- IPO substantially helps company pay down long-term debt.
- Growth in store base refined to include existing markets with brand recognition.
- Margin improvements appear to be low-hanging fruit, but could continue to show improvement.
- Improving margins while reducing debt looks promising.
- Menu price increases aren't a stable way to improve margins long-term.
Capital Ladder Advisory Group has been watching and researching the El Pollo Loco (NASDAQ:LOCO) story over the last few months and prior to the company's recent IPO. While the stock has been met with mixed views, there are a number of "knowns and unknowns" related to the total El Pollo Loco story. In this analytical piece, we aim to articulate some of the variables surrounding the El Pollo Loco story and draw a hypothesis with respect to any investment in common shares of LOCO. So let's start with some of what we do understand about the company and project hence forward.
It has been well established as to where El Pollo Loco fits within the fast casual dining industry. The company recognizes itself as a "QSR+" (Quick Service Restaurant) because they believe that they offer the food and dining experience of a fast-casual restaurant and also offer the speed, value and convenience of a QSR. The average check sizes at a QSR are $3.00 - $8.00. "Fast casual" is defined by Technomic as a limited or self-service format with average check sizes of $8.00 - $12.00 that offers food prepared to order within a generally more upscale and developed establishment. What we have learned from El Pollo Loco's prospectus is that in 2013, the average restaurant check total for the company was roughly $5.83 per check.
El Pollo Loco is often compared to Chipotle Mexican Grill (NYSE:CMG) for its speculative growth going forward, its likeness in food menu items and QSR restaurant format. But beyond these limited points of similarity, there are few variables that align these two restaurant companies. El Pollo Loco is a differentiated and growing restaurant concept that specializes in fire-grilling citrus-marinated chicken in front of their customers. Chipotle Mexican Grill does much of its preparatory and cooking behind the scenes and rapidly brings the ready-made foods up to the service line in order to serve its customers. Additionally, much of Chipotle's toppings (salsa/spice) are pre-made whereas El Pollo Loco allows its customers to concoct and serve their very own, taste specific salsa toppings. One of the biggest differences that jump off the page when discussing the two restaurateurs has to be that Chipotle Mexican Grill does not offer a drive-thru in the way that El Pollo Loco does for its customers. In many ways, this differentiating variable in the two businesses has helped solidify El Pollo Loco in its greatest region of market penetration, California. Some analysts and investors are of the opinion that this may be one reason for which El Pollo Loco has a lower average check size when compared to Chipotle Mexican Grill, but they do have larger average foot-traffic per restaurant location on a yearly basis. In 2013, the average Chipotle in the U.S. did $2.169 million in sales while the average El Pollo Loco did only $1.5 million. If we take the average check size of $5.83 at LOCO in 2013 and compare it with the average check size at CMG in 2013 that was around $9, we better understand which restaurateur had the greatest foot traffic. The drive-thru concept is not lost on Chipotle customers and as early as 2011 some fans of the restaurant chain went so far as to petition the company by commencing a dedicated Facebook page to the topic. Investors should also recognize that El Pollo Loco restaurants are dominated by franchisees whereas Chipotle Mexican Grill restaurants are company-owned.
Moreover, Chipotle Mexican Grill is different from that of El Pollo Loco in menu choice. At Capital Ladder Advisory Group, we think it bodes well, from a competitive model that El Pollo Loco has a greater "family" menu than that of Chipotle Mexican Grill. Chipotle is mainly a single-serve customer menu whereas El Pollo Loco can equally service the individual customer and the family oriented customer. In fact, this differentiating aspect of the El Pollo Loco business can be a leveraged growth driver going forward for the company. The individual and family-sized chicken meals appeal to customers looking to dine at the restaurant or take out during dinner time, while the more-portable Mexican-inspired entrees draw traffic from customers at lunch time or for an afternoon snack, enabling the firm to generate sales almost equally between lunch and dinner. For the year ended December 25, 2013, approximately 28% of El Pollo Loco's company-operated sales were generated from family-sized meals.
As it pertains most importantly to new investors considering a recent IPO, what investors are looking closely at is where the company's growth will be coming from in the future and how the objective can be achieved. Investors in El Pollo Loco are no different we would have to assume. Growth is of key concern and El Pollo Loco has not shown significant aptitude with respect to growing the company in many aspects.
The first El Pollo location was opened on Alvarado Street in Los Angeles, California in 1980, and this singular restaurant front has since grown into 401 restaurants, comprised of 168 company-operated and 233 franchised restaurants as of March 26, 2014. Restaurants are located in California, Arizona, Nevada, Texas and Utah. The typical restaurant is a freestanding building with drive-thru service that ranges in size from 2,400 to 3,000 square feet with seating for approximately 70 people. These restaurants generated company-operated restaurant revenue of $294.3 million and $76.2 million and system-wide sales of $657.6 million and $172.0 million, for the year ended December 25, 2013 and the thirteen weeks ended March 26, 2014, respectively. Some of the company's impressive results are as follows:
- LOCO achieved positive comparable restaurant sales growth in 11 consecutive quarters through fiscal quarter ended March 26, 2014.
- From 2011 to 2013, LOCO increased restaurant contribution margin for their company-operated restaurants by 230 basis points to 21.0% and from March 27, 2013 to March 26, 2014, increased their restaurant contribution margin for company-operated restaurants by 160 basis points to 22.1%.
- From 2011 to 2013, LOCO increased its total revenue by 15.2% to $314.7 million, increased its Adjusted EBITDA by 39.2% to $55.0 million, and decreased net loss from $32.5 million to $16.9 million. Included in the net loss figures for 2011 and 2013 were expenses for early extinguishment of debt totaling $20.2 million and $21.5 million, respectively.
The results above show strong promise and indicate strong relative growth for the company. Based on an external research report commissioned by El Pollo Loco and a customer satisfaction survey, the company believes their positioning appeals to a broad customer base, and that the brand crosses over traditional age, ethnic and income demographics; giving today's consumers the best of both the fast casual dining and QSR segments. Its differentiated QSR+ positioning sources traffic from both dining segments and as a result continues to fuel transaction growth. And naturally, growth is what the average investor is looking for in an investment. So what are some of the company's initiatives going forward as it relates to achieving sustainable growth? Let's take a look at the company's growth strategies.
Growing Restaurant Base
El Pollo Loco currently has 401 restaurant locations with a mix of company operated and franchisee operated restaurants. Long-term, El Pollo Local believes there is an opportunity to grow into 2,300 restaurant locations throughout the United States. In existing markets like California, Nevada, Texas and Arizona where the company benefits from strong brand awareness and a loyal following, they have identified over 325 potential new trade areas for restaurant development. In 2014 alone, the company intends to open 8-10 new company operated restaurants and 4-6 franchise restaurants across California, Nevada and Texas. One of these new restaurants opened in May of 2014 and another just opened on August 1st in Visalia, California.
On August 22nd, El Pollo Loco signed AA Pollo Inc. to a 20 restaurant franchise development agreement as the first step in a multi-year franchising initiative designed to expand the nation's leading fire-grilled chicken restaurant chain's presence in the greater Southwest. As part of their agreement, AA Pollo Inc. will develop 20 new El Pollo Loco restaurants in Houston, a new development market, and San Antonio. The franchisee company has also purchased six El Pollo Loco restaurants in San Antonio. AA Pollo Inc. is owned by Anil Yadav, a multi-unit franchisee who owns and operates more than 260 restaurants with three brands covering multiple states. El Pollo Loco currently has 8 restaurants in the state of Texas and has identified some 80 locations in and around Houston, Texas for expansion.
Over the long term, El Pollo Loco plans to grow the number of El Pollo Loco restaurants by 8% to 10% annually. The typical new restaurant investment model targets an average total cash investment of $1,360,000, net of tenant allowances, an AUV (average unit volume) of approximately $1.8 million and a cash-on-cash return in excess of 25% in a restaurant's third full year of operations.
El Pollo Loco's ability to grow its restaurant base has come under fire by a multitude of analysts and investors and with validity in this analyst's opinion. Having said that, the validity of this doubt is only as strong as one's ability to project forward the possibilities/outcomes and from varying perspectives. In just the last few years, El Pollo Loco has opened over 20 new restaurant locations east of the Rockies only to see each of these locations close for a variety of reasons, but none more daunting than sales generation. The problem with some of the restaurants that closed was primarily due to brand recognition in new markets; brand recognition simply was not there. The secondary issue plaguing these failed expansionary attempts was poor timing. Many of these restaurants launched and failed during the financial crises and those still lingering around post the financial crises found themselves at a disadvantage in attempting to build a brand, with little credit available and in a brand new market for the company. The third issue that plagued these initiatives related to new restaurants was a parent company operating under a massive debt load. In recognition of these restaurant closures and lessons learned all too well, El Pollo Loco has decided to grow in markets, which already recognize the restaurant brand, and while the company is repairing its balance sheet by paying off long-term debt with money generated through its Initial Public Offering.
Texas is an ideal market for which El Pollo Loco can further grow its brand, sales and market share over the next several years and decades. The company has the appropriate menu to cater to this market and it also has the appropriate restaurant atmosphere to service a growing demographic of Hispanic population alongside an ever-evolving American taste preference for "TexMex" food choices. Let's now move on to the second way in which El Pollo Loco aims to grow its sales and profits for the years to come.
Increase Comparable Restaurant Sales
Increasing restaurant sales is easier said than done as many restaurateurs come to find and as El Pollo Loco has found through decades of operation. However, the company has managed to show positive comparable sales for 11 straight quarters. Much of this performance comes to the company through menu price increases and foot traffic. While menu price increases can certainly be viewed as unstable and not necessarily long-term proven methods for growing comparable sales, almost all restaurants employ this tact as needs dictate and are influenced by commodity prices. Year after year, McDonald's (NYSE:MCD) raises its menu prices. Year after year Starbucks (NASDAQ:SBUX) raises its menu prices, so why should El Pollo Loco be any different? Having said that, long-term investors don't have the most appreciation for comparable sales growth through this measure as it leaves little room to reverse course during a stagnant or recessionary economic environment. Nonetheless, the menu is still the most ideal place to drive comparable sales growth.
El Pollo Loco will continue to grow and innovate its menu choices as the company looks to increase traffic and brand recognition for existing and new markets. Healthier alternative food choices are an increasing trend in the United States. With this understanding, El Pollo Loco recently launched an "Under 500 Calorie" menu.
Another way in which El Pollo Loco aims to grow comparable sales is by remodeling its restaurants to emit a more authentic Hacienda ambiance. On average, stores that have gone through the remodel process have shown comparable sales growth of roughly 3 percent. The remodeling process is a long process and the company aims to complete the remodel of all restaurants by 2018.
Enhance Restaurant Operations
If all the aforementioned details surrounding the company's growth strategy weren't enough, El Pollo Loco's management understands the need to grow profits well into the future as a publicly traded company. Since 2011, the company has been able to improve its restaurant margins by 340 bps to roughly 22 percent. The company believes they can further improve margins by maintaining fiscal discipline, increasing fixed-cost leverage and enhancing purchasing efforts. Typically, as the restaurant base matures and AUVs increase, a restaurant chain will be able to leverage corporate costs and improve margins, as general and administrative expenses grow at a slower rate than do revenues through a larger and mature store base.
There are few variables that I find more distasteful about a publicly traded company than a very highly concentrated float. Unfortunately, that is exactly what investors will be confronted with in shares of LOCO through the beneficial ownership held by Trimaran and Freeman Spogli. Trimaran is a private asset management firm, headquartered in New York. Since 1995, Trimaran has completed over 60 private equity investments totaling over $1.3 billion of equity capital, including investments in the manufacturing, health care, restaurant, retail, education, media, financial services and utilities sectors. Following the completion of the IPO, Trimaran owns, through LLC, approximately 46.0% of the outstanding common stock. Freeman Spogli owns, through LLC, approximately 26.3% of the outstanding common stock, or 25.6% if the underwriters fully exercise their option to purchase additional shares.
Based on these two investor stakes in LOCO, more than 70% of the float is directly concentrated and could pose a conflict to El Pollo Loco and its remaining shareholder base. With that said, given the heightened dedication to growth initiatives on the part of El Pollo Loco's management, it would be unlikely that Trimaran and Freeman Spogli interfere with the daily business operations and objectives in favor of their own. Investors should be aware that in the cases of Trimaran and Spogli, either firm is able to unlock the value of their holdings as they see fit and with the recognition of the underwriters' agreement constructed through the initial public offering. Trimaran and Spogli can unwind their holdings, with approval from the underwriters, before the lock up period suggests. Of even greater importance, as it pertains to investor sentiment, if one ventures all the way back to a 2006 S-1 filing for El Pollo Loco they will find that the company was looking to raise up to $135mln for a company with $260mln in debt.
While the debt level is little changed since that period and the company will be paying off a substantial portion of the current $288mm in debt with the proceeds from the IPO, I would find it relevant that the company had a failed prospectus in the past related to a public offering. With almost $100mm accumulated through the recent successful IPO, El Pollo Loco will be taking its debt load down to roughly $189mm. In other efforts to reduce the company's debt burden, last year El Pollo Loco refinanced their $12.5 million first lien revolving credit facility, $170 million first lien term loan facility and $105 million 17% Second Priority Senior Secured Notes due 2018 (the "2018 Notes") by entering into the current senior secured credit facilities, which include the company's $15 million first lien Revolving Credit Facility and its $190 million First Lien Term Loan Facility and their $100 million Second Lien Term Loan Facility. Following the completion of the 2013 refinancing, the company's interest expense declined by approximately $17.8 million on an annualized basis or approximately 49% of their $36.3 million of interest expense for fiscal 2013. Aided in part by this refinancing, El Pollo Loco was able to record a net profit for the most recently ended period.
In closing, we are forced to recognize that El Pollo Loco is taking the proper steps to becoming a profitable QSR+ restaurant chain in the United States. For the 13 weeks ended on March 26, 2014 total revenues were $81.427 million - up approximately $5 million from March 27, 2013. The net income for the 13 weeks ended March 26, 2014 was $5.470 million that established the first positive net income generated in several years by the company. Restaurant sales growth for company-owned stores is 5.4%, while franchised stores posted growth of 8.3%. A majority of the company's turn toward profitability is coming on the heels of its refinancing of long-term debt as recognized in the S-1 filing. The YOY interest expense paid for the quarter ended March 26, 2014 was nearly cut in half from $9.7mm in March 2013 to $5.6mm in March 2014. The reduced debt load has not only improved the metric reporting for the company, but it has allowed the company the ability to record profits year-over-year. Additionally, lowering the debt load year-over-year will aid the company in enhancing its growth initiatives and increase the likelihood of success from these initiatives.
Presently, Capital Ladder Advisory Group would not be inclined to invest in shares of El Pollo Loco until we see a greater trend of improvements made from longer-term initiatives and irrespective of the current share valuation. We would also like to see how the company performs when it reports earnings on September 2, 2014.