Tag Archives: LOCO

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

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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.

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

To access this content, you must purchase Website Subscription.

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.