LauriPatterson/E+ via Getty Images
Investment Conclusion
We were encouraged by Portillo’s (NASDAQ:PTLO) F1Q2022 financial performance. Despite, weak customer demand and operating limitations due to the surge in Omicron cases that persisted through the third week of January, system sales increased significantly on a year-over-year basis. The uptrend was driven by substantial growth in same-store sales, considerable sales associated with the five new stores opened over the prior year, a nominal price increase, and sales mix. However, the advance in menu prices was not enough to offset inflationary pressures related to labor and commodities. Consequently, margins suffered, and as a flow-through effect, earnings and free cash flows, failed to benefit sufficiently from the solid growth in sales. During F1Q2022, the company opened one store, its first drive-thru only location, in Joliet, Illinois. Subsequently, in April, PTLO launched a new restaurant in St. Petersburg, Florida, further developing its presence in the region.
Over upcoming quarters, we expect the solid sales growth PTLO experienced over F1Q2022 to somewhat moderate due to tough comparables, as beyond F1Q2021, sales had rebounded sharply during FY2021, as pandemic restrictions continued to recede. Nevertheless, in our opinion, sales growth will be sufficient to reflect in enough revenue leverage to expand margins on a sequential basis, despite our thesis that inflationary pressures related to commodities will ease only towards the back half of the year and those associated with labor are likely permanent.
Additional margin growth will be supported by: two price increases, one each enacted in the first two quarters of the year, operating leverage fueled in part by labor efficiencies as staffing increases over the year, and some offset of delivery orders in favor of higher margin dine-in transactions. Further, our conviction that a significant fraction of the sales momentum evident during the first quarter is likely to persist is driven by the growth in average unit volumes from ~$7.6 million at the end of F1Q2021 to ~$8.3 million at the end of F1Q2022. Based on the expected uptrend in margin, we anticipate a surge in annualized earnings and free cash flows over the next few quarters. PTLO plans to launch seven new restaurants during FY2022.
Longer-term, PTLO’s focus on sustaining existing strong customer demand, by expanding same-store sales and the number of restaurants, will ensure growth in earnings and free cash flows, in our judgment. Same-store sales growth will be derived from menu innovation, digital sales, and the loyalty program. In regard to new unit development, the company has committed to a target growth rate of 10% every year, with an objective of developing a footprint of 600 domestic restaurants. We expect the number of new units launched every year to exceed planned targets, as the popularity of its brand forces PTLO to rapidly expand the footprint to benefit from the considerable customer demand. In addition, given the clamoring for its product across the U.S., we believe PTLO is being overly conservative with regards to the number of restaurants it can successfully operate within the country. The firm is likely to keep adding stores even after its footprint expands to 600, in our assessment.
Given the scenario, PTLO appears well-positioned for substantial revenue growth over numerous years. Consequently, due to revenue leverage from sharply higher sales, restaurant operating margins are likely to expand, as marginal costs per dollar of sales decrease. Additional leverage will be derived from a decline in commodity prices from current levels, and economies of scale related to the digital platform, advertising, and corporate fixed costs. As a flow through of significantly higher sales and margin expansion, we anticipate boosts in profits and free cash flows, over the long-term.
Considering that F1Q2022 results have only reinforced our secular outlook on PTLO, we remain constructive on the company. PTLO appears well positioned to meet and exceed the estimates for growth in revenues and operating cash flows factored into our 10-year Discounted Cash Flow model. Therefore, we’re maintaining our 1-year Price Target of $30/share. Reiterate Buy Rating. (Please go through our initiation report “Portillo’s: Solid Business With Potential For Significant Growth” and related notes for our long term opinion on the stock).
Key Takeaways From The First Quarter
F1Q2022 Results Summary. For the quarter, revenues of ~$134 million (+14.6% compared to F1Q2021), missed consensus estimates of ~$135 million, and earnings per share flat-lined at $0.00, above analyst projections of ($0.03). On a year-over-year basis, same-store sales advanced by 8.2%. Net income for the period was ~$0.6 million vs. a net income of ~$0.2 million during the previous year’s same quarter. Restaurant level adjusted EBITDA declined to ~$28 million (~-6% compared to F1Q2021), while adjusted EBITDA margin decreased by 460 bps on a year-over-year basis to ~20.8%. During the first quarter, the firm generated operating cash flows of ~$0.8 million.
Focus On Countering Cost Inflation. In order to offset inflationary pressures, PTLO raised menu prices by 1.5% during the first quarter and anticipates another price hike over the second quarter. In addition, considering the 2.5% increase in menu prices implemented in April last year, the firm has increased menu prices by ~4.5% in the last twelve months. It is noteworthy that the annualized price increase is consistent with PTLO’s strategy to implement price raises below or inline with inflationary trends. The company hopes to leverage operating capabilities to further mitigate the impact of cost inflation.
Moreover, with a view to somewhat counter cost inflation associated with commodities, PTLO has locked in prices for 55% of its key ingredients, including those associated with 80% of its beef requirement, through futures contracts. The firm views this component of inflation as transient.
With respect to higher labor costs, PTLO is actively implementing measures to optimize operations, in order to improve labor efficiency, and thereby reduce the hourly cost of productivity. In that regard, it is important to note that employee wages increased by ~13% over the last 12 months, and the company has earmarked additional funds to further improve its cost of labor, with a view to bolster its ability to attract superior front-line talent.
New Development Pipeline Appears On Track. Based on the opening of two new restaurants year-to-date and management commentary on proposed sites for additional restaurants, we expect PTLO to handily meet its annual footprint growth target of 10% during FY2022.
Besides, the Joliet, Indiana, and St.Petersburg, Florida locations, the company has selected two sites in Arizona: Gilbert and Tucson, one in Florida in the Orlando suburb of Kissimmee, one in Schererville, Indiana, and one in Grandscape, in The Colony, Texas. Cumulatively, PTLO has indicated plans to launch seven restaurants during the year.
Looking ahead to FY2023, the strategy is to further penetrate Central Florida, where the firm has four restaurants, the Sun Belt, including Arizona, and Texas, where it expects to further penetrate the Dallas-Fort Worth area. At the end of the first quarter, PTLO was operating 70 stores.
We believe the strong customer demand, that the firm’s restaurants launched in FY2020 and FY2021, and those opened recently have been experiencing, will likely be replicated at the additional debuts planned for FY2022.
Improved Customer Experience Reflected In Higher Guest Satisfaction Scores. Over F1Q2022, PTLO achieved its best guest satisfaction scores in 24 months. Driving the improvement were upgrades to the e-commerce platform and better staffed restaurants.
In regard to the digital experience, following changes to the digital platform, customers have to utilize fewer clicks to customize their orders. The factor has resulted in a 50% improvement in order completion and consequently incremental growth in digital sales. Considering that digital sales typically generate higher margins and that customers that place digital transactions order more frequently and with higher check values, streamlining of the e-commerce platform is a net positive.
With respect to staffing, during the first quarter, staffing levels were back to pre-pandemic figures. The development reflected in the best order accuracy over 24 months. Given statistical data that demonstrates that better staffed restaurants on average result in improved speed of service and order accuracy, and therefore more satisfied customers, we believe that PTLO’s excellent guest satisfaction scores are likely to persist. Considering that satisfied customers lead to more frequent visits to restaurants, the sales momentum the company has witnessed over the last 12 months will possibly continue, in our judgment.
Taking Wage Of The Table To Support Labor Retention. PTLO’s strategy in regards to labor is long-term oriented. The objective per se is to hire quality people notwithstanding price, and train and develop them, in a manner that increases labor productivity and lowers employee turnover. Considering that the firm’s hourly worker retention rates are 20% to 30% above that of the industry, and guest satisfaction scores (which are directly correlated to labor efficiency) are at 24 month highs, it appears that the maneuver is succeeding. Therefore, we are behind the strategy of hiring for excellence rather than price. Given the implicit and explicit costs associated with high employee turnover, including dissatisfied guests and retraining costs, we believe the initiative is prudent.
Balance Sheet Appears Strong. At the end of F1Q2022, the company had a restricted cash and cash equivalents balance of ~$32.2 million and long-term debt of ~$316 million on its balance sheet. In regard to additional funding, PTLO has available for use, a remainder of $45 million on a revolving credit facility it secured in March 2020. Given these factors, we believe that the firm is appropriately funded to operate effectively and execute on its footprint growth targets.
Bottom Line
PTLO’s popularity appears well-set to keep growing, as based on reviews, legacy customers can’t have enough of it and new customers rave excitedly about it. There are scant examples of companies with runaway customer demand (like PTLO) that have not turned wildly successful over the long-term. Our advice is to not confuse the trees for the woods. The current margin challenge will be overcome over time. PTLO’s future remains rosy, and could get rosier, as the business evolves. We view the stock as a home-run for investors with elongated time horizons.