Motley Fool Hidden Gems Investing - Can AI Build Moats?

Episode Date: September 5, 2024

It takes more than a buncha buzzwords to build a company. (00:21) Tim Beyers and Mary Long discuss: How jobs reports impact investment theses A tech company’s changing identity What C3.ai actually does (14:48) Sanmeet Deo joins Mary for a look at how a chicken restaurant cooks up success. Learn more about the Range Rover Sport www.landroverusa.com Companies discussed: AI, NVDA, MSFT, WING Host: Mary Long Guest: Tim Beyers, Sanmeet Deo Producer: Ricky Mulvey Engineers: Dan Boyd, Austin Morgan Learn more about your ad choices. Visit megaphone.fm/adchoices

From morning hockey with a cup of coffee to Timbits and road trips, Tim's and Canadian Tire have always gone together. Now it's official. You can now earn Canadian Tire money at Tim's. Link your Triangle Rewards and Tim's Rewards accounts to earn twice with every Tim's run. Terms and conditions apply. Visit timhordens.ca slash triangle for details. There's a new release from the artist formerly known as C3IOT.

You're listening to Motley Fool Money. I'm Mary Long, joined today by Tim Byers. Tim, thanks for being here. Thanks for having me, Mary. Fully caffeinated, ready to go. Same. Also got my coffee, ready to go. We're going to start today looking at some jobs data and then zoom into something to

company reports that are a bit more specific. There's a few different pieces of jobs data that are out this week. Yesterday, the Bureau of Labor Statistics reported that July saw the lowest number of job openings since January 2021. Today, payroll processing firm ADP put out a report that corroborated a lot of that data. There's another jobs report coming out tomorrow. Lots of numbers, Tim. How should investors be thinking about these, if at all? I mean, I'm going to be honest. I do not think about these numbers at all in terms of investing theses, but it does seem to me that it's an interesting labor market in that it might be a little bit tighter than we expected. So that's

kind of fascinating, especially with all the layoffs we've seen in tech. So I find that somewhat surprising, but also somewhat encouraging. I mean, maybe you have people who are landing back on their feet. What I hope is not the case is that those people have not landed on their feet and just employers have stopped hiring. That would be much more problematic. So I don't know which it is, Mary, but my hope is that a tighter job market means that we are getting people into roles that you know, that, that work for them and that work for companies, it would be more problematic if it just means idle employees that have been laid off recently. So I guess we'll have to see what the unemployment rate is when it, what's paired with these jobs numbers. But I think it would be

harder to like it, if, if there are some tough numbers in, in the unemployment rate, for example, Would it be useful for the Fed to take action the way that they've been talking about this to maybe lower some rates and try to stimulate some things? I mean, that wouldn't be the worst thing, would it? We'll leave the macro behind and turn to a company within the tech industry that reported last night. C3 AI reported yesterday. We're going to dive more into those numbers that they shared in a moment. But first, some clarification. And Tim, I'm hoping that your background in PR comes in extra handy here. Oh, boy. C3.ai is, quote, an enterprise AI application software company. Okay. It helps retailers use data to, quote, this is me pulling directly from their website,

improve profitability and minimize costs. It helps governments, wait for it, Tim, rapidly address their most pressing needs. What does all that mean? Is that what AI does? that is an outstanding example of buzzword bingo right there exactly all the markers hit all the markers there this is something we see from time to time and something that yeah in my pr background there is never a shortage of companies that flood to the narrative of the moment when the narrative emerges. And in this particular case, the narrative is, how can I connect to AI? Everybody, everybody wants to be connected to AI. And in C3.ai's case, they actually have been talking AI for years. And what they say is they're an enterprise AI application software

company. What that means is that they have a suite. They do several things, but the thing that distinguishes C3.ai is that they have a bunch of pre-built applications that allow you to, and some of this is AI workflows. I would call it more machine learning than I would specifically AI, but that's in the same range of AI. They've been around for a long period of time, a lot of data processing, a lot of automated workflows. These pre-built applications that can pop into your environment are what C3.ai has been building for years. They build them across a bunch of different industries. You said C3 IoT earlier in the intro. That is kind of the thing that they do. They've always had a bit of applications that are designed for

a specific business problem or a specific industry. And so they roll these up and they say, we have a big platform. We build a lot of AI applications. And so the argument is you want AI. Great. Let us give you something that provides automation, workflow, machine learning, all that stuff, pre-build it. You plop it in. We'll put some professional services against that, help you get it up and running, help you customize it. And you're off and going versus you use a generative AI tool or you use some other tool and you hire a bunch of engineers and you have a bunch of maybe access to a bunch of NVIDIA GPUs and you build something from the ground up. C3.ai says, why would you build it from the ground up? Use our stuff, use our

applications, our templates to accelerate what you want to build and you customize it. So in other words, why would you invent Legos if I give you a Lego set? It's probably worth noting here that C3 AI is no stranger to buzzword bingo. They've gone through some name changes over the years. They've been C3 Energy, C3 IoT, kind of like have a reputation of attaching themselves to that trend of the moment. And again, AI has been the trend of the moment in the market now for a couple of years, but for C3 AI for a while now. Okay. All that said though, what is their moat? Like you just described what they do. What, what is it about C3 AI's template that say Microsoft doesn't offer? Well, Microsoft's not doing those, those templates per se. They don't have a bunch of

predefined templates that you would use to jumpstart your development or jumpstart your, your application so so that's the that's the advantage here is that c3 ai has done the pre-building for you they've done the work up front whereas other companies that are in this space that want to make it easy for you to build say your ai applications the presumption is you would build it and you would build it from soup to nuts because what ai would do is make you know development, particularly custom software development, way easier, way more automated. So you can do that. You can build your soup to nuts application. But C3 is saying, you don't need to do that. We've done a lot of the work already for you. So there is an argument

that if you've got something that's pre-built that solves 80% of my problem, I'm interested because I'm not going to have to hire a bunch of engineers to do that. You've already solved a lot of this for me, and you may be able to come in and plug into my specific problem because you have what's called domain expertise. You've looked at a problem in an industry or for a particular business problem. You've seen how things go wrong, and so you can help me. That is a pretty good argument, Mary. It's maybe not the best argument, but it is an argument. Let's not dismiss that entirely out of hand. I recommended this years ago on the belief that this idea of pre-built templates is actually a decent one. It may not be the most advanced AI, but it ain't a bad idea.

What ended up happening, though, and ultimately why I chose to get out of it, is that C3.ai was spending so much money to convince the market of their idea that it would really look like a very, very difficult slog and that they were having a hard time growing beyond the limited number of things they were doing. They had core customers, but getting brand new customers and the cost to acquire a customer was just so high. It didn't feel as sustainable as I wanted it to feel. With yesterday's results, you have C3.ai sharing that they do seem to have booked new deals. They've got revenue growing 21% year over year. Stock is still down, all that said. Stock's still down this morning about 12%. Wall Street wasn't terribly happy about the fact that

subscription revenue was a little less than expected. Let's zoom in on that revenue data, though, because I think that that's something revealing. Total revenue is increasing, but if you zoom in average selling price is declining that doesn't sound great well it just it just means that you can't charge a premium and then there's a so there's a couple of from the slides what we see here this is their supplemental data so their total revenue mix here so subscription revenue as a percentage of total revenue last year at this time 85 this this year 84 so professional services are making up a bigger proportion, not a much bigger proportion, but a slightly bigger proportion. In other words, meaning that they may not have gotten all the deals they want or the

big subscription revenue value that they wanted, but they're making it up on their professional services, which they get a 90% gross margin on. They don't just sell you the software. They get a 90% gross margin on installing and customizing that software, which is a pretty good deal. Also, when you look at their total contract value, so this is a key metric called TCB, total contract value, average total contract value. So last year at this time, $800,000. This year, $700,000. So 0.8 million versus 0.7 million. So it's going down. So, it suggests that the commitment to C3 AI may not be as big as we would like it to be. And this is not the only data we have seen looking for their, well, let's keep going.

There's other data here in terms of their backlog. Yeah, this is what's called their remaining performance obligation. So Q1 of fiscal 2023, $458.2 million. Q1 of 2024, $334.6 million. Q1 of 2025, $204.5 million. So that backlog, Mary, seems to also be going down. This is not in any way a death knell. This isn't like, I don't want to say that. I'm just saying it does seem as though C3 AI is having to make some concessions to win deals. But why is that happening? Because we're in the midst of this AI arms race where companies are bragging about how much money they're spending on AI and research and development, et cetera. Why hasn't C3 AI benefited from, this is a company,

their ticker is literally AI. Why haven't they benefited from the larger tailwinds of AI that we've seen elsewhere? I mean, they are doing generative AI now, but that's not how they started. They're a legacy player here. And those templates, even though that is their strategic advantage, that isn't generative AI. And the generative AI they're doing is essentially applying a natural language engine on top of maybe an existing application or in an existing environment in order to ask questions of the data that exists about the company or what the application is doing. That's useful, but that may not be the same thing as what others are trying to do with generative AI. And let's be clear, the hype around generative AI is it is changing

everything. And so I could use it as a general purpose tool, and I could start from nothing and build my thing from scratch. And I could do it in an automated way. I can do it in an accelerated way. I can use a bunch of NVIDIA GPUs to do this. I don't have to use as many software developers because the AI is going to write the code for me. I think you know where I stand on that. I think a lot of that is nonsense. You still have to do the hard yards to get things done. Having said that, the C3 AI story of we've done 80% of the work for you and you just have to customize it, that is not the sweet spot of where the generative AI story is now. The generative AI story is you don't even need that 80% to get started here. The generative

AI is going to do like 90% of the work for you and it's already going to be automated. Again, probably nonsense. I think the C3.ai story is a decent one, but are they in the same narrative bucket as, say, like an NVIDIA? No. No, they are nowhere near it. Tim, as always, pleasure talking to you, learning a bit more about C3.ai. Thanks so much for coming on to the show today. Thanks, Mary. to Timbits and Road Trips. Tim's and Canadian Tire have always gone together. Now it's official.

You can now earn Canadian Tire money at Tim's. Link your Triangle Rewards and Tim's Rewards accounts to earn twice with every Tim's run. Terms and conditions apply. Visit timhordens.ca slash triangle for details. For all the talk about a fast food slowdown, there's one quick service chain that keeps on flying high. Up next, Sandmeat Deo joins me to discuss Wingstop's recipe for success.

One of the stories of the summer has been that so many fast food chains are kind of roughing it. McDonald's, same store sales down about 1%, Starbucks comps down 2%, Chipotle and Kava and a few others offer exceptions to that rule, but even their numbers pale in comparison to that of Wingstop, the chicken wing chain that's seen same store sales increase nearly 30% year over year. Send me, you're a Wingstop fan. In fact, when I slacked you about doing this segment with me, you said, Wingstop is rocking. So what's Wingstop doing that's got it rocking where so many others seem to kind of be flailing? Yeah. You know, I'm a proud shareholder and,

you know, they keep it simple, very simple, clean restaurant operating model with very few ingredients. They sell chicken wings, sandwiches, tenders, sodas, and fries. That's it. Nothing fancy, exotic, or excessive on their menu. Very simple. Also, they have a small footprint with high average unit volumes, which is basically like your sales per store. Their average store is only 1,700 square foot, while a Chipotle or Cava tends to be 2,000 square foot and above. Their AUVs are nearing about 2 million. Now, they're targeting 3 million as of their most recent call. And the newer prototypes are about to be 1,300 square feet. So they're even shrinking it. Only takes four workers to operate the store. And they have limited in-store dining. So mostly

pickup and delivery and digital ordering is what drives the concept. That digital ordering piece is really essential. And it's a metric that Wingstop is proud of. Nearly 70% of their sales come from the digital channel. CEO Michael Skipworth has said that the goal is that that number eventually becomes 100%, that all of their sales come through digital ordering. We started off kind of comparing Wingstop to the story that's going on in other fast food chains. So let's keep comparing for a second. Starbucks has leaned really hard into the digital ordering, and some might argue that that is kind of what's caused their slowdown as of late. So maybe digital ordering isn't all it's cracked up to be.

Why does Wingstop want all of its sales to come through digital orders? I think with Wingstop, you know, obviously digital orders have proven to be efficient, frictionless, and improves the speed of orders for customers. But I think Wingstop too has more of an experiential experience. You know, football season is right around the corner. For me, I love college football. I just started NFL is about to start this week. You know, people order a bunch of wings from Wingstop, take them home, eat with their friends,

watch the game. And you could do it quick on your app online. And so it's more experiential than a Starbucks would be. They're also building out a proprietary tech stack called My Wingstop to improve the app and the web experience, and also likely make it a little more fun, more personalized. Their digital ordering also lets them collect vast amounts of data on their customers, creating new levels of personalization that help them with customer retention and frequency you know imagine getting alert for to order wings in in advance of your favorite sporting event with like the flavor you love you know they send a push notification you're like oh wow it is time for a game and would love to throw a little get together yeah the experiential piece

is so interesting to me there because i think typically when we hear that word in conjunction with restaurants we think of the restaurant as being the experience but wing stop is like no it's diy we'll give you the food you do the experience yourself but you still attach that experience to the brand of Wingstop, even if it's not happening in-store. About 98% of Wingstops are franchises. I want to highlight this with you because I know that you're really interested in the franchise model yourself. When you're looking at this company from a public markets perspective, how does that franchise-heavy model factor into your analysis? Franchise business models are pretty attractive business models. They're asset-light, low capital intensity,

not much capital spend that the franchisor, the parent company has to do. And they get a high margin of royalty and franchise fees from the franchisees. It's an attractive business model. Like I said, if the sales are strong, if the relationship with franchisees and the franchisor is healthy, and if the investments that they're making from the sales that they get into advertising is fueling the brand awareness and furthering the sales to the stores, it can really create a flywheel effect in terms of the franchise model. Also, they're relatively easy to operate. You can quickly turn a profit after opening, especially with these Wingstop

stores. Growing brand awareness, quick return on investment, rising AUVs and average unit volumes, ROICs all play into that strong demand that potential franchisees are having for the business. Skipworth has said that Wingstop's ambition is to become a top 10 global restaurant brand. Right now, they do about $3.5 billion in total system-wide sales. So, to reach this top 10 restaurant brand goal, they'd probably have to turn that $3.5 billion into closer to $9 or $10 billion. How does Wingstop plan to achieve that? You know, they have a pretty aggressive plan. Like they said on their most recent earnings call, they think their stores can reach 3 million in average unit volumes.

That's $3 million per store. Their oldest store that they first opened actually now does $4 million. So there's actually maybe even more upside potential there. They think they have, like, Wingstop has about 2,300 stores right now globally. They think they can get to 6,000 domestically and 10,000 globally. They still have lots of the white space opportunity in the delivery channel through DoorDash, Uber Eats. The biggest risk to achieving this is, you know, franchisee relationships deteriorating, rising food costs, and, you know, any significant slowdown in sales. When you talk about the potential for the relationship with franchisees to deteriorate, like, how might that happen? Because right now it sounds like relationships with franchisees is pretty rosy.

Yeah, no, absolutely. You know, when things are going well, the relationship can go, you know, pretty smoothly. When things hit like a slide, sales slow, food costs go up, maybe the franchisees themselves are not making profits because they're taking on all the capital to open up the stores and spend. And then they send the royalty fees to the franchisee, franchisor, excuse me. And if they feel like they're not getting any value from the franchisor in terms of ad spend technology, then that relationship can deteriorate and it can deteriorate pretty fast. Wingstop's got about $140 million in cash and cash equivalents and over $713 million

in long-term debt. How do you feel about the balance sheet situation here? Yeah, not the cleanest balance sheet that I usually look for, especially with a franchise business. They have a lot of long-term debt. I think it was like $700 million or plus. And they're paying a dividend. So I don't love that they're paying a dividend while they have debt. But given that it's an asset-light model, they get a steady stream of revenue from the stores that they currently have open and the ones that they're about to open. Their net debt to EBITDA has been declining. Their interest coverage ratio has been increasing. So those are trending in the right direction. So while it is a spot for concern, I'm not overly concerned about it.

The company has been around since 1994. And since that time has moved through a handful of private equity purchases. Michael Skipworth has led Wingstop since 2022, but he's been with the company for nearly 10 years. What should investors know about Skipworth himself as CEO, but also perhaps Wingstop's history? Well, I haven't dug into it too much, but in terms of what I was just talking about with the balance sheet, given that there's been a lot of private equity ownership, that debt could have come from that historical ownership of private equity because they tend to load up companies with debt that have generated steady streams of cash flow to juice their return. That might be an explanation for some of that

long-term debt that they have. But Skipworth has been around with the company for a long time. He's previously President and Chief Operating Officer for taking over the CEO role. He has a background in finance and accounting. I like the combination of experience he has with operations and finance, so it makes me feel like he'll guide the company in a profitable and sustainable way and not just try to grow at the sake of growth's sake. He doesn't have as much ownership and shares of the company as I would like, and neither does the rest of management, but that's okay. Wingstop trades at around 115 times earnings, which is pretty expensive for the industry. Just as a point of comparison, McDonald's and Starbucks have PE ratios in the mid-20s.

What say you? Does Wingstop's growth story justify that pretty high price? Yeah. Their valuation has just flapped up to the moon here over the past year and plus. It is a big concern with owning the stock. It's high valuation. If you look at the out years, the next few years, you can reasonably expect that it might grow EPS around 30% plus. Their PE in outwards three years is around 65 times. So it's about a PEG ratio, which is the PE over the growth rate of above 2. It's a famous Lynch ratio that I like to look at as well. In comparison, Chipotle has a forward peg ratio of above 1.5. And Kava has a forward peg ratio that just doesn't make sense, like way above 8. So, Wink's valuation is definitely rich.

But what I find interesting is their fundamental metrics are just, like I said when we slacked, it's just rocking. Their growth is out of the park. Their return on investment, their ROIC numbers and it's healthy, like 20% plus. So definitely great fundamentals. But if those start to slow, the stock will get whacked and the volatility could be very high. And it already has proven to be pretty volatile as it is. Okay. So one last thing. I am embarrassed to admit that I have not been to a Wingstop. In fact, before I started hearing about it in the news and thinking about this segment i had never really even heard of wing stop but i am going this friday to check it out with some other fools you've been before you're a fan of the restaurant you're a fan of

the stock what flavors should we be trying yeah yeah you know i've only eaten there a few times too and their brand awareness is just starting to really ramp up with uh the ad spend that they're doing but lemon pepper is their most classic and most popular sauce so uh that's a nice moderate sauce if you like to ramp up the heat i would go with the mango habanero but i'm tempted i'm warning you, it's very high on the heat scale. If you're looking at something a little milder, you can try the hot honey, which is a popular option too. It kind of plays into a lot of those Nashville hot honey kind of trends that are out there, but their sauces are all pretty fantastic. Okay. Reviews to come. I'll report back on the mango habanero. I am certainly interested in that,

if not a little nervous about it too. Awesome. Thanks, Edmeat. Always great to chat with you. Thanks, Mary. As always, people on the program may have interest 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. I'm Mary Long. Thanks for listening. We'll see you tomorrow.