PTLO - Portillo's: A Decent Q3 Given Tough Macro Backdrop

2023-11-05 23:25:30 ET

Summary

• Portillo's reported Q3 revenue of $166.8 million, a 10% increase from the previous year, which came in just shy of estimates.
• Transactions were down and we saw a negative mix, but margins did improve year-over-year on easing commodity inflation/menu pricing.
• In this update, we'll dig into the Q3 results, recent traffic trends, and at what level it might make sense to book some profits.

Just over six weeks ago, I wrote on Portillo's ( PTLO ), noting that there looked to be a higher probability of the stock missing its Q3 estimates given industry-wide traffic declines, but that this would become priced into the stock below $14.90, setting up a buying opportunity. Since then, PTLO has found strong buying support below $14.90 and traded 13% higher following a mediocre Q3 report offset by smaller cap names finally catching a bid, evidenced by the 8% weekly gain for the iShares MicroCap Index ( IWC ). That said, while PTLO soared 16% off its lows, its relative valuation remains less appealing than several other opportunities, and it's to be overly optimistic about FY2024 given the continued softness from a traffic standpoint. In this update, we'll look at the Q3 results and at what level it might be worth taking some profits.

Q3 Results

Portillo's released its Q3 results last week, reporting quarterly revenue of $166.8 million (below estimates of ~$171 million) translating to a 10% increase from the year-ago period. Meanwhile, adjusted EBITDA improved to $27.3 million (including $4.3 million in SBC). Q3 sales growth was attributed to menu pricing (9.1%) and unit growth offset by a 3.5% decline in transactions and negative mix which weighed on its same-store sales growth. In fact, same-store sales growth came in below my expectations at 3.9% given the high level of pricing (2-year stacked same-store sales growth of 9.9%), and the company will see less benefit from pricing in Q4 as effective steps down by ~350 basis points given the company's choice to pass on menu price increases in October (following a 2% increase in January and 3% in May). However, while this could weigh on its Q4 sales/margins, PTLO is making the right move by focusing on the best quality, serving size, and guest experience while being careful with price to maintain/improve its value scores.

Digging into the results a little closer, Portillo's had 78 restaurants at quarter-end vs. 71 in the year-ago period, with two new openings in the quarter which both included its new and more efficient restaurant design. Meanwhile, as for its recent sales trends, the company's average check grew 7.4% (menu pricing offset by negative mix) vs. a decline in transactions, with the company attributing some of this to the highly promotional environment that affected drive-thru, which may have seen led to a few lost sales to other quick-service brands. In addition, the company may have high loyalty in its core market of Chicagoland but is battling negative population growth, which will be a minor drag on transactions system-wide. That said, the company was upbeat about its labor positioning which should drive a better guest experience and support its aggressive growth, and also shared that Q4 transactions were up with incremental advertising spend in its core market.

Moving over to margins, we saw minor improvement year-over-year, with lower costs as a percentage of sales across the board in food & beverage, labor, occupancy, and other expenses. The most significant leverage came from food & beverage (down 200 basis points to 33.3%) and labor (down 40 basis points to 25.5%), resulting in restaurant-level margins of 25.2%, up 270 basis points year-over-year. And while these margins are down sharply from 2020 levels (Q3 2020: 28.9%), new store openings were a partial headwind and we continue to see low to mid single-digit commodity and wage inflation, with wage inflation up 4.8% year-to-date, and commodity inflation of 3.5% in the quarter. Plus, in Portillo's defense, it has been much less aggressive on pricing than peers (especially given its large serving sizes), while Chipotle ( CMG ) continues to keep piling on pricing increases to boost margins, with more to come next year as we see a ~25% minimum wage increase in California.

However, while Portillo's margins may be weaker down substantially and the statement that "we're on track to deliver year-over-year margin expansion for FY2023" may not mean much given the easy comps from FY2022, we could see some improvement longer-term. This is because the class of 2023 restaurants are already more efficient, with less "wasted effort", cutting out unneeded walking to complete the same tasks. And as shown above, Portillo's Restaurant of the Future is expected to have a lower build cost to improve returns, with a smaller box (5,500 to 6,000 square feet), fewer parking spaces and fewer seats, but equipped with a much larger production line. The result, if executed successfully, should be upfront savings on build costs, improved speed of service and higher productivity, which should ultimately allow for higher free cash flow long-term and slight margin improvement.

Declining Traffic Trends & Long-Term Outlook

While it's encouraging to see that the company is looking at reducing restaurant sizes to significantly improve cash-on-cash returns, the macro backdrop looks to be worsening. This is because not only have we seen quick-service traffic finally take a sharp step lower (August and September traffic were negative), but we're clearly seeing declining growth in seated diners as evidenced by the below chart from OpenTable. And similar to August mid to late July on their Q2 Conference Calls when many restaurant names called out improving traffic trends ahead of a sharp decline in traffic, we may be seeing a similar setup here with traffic steadily improving into late October before rolling back over. Obviously, this is still to be determined, but the combination of sticky inflation and declining personal savings rates are not helping, nor does the promotional environment and deep discounting for names like Dine Brands ( DIN ) help Portillo's as the relative value of its menu erodes temporarily.

Aside from declining traffic in quick-service traffic which suggests that even trade-down beneficiaries (typically more resilient) are seeing some pullback, the other takeaway from the above chart is that we are seeing consistently lower highs for seated diners growth, with over four months spent without a return to seated diners growth, a far worse setup than H1 2023. And while some of this could be a return to more normal seasonality for the industry (weak Q3 followed by better Q4), the above trends aren't encouraging, which makes it tough to be optimistic about the Q4 reporting season for the restaurant group as a whole. Finally, although Portillo's is working to de-risk beef given that it remains a headwind with beef inflation well above pork, chicken and other commodities, this adds additional risk vs. brands like Popeyes Chicken or Chick Fil-A that aren't combating declining traffic and inflation in a key commodity.

So, is there any good news?

Although transaction growth has been a consistent negative for Portillo's, most of its new openings are focused on the Sun Belt (Texas, Arizona, Florida) where we will see meaningful population growth, offsetting some of the drag from Chicagoland (nearly 60% of its system) which should help with reducing the decline in transactions. Second, I believe the company is making the right move by being more careful with price given the tough macro backdrop given that this should pay off long-term vs. other brands that continue to raise prices and where there appears to be a clear trend of pushback on social media for burrito costs like we've seen directed at Chipotle. So far, this hasn't mattered and eaten into its sales, but at a certain point it will, and Portillo's recent choice to pass on a price hike and not being sneaky with shrink-flation or lower quality ingredients should help to maintain loyalty and improve guest scores especially from a relative standpoint. Hence, while the margin declines vs. 2020/2021 may not be pleasing, playing the long game is the smart move.

Summary

Portillo's put together a satisfactory Q3 report given the tough macro environment, and continues to execute its growth strategy despite industry-wide delays, with plans to open 12 new restaurants this year. Meanwhile, the company continues to work towards positioning itself to claw back lost margins and improve transaction growth, with progress on a new Restaurant of the Future and entry into states with higher population growth along the Sunbelt. That said, I prefer to pay the right price or pass entirely no matter the quality of a business, and while PTLO may be more reasonably valued than where it traded in mid-2022 when I warned against chasing the stock above $26.00, I don't see nearly enough margin of safety following the recent rally with it trading at ~15x FY2024 EV/EBITDA estimates. Hence, if this rally in the stock persists, I would view any rallies above $18.05 before January as an opportunity to book some profits.

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