El Pollo Loco has risks, but you'd never know it

Chris Nichols
July 29, 2014
El Pollo Loco CEO Sees Plenty of Opportunity in Fast Casual
El Pollo Loco (LOCO) shares surged more than 30% on Friday after the stock debuted on the Nasdaq. The fast-casual chicken chain raised $107 million after pricing 7.14 million shares at $15 a share, the high end of the given range of $13-$15. CEO Steve Sather tells TheStreet that the 400-store chain, located in five states, has the potential to become a national brand, but for now it is sticking to a five-year plan to expand where it currently is in the Southwest. Sather also says that it is not trying to be the next Chipotle. Rather, there is plenty of opportunity in the fast casual space because consumers are demanding -- and willing to pay more -- for higher quality and healthier food.

El Pollo Loco (LOCO) shares were finally taking a break Tuesday after a smashing two-day surge, but that early advance made it clear Wall Street views this company as a potential standout in the increasingly crowded American restaurant scene.

Though there's merit in that, there's also considerable potential that the stock's rapid rise has already gone too far. Not only does the U.S. have 1 million restaurants, but El Pollo Loco, a grilled-chicken chain based in Costa Mesa, Calif., has to go against a multitude of Mexican-themed stores and chicken sellers.

After pricing its IPO last week at $15, El Pollo Loco opened Friday at $19 and went as high as $24.40. On Monday it was more of the same, with shares trading as high as $34.73. Recently, though, it was down 9.1%, at $31.35. Yet even that supports the point on the outlook among traders. The stock fell as low as $29.05, and within an hour it had reclaimed $2 of the decline.

Why the quick uptick? Because El Pollo Loco is the latest name carrying hopes of replicating the market brilliance of fast-casual burrito maker Chipotle (CMG). Though the phrase "the next Chipotle" has gotten nearly as tired as hearing bad weather is responsible for weak same-store sales, there remains an easy to understand element to both the search for this next great food purveyor and its influence on restaurant operators' stocks. It's sensible enough, considering Denver-based Chipotle has gained more than 1,400% since it began trading in early 2006. With its small, customizable menu and stress on better-quality ingredients, Chipotle has become the standard by which all others are now measured, especially in the fast-casual group, which is where traders want El Pollo Loco to be.

It's also extremely difficult to be the next anything, whether that's Chipotle or Amazon.com (AMZN). Nonetheless, that hasn't stopped bets that El Pollo Loco is a winning ticket, the type of optimism that's paid off in the early history of Zoe's Kitchen (ZOES) -- and not at all in the case of Potbelly (PBPB).

Even if El Pollo Loco is more like the former than the latter, the risks shouldn't be ignored by anyone interested in owning it for more than a few hours.

Higher sales

Being a restaurant, El Pollo Loco's food is where it all starts. Its main dish is fire-grilled chicken, and because grilled implies healthier, that matters in times when traders are cognizant of the anti-fast food movement. Chicken itself has for years been growing in popularity with Americans, and annual consumption of poultry is much higher than beef. Additionally, it's "Mexican-inspired," meaning it even does, arguably, what Chipotle does.

El Pollo Loco, at 401 locations in the western U.S., has the ability to expand. Revenue totaled $314.7 million in fiscal 2013, up from $293.6 million the year prior. It believes it can eventually have 2,300 stores and will gain customers as the nation's Hispanic population climbs and demand for Mexican food increases. Same-store sales have risen for 11 straight quarters, including 7.2% in first quarter of 2014.

From a price-competition standpoint, with a per-person average check of $5.83, the chain is an affordable option among not only fast casuals but fast food more broadly. Its fans aren't remotely afraid to sing its praises. In other words, it's got aspects in its favor.

That said, concerns aren't difficult to find. Of its store total, 352 of them, or 88%, are in California. Restaurants in and around Los Angeles accounted for about 80% of last year's revenue. That's a heavy dependency on a single market -- even a large one. Outside of the Golden State, its restaurants today are in Arizona, Nevada, Texas and Utah. The good news, as noted above, is that the bulk of the nation has yet to get stores, so expansion can be a boon. But it's been a slow build-out, and one not lacking setbacks. At the end of 2009, El Pollo Loco did have 21 units east of the Rocky Mountains. By 2012, none were still open. Past performance doesn't guarantee future results, though it would be a mistake to ignore it.

Financially, though this seldom matters with IPOs, El Pollo Loco is habitually not profitable. It lost $16.9 million last year, and it's had losses for seven consecutive fiscal years. After the IPO, proceeds of which were used to pay some debt, it still will have about $190 million in obligations. At some point, the financial situation will matter to investors.

Also, while there's no evidence we're yet tiring of chicken, El Pollo Loco must hope we stay keen on fowl. Chicken is its trade after all, and a large part of its cost structure. As long as prices are manageable, that's just the cost of doing business. Should they climb markedly, it's a risk to  profit attempts.

Competitors are another. Aside from venues such as Chipotle and Chuy's (CHUY), there are grilled options at large chains, including Chick-fil-A. There are local establishments, and there's cooking chicken at home.

Gaining forever

For now, none of that is particularly troubling buyers. And it might not for a few more dollars. Even after its tremendous start, El Pollo Loco sits at a price-to-sales ratio of about 2.7 (there isn't a price-to-earnings ratio). A group of other fast casuals and Mexican eateries averages a 3.2, according to FactSet data. At that ratio, it would be trading in the $35 range, near where it closed Monday.

Notable here is that Fiesta Restaurant Group (FRGI), which went public in 2012, surged 241% the following year. In 2014, however, it's down 14.9%. Because Fiesta owns grilled chicken seller Pollo Tropical, as well as Mexican-style chain Taco Cabana, worse market proxies for El Pollo Loco certainly could be found. Meanwhile, Chuy's, a Tex-Mex dine-in restaurant, went public the same year as Fiesta. In 2013 it gained 61.2%. This year it's lost 21.6%.

If either of those templates is followed, El Pollo Loco can stay aloft at least for a few months, assuming traders keep thinking it has a differentiated product. But when does a stock do what you want it to do? Hype does expire eventually.

So maybe we should forget "the next Chipotle" and worry about the first El Pollo Loco. Because burrito stores might grow to the sky, but it's hardly certain unprofitable chicken chains do.