El Pollo Loco - What's Left After Very Strong Opening Day Returns?

Jul.29.14 | About: El Pollo (LOCO)

Summary

Shares of El Pollo Loco spike up on their opening day.

As investors are very upbeat about prospects for fast-casual dining chains.

The risk-reward is no longer appealing in my eyes after the first day momentum.

El Pollo Loco (NASDAQ:LOCO) is a rapidly growing restaurant chain focusing on fire-grilled chicken. The company operates in the rapidly growing limited service restaurant segment, combining quality food with speed and convenience for a value-oriented fast casual dining experience.

The relative valuation compared to the market leader in the segment is appealing, yet the company is not showing real growth in its store base, while it is less profitable, is showing slower comparable store sales growth and has more leverage on its books.

The Public Offering

El Pollo Loco offers next to its signature citrus-marinated grilled chicken more sets of varied Mexican-based entrees. This food, prepared in open kitchen provides consumers with a healthier alternative compared to other fast-food restaurant chains combined with great taste.

The ¨Crazy Chicken¨ opened its first restaurant back in 1980 and now operates 401 restaurants in the states of California, Arizona, Nevada, Texas and Utah. Some 168 of these restaurants are company-owned, while the remainder are franchises. Typically a restaurant ranges between 2,400 and 3,000 square feet in size, providing seating for 70 customers.

El Pollo Loco sold 7.1 million shares for $15 apiece, thereby raising $107 million in gross proceeds. All of the proceeds from this offering will benefit the company with no shares being offered by selling shareholders.

Shares were offered at the high end of the preliminary offering range of $13-$15 per share. At the public offering price of $15, shares were valued at nearly $540 million.

Banks which aided the company in its process to become a public firm were Jefferies, Morgan Stanley and Baird.

Valuation

El Pollo Loco focuses on the limited service and quick-service, fast casual segment. While the fast-food segment is focused on average check size of $3-$8, the fast-casual segment of the market focuses on average check sizes of $8-$12 which focuses on higher quality food in a more upscale establishment. El Pollo Loco aims to operate at the intersection of these two segments, offering the best of both worlds to its customers.

According to Technomic, the limited service restaurant segment which involves upfront payment and average check sizes of $3-$12, totaled some $193 billion in 2013. Within the segment, the Mexican and chicken menus performed well, driven by the strong demographics of the ¨Latin¨ population within the US as well as the move towards healthier fast food. Note that some 53 million of US residents belong to the Hispanic portion of the population, expected to grow towards nearly 79 million by 2030 according to the US Census Bureau. Of course, the company will face a huge competition in this market segment, including of course that of Chipotle Mexican Grill (NYSE:CMG).

For the year of 2013, El Pollo Loco posted sales of $314.7 million, up 7.2% compared to last year. The company posted a $16.9 million loss for the year, much bigger than the $7.9 million loss reported in the year before. Past year's losses was the result of $21.5 million in losses related to the early extinguishment of debt as well as stiff interest expenses of $36.3 million.

Revenue growth for the first quarter of the year slowed down to 5.8% with total proceeds coming in at $81.4 million. An improved operating performance as well as lower interest expenses resulted in a $5.5 million profit compared to an essentially break-even result last year.

Ahead of the public offering, the company held about $20 million in cash and equivalents while operating with a total debt position of $289 million. The gross proceeds of $107 million, will reduce the net debt position towards $180 million. The reduction in associated leverage following the offering could improve pre-tax earnings by some $8 million per annum.

Given the huge run-up on its opening day, with shares trading at $24.03 per share, equity in the business is now valued at roughly $860 million. This values the business at 2.7 times sales. Extrapolating the $5.5 million in first quarter profits throughout the year, while adding some additional profits as a result of the lower leverage, and earnings could improve towards $25-$30 million. As such shares trade at about 30 times earnings.

Investment Thesis

As noted above, the public offering of El Pollo Loco has been a huge success. Shares were sold at the high end of the preliminary offering range and at its first day closing price of $24.03 results in shares trading about 71.6% above the midpoint of the preliminary offering range.

Despite the very strong offering, there are of course big risks in this offering as well. El Pollo Loco's business relies on a good economy, as discretionary spending of consumers is very important. Furthermore its operations are very much geographically concentrated, with 80% of revenues being derived in the greater LA region. Of course the high debt position, food cost inflation and reliance on chicken is a risk as well, especially amidst potential food scandals.

What I find very strange is the very modest pace of store openings, with the net store base increasing by just 3 stores on an annual basis to 401 restaurants at the end of the first quarter. This is quite a contradiction with the long term target for 2,300 stores in the country. Interesting, the 7.2% reported comparable store sales growth in the first quarter was driven by 8.3% growth reported by franchise operations and just 5.4% for company-owned restaurants.

As such I am in doubt. On the one hand the company trades at a discount to CMG which trades at about 5 times sales, while the company is growing much less quickly, has much more debt and is much less profitable. Of course it can go both ways, and while I would be very happy to jump into the shares around $15-$20, I am less enthusiastic at an anticipated 30 times expected earnings going forwards.

I remain on the sidelines, awaiting either a more interesting entry point or signs of improved operational performance. Until then, I am not willing to pay 30 times adjusted earnings for a modestly growing, but second-tier fast casual chain with large ambitions.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.