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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

The long term investment appeal of well established franchising companies is accepted by the investment community. Most of the prominent franchisors’ equities sell at price to trailing twelve month EBITDA multiples in the mid to high teens (Denny’s (DENN), Dine Brands (DIN), Dunkin’ Brands (DNKN), Pollo Loco (LOCO), McDonald’s (MCD), Restaurant Brands (QSR), Wendy’s (WEN), even higher in a couple of instances Domino’s (DPZ), Shake Shack (SHAK), Wingstop (WING), lower in a number of “challenged” situations like Jack in the Box (JACK), Red Robin (RRGB), Brinker (EAT), Fiesta Rest. (FRGI).

The attraction of asset light franchisors revolves around the presumably free cash flow for franchisors, a steady stream of royalty income unburdened by capital expenditures to build stores. The operating leverage is at the store level.  Franchisees are responsible for building the stores, then controlling food costs, labor, rent and all the other operating line items. Franchisors receive the royalty stream and have the obligation of supporting the system with brand development, site selection advice, marketing support, and operating supervision. These supporting functions, it should be noted, are optional to a degree, and we have written extensively about system support sometimes being short changed by corporate priorities such as major stock buybacks.

THE CURRENT WORD, IN THE FIELD, AS WE HEAR IT

We acknowledge that in every franchise system there will be some operators less satisfied than others. In the same way, customer reviews on Yelp or Facebook are more frequently written by critics. Bad news is more noteworthy and more customers are inclined to criticize than applaud, so we have to listen to the complaints but dig further for the reality. With that in mind, we hear the following from franchisees of various restaurant systems:

“I’ve been in this business for thirty years, and I’ve never seen it this bad. Everyone is making money but me; the landlords, the franchisor, the banks. My margins have been killed, and I’m up against my lending convenants”.

“All the franchisors want to do is build sales to build their royalties. The dollar deals are trading people down. My franchisor doesn’t care about my margins. I can’t maintain my margins, especially with the increasing cost of labor, let alone build it”.

“The franchisor is putting pressure on me to sell, even though I’ve always been considered a good operator, with high performance scores. I’m up to date on my development agreement, but they want somebody else to take me out, and the new buyer will agree to what I consider to be a ridiculously aggressive development contract”.

“The franchisor has replaced experienced long term field support with lower priced (and inexperienced) younger people. They’re cutting corporate overhead, but these kids, who never ran a store, are telling me to how to control costs.””

“I’m doing my best with the development objectives, but it is almost impossible to build stores with today’s economics. Rents are too high, labor costs are killing me, and I can’t raise prices in this promotional environment”.

“As if things aren’t tough enough, I’m being nickeled and dimed with demand for higher advertising contributions and fees on services (including software) that I thought would be provided”.

The valuations provided to the publicly held companies do not reflect the situation as described by the admittedly anonymous franchisees. The commentators quoted above don’t want to aggravate their franchisor, and we don’t want to be unfair or misleading to particular companies by relying on just a few conversations, though they do support one another. For the most part, franchisees are strongly discouraged from talking to the press or investment community. The companies will say that “competitive” issues require some secrecy, but there are few secrets in this industry.

The optimistic view, as represented by the valuations in the marketplace, is that the comments above are not typical or representative of the health of the subject franchise systems. Allow me to provide a short story which leads to a suggestion.

A SHORT STORY

Twenty six years ago, in 1992, IHOP had just come public. I was a sell side analyst, thought the numbers were interesting and the stock was reasonably priced. The company, led by the now deceased CEO Kim Herzer, invited me to attend their franchisee convention, which I did. I obviously had the opportunity to interface with many franchisees and it was clear that, while all was not perfect, the franchisor was providing a great deal of support that was embraced by an enthusiastic franchise community. IHOP stock tripled over several years for me and my clients who owned millions of shares. I attended several more of their annual conventions and maintain some of those relationships to this day. Obviously, the conviction I gained from their open attitude was critical to the success of the investment. I should add, that many of those buyers in 1992 owned the stock for many years, not living and dying on quarterly reports.

THE SUGGESTION

As you are no doubt by now anticipating, my suggestion to publicly held franchising companies: open up your franchisee conventions to the investment community. The companies may quickly respond that lenders are already invited to franchise conventions, but franchisees are unlikely to express their system oriented concerns when they are making a pitch to a potential lender. Companies may also respond that their lawyers think it would be a bad idea, not consistent with full disclosure and analysts would be getting “inside information”. Let’s not allow the lawyers to provide “cover”. A good lawyer will provide a solution to the problem, not just provide the pitfalls. Analysts attending a franchise convention are not being told what sales or profits are going to be. Attending a franchise convention is  a “channel check”, no more than talking to a supplier or customer of a manufacturing company, which any decent analyst will do.

The anecdotal critical comments, as described above, have likely been heard by others, but may be atypical of most restaurant franchising companies. There are no secrets in this business. One of the investment appeals of this industry is its transparency. Notable news is going to leak out anyway. The objective of any publicly held company is to build stock ownership by well informed investors. Investment analysts pride themselves on their ability to “build a mosaic”, enhance the information provided in quarterly reports, SEC filings, and conference calls, with “channel checks”. What channel check would be more pertinent than meeting the franchisees of a company that is dependent on franchisee success? Putting it another way, and taking the highest valuation relative to EBITDA as an example: Wingstop (WING) is a company I have the highest regard for. However, you could call it irresponsible to pay almost fifty times trailing EBITDA for Wingstop stock (and I haven’t) if I couldn’t talk to franchisees of my own choosing?

There’s no particular need to invite this writer if I’m not considered influential enough. I have not spoken to these analysts on this subject, but qualified industry followers such as David Palmer, Nicole Reagan, Matt DiFrisco, David Tarantino, Jeff Bernstein, Andy Barish, Bob Derrington, Mark Kalinowski, Michal Halen, Gary Occhiogrosso, Howard Penney, Jonathan Maze, Nicholas Upton, John Hamburger and John Gordon provide the beginning of an invitation list.  I rest my case.

Roger Lipton

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EL POLLO LOCO HOLDINGS

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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 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.

COMPANY STRATEGY: 

  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. 

  1. 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.
  2. 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.

FINANCIALS

 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.

*SHAREHOLDER RETURN:

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

http://investor.elpolloloco.com/releasedetail.cfm?ReleaseID=1046934

http://public.viavid.com/player/index.php?id=126126

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.

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WHAT’S HAPPENING ON MAIN STREET ? – FIRST QUARTER SALES AND TRAFFIC TRENDS

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HIGH GROWTH RESTAURANT STOCKS DOWN AN AVERAGE OF 39% – WHAT’S HAPPENING?

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INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.