Roger Lipton: El Pollo Loco is Low Risk, Possibly Rewarding
Roger is an investment professional with decades of experience specializing in chain restaurants and retailers, as well as macro-economic monetary developments. He turns his background, as restaurant operator and board member of growing brands, into strategic counsel for operators and perspective for investors.
An archive of his past articles can be found at RogerLipton.com.
El Pollo Loco (NYSE: LOCO) is fighting the same battles of most QSR and Fast Casual chains, including a myriad of competition, ranging from full service operators to delivery chains to grocery stores and many others in between, higher operating costs, restricted consumer discretionary dining dollars, all resulting in the desperate need to differentiate their offerings. “Experience” is already a cliché’, but the customer must want to be “there”, rather than someplace else, and not for just the “fuel”. Fortunately, LOCO is in a position to do so, with a unique product line, and the potential of substantial further differentiation.
In a nutshell, the challenge is to make the necessary changes and have the customers notice, in a very unforgiving environment. The stock is trading at the bottom of its long term price range, is relatively inexpensive statistically, and is not “broken” in terms of its operating culture. The new tax law should provide a bit of financial relief, since LOCO is a full taxpayer. Though the valuation relative to EBITDA won’t change, the after tax earnings will be automatically higher by 10-15%, depending upon their final tax rate. An investor with patience (which might be an oxymoron these days) could have a lot of ways to win with LOCO, and not too much risk, from this price, in the process.
COMPANY BACKGROUND (2016 10-K) and (Q3’17 10-Q):
El Pollo Loco specializes in Mexican style fire-grilled, citrus marinated chicken. The company originated in the heart of the Latino community in Los Angeles in 1980. Currently, the company headquarter is located in Costa Mesa, CA and became a public company in 2014. As of 9/30/17 it operates and franchises a chain of 473 restaurants (208 company; 265 franchised) located in southwestern United States; specifically: California, Texas, Utah, Arizona and Nevada.
They operate in the limited service (Fast Casual) restaurant segment offering quality food and a dining experience typical of Fast Casual restaurants while providing the speed and value of a traditional QSR segment. A typical El Pollo Loco restaurant is a freestanding building with drive-thru service that range in size from 2200 to 3000 square feet with seating for approximately 50-70 people.
SOURCES OF REVENUE:
El Pollo Loco’s primary source of revenue is from retail sales at its company owned stores and from franchise royalties and fees. A small portion of their revenue comes from rent on locations leased or subleased to franchisees. In 2016 annual systemwide revenue was $795.4M. 93.5% was generated by company stores with the remainder 6.5% from franchise royalties and fees.
In 2015 they opened 14 new company locations and 5 new franchised locations. No stores were closed. During 2016 El Pollo Loco opened 18 new company locations and 13 new franchised locations. There were 2 company and 2 franchised stores closed in 2016. The chain has grown by 15 company, and 12 franchised, locations in the first 9 months of ’17.
CONCEPT / MENU / SALES MIX / DAY PARTS:
El Pollo Loco’s signature product is citrus marinated, fire-grilled chicken which is freshly prepared and fire-grilled in full view of the guests. This experience, along with the colorful décor and value priced menu (items are priced midway between Taco Bell and Chipotle), are aimed to create a value-oriented, Fast Casual dining experience.
The menu includes a variety of Mexican inspired dishes such as family meals, value combos, premium LTO’s, kid’s meals and 500 calorie offerings that are centered on El Pollo Loco’s marinated chicken. They serve family meals as well as individual meals and offer a wide choice of LTO’s throughout the year alternating proteins between shrimp, beef and carnitas. Their salsas and dressings are prepared fresh daily and allow customers to create their favorite flavor profile to enhance their culinary experience.
Daily sales are nearly evenly split between the lunch and dinner day parts; relatively unique among restaurant chains.
Company Location Unit Level Economics – Company (2016 10-K)
El Pollo Loco stores range in size from 2200-3000 square feet, seating 50-70 customers. The majority of company restaurants are leased with only 15 properties owned. AUV’s in 2016 were $1,838,000 for company stores and $1,749,000 for franchise stores. The gap between company and franchise stores has narrowed in the last 3 years as franchise stores AUV’s have increased (up from $1,690,000 in 2014) while company store AUV’s have declined (down from $1,910,000 in 2014). One possible scenario for these contrary trends may be that the company stores are relatively immature. Of the company stores, 26% were opened in the last 3 years while only 12% of franchised stores were opened during that period.
The cash investment for a new unit, including our estimates of pre-opening expense, is approximately $1,800,000 at the 2016 store level EBITDA margins of 20.4%. The cash on cash returns (C/C) for company units average 21.1%. For franchised units, we estimate a C/C return would be 12.3% after royalties and advertising fees – this assumes the franchise AUV of $1,749,000. Company store level EBITDA margin of 20.4% less 9.5% royalty and advertising fees.
The company recently rolled out a new “vision” prototype store hoping to improve returns by value engineering the concept. Also, the new unit is designed to elevate the ambiance to be more consistent with its aspirations of a Fast Casual positioning rather than QSR.
1. Expand Restaurant Base – The company plans to expand their restaurant base at a rate of 8-10% annually with comps of 2-3%. They will continue to strategically develop franchise relationships and grow their franchise portfolio within existing and new markets. This strategy is based on a balance of opening new company and franchise units. In late 2016 El Pollo Loco signed a new multi-unit franchise deal for Lafayette, LA with Jason Trotter (a member of the Trotter family with ties to Chart House, Burger King, Inc. and Rally’s). The first unit is expected to open in early 2018.
To execute this plan, the company has outlined aggressive multi layered initiatives that include: improved site selection, menu evolution, marketing strategy to increase brand awareness and customer engagement, technology to enhance the customer experience, and operations to improve overall store level efficiencies.
One critical note: El Pollo Loco’s most urgent and significant challenge is to demonstrate appeal beyond its current regional footprint. The stores in its legacy markets have done well consistently but stores, in Houston and Dallas in particular have been weaker. At the end of 2009 the brand had 21 units east of the Rockies. All were closed by 2012. From 2014 to 2016 seven stores, four of which were franchised, a little over 10% of the 66 opened during that period.
Obviously, the tepid growth of franchised stores does not reflect a robust endorsement of the company’s plans. Management has acknowledged the challenge of invigorating unit growth and comp sales and announced plans to relax its royalty structure to stimulate franchise growth. Also, they are clearly committed to proving the concept in Texas where it has dedicated significant resources by locating all ten of its new vision prototype stores in Dallas where it entered in mid-2016.
2. Increase Comparable Restaurant Sales – The company has demonstrated positive same store sales growth and plans to build on this momentum by increasing .customer frequency, attracting new customers and improving check averages (see chart below). Until 16Q4, El Pollo Loco reported 21 straight quarters of systemwide positive comps.
3. Enhance Operations and Leverage Their Infrastructure – Since 2011 El Pollo Loco has increased restaurant contribution margins by 188 basis points to 20.6% in 2016. Their current infrastructure allows them and their franchise partners to grow and manage the productivity of each restaurant on a real-time basis.
Until 16Q4 El Pollo Loco reported 21 straight quarters of positive systemwide comps. Company store level EBITDA margins have declined about 90 bps since the IPO to the current 20.4% level achieved in 2016. The decline in operating margin (excluding impairments) has been more severe, down 190 bps, on increased investment and other costs. El Pollo Loco has reduced its debt by about a third from the $166M level on its books when it came public. Its leverage ratios of debt to EBITDA and lease-adjusted debt to EBITDAR at year end were 1.7X and 3.5X, respectively; in line with 30%-60% franchised peers. Free cash flow in 2016 was $11.0M (CFO$49.3M, CapEx $38.4M), or a 2.9% FCF margin.
El Pollo Loco is down about 65% since the IPO and has traded in a range between about $10 and $15 since its low of $10.20 in September 2015. The company does not pay a dividend and has not been purchasing its stock. The company’s largest shareholder is Trimaran Capital, LLC, a private equity company, which effectively has a 43.5% ownership interest at the end of 2016.
RECENT DEVELOMENTS PER Q3’17 EARNINGS RELEASE AND Q3’17 CONFERENCE CALL
The third quarter was “soft”, typical of the restaurant industry as a whole, affected partly by the storms in Texas and Florida. While earnings came in below expectations, systemwide comps were up 1.7%, including 0.9% increase at company stores and 2.4% gain at franchised units. Transactions at company stores were down 0.8%. Company restaurant EBITDA contribution was 18.3%, down from 20.9% YTY. GAAP EPS of ($0.11) was after $16M from asset impairment of 10 stores and the closure of 3 restaurants. Hurricane Harvey affected pretax profits by about $300,000. Pro forma net income (which doesn’t adjust for “Harvey”) of $6.9M, or $0.15 per share compared against $6.9M a year earlier, or $0.18 per share, so the YTY after tax decline might have been about $200k less. The quarter included margin pressure from higher labor costs (up 170 bp) and loyalty program incentives, and higher other operating expenses. Commodity costs were well controlled (down 70 bp) YTY. Occupancy and Other store expenses increased 100 bp YTY to 23.4%. The stores in Texas continued to perform poorly, and an entire “relaunch” is being implemented in Q4 both in Dallas and Houston, encompassing everything from facilities, to operations, to marketing.
Per the conference call, management indicated that sales have softened from mid-September through October, though still positive to the tune of about 1%. Co. comps were relatively strong in July and August, up 2.9 then 2.8%, weakening from mid-September until the conference call on 11/2. During Q3, the promotional effort was focused on overstuffed quesadillas, Taco Platters, and burritos. The creative Taco Platters appear to be differentiated, including their highlighting of fresh ingredients and unique flavor profiles. The loyalty program, accessible through the new mobile app, has 400,000 members and accounted for 4.7% of sales. Growing steadily, this program has a lot of additional potential. Delivery is available in 28% of the system, and should cover 80% by the end of ’18. Full year development in ’17 should total 15-16 company and 7-9 franchised locations. Growth in ’18 will be slower, details to be provided early next year. “Vision” remodels are continuing, eight company locations so far, with six more in the pipeline for Q4’17. There should be 20 company and 30 franchised units done in ’18.
Guidance for all of ’17 was lowered, most notably pro forma EPS, from $0.64-0.67 to $0.51-.53. A restaurant margin of 19.3-19.6% is expected for the full year. Since it was 20.2% through 39 weeks, this implies more sequential deterioration from Q3 to Q4.