Engaged Capital may have the recipe to boost Portillo’s stock price

Business: Portillo’s owns and operates fast casual restaurants in the United States. The company offers Chicago-style hot dogs and sausages, Italian beef sandwiches, grilled burgers, chopped salads, fries and chocolate shakes. Portillo’s also offers its products through its website, app and certain third-party platforms.

Scholarship value: $901 million ($12.27 per share)

Percentage of ownership: 9.90%

Average cost: $11.50

Activist Commentary: Engaged Capital was founded by Glenn Welling, former director and managing director at Relational Investors. Engaged is an experienced and successful small-cap investor and makes investments with an investment horizon of two to five years. His style is to hold management and boards accountable behind closed doors.

Engaged announced that they have communicated with Portillo’s regarding potential steps to improve the company’s business, including by optimizing restaurant performance, improving cash earnings at the restaurant level, improving corporate governance through potential board changes and exploring a sale of the company.

Portillo’s is an iconic Midwest fast casual chain, founded more than 60 years ago. It has a differentiated menu anchored by Italian beef sandwiches, hot dogs and milkshakes. The company was acquired by private equity firm Berkshire Partners in 2014 from the founder for about $1 billion. Berkshire went public in October 2021 at $20 a share, and the stock rose to $54.22 a share about a month later. Since then, Berkshire has sold its position down from 66% to 19%, while the stock has fallen back below its IPO price. Portillo’s Chicago locations are still among the most productive fast casual restaurants in the industry, with an average unit volume (AUV) of $11 million and a 30% restaurant margin. Locations outside of Chicago achieved AUV values ​​of $6 million to $7 million, more than double the industry’s quick-service and fast-casual environments.

While Portillo’s has a much higher AUV than its peers, the company has an even larger average footprint than its peers. While management has decreased store size, stores are still 1.5 to 3 times larger than peers. But the size of the store is only one of the problems. This problem is compounded by the company’s practice of owning its buildings despite leasing the land on which they stand. In a business where cash-on-cash profits are paramount, this structure doesn’t make much sense. In addition to higher costs to build stores ($6 million to $7 million, which is two to three times higher than peers), these large footprints created force inefficiencies labor, maintenance and various other expenses inside the restaurant. In addition, management has been slow to implement traffic-driving mechanisms such as loyalty programs and ordering kiosks, both of which have proven successful for competitors. Finally, while customers rate the food and the brand very highly, brand awareness is not as strong as it could be, probably due to the low marketing budget: 1% of revenue compared to 2% to to 3% for growth partners.

The good news is that all of these problems represent a lot of opportunity – and many value improvements are already underway. Management announced the opening of a new design “Restaurant of the Future” in the fourth quarter, which reduces the floor area to 6,300 square meters (from 10,000 square meters) and reduces construction costs to about $5.2 million (from 6 million of dollars to 7 million dollars). This is a good indication that they recognize the problem and are taking a step in the right direction, but this is a fraction of what can be done to optimize capital allocation. In addition, management began investing in technology and testing small kiosks to drive same-store sales growth, renewing operational focus on the drive-thru and reducing wait times. The company is also undertaking a major advertising initiative in Chicago to coincide with the start of the NFL season. These are great steps, but the pace of these initiatives has been too slow.

Engaged believes that by being an active shareholder and bringing a new COO to Portillo’s, the company’s improvements can be accelerated and optimized, leading to the expansion of this beloved regional chain into a national brand. Portillo’s currently trades at 10 times forward earnings before interest, taxes, depreciation and amortization. This is a significant reduction from other much more established, well-known and national QSRs such as Shake Shack (24 times) and Chipotle (27 times). Closing this gap will require significant improvements in capital allocation, technology initiatives, marketing plans, real estate restructuring and operational advancements. Engaged supports management and expects to recruit a strong operator in the currently vacant COO role. Engaged has a lot of experience in this industry and may be right, but we see this as a tough thing for an activist campaign – more so than usual. We believe it will take more than just a new COO, but executives with finance, marketing, technology and real estate experience. Engaged itself has a strong track record in the sector and has held board seats at Del Frisco’s and Jamba, in addition to settling for an independent seat at Shake Shack. We expect the firm to seek a board seat at Portillo, and the company could certainly benefit from the experience and institutional perspective that Engaged brings to the table.

Finally, if management cannot create shareholder value through these operational improvements, there may be a strategic play. Berkshire Partners brought this company out of the stone age into the 20th century. Now, someone has to pick up the baton and bring it into the 21st century and into the future. This could be another private equity firm or a strategic investor with the infrastructure and team to rapidly expand Portillo into a national brand.

Ken Squire is the founder and president of 13D Monitor, an institutional shareholder activism research service, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of 13D activist investments.