PTLO - Portillo's: Dip In Share Price Is A Buying Opportunity As Business Remains Strong

2023-08-12 02:39:19 ET

Summary

• PTLO's SSS performance remains strong and there are no signs of a slowdown in developing new units in new markets.
• Despite a decline in foot traffic, PTLO's revenue increased by 12.3% in 2Q23, primarily due to a price increase.
• PTLO's restaurant-level margins are stable at 25.3% and should improve as new units mature and COGS trends down.

Summary

Following my coverage on Portillo's (PTLO), which I recommended a buy rating due to my expectation that traffic will recover eventually and that there are plenty of opportunities for PTLO to expand in the US. This post is to provide an update on my thoughts on the business and stock. I reiterate my buy rating as PTLO SSS performance remains strong and there are no signs of a slowdown in developing new units in new markets yet. Restaurant-level margins [RLM] might be slightly depressed now, but it was due to a fine decision to increase wages to stay competitive. RLM should improve as new units mature in SSS and productivity and as COGS trends down.

Investment thesis

Despite the stock price decline, I think PTLO delivered strong 2Q23 results. With a steady RLM, revenue increased by 12.3%. The 7.1% increase in average check size, primarily due to the 9.9% price increase, partly offset the decline in traffic, resulting in an SSS that is within my expected level of "healthiness" of 5.9% compared to 2Q22's 1.9%. Even though foot traffic has decreased slightly due to the price hike, the overall effect has been positive. I believe the improvement in SSS would be more noticeable if we eliminated some of the one-offs currently affecting SSS. One example given by management is how the newly opened units at PLTO impacted SSS by 60-80 basis points in the second quarter but are expected to return to normal as the company ages. Two, there will be a short-term headwind for PTLO as a result of the normalization of channel mix. Once these factors are normalized and the headwind is removed, PTLO's true SSS performance will become more apparent.

Despite an increase in wages and fixed costs, it was heartening to see RLM remain relatively stable at 25.3%, which were partially supported by a decrease in COGS. For the latter, I anticipate that PTLO will continue to see a decline in input prices as commodity inflation clears its way toward a slowdown (5.5% commodity in 2Q, a >300bps sequential decline). For the former (wages), I believe PTLO is not like most businesses that are "forced" to increase wages; instead, they have invested wisely in wages early. In my opinion, this wage investment is worthwhile because it helps businesses keep their most talented workers, who are also instrumental in ensuring smooth operations at the retail level. Due to low entry barriers, competition is fierce in the food and beverage industry. Almost all eateries face the formidable challenge of having to re-hire and re-train staff. Therefore, I agree with management's decision to increase pay in order to maintain a competitive compensation package (management anticipates seeing labor inflation in the mid-single digits for FY23). Another benefit of making early investments and making that fact public is that it helps to establish expectations for the coming quarters (investors would more or less know the impact to margin). As COGS eases and PTLO is done with the increase in wages, we can expect to see RLM further improve from here - which management is also vocal about as they expect margin expansion on a full year basis.

In terms of store openings, 8 of the 2023 cohorts are expected to happen in 2H23, while one will be delayed until 1Q24. What's most important to remember is that the opening of new stores is proceeding normally, so there shouldn't be any hiccups in their eventual growth and, in turn, in the overall SSS and RLM. The best response management could give to bears who are worried about PTLO's TAM, in my opinion, would be the successful opening of new units. I share the concern that PTLO might not be able to successfully export its style and taste across the US, but I do think that the execution so far suggests that this is possible. The upcoming September Development Day may serve as an additional catalyst in easing this worry.

Valuation

I believe the fair value for X based on my model is $29 for the base case and $42 for the bull case. My model assumptions remain the same as what I have assumed previously, which is based on management's long-term growth guidance of 10+% unit growth and SSS of low single digits %, leading to low-teens EBITDA growth. Assuming this runs through FY27 (the next 5 years), PTLO should generate $154 million in EBITDA in FY27. The question is, at what multiple will PTLO trade? I don't have an exact answer to that, but I believe it should be within a range of 18x to 24x EBITDA.

Peers include Kura Sushi USA (KRUS), First Watch Restaurant Group (FWRG), Jack in the Box (JACK), Chuy's Holdings (CHUY), Cheesecake Factory (CAKE), Dine Brands Global (DIN), BJ's Restaurants (BJRI), Brinker International (EAT), Bloomin' Brands (BLMN), and Cannae Holdings (CNNE). The median forward EBITDA multiple peers are trading at is 9.2x, the expected 1Y growth rate is 5%, and the expected 1Y EBITDA growth rate is -8%.

I believe PTLO deserves to trade at a huge premium to peers as it has a fair-to-good growth profile of 18% and EBITDA growth of 59%. This has been the case historically as well. PTLO is now trading at 18x forward EBITDA, and I expect it to at least trade at this level in the near term. However, if we look at it historically, PTLO has an average 2-year forward EBITDA multiple of 24x. I used the 2-year forward because it reflects market expectations of normalized earnings post-COVID during FY21/22. If the market rerates PTLO back to its historical average, the upside is higher.

Conclusion

I reaffirm my buy rating for PTLO. Despite a dip in share price, the business remains robust with healthy SSS performance and a strategic focus on expanding in the US. PTLO's steady RLM, revenue growth, and effective management of challenges such as wage increases and COGS fluctuations demonstrate its resilience. The normalization of factors impacting SSS and ramping up of new units should help with RLM improvement. Considering its superior growth profile and EBITDA expansion compared to peers, PTLO deserves a premium valuation.

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