📍 TL;DR

• As a consumer, I love the Portillo’s business — and there’s plenty of data to suggest I’m not alone.

• But as an investor, I see some yellow, and maybe red flags surrounding the success of national expansion and risks from inflation.

• We’re sitting on the fence when it comes to PTLO — but readers may be much more willing to choose a side.

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We talked earlier this week about the challenges of fundamental analysis in this market. One of the core challenges of this project is finding a compelling idea, long or short, each week.

As a result, on occasion, we’ve chickened out judiciously exercised patience and done deep dives into ideas in which we didn’t necessarily have high conviction.

Back in July, we told the fascinating (if somewhat grim) story of Scholastic CorpSCHL 0.00. That stock would have made a great pick had it not soared 21% just before publication. In October, we detailed the merger arbitrage-ish case for Spectrum Brands SPB 0.00, while also highlighting the very real risks and our tourist-level knowledge of antitrust law.

This week’s idea, on restaurant chain Portillo’s PTLO 0.00, is in that same vein. As an oft-satisfied Portillo’s customer, this looks like one of the better businesses in the entire sector. As an investor, however, PTLO looks like a rather attractive short case, particularly after a 43% rally so far in 2023.

That dichotomy makes PTLO an intriguing topic for this week. Even if we’re not ready to take a firm side, our readers might be.

source: Portillo’s home page

A Chicagoland Favorite

Portillo’s began in 1963 when Dick Portillo opened a hot dog stand called The Dog House in a trailer in Villa Park, Illinois, west of Chicago. Four years later, the business moved into a standalone building and was renamed “Portillo’s”. The restaurant offered hot dogs, Italian beef (a popular sandwich in the Chicago area), and hamburgers, among other options.

The company gradually expanded in the Chicago suburbs, entering the city for the first time in 1994. In 2005, the first location outside Illinois was opened near Los Angeles. By 2014, the chain had 38 locations, and sold itself to private equity firm Berkshire Partners for a price reported to be near $1 billion.

Berkshire took Portillo’s public in late 2021. The initial public offering priced at $20, and PTLO quickly, but briefly, ran above $40. The optimism faded, and since the beginning of last year the stock has mostly traded in a range around $20 (again, the IPO price).

source: finviz.com

As of last month, Portillo’s had 74 locations in ten states, with trailing twelve-month revenue (Portillo’s reports Q4 on March 2) of $575 million. Expansion should continue: Portillo’s sees room for 600 locations nationally over time, with a multi-year plan to grow its location count roughly 10% per year.

The Personal Case For The Business

There are a few businesses that, as a consumer, truly seem to stand out in terms of their operations. In the restaurant sector, I’d argue privately-held Chick-fil-A is the leader. Bass Pro qualifies in retail. Until about two months ago, I’d have put Southwest Airlines LUV 0.00 on the list.

These are businesses where the locations always seem clean and efficient, the staff well-trained, supportive, and cheerful. The experience doesn’t necessarily have to be super-high-end (Southwest does not offer the best flights that money can buy, for instance) but the experience is consistently as expected and as promised, while providing value for the money spent.

Many readers may never have visited a Portillo’s but I’d easily put the company on this list. Efficiency is excellent, both dine-in and drive-through. Lines always seem long yet are worked through at impressive speed. The food is outstanding (though, again, not super high-end), and perhaps surprisingly so (given that the chain has a broad menu

The Fundamental Case for The Business

I’m not alone. Portillo’s is a well-known and well-loved brand in the Chicagoland area. The numbers prove it. At its first Investor Day in November, Portillo’s highlighted NPS (Net Promoter Score) figures for several chains

source: Portillo’s Investor Day presentation, November 2022

In the same presentation, Portillo’s disclosed that its Chicagoland units generate average annual sales just shy of $10 million, at incredible restaurant-level EBITDA margins of 30%.

In 2022, Chipotle Mexican Grill CMG 0.00 — maybe the premier "fast casual" player out there — generated $2.8 million in average sales per restaurant, at restaurant-level margins of 24%. Shake Shack SHAK 0.00, whose own rabid fanbase and whitespace opportunity has kept its stock trading at seemingly nosebleed levels, generated average sales of ~$3.8 million (based on disclosed average weekly sales data for 2022's four quarters), with "Shack-level" operating margins just below 19%.

To be sure, Portillo’s locations are far larger than restaurants operated by Chipotle or Shake Shack — or anyone else, for that matter. Per filings, Portillo’s restaurants average about 8,000 square feet, which appears to be roughly triple the average Chipotle and more than double the average Shack. But, of course, Portillo’s is only building those large restaurants — and, importantly, generating above-peer profitability — because it can fill them. It’s never overshot in doing so, either. As chief executive officer Michael Osanloo noted at the Investor Day, Portillo’s has never closed a single location in 59 years.

This is an excellent business model that by all accounts — anecdotal and otherwise — is run quite well. Portillo’s seems like the kind of business investors should want to own. It certainly seems like the kind of business I should want to own. And yet I don’t.

Valuation

Even with PTLO up 43% YTD, valuation on its own shouldn’t be an impediment to a business-focused bull case. Based on trailing-twelve month results, PTLO trades at about 22x Adjusted EBITDA

That’s a multiple that can work, given the company believes it can increase its location count roughly eightfold. SHAK, probably the most similar story out there, trades at 32x 2022 Adjusted EBITDA.

That said, the YTD run-up does make the stock less attractive. Portillo’s itself is targeting low double-digit EBITDA growth over a multi-year period, which in turn raises some question about the mid-term outlook from a valuation perspective. Assuming Portillo’s doesn’t outperform its growth targets, the multiple here has to hold for several years for PTLO to post double-digit upside from here. (Leverage on the balance sheet isn’t quite enough and cash flow is going to capex, not share repurchases.)

SHAK proves that kind of multiple can hold over time: shorts have been betting on compression in that name for years, but shares are up 45% over the past five years, admittedly with huge volatility. In the mid-term, PTLO may outperform that low double-digit growth target, for reasons we’ll discuss. But still, bulls are paying up for quality here — and willing to ignore a few key fundamental questions in the process.

Can Portillo’s Travel?

The first question is whether the Portillo’s concept is going to work in new markets. As noted, units in Chicagoland generate average sales of almost $10 million, and EBITDA margins of 30%. Units in Arizona, Florida, and California drop to $6.4 million in sales and 20.5% margins. Include all of the non-Chicagoland markets and average sales are $5.8 million, and margins are 19.2%.

Some of the (relative) weakness comes from the fact that locations outside Chicagoland are newer. And even those newer locations still perform at roughly the level of the average Shake Shack (albeit not necessarily on a per-square foot basis). But there’s still a big drop-down in performance as Portillo’s expands. And, notably, it’s expanding into markets like Texas with far fewer Chicagoland natives than states like Arizona and Florida.

This becomes perhaps a bigger problem than it appears when understanding how much larger Portillo’s locations are. The company is developing slightly smaller footprints outside of its home market, but returns on capital can start to get a bit questionable.

In the S-1, Portillo’s said for new units it targeted third-year performance of $5.8 million in revenue and 22% restaurant-level margins, for EBITDA of ~$1.28 million. At the time, the company said that figure represented ‘cash-on-cash’ returns of roughly 25%.

That percentage implies build costs of ~$5 million — but per the Q4 2021 call, those costs have expanded to $6 million. Portillo’s is also excluding pre-opening expenses from that calculation; initial 2023 guidance given at the ICR conference last month suggests those expenses average ~$850K per location.

Add in ~$100K in annual maintenance capex per location (based on first-half 2020 capex, when the company opened no restaurants; that figure may have been depressed) and cash-on-cost returns now are getting to ~17% — based on targets that are roughly equal to how existing restaurants outside Chicagoland, Arizona, Florida, and California are performing. In fact, EBITDA margins in those markets are lower than the third-year target; at the 19% actual figure for those restaurants, cash-on-cash returns are now getting closer to 16%, while under a refinanced credit agreement Portillo’s is borrowing at a mid-7% rate.

There are similar concerns looking backwards. According to reports, when Portillo’s was sold in 2014 it was generating more than $70 million in Adjusted EBITDA on a 38-location base. The trailing twelve-month figure is $90 million, with more than 30 restaurants added since (and open for at least 12 months). The inflationary period of late (and public company costs) aren’t the primary factors, either. At the end of 2019, (per the S-1) Portillo’s had 62 restaurants and Adjusted EBITDA that year of $79.5 million.

It’s possible that the reported figures from 2014 were inflated. But it seems directionally correct. At the time Portillo’s went public, it had 39 Chicagoland locations, and if they’re now generating ~$3 million in EBITDA, it seems reasonable that they posted ~$2 million in EBITDA eight years earlier (with corporate costs getting consolidated 2014 EBITDA to that ~$70 million range).

We don’t have the data to do the math exactly, but cash-on-cash returns for recently built new restaurants appear to be quite poor. Yet at 22x EBITDA, this is a footprint story. It may be that the residents of Texas, Iowa, Minnesota, and the 40 states without a Portillo’s aren’t quite as enamored as I am. Or maybe it’s going to take the company much longer than it believes to capture their affections.

The Inflation Question

A month ago, we discussed the labor challenges facing restaurant operators. And, of course, a purveyor of Italian beef sandwiches is facing significant input cost inflation as well.

Admittedly, there are dueling perspectives on the effect of inflation. Notably, the company has not been particularly aggressive in taking price to compensate. According to the Q3 call, pricing increased 8.3% year-over-year in the quarter, and 7.4% year-to-date. In Q4, Chipotle took 13.5% in pricing, about what it did in Q3. Shake Shack has been more toward the high-single-digit range, but said after Q3 it was seeing mid-teen increases at competitors.

Portillo’s management has framed its pricing decisions as a deliberate attempt to lag inflation, and preserve the chain’s value proposition. There’s no reason to believe management is being untruthful — and that strategy does create a path toward either being more aggressive in 2023-2024, or taking share from fast casual rivals now providing more expensive meals.

To be sure, even if it were the case, gross margin expansion via price increases doesn’t completely change the case here. With TTM Adjusted EBITDA margins near 16%, 100-200 bps in gross margin expansion helps the investment thesis, but it hardly transforms it. Still, Portillo’s might be better-positioned to manage this environment than most rivals (besides Chipotle, which seems close to bulletproof at this point).

On the other hand, wage inflation remains a potential issue. Labor accounts for about 25% of Portillo’s revenue. The company has talked up productivity improvements since 2019, along with plans (like so many businesses) for further productivity, including from redesigned kitchens. But as with the brand itself, one wonders if staffing challenges are only going to increase for a largely unknown concept in new markets relative to Portillo’s experience in and around Chicago.

The concern we raised in January was whether there would be a limit to the price customers were willing to pay amid an absolute explosion in away-from-home options. Portillo’s can probably manage that better than most — but there’s still a risk here, particularly in markets where the company lacks a home-field advantage.

On The Fence

At the $16+ price on PTLO heading into the year, we probably would have been more aggressive on the stock (and not just in retrospect). But even at that price level, a mid-teen EV/EBITDA multiple in new markets would be a risk.

At $23, the importance of those new markets is magnified. And, again, there are real concerns on that front. Add in inflationary risks and valuation becomes a concern. In fact, considering inflation and the risk that expansion doesn’t go as planned, there’s a case for considering a short. Indeed about 13% of the float is sold short at the moment.

But, again, this seems like too strong a business to bet against. And we may have learned our lesson from our recommendation on another impressive restaurant chain. Portillo’s is not the kind of business we want to short — but it’s not the kind of price at which we want to be long. Readers may well see it differently.

As of this writing, Vince Martin has no positions in any securities mentioned.

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