Chit Chat Stocks - Can This Restaurant Stock Deliver Returns Like Chipotle? (Portillo's Stock Report, Ticker: PTLO)

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Starting point is 00:01:32 episode. Welcome to Chitchat Stocks. This is our Wednesday episode and we are doing our monthly stock research report. Brett has done the research for this week. I am one of your hosts, Ryan Henderson. I'm joined as always by Brett Shafer. And we are talking about a little known restaurant brand called Portillo's. It actually has the highest average unit volumes of any fast casual restaurant chain in the United States. So a fanatic following among consumers, but the stock has been crushed since coming public. So we're going to go through whether or not we think this could have multi-bagger potential. With that, I'll kick things to you, Brett, I guess. How was the research process? How did you come across Portillo's to begin with?

Starting point is 00:02:26 Yeah. So we did a show back when we were doing our not so deep dive phase on Portillo's, I think back in 2021 or 2022, right after they IPO'd, we looked at them. It was fairly interesting, but we thought that we wanted to see them in the public markets for a valued. And I don't know who it was. I believe it's the, our Motley Fool colleague, or excuse me, my Motley Fool colleague. You don't work there anymore, but Motley Fool colleague, Travis Hohian, I can never pronounce his last name, also runs the Asymmetric Investing YouTube channel and podcast. He did an update on them and I thought, hey, I should check them out. Stock's been down a lot. They've had some interesting developments. Business still looks okay. We're going to kind of

Starting point is 00:03:14 try to look at as they go through a national expansion strategy, because I think it's a little tease for the listeners. The upside here is quite high. Now, there are some major risks to this business, which we'll get into, particularly with the balance sheet and self-funding their growth, as well as with the debt load. But yeah, let's get right into it. what is portillo's if you have lived at all in the chicago area you definitely know what portillo's is but if you haven't you might not know that so it is a fast casual restaurant serving chicago style street food the main what you'd say unique items that someone would go to a portillo's for are their italian beef sandwiches and chicago style hot dogs so two of the mainstays of the

Starting point is 00:04:02 chicago culture food all that good stuff however they also sell burgers chicken sandwiches and salads according to management the salads are wildly popular i think a lot of these items are popular as well uh for sides and extras they sell like standard stuff fries and then they have kind of these famous chocolate cake and milkshakes so i think that is part of their um brand as well we you know we sell these homemade or not homemade we make the chocolate cakes they're pretty damn good. We bake these milkshakes as well, and they have something that combines the two with a chocolate cake milkshake, I think, which I'm not sure exactly what that is, but apparently that one's popular. So as you can tell, as a fast casual chain, this one is not focused on healthy

Starting point is 00:04:47 eating. It is what maybe we'd call hearty food with the opposite spin of someone like Chipotle or Cava. You know, they focus on saying things like Portillo's is quote craveable or for a fun family dinner without breaking the bank. It's somewhere where you might stop for lunch during the workday for a hot dog, but you also might take the kids for a Sunday evening for a sit-down meal. A family with a six-year-old and a 10-year-old or something like that, you could definitely see them going to Portillo's, not breaking the bank. Kids will love it. They have this atmosphere in there. On a scale from McDonald's to Sweetgreen, this skews a little more towards the mcdonald's side of things exactly but hopefully as they might pitch it

Starting point is 00:05:34 a little bit higher quality than mcdonald's so it's almost like if chipotle or kava and i know maybe chipotle is the better example for healthy eating it's like the fast casual of i don't know it's italian style chicago food and not mcdonald's So it's a little bit different, but it's almost like that one step up from fast food to the fast casual. They want that quality there, but at a reasonable price, which is why we put the title in this episode as something. There's a lot of similarities here to Chipotle.

Starting point is 00:06:08 Also, I'd say maybe another one that's very similar and the one that has the closest in AUVs and might be the only one that passed them is Chick-fil-A. So also similar to that as well. But obviously Chick-fil-A is very national, has a lot more location. Okay, so I think we've given a pretty good grasp on the kind of food they serve. Put a picture on people's heads of what a store looks like. yeah so these are unique designs well they're paring back on the importance of this as they scale portillo's works to serve each market they enter with unique local qualities to a restaurant so this doesn't mean changing up the menu right it's not like a mcdonald's in india where they

Starting point is 00:06:53 serve some of the stuff that's catered to that local market it's always going to be the chicago style street food but they add in something that locals will like for example they custom made the Detroit location with Ford related stuff, all that. In Arizona, they've been expanding to that market and they have obviously some desert theme there. I don't know if it's a huge thing, but more importantly, from a unit economic standpoint or from an investor standpoint, Portillo's is built at a large size to achieve high sales volume. So they offer all channels for customers. You have digital pickup, delivery, drive-through. They usually have the double barrel drive-thru, similar to a Chick-fil-A. And they even have a catering business. And you can get

Starting point is 00:07:36 national shipping. So you can technically, we live in the state of Washington, you can technically get Portilla shipped from Chicago out to Washington. I'm not sure how popular that is, but it is probably a good way to build a brand before launching in new locations. And you might, okay, if you're from Chicago, or you're from a place that has a Portilla, is you're like, well, I can visit a restaurant, check it out, see if people like it, see if the food is good. You might ask, is the food even good? If you're listening to this, you live in California, the Northeast, wherever. And that was one of my main questions as someone that's never been there. I don't think I've ever seen even a Portillo's. One of my main questions when

Starting point is 00:08:16 looking at this business, because if the food is good, if the customers enjoy it, if it's a good experience, I think it's likely going to scale throughout all parts of the country. And if it's just marginal and they're kind of riding off of their Chicago heritage, I would be worried about, because the main part of this thesis would be, is the expansion not from... The Chicago area ones have shown over decades and decades that they're profitable, but it's all about the new locations across other parts of the country. And the big concern would be, is that the unit economics, the profitability, the cash flow from new restaurants aren't going to be the same as the old ones.

Starting point is 00:08:52 I think there's a lot of, which we'll get into in this episode, a lot of reasons to think people love Portillo's. I mean, they're one of the only restaurants I've ever seen that has to temper down when they open a new location and specifically make it so less customers go. I would think the only other place I've seen like that would be an In-N-Out. And if you're from the Pacific Northwest, we have like an In-N-Out style thing called Dick's Burgers as well, which those are the only ones I've seen where like the openings are a huge crowd, two hour line, all that type of stuff. So I think that's a great sign for expansion when you have literally too many people trying to go on opening day. Yeah, I saw this one time. This is not a Portillo's, but I saw an example of this. And it's kind of a similar, if I'm not mistaken, they're sort of at a similar stage to Portillo's actually.

Starting point is 00:09:51 There was a Dave's Hot Chicken, which was kind of a growing concept, I think, that came out of California, if I'm not mistaken. And it was just like that. You basically had to, you had a line out the door and it's this, you're literally tempering expectations. You're telling people that it's going to be packed because you literally can't deal with all the throughput. That's what you get with a lot of these Portillo's locations. And especially, we're going to talk about the comp sales and how it works. There's sort of this nuance to it. But it just goes to show that all the Chicagoites that have moved across the country truly, truly do love this brand because they become such fanatic customers as soon as they move to one of their locations.

Starting point is 00:10:39 Yep. And they see it with their national shipping business as well. that talked about data with that. We'll save it for the population transition from the Midwest to the Sunbelt. Why don't we... Well, you're supposed to be the one fake interviewing me here, Ryan. So what's the next question? Let's go through some of the history. How did Portillo's become a public company? How were they founded? Go through some of the background. Okay. So there's three main sections for an investor to understand here. There's the founding period, the private equity period, and then the post IPO period. I'll try to go through

Starting point is 00:11:11 this quickly, but Portillo's began in 1963 when Dick Portillo opened a hot dog stand in Chicago. And then for the next few decades, the company became a staple in the Chicago area with an intense focus on serving this market. And you can see that with the results of the Chicago AUVs today, average unit volumes. We'll talk about that in a later section. Then in 2000, they started nationwide shipping, as we mentioned, and then they expanded to California. There are only two stores that remain open in california today and management today essentially admits it was a mistake to go there but if you look at this chart that i'll have in the newsletter um and maybe i can share the screen here a bit too uh sorry one second okay i can share it while you yeah why

Starting point is 00:11:55 don't you share it so um okay in 2000s portillo's didn't do much with store expansion but from my see what i'm seeing here is that it was a business that was thriving in chicago where you know the founder was there the family was there they had a long time management team that didn't really care about getting bigger you know you had a chicago business it's doing quite well why do you need to expand but i think likely uh you know when the family left uh they were probably looking for a seller and in 2013 berkshire partners which is not affiliated with buffett or berkshire Hathaway, but I thought it was an interesting name choice, acquired Portillo's in a private equity deal. From then, they decided to grow store count across the Midwest and then a bit

Starting point is 00:12:40 into the Sunbelt. Now, the Midwest didn't do as good as they would have liked, so they transitioned more to focusing on the Sunbelt, and they have aggressively continued with that push after going public. So in 2021, about eight years after taking this private equity deal, they went public to pay down some debt and repurchased what they have these LLC op-com units from. Essentially, the IPO was transferring ownership from Berkshire Partners to public shareholders. Now, Berkshire Partners still has a 20% stake today, but it was a way to just go public and I think probably return capital to the private equity investors. From then on, they have decided to expand the unit count at about a 10% rate throughout the Sun Belt, which would be Arizona, Texas, and Florida as their

Starting point is 00:13:33 main states. And then, yeah, that's really it. We'll talk about what the returns on this expansion could be, but they've gone from the founding period, which basically, you know, they grew in Chicago, had stagnant store count, not really much of a strategy. Private equity comes on, they go for a Midwest expansion, doesn't work that well. Then they IPO, and now they found some success with good AUVs in the Sun Belt, and they're going to try to aggressively expand throughout some of those large states. So question for you, do you like that this was owned by a private equity group prior to coming public?

Starting point is 00:14:12 I think there's some positives here where they're going to be focused on shareholders, right? They still have a 20% stake. But as we'll get into with the balance sheet, they run, some people might call it lean, Some people might call it efficient. Some people, I might call it dangerously efficient. The balance sheet is like, it's a private equity type balance sheet. And sometimes for us, we're more fans of the conservative balance sheet.

Starting point is 00:14:40 So there's some give and takes here, but I don't think it would keep me away. And I don't think it would be the reason solely to invest just because a private equity firm was in there and still owns a sizable stake today. Okay, let's go through the unit economics. how much does it cost to build a Portillo's? I think we're going to go through some of those numbers here. And then what kind of returns do they get on an individual store? Yeah. So I will note this is the most important section. I mean, unit economics for restaurant concept, especially one looking to expand is crucial because if they are good, it's going to

Starting point is 00:15:17 lead to high returns on invested capital. And with the size of Portillo's, a huge reinvestment runway. And then if they're not, well, it's not going to go well. So, theirs are a bit tricky because we have to separate out the Chicago restaurants versus the non-Chicago restaurants. And luckily, at the 2023 Investor Day, which anyone that's interested in this company should at least read through that slide deck, and then they have a transcript as well. Definitely check that out. They give a lot of detail on their strategy at that Investor Day. First, we need to talk about what they care about with unit economics. This is what they're looking at. And I'm going to kind of try to go through that and see if whether we care about that as

Starting point is 00:15:56 minority shareholders, because one of the big things that Ryan and I try to look at when studying companies is if the targets that management is going for and what they're going to get rewarded on and what they're focusing on are actually going to drive shareholder value for us. And we want to hope those are aligned. So there's two things they look at. Average unit volumes, which is the number of annual sales at a restaurant location and then restaurant level profit margins. AUV is pretty self-explanatory. It's whatever is in their comp sales base. So only stores that have been around for 24 months and then divided by the number of restaurants. So it's just average unit volumes of locations that have been open for 24 months. And then

Starting point is 00:16:42 I guess we should talk about why they use 24 months. Most companies use 12 months, But Portillo's likes to use 24 because, as we mentioned, they have a huge pent-up demand at each new location. So in the first few months of opening, they're going to have way higher sales volumes than they will typically. And that would, if they put them in the 12-month comp period, would create a huge headwind of comp sales, even if the location is doing fine and is still highly profitable. I think if you looked at it on its face, you might say this is kind of a way to manipulate some of the numbers. But I think it is – it's honestly a good thing that there are so many existing fans of Mortillo's across the country that are waiting for a new location that they have to – that they have these huge openings and stuff like that. Now, let's talk about restaurant-level margin. Ari, you have a follow-up there, right?

Starting point is 00:17:33 If you follow Topgolf or if you've ever studied their business, they kind of have a similar thing where there's a honeymoon period when they first put a Topgolf location in a city. So the first year's numbers look really elevated relative to what they would do on an ongoing basis. Yeah, exactly. I would compare that to this as well. It can make some numbers look complicated, but I do like that they set it at 24 months. But that is something to understand here because as they open more locations, you can't just look at comp sales when understanding because there's going to be 24 months of stores that are open. That could be like 20% of the total unit count as of this time. So you got to look a little deeper in that.

Starting point is 00:18:17 Now, they have restaurant level margin, which is looking at the profit margins for each location. I'm going to read the full quote here. And Ryan, you let me know what you think of it. And then I'll give my thoughts as well. Restaurant-level adjusted EBITDA is defined as revenue, less restaurant operating expenses, which include food, beverage, and packaging costs, labor expenses, occupancy expenses, and other operating expenses. Restaurant-level adjusted EBITDA excludes corporate-level expenses and depreciation and amortization on restaurant property and equipment. Thoughts, Ryan? Most of it makes sense to me.

Starting point is 00:18:53 You know, there's no point in including corporate expenses at the restaurant level, and all the costs that they strip out make a lot of sense, except for, for me, I think the depreciation, the restaurant property, any of the machines, equipment that they have at the restaurants, that part doesn't really make sense to me. I don't see why you'd strip that out. Yeah, I think you might argue that there's just a lot of, like, they have to spend all this money, especially because they're not licensing locations. They're going for the full ownership model of all these locations. They might argue that those are going to be non-cash expenses and it's going to be a lot of costs up front. And then this is kind of the operating cash flow of a location. But I did get where you might want to look at both. I think, in my opinion, it's a fine metric. They're not tossing in and excluding stuff that we've seen from other companies when they're doing kind of unit level economics. I don't think they're tossing out too much that's bad. And I think this kind of, this is probably a pretty good proxy for restaurant level operating cash flow. And, you know, there might be some maintenance capex in there as well, but I don't think it's going to be too crazy. they estimate, and we're taking them for their word here, that only 10% to 15% of their total capital expenditures at the moment are maintenance capex. So I don't think it's going to be a huge difference either way. Now let's go through some of the numbers though. At the September 2023 investor day, the Chicago locations had 10.8 million AUVs and restaurant level margins of 31%.

Starting point is 00:20:24 percent both of these i think are the highest i've ever seen for for any sort of restaurant um they're really good i think the only the only takeaway is these are probably generating a good amount of cash flow for the company that they can send up to the corporate headquarters every day or every year yeah for reference chipotle does i want to say they do just over three million dollars in average unit volumes and you think about the throughput at a chipotle location it's pretty good three yeah i mean that's top usually top-notch throughput and portillo's is doing almost triple that so kind of it's honestly an astounding number when you really think about it yeah for these locations it's they are going for big location they think that when they're in a city they'll

Starting point is 00:21:21 talk about expanding into phoenix or dallas they're at a good amount of restaurants when they hit like six in a giant metropolitan area like the phoenix scottsdale area or the dallas fort worth area whereas chipotle might be able to fit 30 so it's just a larger size more people flock there for dine-in more people are going to flock there for you know they got drive-through that's doing a lot of there's just there's just way more volume going through these things and they're going to have fewer locations in each city now importantly you know we're confident chicago it's profitable it's going to keep being profitable it's been profitable for decades but the important one is sunbelt and they said that they do about according to the september 2023

Starting point is 00:22:03 presentation um 6.6 million in auvs and 20 restaurant level margins so these are not as good as the Chicago area locations, obviously, but they're still solid numbers. And I think investors should remember that the comp store base doesn't start until 24 months in. So a lot of the new Sunbelt locations are not included here. And I don't know, like there's still good numbers, I guess is what I would say, but it's an important number to track because hopefully they'll give commentary on these new store locations and whether these AUVs are improving in the Sun Belt, and the margins are staying stable. Now, if we look on a consolidated basis, in Q1 of 2024, luckily, they just reported, they have blended unit economics of AUVs of $9 million

Starting point is 00:22:53 each year, up from $8.7 million a year ago, but kind of stagnant from Q4 2023. And then consolidated restaurant level adjusted EBITDA margin of 24%. Over the last 12 months, We have a chart in the newsletter that's been fairly stable compared to 2023 and is up from 2022. I think they had some inflation costs and like a lot of restaurants, it took them quite a few quarters to climb out of the pandemic. All right, that was a big section, Ryan. Any follow-up questions there?

Starting point is 00:23:24 I know that unit economics are vital, but I think my big takeaway is that Sunbelt and Chicago both have very, very good to fantastic unit economics for each restaurant. Finchat.io is the complete stock research platform for fundamental investors. They have all the standard financial data on more than 100,000 stocks globally. And beyond that, they have company-specific segment and KPI data on more than 1,500 stocks. So to give some examples here, you want to see Netflix's average revenue per member over the last 10 years? They've got it. You like to track YouTube's advertising revenue?

Starting point is 00:24:01 They've got that too. If you want to see Celsius's revenue that comes from Costco, how much of their revenue comes from Costco, they also have that. So the breadth of FinChat segment and KPI data truly is one of a kind. I use FinChat every day to track and manage all my investments. I also use it to discover new investments. And if you want to get 15% off any paid plan, go to FinChat.io slash chitchat. That's finchat.io slash chitchat to get 15% off any paid plan. The link will also be in our show notes. Be you, be you, sound the alarms. We have a new sponsor alert. That's firmreturns.com. It's a stock research blog. Our friend runs that and it covers companies from all around the globe,

Starting point is 00:24:48 but it leans really more towards the UK as that's his home market and it gives him easier access to management and he provides ongoing updates on the companies that he's invested in, as well as an archive of longer form write-ups that you can access all for free. There is a paid tier, but there is tons of free content out there. And these reports are very thorough. To give you an example of just how thorough some of these are, at one point he was digging into a company's account and for one company he wrote up recently, he actually managed to find a material misstatement that had been missed by the auditors and management reached out and confirmed the error to him. And these are companies of all different sizes from all different sectors and all different

Starting point is 00:25:29 markets around the globe, but with a focus on his home market in the United Kingdom. If you want to check this out, firmreturns.com. Like I said, tons of free content on the website. If you're interested in one of the paid plans, you can go to firmreturns.com slash chitchat. That's firmreturns.com slash chitchat, and it'll get you 20% off. yeah and i'll just give two numbers just to summarize because i know we went through a lot there average unit value on average across all of its stores nine million dollars a year the average restaurant level adjusted ebitda margin 24 so both of those are really best in class numbers actually um i think i believe chipotle might have a slightly higher restaurant

Starting point is 00:26:17 level adjusted EBITDA margin. They have 3,000 stores. Yeah. And they're a little more mature. Yeah. Right. Let's keep going then. Now, there's been a little bit of a slowdown in comp sales. We've talked a bit about comp sales in general and some of the nuances between the 24-month and the 12-month numbers. What have these figures looked like historically? Is this a business that Once it's in, once you put a new store in, they tend to grow sales volumes on a per store basis each year. What does it typically look like? And then are you worried about the recent slowdown? Okay. Yeah. So comp sales have been trending in the wrong direction over the last few quarters. Portillo's posted negative 1.2% comparable store sales in Q1 of 2024. And I will say,

Starting point is 00:27:05 Ryan, if you want to share, I have some charts in there. If you want to share those from FinChat, I did make a request to the team to put in some KPIs there. So that's how nice they are to us and how nice they can be to you if you're a subscriber as well. But I will say, yes, they have trended in the wrong direction for the last five quarters. I would say this obviously is a slight concern to me. But in Q1 of last year, comp sales growth was 9.1%, positive 9.1%, making it a really tough comparable figure. And then if we look at the two-year comp stack, it's been trending a little bit lower, but it's still positive. And there are two other things I would say about anyone worried about

Starting point is 00:27:50 comp sales. Sure, it does impact the unit economics if comp sales are stagnant or declining and you have some slight inflationary costs coming in on your operating expenses. Your margin is going to go down a little bit, you know, the cash flow from each location is not going to be as high. However, Portillo's locations already have such strong margins and such strong, you know, ROICs, return on invested capital, that it's not the end of the world if they take a slight hit for a couple of quarters. You know, they're going to still have positive ROIC and I think they can do fine if we're operating in a tough environment for restaurants as a whole. And the second thing I would say is that a lot of restaurants are struggling with the same issue right now.

Starting point is 00:28:37 Starbucks, McDonald's, others are seeing comp sales move in the wrong direction. And I don't think these comparable sales developments or anything specific to Portillo's, I don't think it's like, okay, this company's brand is deteriorating in value. So I don't think it's a huge concern for me. But what I would be watching is that they have bad comp sales growth at a time when other restaurants and other fast casual places are thriving which as a side note it makes chipotle's numbers like that that much more impressive while they're putting up strong comp sales while everyone else is um everyone else is struggling in early 2024 yeah it is worth i think it's worth repeating that as this business grows tries to grow their store count quicker

Starting point is 00:29:30 Those comp sales figures, the two-year comp sales figures, there might be some, I guess, volatility in that number as they open in locations where the number of customers is just lower relative to their big Chicago-based ones. So it's going to make comp sales look slightly worse. However, those can still be profitable stores and they can be net restaurant level, gross profit, whatever you want to call it, accretive, even if comp sales are coming down. Right. And then another thing to watch out for is that as Chicago becomes a smaller percentage of the overall locations, AUV is not going to look good. It actually might go down over a multi-year period. And I've kind of put that into the rough financial model that I did to try to estimate some sort of numbers. and so so that's what i would you know that that's not going to be a concern to me as well if auvs are stagnant because the sunbelt locations are profitable but they do not have the same auvs at the moment as the chicago locations that have been open for multiple decades okay so we know what the auvs look like we know what the restaurant level profit margins look like how can they improve these per store returns over time right so we need to look at costs because

Starting point is 00:31:03 that's the other side of the union economics equation we're not going to look at chicago because those are fully depreciated restaurants they've been open for a while they're not spending a lot of growth capex there but we want to look specifically at the sunbelt locations where they're going to try to double their store count over the next however many years and they're all mostly going to be in these areas we want to make sure that the costs are in line and they can get a good return on invested capital. Let's go through all this stuff. They have some stuff from the 2023 investor day. Due to building cost inflation that hit anyone that was building this sort of stuff, we saw lumber prices, all that stuff happening in 2021 and 2022. The class of 2022

Starting point is 00:31:48 locations cost an average of $7 million per location to build. And I have a graphic in the newsletter for people to check out. However, with $8 million in AUVs for these Sunbelt locations and 20% restaurant level margins, these locations are still producing 23% cash returns each year. So even with the high inflation that came in during that period, they're still seeing a 23% return in cash flow each year on these investments, which I think not a bad ROIC. But they do believe, and I'm not sure if I agree with them, that building costs are coming down and they have a more optimized restaurant design coming in to kind of lower just as they professionalize, as they get more experienced managers into the executive suite and more

Starting point is 00:32:40 experienced general managers. They've made incremental improvements on how they design of location, all that stuff as they go to a more professionalized, fast, casual nationwide chain. They think they can bring costs down to $5.5 million in today's dollars or lower for future locations. And that would bring the cash returns to 30% per year if AUVs and margins can remain stable. Even if this is not achievable, and I think they might be a bit aggressive in saying they can just bring down their building costs this much. I want to see it when it occurs because this is all theoretical for future locations. Even if that doesn't happen, the unit economics are still strong. So no real concerns here. Ryan, what are your thoughts on their build cost? Do you

Starting point is 00:33:24 see anything that stands out as a huge positive or negative? Well, there was certainly cost inflation over the last, call it two or three years coming out of COVID with all the supply chain constraints. We saw that. We followed Sprouts Farmer's Market closely and they actually It delayed a lot of their store openings because it was taking too long to get stuff to the stores and it was just way too costly. So I believe that there, yes, there was cost inflation. We'll see if they can really just bring down their costs that much. I think that might be a little optimistic.

Starting point is 00:33:56 And to be honest, what happens a lot of times with these investor days is people post charts like this. and if they if their optimistic assumptions don't materialize they just never talk about it again that is true and this stuff is particularly granular they're not putting this in their you know they're not putting the cost per store to build in their typical financial statement so they could easily hide it i would hope that they kind of announce some progress on this throughout the conference calls over time but we'll see yeah and it's going to be a multi-year proc uh process because you know they got to design the

Starting point is 00:34:39 new restaurant then they actually have to build them which takes you know the design to build it takes a while but what i think is good is that either way even if they you know this is a good goal to have to try to reduce your build costs i think it's a good direction to have and a good focus to have but even if they can't bring it down to 5.5 million from 7 million well the numbers still look good. Okay. Kind of tailing off that a bit, we're talking about the national expansion. How do you think the unit economics might change? Or I guess, do you think they can stay the same as Portillo's pursues this national expansion? Right. So the big question is, are these unit economics going to be still strong as they move nationally? And I think they can. I'm fairly

Starting point is 00:35:26 confident they can. They have Arizona, Texas, and Florida locations that have already shown promised. They're not as strong as Chicago, but they can still generate AVs of $7 million to $8 million each year with solid restaurant-level margins. And remember, Portillo's already has fans spread out around the country. They are clamoring for a location to open up in their city. I mean, there was anecdotes of when the Florida locations opened, people driving two hours to go to these new stores. So I think there is plenty of demand here. Specifically, they chose Arizona, Texas, and Florida. I think this is a smart move, as states to expand to because they are seeing population tailwinds to these markets.

Starting point is 00:36:04 What's funny is that a lot of them are moving from the Midwest down to the Sunbelt. So I think, you know what I mean? They were probably prior fans of Portillo's when they lived in the Midwest or Chicago, and now they can move to a place where they're going to open up one as well. And with this management team that I'm actually really, really impressed with, you know, they're making incremental improvements to their opening process. We'll talk about them later. I have confidence that the unit economics will remain solid over the long term unless we hit some crazy stagflation period or something like that.

Starting point is 00:36:36 Of course, you know, each quarter, subject to the health of the consumer, comp sales will have some inconsistencies. But as you can see from the charts, we'll keep in the newsletter here. I mean, everything looks pretty solid on a restaurant level basis. yeah they've done a good job holding up their store level productivity like their their average store numbers despite this expansion because it's you know you think about this from the perspective of portillo's if you start this expansion into these states where it's kind of uncertain how you're going to do. You are compromising your short-term financials, especially on a per-store basis, because Chicago stores are such gems. They're such cashflow machines. They're old.

Starting point is 00:37:34 The depreciation is gone. It's all maintenance capex, and they don't have to open a whole lot to really choose cashflow. Now, they're making this push, so it's making the financials look a little rough. Let's model it out a bit. What are the company's expansion plans? And are we confident that this expansion can work? Yeah. So I'll have more details in the newsletter, but essentially they have 85 stores right now. That's at the end of Q1. They believe that there is room for 800, maybe even a thousand. They tend to change the number depending on if you include in their TAM estimates, pickup locations, airports and colleges. But for me, I'm going to go with a round number of 500. Let's just be conservative. Even if there's room for only 500 locations that

Starting point is 00:38:25 are going to be profitable throughout the US, well, we can go from 85 to 500 and it's going to be many, many years, perhaps two decades at their current growth rate until they hit that ceiling and become saturated just in the United States. Management believes they can grow locations at 10% plus a year, achieving slightly positive comp sales growth. Remember, there's going to be a Chicago versus Sunbelt headwind on AUV, so they don't really guide to that, but they hope to have slightly positive comp sales and they hope to get consolidated 22% restaurant level margins. I think those are fine goals to have. This is a fairly simple model. I ran some estimates to see what this could spit out from a restaurant level profitability in the future. With the AUVs,

Starting point is 00:39:10 is a little bit tricky because there might be some weird dynamics going in here, but I chose 10% unit growth. I chose 8 million AUVs that start growing at 3% from 2026 onward. Maybe that's a bit aggressive, but remember, Chicago is going to become less relevant. AUVs are going to fall, but then hopefully they get kind of inflation level, maybe even a little bit higher of comp sales once they become more of a national chain. I assume 22% restaurant level margins, and I assume $7 million per new location for build costs. Again, I know the numbers are tough here to listen under audio, but we'll have in the newsletter, which the link is in the show notes, some charts and stuff to help with this. So if those numbers are correct, under my estimates,

Starting point is 00:39:58 they can generate $1.66 billion in restaurant level profits from 2024 to 2030. And then new restaurants will cost $558 million to build. So, take that first number, subtract the second number, and you have $1.1 billion in cumulative cash flow to help pay for corporate overhead costs, interest expense on debt, debt principal payments, and other non-restaurant level costs. i think that's a good amount of wiggle room for them to self-fund their growth what do you think ryan does that give them plenty of room to not try to have to take on so much debt as they go for this national expansion yeah i think that's a fair model the three percent auv growth it's kind of a crapshoot you know i assume the level will be sustained but you know could be optimistic

Starting point is 00:40:56 the only caveat i might throw in here is that sales general we should not underestimate the corporate expenses those are something that will likely scale to with the business it they're maybe not quite as much hopefully it'll grow slower than revenue but over time their sales general and administrative expenses have gone up over the last three years they've yeah almost doubled in that time frame so now not quite but uh they've gone up about four percent it looks like annually over the last two years so just something to keep in mind there earlier on the show you heard us talk about the investing platform public.com that's where you can trade options with no commissions or per contract fees

Starting point is 00:41:46 and you get a rebate of up to 18 cents per contract. NerdWallet recently gave public five out of five stars for options trading. If you want to see why, go to public.com and start getting a rebate of up to 18 cents per contract traded. This is paid for by public investing. Options are not suitable for all investors and carry significant risk. Full disclosures are in the podcast description. US members only. When someone looks at this number of, I'm saying, $1.1 billion in cumulative, say, restaurant level operating cash flow. That is not going to mean consolidated cash flow at the core basis. This is going to be a situation, I think, given that they need to invest a lot in new locations each year and they're not a licensing

Starting point is 00:42:30 strategy, we're not going to see a lot of free cash flow accumulated on the balance sheet if they keep growing their unit count at 10% plus a year. And if they do, it means that, well, these restaurants are performing so much better than any restaurant has ever done in the history of restaurants, which I think is highly unlikely. Let's see, any other numbers here? Yeah, I did some 2035 stuff as well, but it just continues on at 10% unit growth. And even if, here's one thing I would say, at 10% unit growth by 2035, they would only have 264 locations. So one of the most potentially exciting things about this stock is that they have a very long reinvestment runway. And if they can achieve, if the ROIC, if the return on invested capital stays high, they could have durable above average return on invested capital, which for a capital intensive business is the magic formula for stock market outperformance.

Starting point is 00:43:29 Okay, let's talk about the balance sheet. does this concern you at all? They tend to run it pretty lean. They've got private equity in their background, so no surprise there. Thoughts? Give some comments on the actual balance sheet itself and whether or not it concerns you. Yeah. As I mentioned, they might call it efficient. We might call it aggressive. There's two sides of that coin there. Look, last quarter, they had just $14 million in cash. Actually, I think it was $13 million. I think I rounded up for some reason. I forgot to change that. And that's not abnormal. So they just had $13 million in cash on the balance sheet. The company has a variable term loan and a credit facility that was done in tandem.

Starting point is 00:44:08 And those are both due in 2028, I believe in 2023, they refinanced it. So they're not having trouble going to the capital markets, even with interest rates rising, but they did refinance at a higher rate. And I think, well, it is variable. So I guess the rates are going to be higher. The term loan is $300 million. And then they have $100 million in a revolving credit facility. $32 million is taken out right now. So they do have a little bit of capacity if they need to invest in more unit locations and they kind of hit a little bit of a cash crunch. And then as of march 2026 uh 2020 2023 hmm i believe that's 2024 but i don't know their effective interest rate it's essentially based on the new the uh benchmark rate that replaced libor uh sofr

Starting point is 00:45:06 and right they said it's about eight percent so that makes sense to me feds at uh federal reserves at about 5%. It's going to bump up to 8% there. The company, now this is an interesting chart I have here, Ryan. As I read through this, maybe you can pop this up. I did operating cash flow versus free cash flow. So they have been consistently generating positive operating cash flow, but they've been around break even on free cash flow. However, the last few quarters, and I believe I have it in last 12 months. Yeah. So the last few quarters, free cash flow has been negative. I would hope that they can at least hit that at break even or slightly positive because look, they talk about self-funding growth. They have that term loan. They only have a little bit

Starting point is 00:45:59 of cash on the balance sheet. Yes, they have that credit facility that they can tap, but I would rather have them maybe try to clean up the balance sheet a little bit, build a little bit of cash, and if need be, try to generate slightly positive free cash flow. And I think investors such as myself would be much happier, and it could put them in a less precarious financial position. I don't think this is not like a teetering balance sheet. It's not like a cruise line, one of those companies that needed almost a miracle of consumer demand.

Starting point is 00:46:33 to not go bankrupt. But overall, I think the balance sheet is perhaps a yellow flag for me. I don't mind an efficient balance sheet for companies that are consistently profitable, but they're in a low cash position and they're going to have this aggressive unit expansion. It adds some uncertainty here because if things fall wrong on your unit economics for a while and you're growing your units and the cash flow is negative, all right, well, we got to take out some more debt guys so you know it's what are your thoughts i guess after seeing this this kind of tells me that they are very confident in their ability to not only generate cash from their existing stores but that they're going to generate good returns on their new ones and maybe it's

Starting point is 00:47:22 because yeah i mean they've got a lot of wiggle room right 20 restaurant level adjusted margins that's pretty pretty damn good so anytime that they're putting up a store and then you know within the next two years they've done 16 17 million dollars in revenue they've got a lot of wiggle room so i do think um they are quite confident in their ability to generate profits out of these stores the balance sheet's not it's not so over levered that it's concerning i think you mentioned basically $332 million in debt right now between the term loan and the revolving credit facility versus $70 million roughly in operating cash flow. So it's okay. It's a more predictable business than the cruise lines like you talked about. No surprise there. It doesn't worry me

Starting point is 00:48:14 that much to be honest, but it's important to keep track of the enterprise value because they're going to be paying this down over time. True. We'll talk about with the ownership, Maybe the biggest concern is some of the funky stuff they've done with the private equity deal. I say a couple of notes there. One, they say that their new locations are immediately cash flow positive, but you have that upfront capex. Two, if they run into any liquidity concerns, they can stop growing units so quickly.

Starting point is 00:48:41 But like some of these restaurant chains, you want to get to that higher store base to cover your overhead costs and then start generating positive free cash flow. You know, all of the storied, really, really strong, at least the American ones, I'm assuming international as well, you know, Home Depot, Walmart, all those places, they had negative free cash flow, but good unit economics and had to get to a certain amount of scale before the consolidated numbers were consistently, I'd say, healthy. Okay, let's move to the management team. Give me your thoughts here. we're we tend to be pretty critical because it's an important aspect of investing in a company you read the proxy statement you got to know the management team a bit not personally but through the proxy statement what do you think of them yeah so after reading the transcript for the

Starting point is 00:49:33 2023 investor day i will say i didn't watch it because uh portillo's you did not your your webcast recording thing is broken the link is broken so no one can watch the replay uh not surprising. This happens all the time with IR teams. But after reading the transcript, reading the presentation, I came away highly impressed with the management team they put in place here. So the CEO is Michael, hopefully I'm pronouncing your last name right, Sanlu. He came from P.F. Chang's where he was the CEO of a brand with 300 restaurant locations. I think that's a good sign. This is a company that hopefully will eventually have 300 locations and he has that experience of managing someone that is just a national chain like P.F. Chang's.

Starting point is 00:50:19 Now, more impressive may have been these other executives. I have some quotes for the newsletter. I'm not going to read them all here, but I included them in there for people to follow up on some good, I think, pullouts from the Investor Day. So in 2022, they hired Mike Ellis as the chief development officer. This is basically the guy who's in charge of opening new restaurants and making it as efficient as possible. He has multiple decades of experience in the restaurant development space. Recently at Cracker Barrel, seemed very sharp to me at the investor day, talked about

Starting point is 00:50:49 professionalizing their product, talking about making things streamlined and having just like a standard process for opening restaurants they didn't have before. Now, the CFO joined in 2020 after working for 17 years at Domino's. I think that is a fantastic place for an executive in the finance department to learn, especially anyone in the restaurant space. I mean, that's just a really, really well-run company. And I hope she learned a lot while there. I think she seemed sharp as well. Domino's very successful operator.

Starting point is 00:51:25 The only – well, I shouldn't say operator. The only difference for me is that it's really kind of a different model just in terms of expenses, right? You're trying to attract franchisees when you're at Domino's versus trying to attract customers when you're at Portillo's. So definitely different costs involve different margin profile in both those businesses. But yes, between the chief development officer and CEO, they seem to check the right boxes. They seem to have the right resumes. The only other thing I'd also mention is, speaking of this Investor Day, the audio for the Investor Day, the slides and the transcript are all up on FinChat if you want to read

Starting point is 00:52:05 it, watch it, listen to it. All right. Yeah. If you can't watch it, the audio might be there as well. That's good. Yeah. Actually, yeah. That does make sense.

Starting point is 00:52:13 I guess I didn't think about that. But the person I came away the most impressed with was the COO. He joined in September 2020, previously worked as a high level operator at Starbucks and McDonald's. He wasn't the COO, but I think he was a kind of a VP or a regional one, which either way, I mean, that is a great place to learn and, you know, how to be an overseer of a lot of restaurant units and getting them to run smoothly, profitably, efficiently. And his presentation was thorough.

Starting point is 00:52:44 I think he has a military background. So he sounded like a sports coach or something. I mean, he just really seemed to understand the relationship between the executives, the employees, the customers, and the shareholders. I have some quotes, but I think I'll just read this one. He said, quote, my commitment to Michael, our team, our brand, to you as investors is that we will not let people development, our capability as an operating group to be a gating factor to our growth.

Starting point is 00:53:10 We will stay one year, at least out in front of his pipeline from a capability standpoint. point he said it cannot be hard to do our business it has to be easier to do our business easier to do it right michael talked about all those steps back and forth conveyance waste not adding value but more importantly it creates fatigue and delay people walk out we've seen people at times look at the daunting task of operating our business and have second thoughts we want to treat those people like gold and help them be successful i think he like i think this guy is he's excited and he seems to be working extremely hard to get their operations more efficient and professionalized and more like a successful national chain. So yeah, I was very happy with that guy.

Starting point is 00:53:53 Yeah, it's pretty impressive. Do you want to talk briefly about the ownership and then maybe one of the flaws you found in the proxy statement? Yeah. So ownership, Osanlu owns 3.76% of the stock. So sizable chunk, kind of like that. Most importantly, Berkshire Partners owns 20% of the outstanding shares, and that is that private equity firm. So I'm not sure what their plan is. Maybe they're going to sell it. But as a PE firm with outside investors, I'm guessing they made their investment a decade ago. I think they will likely want to get out the investment at some point because with these firms, the investors eventually want their cash back. Now, the largest concern I had, I'm reading the proxy statement, and this just frustrates me.

Starting point is 00:54:40 Maybe I'm reading into it wrong. Any listener tell me why they did this because they have this thing called a tax receivable agreement. I'm assuming it's with Berkshire Partners, but it could be with others as well. Here's what it says. Quote, under the tax receivable agreement, we are required to make cash payments to certain of our pre-IPO LLC members equal to 85% of the income tax benefits we accrue. And they've accrued a lot of income tax benefits. Right now, the liability on their balance sheet is $321 million. And they expected to pay a payment of $7.2 million in cash related to the tax year 2023 to be paid out in the next 12 months. That was as of the proxy statement from this spring. So they have $300 million in tax liabilities for these

Starting point is 00:55:31 other shareholders of the Opco units. Call me crazy, but as a shareholder that's not getting these benefits. I'm not a fan of this. And to be conservative, I have added this tax receivable liability to my enterprise value calculation. I have more notes on this in the sub stack. That's really it. If we look at executive compensation, they're boosted on some adjusted EBITDA targets. 75% of bonuses are for that. SBC was a little crazy right after the IPO, but it's tamed down a bit. I have a chart from FinShed on there that I think highlights that well they're at 15 million dollars in sbc versus about 700 million in revenue which i think is fine no concern there but the biggest concern for me is this tax receivable agreement and they said it

Starting point is 00:56:17 could be they could have liabilities for this for quite a long time which would be quite frustrating yeah i'm not familiar with this at all like i've never seen a it's rare for one for the private equity that i've looked at a company that's being spun off by a private equity group um but i've never really seen terms like this smells like private equity that smells so much like private equity company trying to uh trying to juice returns there might be some reasonable rationale for doing this but i would maybe appreciate a little more of an explanation throughout the proxy statement okay let's move a little forward because i i guess if you had to characterize the proxy statement as green flag, yellow flag, or red flag? What would you give it?

Starting point is 00:57:06 Yeah, it's interesting. There's some huge positives and then some huge negatives. So ownership, fine. It's kind of down the road in how they comp managers. No concern there. Pretty basic, no positive, no negative. But the management team, I came away highly impressed. I think there's someone that can run a 500-unit location, this existing management team. But the ownership with the PE firm, the tax receivable liability, that's a huge downside. So I think mixed bag. Again, similar to the balance sheet, I don't think it's going to keep me out of this stock, but it's something to watch out for. And it would be some sort of yellow flag that I would want to track if I was planning to be a long-term shareholder. All right. Is the stock cheap?

Starting point is 00:57:47 Yeah, let's wrap things up here with the fun part. Save it for the end. Is the stock cheap? So I think if you believe in the unit growth formula, stable restaurant level margins, and single digit comp sales, Portillo's stock is cheap. If you add in the total debt and the TRA liability, that tax receivable thing, Portillo's has a current enterprise value as of this reporting of $1.37 billion. Market cap is about $736 million fully diluted. And as I mentioned, through 2020, excuse me, through 2030, I think the company can generate restaurant level cash flow after accounting for build out costs of over $1.1 billion. And with only $78.8 million in overhead capex in 2023, I think they can generate a good amount of excess cash flow. As Ryan

Starting point is 00:58:39 mentioned, overhead costs are going to grow, but I think they can generate a good amount of excess cash flow while still reinvesting heavily to grow the business. As I said before, though, and this is a negative, although again, some good strong performing stocks over the long term have had this dynamic. We're not going to see bottom line free cash flow for a while. It's delayed. So even if we do, it's going to be understated or probably close to zero given their plans. But I think this is okay given the solid ROIC and the long reinvestment runway they have to take their store count from 85 to 100 to 200 to hopefully two decades from now 500 are you gonna buy shares

Starting point is 00:59:23 portillo's has made it on my watch list i i'm not certain i will be purchasing shares for my portfolio i think there are three to five other stocks i've hired my watch list right now which ones i'd say well going up i think nintendo is one that has yes less concerns to me on a ownership and kind of the proxy statement stuff and and the balance sheet um we're looking for you know a more conservative balance sheet uh coupon um gogo as we talked about that other one i like that a little bit more but i would say it's i could see myself owning this in the future it's on my watch list is probably going to make it into my top 10 of the watch list. I mean, I think the stock is cheap. You have the reinvestment runaway. I think, look, given the current enterprise value and given the

Starting point is 01:00:17 fact that the market cap is only $736 million, there's a chance this is a 10 bagger over the next 10 years. So I think the upside there is high. Do I think this is a good business? Yes. Do I think the valuation is cheap? Yes. Do I trust the management team? Yes. But I do have some concerns on the ownership structure, the TRA liability, and how this PE investor is going to treat minority shareholders. I have a slight concern there, but I do like this opportunity. What do you think, Ryan? I think it'd be cool if the private equity group was selling down their stake and creating selling pressure for me. Yeah, let's get them out of here. Yeah, that'd be nice. That would be nice. Those are the situations that I really love,

Starting point is 01:01:01 actually there was a lot of post ipo companies last year that got sold off so hard just because of pure selling pressure from venture capital firms and it creates good buying opportunities for people that don't care about what happens in the next quarter or two or if they don't have anyone to report to and then you know if you're not a fund and you're just managing your own money for the long term and that creates a great opportunity so i i think we could look back on this pitch and we're gonna say how did we not know this was like if things really worked out we would look back yeah it could be a hundred bagger over two decades we're looking at stores that do better than any other fast casual chain maybe other than chick

Starting point is 01:01:51 fillet do better than all of them and we're sitting here wondering like oh is it gonna work out you know like are people gonna love it obviously people do yeah or like griping over this tax receivable liability thing which could be nothing yeah i mean the way i'm reading into it it is something they're gonna have to pay it out every year and just include that in your enterprise value, which I did. The balance sheet is a little bit, right? Like that could go. Okay, look, if we hit right now, consumer spending has been strong. It's starting to hit restaurants given the inflationary pressure on a lot of lower income consumers in the United States. Portillo's is getting hit by that. Look, if we go through a recession, yeah, I guess interest

Starting point is 01:02:38 rates will probably be lowered and that'll help with their debt costs. But that could create a headwind i i think it is a good risk reward i definitely see myself owning this i'd have to kind of rank it versus other stuff but i do like this company yeah you know obviously with any company there's downside but i think the upside is quite strong and i do trust this executive team and the major risk i'm watching they're pretty obvious is deteriorating comp sales growth which if that continues it's going to be tough for them it means the units in the sunbelt are not performing as well as we hoped, or restaurants as a whole are struggling, which is tough for them because of that lean balance sheet. Someone like Chipotle, they have a way better balance sheet,

Starting point is 01:03:24 and it's just not going to be a concern for them if they have to ride out a couple-year period or even five or six quarters of tough, consolidated, just tough environment for the restaurant industry. And then if free cash flow remains negative, that is also going to be a concern for me, not because I don't think the restaurant level margins and the restaurant level unit economics are not strong, but again, the balance sheet could be an impediment here. So I think that the downside for me is that kind of from a minority shareholder's perspective, they have the, I like the analogy, as we talked about before, of a company working really hard, running on a treadmill, but going nowhere versus a company that floats down like a river.

Starting point is 01:04:10 I just like that analogy in my head, where they have to work really hard, but not actually create much in value for class A shareholders. Sure, the restaurants are going to generate cash flow, but they have interest expense, which is high, debt pay down, or they'll probably refinance. They have executive payments, the TRA liability, board of directors salaries, which are high. That has certainly been the case. Since they've gone public, they've been doing this. Now, I think there's a good chance it changes, but that's a concern I have. Do you have any final thoughts, Ryan?

Starting point is 01:04:48 I know you haven't. I did the research here, so this is almost like a first look for you reading through this report I made. But what are your thoughts? Would you add this to your watch list? Are you going to research this company further? Yeah, it'll be on my watch list. It kind of reminds me a bit of Sprouts Farmer's Market, just with a worse balance sheet. When we started looking at Sprouts, the story was kind of that they had gotten to a good place with their existing stores, gotten rid of some of the bad ones, and they were kind of right on the precipice of embarking on a new store expansion.

Starting point is 01:05:24 It seems like that's kind of similar here. um only difference is sprouts had a net cash position if i'm not mistaken so they had the room to kind of make mistakes so i think the difference there and i think yeah i think there is there is a lot of similar similarities there's one thing that would be a negative for portillo's as you mentioned that balance sheet right versus sprouts it was a lot less of a worry even as we were going through the covid pandemic and stuff like that there was less concern that they could ride it out. But I think on a positive for Portillo's versus someone like a Sprouts is that they have better unit level economics, I would say. They're getting better ROIC where I

Starting point is 01:06:02 think Sprouts is like 12%, which is pretty good when you're buying something at seven times earnings, right? But Portillo's could be plus 20. Yeah. The other thing is I'd love for Portillo's to get in the situation where they would be able to buy back stock. However, given the high debt load they're probably a long ways away from that they basically have to be at less than 10 times free cash flow for it to be make any sense really yeah given the interest expense on their debt 100 and they're they're likely not going to do that for a while so i could also like part of me is thinking i wouldn't be surprised if this is flat for three years even if they're making some progress but on the other hand it's like okay if you're truly a long

Starting point is 01:06:43 term shareholder, don't worry about that. Make the bet. And if it has the potential to be a 10-bagger over a decade and maybe even better over multiple decades, given the reinvestment runaway, don't worry about it. Okay. I think that's going to do it. As we wrap things up here, we should remind listeners, well, if you like us, if you think these shows are well-researched and you appreciate our thoughts, please, please, please, please, please give us a review. It really helps. And we got recently some bad reviews, so we need someone to combat those. So get in there and fight for us. Anyways, that is going to do it. We want to remind listeners that we are not financial advisors. Anything we say or discuss

Starting point is 01:07:27 here on Chitchat Stocks is not formal advice or a recommendation. We may buy, sell, or hold positions discussed in this podcast. Thank you all for tuning in and we'll see you next time. We'll see you next time.

Chit Chat Stocks - Can This Restaurant Stock Deliver Returns Like Chipotle? (Portillo's Stock Report, Ticker: PTLO)

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