EL POLLO LOCO HOLDINGS UPDATED WRITE-UP WITH CONCLUSION

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CONCLUSION:

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 toward the bottom of its long term price range, is not expensive statistically, and is not “broken” in terms of its operating culture. However, there is no visible relief coming in terms of better operating parameters. Store level EBITDA continues to slip, overall corporate EBITDA is flat over the last 2-3 years, and two or three percent SSS gains are not enough to leverage cost pressures. We thought it was interesting at $10.35 about 17 months ago (and it was). It’s only a couple of points higher now, but the reward/risk ratio is a lot different at $12.35. Much as we admire the job management is doing, we are content on the sidelines at this point.

COMPANY BACKGROUND

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 headquarters is located in Costa Mesa, CA and became a public company in 2014. As of 12/31/18 it operates and franchises a chain of 484 restaurants (213 company; 271 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 2018 annual revenues were $435.8M. 94.1% was generated by company stores with the remainder from franchise royalties and fees.

In 2016 they opened 18 new company locations and 13 franchised locations with 4 closures. During 2017 El Pollo Loco opened 16 company locations and 7 franchised locations, with 6 closures. In 2018 there were 8 new company stores, 9 franchised, and 10 closed.

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 Store (Third Year Targeted) Unit Level Economics

El Pollo Loco stores range in size from 2200-3000 square feet, seating 50-70 customers. The vast majority of company restaurants are leased. AUV’s in 2018 were $1.825M and the third year target is $1.8M. The cash investment for a new unit, is quoted in the 10-k as a broad range of $0.8M to $1.7M, with a targeted store level EBITDA of 20%. (Company store EBITDA returns were 19.0% in ’18, down from 19.8% and 20.5% in ’17 and ’16.) A cash return of 20% on $1.8M would be $360k, or a broad range of 40% to 20% cash on cash return, depending on the initial investment.  For franchised units, we estimate a C/C return would be 30.5% to 10.5% after royalties and advertising fees – assuming the AUV of $1.8M, store level EBITDA margin of 20.0%,  less 9.5% royalty and advertising fees.

COMPANY STRATEGY: 

1.Expand Restaurant Base – The company has planned to expand their restaurant base at a rate of 8-10% annually with comps of 2-3%, but has fallen short the last two years, particularly relative to the unit expansion, as competitive pressures and the general economy has intruded. 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. A 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 not performed well. At the end of 2009 the brand had 21 units east of the Rockies. All were closed by 2012.  Management has acknowledged the challenge of invigorating unit growth and comp sales and announced plans a couple of year ago to relax its royalty structure in the hope of stimulating growth.


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. As shown in the template above, SSS results were inconsistent from Q4’16 until Q2’18 but have turned positive in the second half of ’18.

3. Enhance Operations and Leverage Their Infrastructure – From 2011 El Pollo Loco increased restaurant contribution margins by 188 basis points to 20.6% in 2016, but it has declined to 19.0% in’18. Management is obviously working diligently to stabilize and then improve thi1 matric.

4. Remodeling – Starting in 2011 the company 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. At this point 85% of the system has been renovated, with a total of 99 stores having the most recent version. The cost of this remodel is $3-400k.

5. Loyalty Program – A recent emphasis has been the development of a Loyalty program, which has now signed up about 1.2M members, and the objective is to have 5M subscribers within the next several years.


FINANCIALS

It is worth noting that El Pollo Loco had reduced its debt (as of 12/31/18) by over half from the $166M level on its books when it came public. Debt, however, will have increased by about $25M as a result of the recent class action settlement. Still, the ratio of debt to EBITDA is currently modest by today’s standards at less than 2.0x, even after the settlement. Adjusted EBITDA at $62-65M (from 2017-2019) will have been very consistent the last several years, and should allow for debt paydown in 2019, with only 3-4 new company stores planned and total capex of $14-19M.

SHAREHOLDER RETURN:

El Pollo Loco is down about 50% from where it started to trade after the IPO in 2014. It traded between $10 and $15/share from late 2015 to early 2018, traded up to about  $18/share very early in 2019 (We said in Dec’17 that it had more upside potential than downside risk at $10.35) but has retreated after reporting Q4’18. The company does not pay a dividend. 66,000 shares were purchased, under a new authorization, in Q4’18. The company’s largest shareholder is Trimaran Capital, LLC, a private equity company, which  has a 43% ownership interest at the end of 2018.

 RECENT DEVELOPMENTS: Per Q4’18 Report, as of 3/7/19

Same store sales improved for the second quarter in a row, up 4.4% systemwide (3.7% for the company and 5.1% for franchisees). Transaction growth of 2.0%, encouragingly, was part of that progress. Adjusted EBITDA was $14.5M vs. $13.4M in ’17. Pro forma net income was $6.1M ($0.16/share) vs. $4.4M ($0.11/share). 12 new company restaurants, and 10 franchised, were opened in the 15 months ending Dec’18, obviously helping systemwide sales.

The GAAP numbers were not as encouraging. Legal settlements of $36M was accrued in Q4 and there was a substantial tax credit as well. Store level expenses were fairly well controlled, but for the year Labor was up 60 bp to 28.9%, Occupancy and Other was up 80 bp to 23.5%, partially offset by 60 bp of savings with 60 of goods, store level EBITDA declined (for the second year in a row) by 80 bp to 19.0%. (Q4 store level EBITDA was 18.7%, up 20 bp YTY)

The Company guided, for 2019, to “flat” earnings per share at $0.70-75, with: systemwide comps of 2.0-4.0%, 3-4 company and 3-5 franchised openings, restaurant EBITDA of 18.2% to 18.9%, G&A Expenses of 8.4-8.6% (vs. 11.5% in ’18), a pro forma tax rate of 26.5%, and Adjusted EBITDA of $62-65M. The savings in G&A are obviously expected to offset continued pressure at the store level.

The conference call filled in a few of the details. The restaurant margins (improvement in Q4, down 80 bp for the year) were achieved in spite of California headwinds in labor costs and wildfires, an avocado shortage, a spike in tomato prices and a nationwide recall of romaine lettuce. Wage inflation of 6% is expected for 2019 and commodity costs will hopefully be more stable, but are planned up 1-2%. The customer Loyalty Program, with 1.2M members is hoped to grow to 5M within two years. All the restaurants offer delivery through Doordash , with Postmates and Uber Eats used in spots. New digital ordering approaches are being added as well. In addition to the openings, there will be 10-15 company remodels in ’19 and 10-15 by franchisees. Responding to a question, the remodels are said to be generating about a 5-7% average sales lift, but most stores have been done by this point, and the remainder are expected to do less. (If 300-400k is spent, and 7% of $1.8M, or 126k is the presumed lift, if 40% of that flows through to EBITDA, that would be 50K, 12-17%, return, at most, but renovations have to be looked at from a competitive standpoint, not just return on capital, and we keep saying that depreciation is not free cash flow.)

The first quarter of ’19 started off slowly, primarily because of the weather and higher gas prices, though still showing positive SSS. Also affecting bottom line results in Q1 will be severance payments, so results for the year as a whole will be back loaded.

CONCLUSION: Provided at beginning of this article

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