When it comes to investing, one difficulty that some investors face is determining whether a company is underpriced, fairly valued, or overpriced. The lines can blur rather easily, with some cases looking rather deceptive. One sort of scenario where this can be the case is when a business is trading at low multiples but its fundamental track record lacks any meaningful growth in cash flows for an extended timeframe. This does not mean that the business makes for a bad prospect. But it could mean that the enterprise warrants trading at a discount compared to other similar firms that might be expanding nicely. A real-world example of this particular scenario involves restaurant chain El Pollo Loco Holdings (NASDAQ:LOCO). Although the company does intend to start growing more this year, the overall track record for the enterprise has been rather lackluster. The good news is that at least financial performance has been fairly consistent in recent years. But when you consider the absence of growth on its bottom line, the firm is much closer to being fairly valued than it is underpriced.
El Pollo Loco operates as a restaurant chain that focuses on a very particular type of food. Management describes the company as a differentiated and growing restaurant concept that specializes in fire grilling citrus-marinated chicken. It also sells Mexican and LA-inspired entrees such as its chicken avocado burrito, its Pollo Fit entrees, chicken tostada salads, customized Pollo Bowls, and more. Generally speaking, its locations are fairly small in size, ranging from 2,200 square feet to 3,000 square feet with seating for between 50 and 70 people. Most of its locations are free-standing buildings. Unlike many restaurants that might have the food and dining experience associated with a fast-casual restaurant, El Pollo Loco Provides a drive-thru service with the speed, value, and convenience of a quick-service restaurant.
It's also worth noting that management has taken a dual approach to growing the company. While some restaurant chains like Chipotle Mexican Grill (CMG) make sure that their locations are all company-owned, El Pollo Loco has opted to own some of its locations while franchising out others. This can be a double-edged sword. On the positive side, it enables the business to grow more rapidly than it might otherwise organically. In addition, the cash flows that it generates from its franchisees should be high-margin in nature. On the other hand, it reduces control that the company has over its network and results in overall lower revenue for the business.
Over the past few years, El Pollo Loco has been on an interesting ride. Revenue for the company did expand consistently prior to the COVID-19 pandemic, with sales climbing from $401.7 million in 2017 to $442.3 million in 2019. Even during the pandemic, revenue remained stronger than one might have expected, with sales for 2020 totaling $426.1 million. Then, in 2021, the business saw revenue jump to $454.4 million. This growth in revenue over the years has been driven by an interesting shift in strategy. Perhaps surprisingly, the actual number of stores in operation has not changed all that much in recent years. At the end of 2017, the company had 477 stores in its network. This number increased to just 480 by the end of 2021. However, the composition of these stores changed. The number of franchised locations increased from 265 to 291, while the number of company-owned restaurants dropped from 212 to 189. Although this would normally result in a reduction in revenue, all other things staying the same, same-restaurant sales increased during this time frame. Total systemwide sales grew from $841.8 million in 2017 to $973.2 million last year. Even company-owned locations fared well, with revenue rising from $376.6 million to $394.7 million.
Despite the increase in revenue and the higher composition of franchised locations, profitability for the company has shown no real trend. Yes, net income did increase over the past five years, rising from $8.6 million in 2017 to $29.1 million last year. But operating cash flow has remained in a fairly narrow range of between $36.1 million and $53.7 million. In the four years ending in 2020, another profitability metric, EBITDA, managed to decrease, falling from $65.3 million to $61.6 million. However, this metric did improve in 2021, coming in at $63.4 million for the year.
Looking to the present year, we have seen some mixed results. Revenue improved in the first quarter of 2022, rising to $110 million compared to the $107.7 million seen one year earlier. This came as the company added one additional restaurant to its network, bringing its total count to 481. The number of company-owned locations dropped to 188, while the number of franchised locations increased to 293. Management has not provided any guidance for revenue for 2022. But they did say that they plan to open between 3 and 6 new company-owned restaurants this year, plus another 6 to 10 franchised locations over the same timeframe. Absent the economy weakening, this should help to push revenue higher for the rest of the year as well. As for the company's bottom line, results have worsened. Net income of $2.1 million in the first quarter was nearly half the $4 million generated one year earlier. Operating cash flow went from $7.4 million to negative $2.3 million. If we adjust for changes in working capital, it would have fallen from $8.8 million to $5.6 million. And EBITDA declined from $11.9 million to $8.5 million.
If there is one really good thing about El Pollo Loco, it's that shares look rather cheap right now. Using our 2021 results, we can see that the business is trading at a price-to-earnings multiple of 12.9. The price to operating cash flow multiple is 7.2, while the EV to EBITDA multiple comes in at 6.2. To put this all in perspective, I decided to compare the company to five similar firms. On a price-to-earnings basis, these companies ranged from a low of 7.9 to a high of 736.3. Only one of the five firms was cheaper than our prospect. Using the price to operating cash flow approach, the range was from 8.1 to 26. El Pollo Loco was the cheapest of the group. Meanwhile, using the EV to EBITDA approach, the range was from 4.8 to 142.9. In this case, two of the five firms were cheaper than our prospect.
|Company||Price / Earnings||Price / Operating Cash Flow||EV / EBITDA|
|El Pollo Loco Holdings||12.9||7.2||6.2|
|Chuy's Holdings (CHUY)||13.5||8.8||4.8|
|Kura Sushi USA (KRUS)||N/A||26.0||142.9|
|The ONE Group Hospitality (STKS)||7.9||8.1||5.4|
|Noodles & Co (NDLS)||76.1||8.8||12.0|
|BJ's Restaurants (BJRI)||736.3||10.3||9.7|
Although revenue for El Pollo Loco has risen consistently in recent years, ignoring of course the 2020 fiscal year, and net income has also risen, other profitability metrics have fallen short. And the sad thing is that this is where it truly counts. On the positive side, shares are cheap on both an absolute basis and relative to peers. And on top of this, management does intend to grow the company's footprint this year. But with a weak start from an earnings and cash flow perspective for the 2022 fiscal year, and the historical track record of flat cash flows, I believe that this discount relative to the competition is warranted. Because of this, I have decided to rate the enterprise a 'hold' at this time.
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This article was written by
Daniel is currently the manager of Avaring Capital Advisors, LLC, a registered investment advisor that oversees one hedge fund, and he runs Crude Value Insights, a value-oriented newsletter aimed at analyzing the cash flows and assessing the value of companies in the oil and gas space. His primary focus is on finding businesses that are trading at a significant discount to their intrinsic value by employing a combination of Benjamin Graham's investment philosophy and a contrarian approach to the market and the securities therein.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.