Episode Summary
In this episode we spoke with John Zolidis, President at Quo Vadis Capital. John has over 25 years of Wall Street experience analyzing unit-based businesses, such as restaurants and retailers.
We covered a number of topics including unit economics, Return on Invested Capital (ROIC), and Return on Incremental Invested Capital (ROIIC). John also discussed specific aspects of ROIIC, including cohorting, differences in capital allocation decisions of public and private concepts, understanding franchisee economics in the case of franchised businesses, and a lot more. The guest explains in detail the work that goes into understanding the true performance of the newest cohort of stores, finding inflection points in ROIIC which leads to estimate and revision changes.
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Guest-at-a-Glance
💡 Name: John Zolidis
💡 What he does: He’s the president of Quo Vadis Capital.
💡 Company: Quo Vadis Capital
💡 Noteworthy: John has over 25 years of experience analyzing unit-based businesses, such as retailers and restaurants, and is a very sophisticated practitioner in the space.
💡 Where to find John: LinkedIn
Key Insights
⚡ What is Return on incremental Invested Capital (ROIIC)? We use ROIIC to make investment decisions and determine the impact of strategic investments on a business. But what is ROIIC? John explains, “Unit-level ROIC is what is the return metric of the average store restaurant, et cetera of a business. When we talk about return on incremental invested capital, what we mean is what’s the return profile of the most recent cohort of stores, restaurants, et cetera, that a business has opened. Put differently, what is the return profile of the most recent dollar being allocated by the business into growth.”
⚡ The return that the franchisees get is essential. When analyzing franchised businesses, John pays very close attention to franchisee performance. John explains, “Nevertheless, the return that the franchisees achieve with their stores or restaurants or car washes or whatever it is, that, among the list that you mentioned, is really important. And it’s important for a couple of reasons, but I think the main reason from a Wall Street investment standpoint is that the returns that the franchisees generate act as a direct governor on growth, which is to say the cash flow produced at the unit level relative to the cost of opening up a new unit tells you how fast the franchisees can increase their system and that’s important to the franchisor, the parent company, which is where the equity in Wall Street typically is. So it is relevant to see what the return metrics are like for the franchise. It does have a direct implication on growth. And then, I think it’s also important to know that you’re investing in a concept that creates value for all members of the chain, not just the parent company. And that is a sustainable continuous business that you can feel good about being involved with.”
⚡ There are different criteria for determining whether a certain stock is a ‘buy’ or ‘sell.’ How can you use ROIIC to determine whether a certain stock should be bought or sold? John explains. “There’s a ton of work. It is quite tedious. I wouldn’t say it’s a lot of fun to build the models that generate all of these metrics. But essentially, we have a battery of tests that we apply to the output of this. So the first one is a quality filter. […] The second piece is a trend analysis. […] Then, the third filter is related to return on incremental invested capital. So this is where we zero in on the company’s most recently opened cohort of stores. […] Then lastly there, we also have a valuation-based approach for unit-level concepts.”
Episode Highlights
Unit Economics Aims to Measure and Simplify a Company’s Profitability
“Rather than just looking at the income statement and the balance sheet, we try to take it a step further by really zeroing in on the store, the restaurant, the hair salon, the fitness gym, whatever the partitionable unit of the business might be, and calculating what kind of return metrics are generated at the unit level. And once we do this, what we yield is a better understanding of the profit driver of the business.”
Franchises Are Capital-Light
“You’re correct that, generally, Wall Street likes to see franchises or concepts and assigns a high multiple because of the idea that they’re capital-light, that they don’t own the capital in the franchisee network, and they’re not responsible for putting incremental capital into the business.”
Public vs. Private Market Perspective on ROIIC
“If you have a concept that is incredibly profitable and it’s kind of reaching maturation, and a company comes up with a second concept — there are lots of businesses like this in the retail and restaurant space — or they’re making an acquisition which is still generating a really great return relative to the cost of capital, but materially less than the core business, that is rarely a good scenario from a public equity performance standpoint. But in the private world, if you have excess cash flows and you can reinvest them in another concept, which also generates good returns — just not as good as whatever the base business that you had got you to this point — you would clearly make that decision. That would be a good decision relative to potentially other uses with your capital. There, I think, is a separation ’cause you don’t have to report; you don’t care what the mark to market is from a public equity standpoint. What you care about is generating a positive return relative to your cost of capital with your excess capital that you have available.”
Top quotes:
[02:39] “The point of unit economics is to find a more sophisticated way to understand how a company generates its profitability, and that is not just on the EBIT or EBITDA line but also from a capital allocation standpoint.”
[10:25] “The returns that the franchisees generate act as a direct governor on growth.”
[20:33] “In the public equity world, the margins that a concept is producing and the earnings revisions trends are very impactful on the multiple that investors are willing to pay for a stock.”
Full Transcript
[00:00:00] John Zolidis: What we’re looking for are, again, trends or inflection points at the most recently opened units. And what we find is if you have a rising trend in new unit sales margins and returns, overall margins for a concept tend to go up. And this correlates frequently with upside surprises to earnings estimates.
[00:00:25] Nick Mazing: Hello and welcome. You’re listening to Signals by AlphaSense, and I’m your host, Nick Mazing. Today we’re going to talk about understanding unit economics, return on investment capital or ROIC. We’re going to talk about return on incremental invested capital as one of the long-term value drivers, both from a stock market perspective, since it’s a pretty large investment universe that is driven by factors like this,
[00:01:01] and from a corporate perspective. In other words, how are value-added expansion decisions being made? Our guest today is John Zolidis, President of Quo Vadis Capital. John has over 25 years of experience analyzing unit-based businesses, such as retailers and restaurants, and is a very sophisticated practitioner in the space.
[00:01:21] John, welcome. And can you tell us a little bit more about yourself and about your company?
[00:01:27] John Zolidis: Sure. First, Nick, thanks so much for inviting me to the program. I’m really excited to talk about unit economics and return incremental invested capital and how we use that. I set up Quo Vadis Capital in 2017 after a long career working mostly on the sell side but also somewhat on the buy side,
[00:01:51] with Buckingham Research, Buckingham Capital. Got my start at Sidoti & Company before the internet bubble. And in 2017, I decided to set up my own business with the idea that there was really a need out there for differentiated research. But that, the format within both boutiques and within investment banks was quite restrictive in terms of doing original analysis that you could provide to investors.
[00:02:24] So, we have two businesses. We’re a registered investment advisor, and we manage some accounts for individuals. And then, we act as what we call an outsourced buy-side analyst, where we review companies in the retail and restaurant space with advice that we provide to hedge funds, mutual funds, and pension funds.
[00:02:44] Nick Mazing: So, let’s settle the basics, and that is unit economics. I think this get overlooked pretty often because it sounds basic, right? You take the revenue, you’re developed by the number of stores or whatever. What am I missing here?
[00:02:58] John Zolidis: So, the point of unit economics is to find a more sophisticated way to understand how a company generates its profitability. And that is not just on the EBIT or EBITDA line, but also from a capital allocation standpoint. And so, rather than just look at the income statement and the balance sheet, we try to take it a step further
[00:03:28] by really zeroing in on the store, the restaurant, the hair salon, the fitness gym, whatever the partitionable unit of the business might be, and calculating what kind of return metrics are generated at the unit level. And once we do this, what we yield is a better understanding of the profit driver of the business.
[00:03:57] So, I think that’s the kind of high-level answer to your question about the purpose of unit economics and, and what we’re really looking for.
[00:04:07] Nick Mazing: So, jumping one step up from there, in terms of sophistication, and let’s talk about value creation through the lenses of ROIC, return on invested capital and return on incremental invested capital. So, when I look at the success stories in the stock market, like Starbucks, like Chipotle, these are companies that have had a very long runway of profitable unit growth, basically reinvesting in new units that create a lot of value for shareholders.
[00:04:41] On the other hand, we’ve seen many concepts, restaurant concepts, meaning, crash and burn in the public markets, either because the concept was too regional, so it didn’t scale outside of whatever the original region was, or, in other cases, we’ve seen concepts where the unity economics were based on, let’s say, restaurants that operate in very, very dense markets.
[00:05:12] And when that concept moves to a suburban or lower-density market, the economics just don’t work nearly as well. So, what do listeners need to know about ROIC and return on incremental invested capital, both, you know, from an investor perspective, but also since we have a lot of corporate listeners when making CapEx expansion decisions?
[00:05:35] John Zolidis: Okay. So, let’s start by defining return on incremental invested capital. ‘Cause there’s a lot to unpack in, uh, the question that you just posed there. So, unit-level ROIC is “What is the return metric of the average store, restaurant, et cetera of a business?” When we talk about return on incremental invested capital, what we mean is, “What’s the return profile of the most recent cohort of stores, restaurants, et cetera, that a business has opened?” Put differently,
[00:06:13] “What is the return profile of the most recent dollar being allocated by the business into growth?” And so, I think, if we widen the aperture just a little bit here, from an investment standpoint or from a corporate standpoint, what you’re looking for are concepts that generate very attractive returns relative to a business’s weighted average cost of capital, but also can grow, can be replicated over a long period, or large geography, over large numbers.
[00:06:52] And so, when you’re looking at return on incremental invested capital, that is your evaluation metric that justifies or tells you whether the growth opportunity is in fact valid. So, a couple of the, the situations which you called out. So, for example, moving from one region to another. So, I’ve seen several concepts that were West Coast businesses but then moved into, for example, Texas, and the return metrics were not as favorable.
[00:07:24] In other cases, you go from high-dense, urban areas don’t work as well in suburban markets. And that’s, of course, not always the case. Sometimes what we see is that return on incremental invested capital is actually greater than the core business, and those are, can be explained by various things as well. So, I’ll stop there, but what we look for is to separate out
[00:07:52] the return metrics at the units, solve for what’s happening at the most recently open units. And then, we need to create a narrative behind that explains why these metrics are moving in the way that we see.
[00:08:08] Nick Mazing: So, a follow-up question kind of along the lines of, of the basics, and that is on franchising. Many unit-based businesses are franchised, especially in the quick-service restaurant space. And, you know, you have it, you have franchising for hair salons, for oil change locations, for chiropractors and gyms, like you already mentioned, and so on.
[00:08:33] And it does take the complexity of the analysis to a new level because you have franchisors, and then you have the franchisee system. And, in general, the stock market tends to like franchisors. When you look at the multiples of, let’s say, McDonald’s versus Arcos Dorados, you look at the restaurant brands International, which is the parent of Burger King, versus Carrols, which is a publicly traded franchisee.
[00:08:57] When you look at Domino’s Pizza against their multiples against the publicly traded franchisees they have in, in the UK and in Australia. And, but when you think about it in the long term, you want to have a healthy franchisee system. And I, personally, like looking at the franchise disclosure documents, which is the standard US document where the franchisor does put out quite a bit of information about the health of the franchisee system, including bankruptcies and unit economics and, and things like that.
[00:09:28] So, what is your general approach when you analyze franchisors?
[00:09:34] John Zolidis: Thanks. Great question. So, as you’re, you’re correct that generally, Wall Street likes to see franchise or concepts and assigns a high-multiple because of the idea that they’re capital light, that they don’t own the capital in the franchisee network. And they’re not responsible for putting incremental capital into the business.
[00:09:56] Nevertheless, the return that the franchisees achieve with their stores, or restaurants, or car washes, or whatever it is that, among the, the list that you mentioned, is really important. And it’s an important for a couple of reasons, but I think the main reason from Wall Street investment standpoint is that the returns that the franchisees generate
[00:10:19] act as a direct governor on growth, which is to say the cash flow produced at the unit level relative to the cost of opening up a new unit tells you how fast the franchisees can increase their system. And that’s important to the franchisor, the parent company, which is where the equity in Wall Street typically is.
[00:10:44] So, it is relevant to see what the return metrics are like for the franchisees. It does have a direct implication on growth. And then I think it’s also important to know that you’re investing in a concept that creates value for all members of the chain, not just the parent company. And that, that is a sustainable, continuous business that you can feel good about being involved with.
[00:11:10] Nick Mazing: Mm-hmm. So, let’s get into some, some of the details of the analysis. Now, can you share some of the mechanics behind the calculations that you do to look at return on incremental invested capital for a retailer or another unit-based business? Like, how do you separate returns by cohort and, and so on.
[00:11:31] John Zolidis: Sure. So, the first thing we do is, we generally do not use the proforma ROICs provided by the companies. General, frequently these are idealized, proforma numbers. They tend to be three years into the future maturity. They’re not consistent across different companies. Occasionally we do find that it aligns with our calculations, but more frequently these numbers are not, these are not great
[00:12:01] starting points, from an analysis standpoint. So, here, from a mechanic standpoint, we take the income statement that everyone else uses. We solve for unit-level revenues but we don’t do this on a quarterly basis, we do it on a trailing 12-month basis updated each quarter. We look at the per-square-foot performance for revenues if we have the specific square-foot information for the businesses.
[00:12:34] If not, we could estimate that. Then we solve for the unit-level cash contribution margin. In some cases, companies provide this. In other cases, we have to do incremental work to remove parts of the SG&A, which we think are not attributable to the store, for example, the G&A, expenses related to stock options, distribution, and transportation expenses.
[00:13:01] And we arrive at where we think the cash flow at the store level really is. The second piece is to calculate the capital at the unit level. So, we may use what the company tells us to get the CapEx per store, per unit. We may derive that from the balance sheet and the cash flow, or we may back up what the company says with this analysis.
[00:13:26] Then we assign working capital to the business if that makes sense. For retailers, we estimate the amount of inventory that might be at each store. And then, lastly, and I think this is an important part, we look at both a lease adjusted return on invested capital and a cash-on-cash return, as it’s frequently called.
[00:13:48] So, we capitalize leases at eight times and generate the return that way. So, that’s, that’s how we get, like, one slice of a unit-level return. From that, we derive the new store or the cohort-level returns. And that involves looking over time at the revenues generated by new units versus the existing base, separately managing, estimating the cash flow contribution margin for the newer stores,
[00:14:22] which also involves going to the 10 K, getting the rent data so we can estimate how much the rent is at the new units compared to the existing base. And then, we solve for the return metrics at those newest stores and the same function that I just outlined for the existing business. The separation between the new units, the return on incremental invested capital, and the base business, the return on average unit capital, is very illustrative of
[00:14:55] what is happening from a margin standpoint, and what, something we use to forecast the future performance of the business. That’s where the benefit of all this work comes to play, when we try to take what’s happening from, with the cohorts to use as a forecasting tool.
[00:15:16] Nick Mazing: So, once you’ve done all this work, obviously you have a lot of outputs in a, you know, in spreadsheets. You understand the unity economics probably better than anybody who is an external analyst. How do you use the return on incremental investment capital to actually make investment decisions? In other words, what are you looking for that tells you whether a certain stock is a buy or a sell?
[00:15:42] John Zolidis: Okay, great. I mean, this is the point of this work. There’s a ton of work. It is quite tedious. I wouldn’t say it’s a lot of fun to build the models that generate all of these, uh, metrics. But essentially, we have a battery of tests that we apply to the output of this analysis. So, the first one is a quality filter.
[00:16:02] So, we look at, “What is the return metric at the unit level, how good is this concept relative to other concepts that are out there?” And we try to, you know, we want to own concepts that have high return on invested capital. We want to avoid those that have mediocre returns. So, that’s kind of point number one and relatively straightforward.
[00:16:23] The second piece is a trend analysis. And so, we want to, we look at whether the returns are improving or are deteriorating, and we try to understand the factors that are behind that, “Is it driven by macro or is it company-specific decisions with regard to the format of the store, the capital of the store, other merchandising decisions that they’re doing?”
[00:16:48] And, as you might imagine, we wanna own concepts that have a rising trend in return on invested capital, and we want to avoid those with the reverse. And then, the third filter is related to return on incremental invested capital. So, this is where we zero in on the company’s most recently opened cohort of stores.
[00:17:09] And, as you might imagine, the importance of those stores is directly proportional to the rate of unit growth. So, the faster the concept is growing, the more critical it is to understand the profile of the most recently opened stores, a concept with 2% unit growth, same store sales are more important. So, you can do this analysis, it’s nice, but it probably won’t tell you what to do with the business.
[00:17:37] Whereas if you have a business that’s very fast-growing, changes or inflection points at and the new units are very important and impactful on future margins, et cetera. So, in this case, what we’re looking for are, again, trends or inflection points at the most recently opened units. And what we find is if you have a rising trend in new unit sales margins and returns, overall margins for a concept tend to go up.
[00:18:11] And this correlates frequently with upside surprises to earnings estimates. So, we wanna own that kind of profile. In contrast, if each set of cohorts is getting incrementally worse or there’s a negative inflection, it probably means that margin and EPS estimates are too high. And, in that scenario, you’re gonna see a series of downward revisions.
[00:18:38] We want to exit positions in businesses like that. And then, lastly, there, we also have a, uh, valuation-based approach for unit-level concepts. We look at, we have like a modified DCF, and we estimate the value that each individual unit can produce over time. And we compare that to what the market is paying for the overall company.
[00:19:02] And that just provides another level of analysis that helps us tell our clients whether we think a business’s future growth is adequately reflected in the stock, or whether there’s an advantage, or there’s a disconnect, or whether it’s overvalued.
[00:19:18] Nick Mazing: Mm-hmm. And the last question that I have is what might be different when you do this analysis from a public markets perspective versus a, a private perspective, when you look at, you know, the returns of, the return profiles of different projects?
[00:19:34] John Zolidis: So, it is quite different, I think, because in the public equity world, the margins that a concept is producing and earnings revision trends are very impactful on the multiple that investors are willing to pay for a stock. So, if you have a concept that is incredibly profitable and it’s kind of reaching maturation, and a company comes up with a second concept, there are lots of businesses like this in the retail and restaurant space, or they’re making an acquisition,
[00:20:09] which is still generating a really great return relative to the cost of capital, but materially less than the core business, that is rarely a good scenario from a public equity performance standpoint. But in the private world, if you have excess cash flows and you can reinvest them in another concept, which also generates good returns, just not as good as
[00:20:38] whatever the base business that you had got you to the, this point, you would clearly make that decision. That would be a good decision relative to potentially other uses with your capital. So, there, I think, is a separation ’cause you don’t have to report, you don’t care what the mark to market is, from public equity standpoint. What you care is generating a positive return relative to, uh, your cost of capital with your excess capital that you have available.
[00:21:04] And so, I do see a distinction in, in, in public versus private equity scenarios with incremental, return on incremental invested capital.
[00:21:13] Nick Mazing: John, thank you for joining us.
[00:21:15] John Zolidis: My pleasure. Thanks for having me.
[00:21:17] Nick Mazing: Today, we spoke with John Zolidis, and we covered a lot of ground on how to analyze unit-based businesses, such as the restaurants and the retailers. We discussed unit economics, ROIC, incremental returns, and analyzing franchise system. We’ll have all the relevant links in the show notes.
[00:21:33] My name is Nick Mazing, this is Signals by AlphaSense. You can subscribe to us on all the major platforms. Thank you for listening.
