PTLO - Portillo's: Long-Term Outlook Remains Intact

2023-05-31 00:14:46 ET

Summary

• I reiterate my bullish stance on Portillo's due to its long-term earnings growth potential, ability to raise prices effectively, and strong restaurant-level margin.
• PTLO's pipeline of new stores, particularly in Texas, where AUVs have exceeded expectations, further supports the company's growth prospects.
• Despite short-term concerns regarding traffic recovery, I believe that patient investors will be rewarded as PTLO continues to expand and enhance its margins while delivering strong financial results.

Overview

This post serves as an update to my previous coverage . I continue to see Portillo’s ( PTLO ) as undervalued. My overarching thesis for PTLO stock has not changed; instead, I believe the recent results have reinforced my view on PTLO long-term earnings growth prospects. In my opinion, the key debates revolving the stock are mainly short-term issues like whether traffic would recovery in 3Q or 4Q given that traffic has only increase by low single digits in 1Q23. While I am not able to predict the exact time of recovery, I note that PTLO has been able to increase prices effectively (7% in 1Q23) which indicates that revenue and earnings growth can still be well supported. Eventually, I think traffic will improve over time, and the important thing is there is still a lot of location opportunities available in US for PTLO to continue expanding. I reiterate my buy rating with the same valuation upside I expect previously, and I believe that investors that are patient will be well rewarded.

Top-line performance was positive

In my opinion, regardless of what the narrative was that PTLO will see pressure on lesser traffic and lower mix, I think the absolute figure of 9% SSS (7% price and 2% traffic) is a positive one. This is especially in the current environment that cost inflation is putting a lot of pressure on businesses margin. The fact that PTLO can raise prices while traffic continues to grow reinforced my initial thesis point that PTLO’s value meal insulate itself from recession pressures (i.e. the initial price point is already very low, and price increases are not very impactful on the consumers’ wallet). Management has also highlighted in-store operation excellence particularly around speed of service, accuracy, and guest satisfaction, which I believe has continued to play an important role in supporting the strong brand – which drives recurring traffic (even if prices were to increase, in my opinion). Despite the positive trends observed in 1Q23, I do not believe investors can rest assured that the recent price hikes will not affect customer volume. For the rest of FY23, I would continue to exercise caution regarding PTLO's performance and make sure the investment position is appropriately sized.

Margin was the highlight

Along with the improved SSS, the restaurant level margin [RLM] also performed exceptionally well. The improvement in labor cost efficiency helped push RLM up to 22.3%, and the increase in other operating expenses was partially offset by that. The fact that management has confirmed FY23 will be a year of margin expansion is also encouraging. I believe this margin expansion would come over from the roll-over in pricing actions and also commodity price deflation – which has decelerated from 14.5% last quarter to just 8.9% this quarter. For the rest of FY23, management stuck with their mid-single-digit inflation guideline for commodities. Looking ahead, I also continue to see further margin expansion opportunities as PTLO learns from its inefficiencies in current market before rolling out to other markets in the US. In my opinion, PTLO is still refining its ability to scale while simultaneously enhancing its underlying RLM. If we look over the long-term, I would not be surprised to see PTLO current markets to be the minority % in the portfolio. Thus, the overall margins would benefit from the opening of newer locations, which are expected to have a higher margin (as PTLO continues to remodel/resize/reuse its learnings on existing and new stores to improve margins). That said, in the short-term, I expect PTLO to continue seeing volatility in margin due to new store openings, credit card fees (focus on cashless), etc.

Pipeline stores performing well

I think the most positive indicator of future growth is that PTLO is experiencing positive developments with its FY23 pipeline. Importantly, I think recent opening volumes have reinforced confidence that PTLO can meet its long-term growth targets (unit growth 10+%). To provide some background, PTLO Company has completed its FY22 class of openings with three units opening in 1Q and one in 2Q. Management expects to launch 9 FY23-class of units in 2H23. This is not the only positive thing to look forward to. I'd like to point out that the state of Texas has recently outperformed expectations. With opening AUVs of around $17 million, the state has already surpassed its first-year goals and is poised to do so again in year two. If the new AUVs are all going to perform like the one in Texas, I believe the financial profile of PTLO business as maturity will be a lot more attractive than what I am expecting today. The class of FY22 openings are already validating this point as they are exceeding underwriting expectations, indicating the brand's portability. The way we can have further validation on this is monitor the performance of the upcoming 3 units in the Chicagoland area.

Conclusion

I reaffirm my bullish stance on PTLO and its long-term earnings growth potential. Despite short-term concerns regarding traffic recovery, PTLO's ability to effectively raise prices (7% increase in 1Q23) demonstrates its resilience and ability to support revenue and earnings growth. Additionally, the strong restaurant-level margin (22.3%) and management's guidance to margin expansion in FY23 further support PTLO's financial outlook. The pipeline of new stores and their successful performance, particularly in Texas, where AUVs have exceeded expectations, solidify PTLO's growth potential. Overall, I maintain my buy rating and believe that patient investors will be rewarded as PTLO continues to expand and enhance its margins while delivering strong financial results.

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