Portillo: Activist involvement should enhance outreach efforts

Founded in 1963, Portillo’s Inc. (NASDAQ: PTLO) operates restaurants that serve Chicago-style hot dogs, as well as grilled burgers, beef sandwiches, and other food items. The company continued to expand its chain of restaurants nationwide in the United States with good results increase in income.

The company’s post-IPO stock performance following its 2021 IPO was weak, as shares lost more than two-thirds of their value since initial trading. After the stock underperformed amid Portillo’s continued nationwide expansion, activist firm Engaged Capital has now taken an interest in the restaurant chain to change its expansion strategy.

Portillo’s is growing ambitiously, but with too much capital investment

After the IPO, contrary to what the stock price suggests, Portillo’s continued to expand its restaurant footprint with healthy operating income. After The company had a total of 69 locations at the end from 2021, located primarily in Illinois, the company expanded to a total of 85 locations at the end from Q2 2024 with the new expansion being primarily outside of the Illinois market where Portillo’s was founded. Income they grew at a CAGR of 8.9% from 2019 to Q2 2024, revenue of $702.4 million with healthy same-restaurant sales growth.

The growth was achieved with mostly healthy profitability, as Portillo’s current operating margin is 8.1% on operating income of $56.6 million. The margin is still below 2019’s 10.1% operating margin, primarily due to higher pre-opening costs, at $9.9 million last year, but has expanded healthily from Covid-era margins as the slowdown inflation and normalized traffic.

The recently reported second-quarter comparable sales growth was only a weak -0.6%, but that appears to be related more to weak industry traffic rather than Portillo-specific issues.

The growth achieved is just the beginning of Portillo’s ambitious goals. The company is targeting 12-15% annual unit growth, with more than 10 new units being developed in 2024 alone, adding up to a total annual revenue growth target in the mid-teens when combined with the target for slow same-restaurant sales growth – with only 85 outstanding locations, Portillo’s is still a fairly small chain, with exposure mostly in Illinois, allowing it to have a long runway for growth.

While Portillo’s growth has been good so far, the stock hasn’t appreciated as the restaurant chain has expanded. The reason may be based on Portillo’s strong capital expansion, where the company is developing its own real estate properties – capital expenditures reached $87.9 million in 2023, with similar capex guidance for 2024, pushing cash flows negative despite healthy earnings. Heavy real estate development has also weakened capital efficiency considerably to a low return on equity of 6.9%, not making the current expansion very attractive to investors.

The aggressive expansion strategy has also caused dilution and forced Portillo’s to take on significant debt, with total interest-bearing debt of $305.1 million currently on the company’s balance sheet. Weighted shares outstanding increased from 35.8 million in 2021 to 57.5 million today.

Given the fairly cyclical earnings nature of the restaurant industry and the immense competition, the current value of the debt is unhealthy, although I believe the current real estate portfolio can still support such debt with potential sales and leases.

Engaged Capital takes a stake in Portillo’s

Recently, activist firm Engaged Capital was announced as taking a stake in Portillo’s, sending the stock up moderately. The move from activist investor firm could be significant for Portillo – typical of activist investors, Engaged Capital’s strategy revolves around maintaining a good ownership of a company (currently close to 10% of Portillo’s) and pushing for change operational to ultimately generate shareholder value from the long-term owner perspective. The firm is also known for its successful turnaround efforts with Shake Shack ( SHAK ).

While Engaged Capital isn’t tracking leadership changes, CNBC’s report on the matter outlines some of the operational changes Engaged Capital identified with Portillo. In particular, the activist investment firm is pushing for a different expansion investment strategy — instead of spending huge amounts of capital to develop company-owned real estate properties, outlined by Portillo’s current capex guidance of $85-88 million for 2024, Engaged Capital is pushing for more agile expansion. Engaged Capital believes that combined, lighter real estate investment and smaller new location sizes could ultimately double the cash-on-cash return on new restaurants from 25% to 50%. With the easier expansion model, Engaged Capital is pushing for accelerated nationwide expansion.

I think Engaged Capital’s involvement is very good for Portillo. While I was bullish on Shake Shack because of its incredibly high valuation, the activist company’s involvement has led to improvements in the company’s earnings. The smaller location expansion strategy proposed for Portillo’s also seems to make sense for a hot dog and sandwich restaurant chain, and capital spending has increased due to expensive real estate development. A lighter expansion strategy could also put an end to Portillo’s previously rather high dilution.

Portillo’s management and board’s reception of the proposed turnaround is still unknown, but according to CNBC’s sources, conversations between Engaged Capital’s management and Portillo have so far been constructive — I think Engaged Capital’s commitment should see at least some changes .

Engaged Capital believes that once its suggestions are implemented, the stock could be worth at least 100% more than it is today.

Evaluation of PRTO stocks

We built a discounted cash flow (DCF) model for Portillo to estimate a fair value for the stock. In the model, I account for changes in the company’s expansion strategy as suggested by Engaged Capital.

For revenue growth, we estimate a CAGR of 10.2% from 2023 to 2033 and perpetual growth of 3.0% thereafter, still behind Portillo’s long-term target level as I believe this is due to some conservatism. Revenue estimates could still prove too low, especially if Engaged Capital’s accelerated and agile growth strategy is well implemented.

We estimate EBIT margin to slowly climb back to 10.0%, close to the company’s pre-pandemic level of 10.1%. In my view, the margin should expand well on better traffic over the medium term, with the industry recovering from better consumer sentiment, as well as high operating leverage from larger operations allowing for more efficient costs marketing, procurement and corporate. Slower growth should also push down Portillo’s considerably high pre-opening cost level, likely allowing for the 10.0% long-term estimate, despite the less-owned real estate development in estimates.

With the company’s excellent historical working capital management, I believe Portillo’s has a chance for good cash flow conversion even amid aggressive expansion, if the company moves to the more nimble expansion strategy that Engaged Capital suggests – the DCF model includes the assumption that Portillo is moving more into rental properties in its growth strategy in the coming years, slowly improving conversion.

Estimates put Portillo’s fair value at $15.73, 31% above the share price at the time of writing – I think if Engaged Capital’s suggestions are accepted, the stock could have finally bottomed out and could be an attractive investment opportunity.

Revenue estimates could also prove too conservative in the DCF model if Portillo’s growth strategy grows better than expected.

CAPM

A weighted average cost of capital of 8.36% is used in the DCF model. The WACC used is derived from a capital asset pricing model:

In Q2, Portillo’s had interest expense of $6.6 million, which makes the company’s interest rate 8.65% with the current amount of interest-bearing debt. We estimate a long-term debt of 40% quite high, as Portillo is carrying quite a large amount of debt.

To estimate the cost of equity, I use the 10-year bond yield of 3.82% as the risk-free rate. The equity risk premium of 4.11% is Professor Aswath Damodaran’s estimate for the US, updated in July. I use Aswath Damodaran’s restaurant industry beta estimate of 1.19 for Portillo’s. With a liquidity premium of 0.4%, the cost of equity is 9.11% and the WACC is 8.36%.

Take away

Portillo’s has been growing its restaurant footprint at a good pace, but the stock hasn’t appreciated with the chain’s growth, as heavy real estate development investments and the financing required have made expansion unattractive to investors with a poor return on invested capital. Engaged Capital, an activist investment firm, has now taken notice of the underperforming growth strategy and is pushing for strategy changes into more agile expansion, which is an important factor in my view. With less real estate development and smaller unit sizes, the restaurant chain’s underlying value could be better highlighted, potentially making the stock an attractive investment at today’s low share price. As such, I initiate Portillo’s with a Buy rating.