3 Stocks With Something to Prove

In the melee of earnings season, some stocks have more to prove than others. A big earnings surprise can send a stock soaring, but in many cases a robust earnings beat also delivers an emphatic message from management to shareholders: Don't count this company out yet.

In this episode of Industry Focus, Vincent Shen and senior Motley Fool contributor Asit Sharma discuss the robust earnings results from three companies looking to win back their shareholders' confidence: Under Amour (UA 1.73%) (UAA 1.81%), Starbucks (SBUX 0.53%), and El Pollo Loco (LOCO -0.12%). All three organizations have faced operational challenges over the last several quarters, and our podcast team discusses where each one might go from here.

A full transcript follows the video.

This video was recorded on Nov. 6, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and it's Tuesday, November 6th. We've been meaning to catch up on earnings with some major reports in the past week. We'll be updating listeners on two leading consumer retail companies before introducing a restaurant chain to Industry Focus. Joining me for this discussion is senior Motley Fool contributor, Asit Sharma, who's calling into the Fool HQ studio via Skype. Hey, Asit! Thanks for hopping on.

Asit Sharma: Thanks a lot, Vince! Great, as always, to be here. 

Shen: We have a lot to cover today, so we're going to jump right into our first report from last week. That's Under Armour. The company released its third quarter results on October 30th. The stock is up almost 30% since reporting. That pushes its year to date gains to 60%, which has got to be a pretty encouraging sign of recovery that I'm sure shareholders have been hoping to see since the stock fell off a cliff in 2016. CEO and company founder Kevin Plank announced a major restructuring effort this time last year. With this latest Q3 report, where do things stand now, Asit?

Sharma: One of the things that is really important for investors to grab out of this report is that Under Armour is really ratcheting up its operational efficiency. As investors remember, the company's had some problems with high inventory levels. In this industry as of late, that's not unusual, but we always talk in terms of behemoth competitor Nike. Nike has a system that's evolved over decades to manage these blips in inventory, when they rise and you have to cut back. Under Armour, not much. It's a younger company. They installed a new COO last year, Patrik Frisk. I think he's done a great job of instilling discipline within the executive team and throughout the company. 

One of the things I liked about this quarter was that while the revenue increase was small, inventory decreased 1%. That that may not seem like a lot, but with the flood of merchandise that the big apparel companies, sports companies, have had to work off their books, that's actually pretty good. I'm encouraged by that. 

One thing that overall I wanted to say about Under Armour's approach, it recalls to my mind a famous quote by Jan Carlzon, who was the CEO of Scandinavian Airlines when they were having problems in the 80s and 90s. He turned that company around. He's famous for saying, "You cannot improve one thing by 1,000%, but you can improve 1,000 little things by 1%." I think that's the story of this quarter.

Shen: The weakness in Under Armour's domestic business, it was down 2% in the latest quarter, that still seems to be a little bit of an elephant in the room since. The domestic business still makes up the large majority of revenue. Remember that Under Armour was on a hot streak. They reported 25 consecutive quarters of over 20% growth. The stock was priced accordingly until that growth story fell apart about two years ago. Once that momentum dried up, some other issues flared up around profitability, their distribution partners, and also inventory levels, which you touched on a little bit.

But the latest guidance from Plank and his team is for full-year revenue growth of 3-4%. North America is still down while international is up 25%. Asit, what do you think will be the top developments for investors to watch in the new year? International is likely to play a more important part of the Under Armour story. Same for the direct-to-consumer business. That now makes up about one-third of the top line. What's on your radar for 2019?

Sharma: For me, it's a continued working down of the product availability, in terms of a number of different products that Under Armour puts out. It's reduced its SKU, stock keeping units, by about 40% year over year. That's going to be important in North America, where the question of the day is not how much of a bunch of items it can sell, but what it can sell that gains traction with consumers without then putting into its channels a lot of stuff that the younger consumers don't want.

I note that in the past, it was enough for Under Armour to sign up superstars like Steph Curry. And, yes, they did just sign Joel Embiid, which is a great win. But this company, the story going forward is managing product levels, continuing to shove out the innovation it's known for, but really being that disciplined kid that's grown up to compete with the larger organization. That's what I'm looking at. Next quarter, I'd like to see how they've done on reducing those stock keeping units a little bit further. 

Shen: We have to move on here. Our next update is for Starbucks, which also enjoyed a boost from its fiscal fourth quarter results, with shares up 10% since the report. This is another company, an industry leader, that has had to deal with decelerating growth, though not to the same extent as Under Armour. Prior to this latest report, Starbucks delivered just 1% comps growth in the U.S., by far its biggest market. More concerning than that was the fact that comps were down 2% China. Management has really talked up China as Starbucks' next big growth opportunity thanks to the hundreds of millions of people in its massive middle class. But management had better news to share last week. Asit, what were the big highlights for you from that announcement?

Sharma: The number that really jumped out at me was this fiscal fourth quarter revenue of $6.3 billion. It represented 11% year over year growth. Why I like that number, long-term shareholders will remember, even as recently as two years ago, Starbucks included in its earnings algorithm this long-term growth rate of 10-11%. As Howard Schultz transitioned out, Kevin Johnson took over, and the company started to encounter these difficulties with traffic, not just in the U.S. but in each of its major regions. That number has fallen by the wayside. Now, Starbucks is emphasizing that it's going to grow its non-GAAP EPS -- earnings per share that can be adjusted beyond what generally accepted accounting principles allow. That adjusted number is now going to be 12% or greater each year. 

Everyone knows, that's not a hard number for a big corporation like Starbucks with a lot of spare cash at its disposal to generate. It has a number of ways it can do that. It can cut some costs, buy back some shares. So, when I saw the number pop up that it had 11% year over year growth, it gave me a glimmer of hope that maybe the company can return to its former aggressive growth levels. 

But I want to ask you, Vince, one of the things that jumped out at me -- in all of its comps numbers, this includes the Americas, China, Asia Pacific, the emerging markets, the comps growth was due to higher prices and better mix. So, a better mix of espresso beverages, better food. The change in average ticket rose in each region -- in some cases, 2%, in some cases, 4-5%; but traffic declined 1% in every region except the emerging markets region. And if you look at the four quarters that Starbucks has just put in the book, that ends its fiscal year, this is a trend that's gone on all year. I say that's not a sustainable trend. If you had to choose between the two, you'd want traffic to always increase, because at some point, as economic growth around the globe ebbs and flows, consumers pull back. Right now, they're in a spending phase because of good economic growth. I was curious, Vince, what did you think about that divide between less traffic, but maybe a bit better pricing, better mix?

Shen: That was one issue that I had looking at this report. Investors, especially with the positive market reaction to this earnings report, really hung their hats on that 4% comps growth in the U.S. market. But traffic was down 1% in the quarter, and I believe for the full fiscal year. This has been an ongoing challenge for the whole quick service restaurant industry, where price increases have basically been masking a few years, at this point, of weak customer traffic. And you're right, that's not sustainable in the long-term.

But at the same time, with some of the changes that the company is making to its business -- and a big part of that story, again, going back to China, we're back to positive comps there, which is an absolute must after the company spent over a billion dollars acquiring its Chinese operations from a joint venture partner. By 2022, management hopes to more than double its Chinese store base to 6,000 locations. But combine that with the fact that that went from basically a licensing, collecting royalties system, to now, those are company-owned locations in China. Also, something I saw come up from management, food is becoming a bigger and bigger part of the revenue generated at Starbucks stores. Those items carry a lower margin. We're seeing an overall hit to profitability in that way, especially the operating margin for the company. I don't necessarily think that's a bad thing. How that relates in terms of the traffic decreases that we're seeing and the long-term challenges that poses, I think it's the right move for Starbucks to expand its menu, to focus on some of these food-based items, and other opportunities. They have this partnership, a $7 billion deal with Nestle, having Nestle handle their goods outside of stores, in store in grocery market aisles, for example. These are some of the opportunities that will help offset that challenge. But overall, I'm not quite sure where Starbucks will ultimately be, especially with that traffic number declining, while they're rolling out a lot of these new digital capabilities, these initiatives. But, I am encouraged by the fact that they're focused on efficiency in the store, trying to clear more time for their employees in the store to focus on service rather than spending two to three hours per day on administrative tasks. I do think management is cognizant of the challenge with that decline in traffic, that decline in transactions. Wrapping up this part of the discussion, that's something I'll be watching in 2019, as the big factor for Starbucks. I'm curious, what are you hoping to see? What are you going to be tracking closely in the next year for the company?

Sharma: I'll be looking for the effect of some of the initiatives that you mentioned, including that higher touch with customers. I do think that underscoring Starbucks' strengths, which are its relationship with its customers, is important for the long-term. And I, for one, am interested in the next couple of years to see when Starbucks tells investors that it wants to slow its growth in China. That's a huge capital investment. If you think about all the stores that the company is building, they've become fixed costs over the long-term. On the other side, it's got this great deal with Nestle, which is a capital-light model. I'd love to see a little bit more, if possible, of franchising deals, bottling deals, as it has also with PepsiCo. I'd love to see those going forward. And, at some point, a sunset on the idea that all of our dice are being rolled in China, and to hear from management, "Here's our next generation plan." This is probably looking two years down the road, but we might as well put those issues out on the table.

Shen: I'm going to leave listeners with a summary that's written by fellow Fool Jason Hall. I like this because he covered the earnings report last week, and he brought into focus just how much change Starbucks has experienced in the past year. "Fiscal year 2018 was a transitional period for Starbucks in a multitude of ways. Longtime CEO and chairman Howard Schultz has largely stepped away from the business for the first time since taking it over decades ago, while longtime CFO, Scott Maw, will retire in November. The company made the bold move to take full operational control of its China stores this year while closing its Teavana retail operation, selling its Tazo Tea brand, and also shifting operational control of its consumer packaged goods to Nestle in a $7 billion plus deal." 

Where that leaves us for 2019, again, definitely wanting to see that traffic number strengthen for the company, given its investments in some of those digital capabilities, the mobile order and pay, also the loyalty program, the growth they're seeing there, and then the push to provide better service. That is definitely going to be a big theme for the new year. 

Our next topic is El Pollo Loco, ticker LOCO. This fast-casual restaurant chain specializes in citrus-marinated, fire-grilled chicken and other Mexican-inspired cuisine. The chain was founded in 1980 in California. They've since expanded to about 500 locations, with a close split of company-owned and franchised locations. They're active in other markets like Texas, Arizona, Nevada, and Utah. In the trailing 12-month period, the company generated $425 million of revenue and was profitable, but the stock has underperformed since its IPO in 2014. Shares priced then at $27. Even though the stock is up 25% since reporting earnings, they still trade well below that IPO price at just $16 per share. 

Asit, whenever you and I plan our episodes together, you'll usually send me a list of topics or tickers that you're interested in covering. I've seen El Pollo Loco pop up on that list for some time now. I'm glad we're finally able to talk about it. I'm just curious if, one, you've had a chance to try their food; and two, how this specific restaurant chain ended up on your radar.

Sharma: I'm on the East Coast, so unfortunately, there aren't a lot of El Pollo Loco locations. There's one that I know that recently opened in Louisiana, I think there are a few others. None near me. But I'm a big fan of Latin American grilled chicken. I think Latin Americans do chicken on the grill really well. There's a local chain here called Mami Nora's, which takes Peruvian-style chicken, they import their ovens all the way from Peru, charcoal-grilled. It's really delicious. [laughs] How this company caught my eye is my weakness for this food that I love. So, I'm anxious to try El Pollo Loco at some point in my travels.

Shen: Before we get into the quarterly results they reported last week, and also the outlook for the company, the big themes from what I've seen for El Pollo Loco have been: new leadership under CEO Bernard Acoca, and also the hit the company took from its rushed expansion into new markets. Asit, can you provide some color, some background for listeners new to the story about what is driving and framing the business right now?

Sharma: El Pollo Loco went public in July 2014. If you wind back the clock, you can remember an age in which Chipotle was steaming ahead. Everyone was looking for the next Chipotle. That's a phrase I became tired of seeing in the news feed. "Is X the Next Chipotle?" El Pollo Loco was one of the proposed candidates as soon as it went public, of course. Chipotle's fortunes changed, which put a drag on the rest of the sector. And this company ran into problems of its own creation. In late 2014, El Pollo Loco made a major push to expand into Texas markets like Dallas and Houston. This was its first non-contiguous big expansion. Most of its locations are in California. The concept did not catch on. In fact, it was so bad, the company had to write down about $27.7 million in impairment charges in 2017 against about 20 company restaurants. It also wrote off about $5 million impairments against some underperforming restaurants in California and Arizona.

In that process, the company's total restaurant margins, that is, the margins which individual restaurants make on their revenue when you take out food, packaging costs, rental costs, labor, etc., those margins declined from about 27% all the way down to around 18-19%, where they are today. This stock went from being a newly public potential candidate to replace Chipotle to a value play in a matter of months. 

This here caught my eye. After those impairment charges, I noticed that El Pollo Loco was making a much wiser and more deliberate expansion into new markets. It's upgraded its store concepts. And, of course, bringing on the new CEO has had an effect, which we'll get to in just a moment. But, before we talk about this quarter, that's basically the situation that the company has found itself in, and why it's recovering rather than having stellar growth over the last few years. 

Shen: I'm looking at the press release for this third quarter, reported on November 1st. Some of the encouraging signs that really jumped out to me: 2% and 3% comps growth for company-owned and franchised locations, respectively. 11% year over year top line growth. Given that you've been following the company for, it seems like the past year or so, how encouraged were you buy these Q3 results?

Sharma: I was pretty encouraged. One of the things that the company did in this earnings report was to revise its comps growth projection from what was previously negative to flat, and from flat to 1%. Now, that doesn't seem like a whole lot. However, average check size is improving. When you have flat to positive comps growth supported by average check size -- this is very similar to the Starbucks situation we talked about, except that El Pollo Loco has every opportunity to increase its traffic -- that's a recipe for future growth. It also represents a flattening or bottoming out of the curve that we've seen over the last couple of years. Basically, if you can imagine a stage being set for greater turnaround. That was very encouraging to me. 

I also liked that, even if you take out an adjustment for a new accounting method that the company had to implement -- which is germane to a lot of fast casual restaurants which have franchised advertising revenue, even if you take out that -- the top line still jumped by 5.5%. It was 11% reported, but take away the adjustment it had to make, and it still had nearly 6% total growth. That's a function of opening new stores again. The CEO, Bernard Acoca, has promised to maybe next quarter give some numbers for store openings going forward. I think they're going to have a more aggressive schedule in the coming year.

And finally, the thing that I really liked about this report is the discipline that El Pollo Loco implemented in its strategy to increase its check and traffic. It went to basically a $5 promotion. This company straddles the line between fast casual and quick service. And it avoided trying to become a quick service restaurant, like a McDonald's or Burger King, and offer two for one specials. You might think that a company like El Pollo Loco, which is a sit-down fast casual family oriented place, wouldn't necessarily jump into that type of a menu change. But I'll give you a great example, local to me, and many listening today would know that Bojangles actually has had some very deep promotions over the past couple of years, and tried to play this fast food value menu game. That's actually hurt their growth. I like that this discipline helped the company stabilize its revenue.

Shen: For a restaurant chain, a lot of the big metrics that tend to drive headlines are the comps that we've touched on, the top and bottom line growth, and with some of the expansion challenges and the effect that weakness has had on profitability. You mentioned how the restaurant contribution margin for El Pollo Loco fell from that high 27%. I think guidance for this year is about 18-19%. Given how the company's had this experience, where they were slapped on the wrist with issues going into a new market like Texas too aggressively, I'm curious, management hasn't spoken to their guidance for expansions next year. What's your outlook, in terms of if they are able to take this more cautious or conservative approach to new restaurant openings? Do you think over time, they're going to be able to bring that restaurant margin back up to these levels? Maybe not quite as high as that 27% peak, but at least above the 20% mark? And, do you think that's something the company might be able to achieve in 2019?

Sharma: I think it's certainly in sight. One of the factors that's pressuring all restaurants in the industry now is increased wages. It's actually a good thing for the folks who run the restaurants where we go out to dine. But increasing labor, inflation in the labor category, is going to put a cap on ever returning to that 27%, at least in the next year or two. However, I think it's very achievable to break above 20% again. That's more operational discipline. It's getting customer traffic flow to be just a little bit higher. 

It's also marketing to the right people. One of the things that Bernard Acoca has done at El Pollo Loco is to quickly find out from an external survey what customers love about it. He's found that customers love the family oriented atmosphere, so El Pollo Loco is starting to market in that direction. He's found, unsurprisingly, that the company is very strong in the Hispanic market. It's also very strong with those who seek out healthy dining options. In just the space of a few months, El Pollo Loco has fine-tuned its marketing, and I think we're going to see traffic start to build with this more focused approach on the core customer. That's something else.

And, if we have a moment, I'd also like to talk about the valuation before we wrap up on this company.

Shen: Yeah, let's wrap up with that. We have a couple more minutes. What do you think here? With how the stock has traded since its IPO, it's reached levels that are probably more in line with some of its bigger restaurant peers. What's your take on where El Pollo Loco is trading right now and the valuation?

Sharma: The company's forward P/E ratio, price to earnings ratio, right now sits at 22X. That's after the shares have gained 60% year to date. That just shows you what kind of bad shape it was over the last 12 months. This places it in a range of the quick service restaurant area. McDonald's trades at 23X forward earnings. Burger King parent, Restaurant Brands International, trades at 21X earnings. Let's look at Chipotle. Chipotle trades at 55X forward earnings, despite all of its travails over the past several years. Shake Shack, which has been quite successful since its IPO, trades at 72X forward earnings. Habit restaurants trades at 113X forward earnings. 

I don't think this company will reach any of those levels. However, a benchmark that I follow, the Russell 2,000 Small Capitalization Index, to which this company belongs, the average stock in that index trades around 30X forward earnings. I definitely think there's still more upside left. This is still a value play. 

That's not to say it's not without risk. As we know from watching some other turnarounds on Wall Street, you're not at a true turnaround phase until you can look in the back mirror and say you've completed everything you've set out to complete, and your stock has proven that on the price chart. However, I think there's room. I'm curious, Vince, what do you think after delving into this company a bit? Do you think it can rise a bit more and its valuation can improve? 

Shen: I'll say this is a newer company that I'm going to be adding to my watchlist -- a little bit as a foodie, in terms of my hope to eventually try their food at one of their restaurants in the near future. I've actually heard great things from some friends who've been out west and had a chance to dine with them. But, in terms of the investing angle, I'm going to be watching how these efforts under the new CEO, especially like you mentioned, those three themes -- family oriented, increasing their marketing, that element with the Hispanic customers, and the healthy dining element -- and see how the company can curate that marketing and that focus to see if it helps boost their traffic, helps keep their comps at a nice, positive momentum, and how that works out for them in the coming year. 

That's all the time we have for today with this recap for Under Armour, Starbucks, and El Pollo Loco. Thanks for joining us, Asit. 

Sharma: Thanks, this was great fun!

Shen: Fools, thanks as always for listening! People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!