongly about. And so they took share by having great product

with very strong service and small stores in a branded environment with values that the consumer cared about. Now, over the last 10 years, they've tried to expand more into men's, which I think is maybe a quarter of the business now. So it's less female only than it once was. And men seem to have adopted the brand,

even though I was a bit skeptical that that would happen initially, given what I've already mentioned about the kind of female focus. But they've been really great at building assortments and continuing to excite the customer with new cuts and new apparel. sorry, new fabrications and new color schemes and get the customer to continue to buy more. Simultaneously, there have been secular trends in the company's favor around casualization, so that is not wearing as much formal clothing, comfort. They're closing to be very comfortable and being healthy.

So you need to have athletic apparel. and footwear to wear during your activities. One anecdote, which I'll share, you may remember of Under Armour, which is not a company that I followed carefully today, but I used to follow. When I was, I'm a fairly active person and I like to run, and I used to run after graduate from college. At that time, you just wore whatever dirty old t-shirt you had lying around. when you ran and then you threw that in the wash, I never thought I think about it.

But then when Under Armour came along, they took a material, which granted was very old, called polyester, and started talking about its moisture wicking and cooling properties relative to cotton. And then that became something that people needed to wear to do their exercise. and I started to feel, even though I personally didn't care, that if I weren't wearing some kind of fancy fabric that I was just not a serious runner at all. Now, why would you feel this way? Because fashion influences you, whether you like it or not, whether you're trying to have it influence you or not. And so Lululemon and Under Armour and Nike, they just upgraded the entire athletic spectrum in terms of what people were willing to pay for and what their expectations were for the performance. of the product and apparel that they that they were wearing. And so Lou Lemon is now trying

to replicate this success in other markets outside the U.S. while still growing in the U.S. So they open stores in the U.K., in other European countries, and in Asia. And I think they have not been able to replicate that in, for example, France, somewhat in U.K., But where they have done well is in China, Singapore, or some of these Asian markets where they've seen a strong demand for their product, which is interesting in my mind. But it's super powerful from a financial standpoint. The margins are really high. It's all vertical.

They only sell their own brand. They don't wholesale it except in very small amounts. And so you've got a very profitable business that's quite large and growing quite fast in a global basis. And so the market is assigning a very high multiple to the stock for these characteristics. Do you think they can still grow in the future so that the multiple is justified? So certainly you're taking more risk, right, whenever you pay a big multiple. And I think they may be trading at four times revenues. but it's probably a 25% EBIT margin business, you know, which is just to say that every

dollar of revenue they produce, the 25 cents is profit. And they're buying, you know, spinning off quite a lot of excess cash as well. So, and the answer is they have been growing. I do think they can keep growing. You know, they crushed the guidance or their objectives with the last. last three years. So they had to update it and put even more ambitious targets out there. You know, if they do not achieve those as an investor, you're going to get really hurt in the stock because earnings could still grow, but the multiple in the stock will contract quite substantially.

So this is a growth stock. This is not a value stock. This is a name that has considerable risks from an execution and multiple standpoint. But, you know, they've been able to do it. And so far, it's been a smart bet to bet on them. Then thank you very much for the insights into Lulu Lemon as well and in black and coffee. For the end of our conversation, is there anything you want to add people should consider when thinking about retail and restaurant investments?

I mean, the thing, you know, we look for our new concepts, new brands that you can buy when they're still small at, and hopefully at a reasonable multiple. So I think, you know, if you're an investor, you're an individual investor and you're looking at the space, you should use your own experience. You should say, hey, where do I like to shop? You know, why is this concept good? And then you can use that as an edge, you know, as a legitimate edge to think about

the business from an investment standpoint, then do, you know, the rest of the real work that you need to do. But that is a legitimate way, in my view, to start from a stock selection standpoint. Then thank you very much for our great conversation. Thanks for having me. It's been great. And thank for the audience staying till here. Bye, bye. As in every video, also here is the disclaimer.

You can find a link to the disclaimer below in the show notes. The disclaimer says, always do your own work. What we're doing here is no recommendation and no advice. So please always do your own work. Thank you very much.