EP80: Fries With That
Stock Ideas From Investment Professionals
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White Brook Capital recently released their detailed thesis on Portillo’s (PTLO), a regional (specifically Chicago) fast casual restaurant in its expansion phase. The shares have done poorly since going public, but White Brook sees upside of ~100%.
Portillos (PTLO): Company Evaluation
Summary Thesis
Despite solid results as a public company, Portillo’s stock has been a disaster since its initial public offering, trading from a post IPO high of $53 to ~$10 today as stock strength was met by selling by Berkshire Partners, their previous private equity owner. While the Company still has significant opportunity to grow in the Midwest, the Company has embarked on a Sunbelt growth strategy to grow bigger, sooner, and has successfully executed against that strategy for the last two years despite law of small numbers creating optical headwinds. As the Company grows to become more than a Chicago brand and educates the market on apparent, but transient near term headwinds caused by its accelerating growth, White Brook sees significant upside in the near term and upside measured in hundreds of percent if it continues to execute.
Great store economics combined with sought after food is translating to a successful expansion that will accelerate as the Company grows from 85 to 800 stores. The Company has operated since the 1960s and figured out how to grow and open restaurants in the past 4 years, with significant improvement coming over the past 2 and the new strategy of opening stores in the Sunbelt an early-inning, but overwhelming success.
The Company’s valuation is exceptionally cheap, the near term issues, addressable, and White Brook’s target price is over $22 in the short to medium term. We base our price target on a reversion to a comparable multiple in line with its mid teens EBITDA growth target (which we believe to be relatively easy to underwrite), large and expanding addressable market, robust per store FCF generation, attractive single store ROIC, and improving consolidated ROIC. We believe it will be a candidate to be a long term holding even after achieving that relatively near term price target.
Recent Stock Weakness
Three issues have emerged and are significant concerns to investors in the past year but particularly since 1Q24 earnings.
1. Consumer strength concerns. The Company has spent the past several years offsetting inflation pressures with price. Traffic has been flat to down as price has increased, but price elasticity was positive until 1Q24 when bad midwest weather also contributed to sharply lower transactions. It’s likely that along with restaurants generally, pricing power has limited utility moving forward.
The Company indicated that transaction frequency, which drove same store sales negative in the first quarter, was improving through the quarter and into April and same store sales had improved, but transaction frequency was still down y/y, a symptom of weakness in the lower end consumer.
New efforts by McDonalds and Burger King to drive value into their menus in 2Q/3Q present headline risk and may have some impact at the edges. In many ways, Portillo’s is in a different class despite menu similarities to those QSR chains, similar to Chipotle vs Taco Bell. Additionally, we believe the no margin $5 value meals are going to cannibalize higher margin sales for those chains, resulting in relatively short windows for those offerings.
2. New restaurant metrics don’t look great (but don’t reflect reality). ~20% of sales now come from restaurants that have opened in the past 2 years and therefore aren’t in the same store sales comparable calculation. Sales in these “new” restaurants underwhelmed expectations in the first quarter. The performance of new stores is a key to Portillo's investment case and this is therefore an understandable concern. White Brook believes there are reasonable explanations that the street did not account for and that the Company needs to better detail.
3. Cost inflation. The Company took two price increases in the first quarter, one limited to California to offset the increase in labor cost, the other in the rest of the footprint to offset increasing input costs - namely beef. With restaurant pricing power waning industrywide, the Company has limited ability to offset further unforeseen cost increases. We believe, given historical pricing and the time to grow cattle herd sizes, that beef costs have more risk to the downside in the near term even if they are more balanced over the next 6 months.
Thesis
White Brook believes that much of the long term value will come as the Company answers some of the near term concerns.
1. 1Q’24 Unusually tough weather. The Company argues that same store sales declines are due to strain in lower end consumers and the concentration of stores (60/69) in the same store sales calculation in the midwest (undeniable) - and the exceptionally poor weather experienced in January 2024, particularly compared to January 2023. The Company attributes the decline in same-store sales primarily to three factors: 1) Economic strain among lower-end consumers, 2) An overly high concentration of stores in the same store sales calculation (60 out of 69) in the Midwest region, and 3) Exceptionally poor weather in January 2024, especially when compared to the same month in 2023. We know it was an usually difficult January, even for Chicago, and will be proven out on the 2Q’24 call as same store sales transactions rebound.
The Company’s same store sales will stay concentrated in the Midwest for the foreseeable future, however as by the end of 2024, there will only be an additional 2 stores in the comparable base. 1Q25, should have an easy year over year same store sales comp.
2. The Company is a victim of timing. The Company’s growth prospects are strong, and its near term growth weakness is misunderstood.
Portillo has 3 types of stores:
Comparable stores: These stores have been in the store base for over 2 years and are mature. Their growth is subject to population growth, store popularity, pricing actions, targeted advertising, and local considerations. The issues here are highlighted in the first point.
New stores (under a year): Newly opened Portillos typically open to demand that has to be constrained before tailing off and operating sustainably lower after several quarters.
On a quarter over quarter basis, after the first two quarters, a particular store is a headwind to the non-comparable same store sales calculation that isn’t explicitly disclosed by the Company, but is computed by most analysts. Year over year these stores are a significant tailwind for total revenue growth.
New stores (1 - 2 years): Stores that are 1-2 years old are maturing and have lower overall annual sales than their first year. They also are not in the comparable store same store sales calculation.
While theoretically this is easy enough to understand, the development of stores is still a new strategy for Portillos. They only have three years worth of new store openings in the “modern” era, Covid skews even those, and they weren’t all opened at the same time, at the beginning of the year. 1Q’24 for instance, had several midwest stores that are still in the under 2 year category (and therefore impacted by weather + were “complementary” opens that have lower AUV (“average unit volume”), but less of a deterioration curve), as well as the Colony, it’s tentpole Dallas location, which when new, opened beyond any expectation, but as it has matured in its second year has hurt “new store” comps.
These new stores, even if they weren’t “complementary stores” or super large openings in the first year, would have been a headwind as they lapped their first year in 1Q’24 optically deflating new store sales growth.
Q2’24 and Q3’24 should see a quarter on quarter tailwind as that percentage recedes again and under 1 year old restaurants become a relatively larger contributor.
We don’t view this dynamic as a real issue, but instead an optical one that confuses investors. We believe the Company should and will address this confusion with additional data, and as additional opportunities to address investors arise.
3. The store economics are fantastic and growth will result in improving consolidated ROI. The Company outlines 3-year cash on cash returns of 25-31% with the Company financing the construction of its stores (it rents the land), and best in class, cash on cash returns of 80% if construction is financed by the land owner, similar to other fast casual restaurants. We believe cash on cash returns are closer to the low 20%, but these numbers still represent, “money tree” like returns that compel every dollar of available cash flow to be invested in the growth of new stores.
Improved returns on capital are highly correlated with the market rewarding a company with improved valuation. If the Company grows stores in the forecasted 10-15% range every year, the returns on capital for the company should improve by 50-60 bps a year. With only 85 stores and a target of 850, the Company should have >50 bps of year over year ROIC improvement beyond the forecastable time frame. We believe, resulting in a rerating.
Importantly, the reason that the stores do well is because the food is compelling and broad, and throughput issues have been solved at a base level, even as the Company works to unlock higher echelons of performance. Market history is replete with “Chicago stories” that didn’t ultimately travel, like Cozi, or took time to find their legs, like Potbelly. Last year, one of Portillo’s highest grossing restaurants was in Dallas, not Chicago, at a $17mm AUV pace, and has settled into a $10mm AUV pace, or 4x a typical McDonalds - Portillos is already ready for prime time.
4. Option: Medium term - Capital light growth. White Brook believes that the Company’s efforts to shrink the store format will lead to a significant increase in the addressable market. The Company’s rationale for operating its stores is that the extremely high AUVs result in significant operating leverage. The Company has had a bad experience when allowing all new employees to open stores. The Company’s evolution towards smaller formats, we believe will lead to formats fit for smaller markets than currently targeted. In our view, smaller AUV formats can be handled by franchisees. The Company has already introduced the express concept to address transportation locations, and added to the total addressable market by 100 stores. We believe the opex of this type of expansion would be significant early, but would result in a high margin revenue stream and would re-rate the Company’s multiple as investors consider the Company’s ability to operate as a capital light franchisor.
5. Berkshire Partners is now under 20% ownership. Historically, and anecdotally, we’ve found that ~20% is the threshold when stocks work even as private equity is exiting their stake. Before then, as Portillo’s stock has witnessed, all strength is met with new selling that creates a significant overhang.
Company Overview:
Portillo’s is to Chicago what In and Out Burger is to California or Shake Shack was to New York City. People who know it, love it and those concepts have traveled decently well.
The Company has gone through 3 phases. The Portillos family era where the Company grew glacially, was Chicago based, but developed its menu and sturdy reputation; the private equity era (2014-2021), where little long term value was created with the exception of attracting a solid management team, and the public market era the Company now embarks on, with an intelligent growth plan and improving store return profile.
The Company serves a solid burger and fries, while differentiating from competitors with genuinely good Italian beef sandwiches, high quality salads, Chicago style hot dogs, and a restaurant quality cake. Their menu’s assortment makes the chain “veto proof”, while also serving items that make it a genuine draw. The food is made to order and the prices are competitive with other fast casual offerings.
The breadth of the menu means that the kitchen is generally more expensive than other concepts to establish and run and larger orders can be somewhat slower as there are more chokepoints to delay orders. Recent store visits for a family of four have made this a theoretical rather than an experienced problem in various Chicago area stores.
Portillos caters to a general audience. A former CFO noted that there isn’t a strong ethnic aversion to the food. It has something for everyone, spicy, sweet, middle of the road, unhealthy, healthy.
The Company has a solid app, in-store pickup, dine in, and usually two drive through lanes. In the Chicago metro area, the drive through lanes are usually exceptionally full, while the in-store pickup is underused, and the dine-in has typical restaurant business patterns. There is opportunity there to shape orders to increase throughput. The Company has undergone/continues to optimize the format of the store to encourage throughput, lower the cost of the restaurant, and increase returns.
New Restaurant Growth
The Company’s stores are generally in 3 areas.
The Chicago metropolitan area: Restaurant was founded in 1968 and grew slowly until recently. The restaurants operate at an industry leading GMV, while this author only recently tasted the wares, the market is mature, and new store growth should be expected to be fairly minimal fill-in optimizations. Historically the stores were castles meant to service a wide area, but the Company continues to innovate to serve the southern expansion, shrinking the store format, and likely improving the total addressable market.
The Broader Midwest. The so-called “cheese spill” area is deceptive. The Indiana stores for instance are limited to Indiana’s Chicago metropolitan area, 4 stores in the Indianapolis metro area, and 1 in Fort Wayne. There is 1 store in Michigan, 3 in Minnesota, 4 in Wisconsin, 1 in Iowa. These stores are all well rated, but there’s considerable opportunity for more, particularly in areas with a metropolitan area over 100k. Portillo’s Chicago, Texas, and Arizona current cluster growth strategy is ineffective in these more rural areas, however.
The Sunbelt. The Company is doing well and growing quickly in Arizona, Texas, and Florida and is currently identifying new, and additional store growth in these areas. But it is still subscale. In these places, the decor of the stores is matched to the state’s culture rather than harking back to mid 1900s Chicago lore.
Portillo’s current expansion strategy is to lease the land on a 10 year lease, but to build the buildings themselves. The Company owns all of the stores and due to the exceptional high AUV per store and past mistakes made, now only grows when current personnel are available to lead new expansion. Given the slow pace, the balance sheet can currently support this financing strategy. Self financing results in higher new building costs upfront, but also an estimated, additional ~8% points of additional margin. Slow absolute unit growth, expansive kitchens, and highly designed decor means their stores are expensive, but work has been done to reduce store footprint and enhance returns as the Company grows.
The Company believes it has best in class economics for a fast casual restaurant. While the Company used to open restaurants at a cost of over $6 million a restaurant, it has driven the startup costs down and its likely it will be able to continue to do so, both with new store floor plan introductions, but also as it continues to scale and grow in new geographies encouraging more competitive bids with less vendor risk.
White Brook’s calculations suggest a somewhat lower return profile than those outlined by the Company and presented here, but believes returns are extremely solid and near best in class. Opening stores offers extremely compelling returns. Any business owner would impress upon management to grow as quickly as possible, with only 85 stores, we believe they have a very long runway to expand.
A significant limiter to Portillo’s growth is the operational complexity of a Portillos, the need to maintain the culture and operational excellence and how they overcome it to launch a successful store. A former employee pointed to Minneapolis store that was opened with new employees that took years to fix to get to where a new store opens today. Today, new stores are opened with existing managers, in a staged open that turns on in store dining, drive through, and app, online and carryout orders at different stages allowing for the Company to shape its crowds and improve the probability of a good experience, no matter the channel, over the first year.
The strategy means that small size begets small size, but as the Company grows, the available personnel to launch new stores also grows. Currently, the Company’s repetitions are relatively low, as more stores open, the returns are proved and operations are standardized, we expect an expansion and acceleration of growth strategies that can also become more capital efficient.
Valuation
Tegus’ restaurant dashboard shown below makes a strong case that Portillos is cheap on an absolute basis, relative to available growth potential, relative to current growth, and relative to return on capital metrics which will improve as more stores are added to the fleet and current stores mature.
White Brook’s target price is north of $20 in the near term, with upside potential over 3 years far beyond that.
Below, we have 4 more ideas for our paid subscribers.