Fiesta Restaurant Group, Inc. (NASDAQ:FRGI) operates the Pollo Tropical and Taco Cabana restaurant chains. The vast majority of the restaurants are corporate owned, though there are a few franchised locations. The company has been a beast over the last couple years since it began trading on its own in May, 2012. Shares opened around $12 bucks before a massive climb. I believe the company may still have some room to run because the fundamental factors that allowed it to outperform the market by such a large margin are still in effect.
This article is prepared using several slides from the company's most recent shareholder presentation. The source for these images is the events page for FRGI.
The image below gives a very quick overview of the two brands:
As you can see, despite only 42% of the restaurants being Pollo Tropical, they still produced 47% of revenues and 63% of EBITDA. Pollo Tropical is the future of the brand and it is the rapid growth of Pollo Tropical that has justified such a dramatic increase in share price. Taco Cabana is important because it provides a source of cash for the company to use in growing Pollo Tropical, but management says it isn't cash that is limiting the company from growing even faster. I'll get into those limitations towards the end of the article.
The company has only 43 franchisee-owned restaurants compared to the 285 company-owned restaurants. That isn't a ton, but it is enough to show that the company understands how to operate a franchising system.
Geography: Pollo Tropical
The map below shows where Pollo Tropical restaurants are located:
Numbers left of the slash represent company owned restaurants. Numbers on the right side represent franchisee-owned restaurants.
This company is extremely reliant on Florida and investors should be aware that this is a major geographic risk. It would be introducing extra risk to have a portfolio that is entirely focused on only a few parts of the company. If the economy in Florida falls off substantially it could cause a major earnings miss for the company and limit the effectiveness of their growth.
Geography: Taco Cabana
See the map below for locations:
Taco Cabana has a huge focus on Texas. While it is nice that the two brands are operating in different states, the overall company still has a large geographic risk factor that must be either diversified away or priced into the stock, depending on the investor's ability to bear diversification costs. For an investor that won't be substantially impacted by the trading fees of a very diverse portfolio, the company is more appealing because the geographic exposure requires limiting the position.
Even though Taco Cabana is less important to the future of the company than Pollo Tropical, it is still a very valuable brand and the Texas economy is critical to the performance of the company.
The reason the company wants to concentrate their restaurants is not a love of diversifiable risk, it is a desire for media efficiency. The highly concentrated geographic structure allows the company to leverage their advertising dollars. See the chart below:
The media efficiency is critical and is a driving factor in the strong performance of the company on some operating metrics. Investors should take note of the very large difference between comparable stores and non-comparable stores. In short, management is telling us that new restaurants perform significantly weaker than existing restaurants despite management focusing on high quality locations for new restaurants. The company builds their sales dramatically through repeat business and needs time for each location to build up to that level.
What are the limitations on growth rate?
Frequently new restaurants that are attempting to rapidly expand will cite cash as one of the major factors that limits their growth rate. That isn't a bad answer, but FRGI gave a better answer. When FRGI needed to explain their limiting factor, they brought it back to employees. I loved that reasoning. Frequently management believes that the system they have is perfect and that they just need cash to keep pushing the system out to more areas.
The company does have some very attractive economics on building new restaurants, but they took the time to go deeper. I'll do the same.
The new site selection criteria are simple enough. The company is focused on getting top quality locations, rather than getting cheap locations. That makes sense, given that the company is posting AUVs (average unit volumes) of $2.7 million for Pollo Tropical. When a company is that effective at bringing in customers, they really want to ensure that the restaurant is going to be easily accessible.
They also look for opportunities to develop free standing buildings because the drive-thru is an important aspect of their business. However, despite looking for the free standing buildings in the most in demand areas, the company can still find locations faster than they can find competent employees. "Development pacing is not limited by development resources, available sites, or capital; it is dictated by sourcing great general managers and team members that are fully trained". That is a powerful answer in regards to the importance the executives place on having the right people to handle the day to operations.
This isn't just a slight change to the philosophy. Consider McDonald's (NYSE:MCD) for a moment. MCD blanketed the country with locations because they were able to envision and rapidly reproduce the business with almost no regard for what workers were put into the system. I believe both systems have some merit, but it is very interesting to see the commitment that management is placing on finding the right people to run their restaurants.
Fiesta Restaurant Group has a very strong geographic focus that requires investors to diversify the risk or price it into their valuations. However, the company has used that geographic concentration to leverage their costs of advertising and improve the margins at their restaurants. Because investors can diversify away the geographic risk, but cannot improve restaurant margins, I believe management has taken the right approach to driving returns for shareholders.
Their willingness to focus on finding the right general managers for their restaurants rather than hoping that their system is strong enough to withstand poor managers represents a keen understanding of the importance of having the right employees throughout the organization. It is important for investors to understand that this does represent a very real limit on the growth rate for the company, but I think management got it right. If, at some point, management decides to rapidly expand through franchising, they will need to modify the system to reduce the importance of choosing the right people. I believe this represents a headwind to the company's growth through franchising, but I'm still slightly bullish on the company.
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.