Portillo’s Stock: Great Promise Of Growth, High Debts And Lot Of Speculation (NASDAQ:PTLO)

Corporate Overview

Founded in 1963 by Dick Portillo, as a modest street food trailer in Chicago that was affectionately named “The Dog House”, Portillo’s (NASDAQ:PTLO) is today a large restaurant chain that aims to combine the best attributes of QSR and fast casual , offering American favorites such as hot dogs, Chicago-style sausages, Italian steak sandwiches, grilled burgers, salads, fries, homemade chocolate cake and signature shakes.

The company has 84 establishments in operation and 4 under construction, geographically distributed across 10 American states. These states are: Arizona (8 units), California (2 units), Florida (6 units), Illinois (48 units), Indiana (8 units), Iowa (1 unit), Michigan (1 unit under construction and 1 unit in operation), Minnesota (3 units), Texas (3 units under construction and 5 units in operation) and Wisconsin (4 units). Almost all of these restaurants are directly operated, while only one unit is jointly managed, with Portillo’s owning about 50%.

The themes of the restaurants vary between: ’20s, ’30s Prohibition, ’30s, ’40s Gangster, ’50s and ’60s, Old Chicago, and other similar decorations. These symbolic elements are used within Portillo’s value proposition precisely to generate non-functional benefits. Symbolic and sensorial elements that hark back to times gone by are part of the authentic experience that Portillo’s wants to convey to its customers. We have to remember that, even in the case of restaurants, the central product of the value proposition, which must always be food, is not the only element that must be worked on to create value.

Furthermore, themed restaurants are part of the authenticity of the producer and the product. When Portillo portrays in its restaurants, scenes from the imagination and/or experiences of its customers, remarkable and nostalgic times in American history, they are in reality creating a link between the experience, the food enjoyed, the times gone by, and the moments lived within Portillo’s.

This retention capacity through the environment can and should be used by Portillo’s in order to capitalize on the time spent by its customers within the establishment from a more robust check per customer, this capacity is not maintained by other QSR or fast casual restaurants , since they have generic settings and/or no appeal or connection to anything in the imagination.

When we talk about food, in addition to the classics, Portillo’s is constantly working to add some innovations to the menu that have some appeal to the company’s segmented customer base and allow it to maintain the desired level of operational efficiency in preparations. To keep the menu to a manageable size, when Portillo’s adds a new recipe to the menu, it generally excludes a less appealing item from the menu. Two examples of this are the Plant-based Garden Dog (launched in 2022 and prepared to order for Portillo’s by Field Roast) and the Rodeo Burger (launched last year).

Furthermore, since 2023, Portillo’s has maintained an innovation center that aims to improve operational efficiency during preparations and the inclusion of new items that meet the aforementioned standards.

Let’s talk a little about Portillo’s oft-mentioned growth strategy. During this analysis, I will deal more deeply with the numbers, but I think a more qualitative analysis of this expansion project aimed at by the brand is appropriate here. Since 2015, the company has grown its number of units by approximately 9.2% year on year. In 2023, Portillo’s increased this number to ten, and plans growth of 12% to 15% for 2024 and 2025 at least. The focus of this expansion is the Sunbelt, a highly sought after region when it comes to fast-casual and casual dining restaurants.

To reduce the initial investment, Portillo’s developed a new restaurant prototype that will cost approximately $1 million less and will be between 5,500 and 6,000 square feet. According to management, this new model would not differ from the prototype already used in terms of operational capacity.

In the very long term, Portillo’s, through an outsourced market study, plans to have around 900 restaurants geographically spread across the United States. This means that if we use the 15% growth rate of new units per year, Portillo’s would reach this milestone in approximately 17 years, in 2041. If we use the 12% growth rate of new units per year, this milestone would only be achieved in approximately 21 years, in 2045. See, I am not yet evaluating whether this project is economically viable, but analyzing the premises that the company itself is establishing.

The company has already been drawing up some paradigms on the modernization and remodeling of existing restaurants, in order to increase operational efficiency and, consequently, the margin per restaurant.

Financial analysis

Formatting of capital sources, net working capital, working capital, average terms and financing policy

Before we draw more in-depth conclusions about Portillo’s financial situation, it is extremely important to assess the sources of capital that the company finances its business. The indices that we will analyze below seek to relate the sources of funds to each other and to the totality of Portillo’s capital, in order to portray both the position of its own resources and that of third-party resources in relation to themselves and the total capital.

Initially, we will analyze the Third Party Capital Participation Ratio over Total Resources. This first indicator will show us the percentage of third-party capital in the company’s total capital.

From the graph above, we can infer that Portillo’s, in 2023, raises around 66% of all its funding sources from third parties. The company started accounting for its capital leases from 2022 onwards, resulting in a “peak” movement in its debt ratio. This adoption comes from ASC 842 and represents only nominal effects on the balance sheets, since its triggering event produced and continues to produce the same operational impacts before this inclusion in the balance sheet. Other than that, natural movements in the current liabilities account, together with a 22% growth in accounts payable are initial signs of an extension in the average payment period, and this, as we will see in the working capital analysis using the Dynamic Model (Model Fleuriet) is very important for managing cash flow and working capital in restaurants, as commercial credit is a central figure in these topics in the industry.

When we look at current liabilities, still in 2023, Portillo’s used a short-term loan line of $15 million to meet its short-term liquidity needs. Now, this could be some indication of poor optimization of the operational cycle. The inventory account grew 17% from 2022 to 2023 and receivables grew 65%! It is not our intention to analyze Portillo’s cycles closely now, but I am trying to explain to you this short-term loan line that the company took and the involvement of all this with the preponderance of third-party capital in the formation of the company’s capital.

Remember, in the long term, the percentage of debt capital on total funds must always be equalized with the spilloffs of financial revenues on operating profit. When this preponderance is very accentuated and a degree of financial leverage is not achieved that justifies, through a marginal rate of return on loans higher than the cost of debt, the company will not be optimizing its sources of capital, and it will be safer to work with a preponderance of own capital.

Below, I have compiled the Degree of Financial Leverage, which is nothing more than an indicator that aims to identify the impact of using third-party capital on shareholder returns. If the DFL indicates a result of 1, this indicates that the leverage had no effect on the ROE (in the case of exclusive use of equity). On the other hand, any value above 1 indicates that leverage amplified shareholders’ profits (or losses) in a given fiscal year. In perspective with this analysis, I adopted a DFL analysis approach in conjunction with an analysis of debt interest paid.

The above analysis is subdivided into two fronts. Firstly, I analyze the intensity of leverage in terms of boosting returns to shareholders, whether upward or downward. We can see that Portillos, due to the growth in its Total Debts and approximately 2.60% CAGR since 2019, reaching a peak in 2023, maintains a higher DFL. This means that if the company maintains its same proportion and financing strategy, the return on shareholder capital will continue to be highly leveraged in relation to both the industry and Portillo’s historical data.

In the next few lines of the chart, we see the second section of Portillo’s debt analysis. The reason I included this other variety of indicators is to assess whether the company is managing to cover the interest paid on this third-party capital and what return they are earning when this capital is operationalized in the form of investment of resources. Therefore, if the return on this capital is greater than the cost the company pays for it, this leverage is effective (the company is able to create value from obtaining this capital).

It can be seen that the secret to creating this value from loans is defined by the gap between the return generated on the debt (operating profit or loss acquired on total debts) and the cost paid on third-party capital, accounted for through interest paid on total debts. Therefore, a company that seeks to increase the value created from loans and financial leverage must work on two fronts: the first is to reduce the cost of its debt (through refinancing, consolidation, negotiation, incentives or improvement in score) and the second is the increase in the profitability of debt (through the creation of value, that is, increasing the return on this capital at rates above the cost of debt).

Effectively, we saw Portillo’s working on these two fronts from 2022 onwards. With the increase in total debt, we can infer that the company increased its total debt level based on more pleasant rates, reducing the cost of debt and, consequently, its impact on operating profit. As the principal value of these debts also increased, there was a decrease in the return on total debt from that year onwards, but the most important thing happened: the gap between the cost of debt and the return on debt grew. This means that Portillo’s was successful in reducing the cost of its debts through refinancing and increasing the principal without decreasing the return on that debt in the same proportion.

And yes, this means that this increase in total debt opened space for the purchase of fixed assets that are generating satisfactory returns for Portillo’s, after all, the increase in return on debt that we saw from 2022 to 2023 was only possible by operationalizing non-current assets tangible assets, which grew by approximately $115.2 million during this period, totaling a 23% year-over-year increase.

To interpret the correlations between DFL and Debt efficiency, we need to keep in mind that one gives us direction and the other amplifies the results. Therefore, if we have a Debt efficiency lower than 1, meaning that the cost of debt exceeds the return on it, a high DFL is harmful, as it will amplify shareholders’ losses in the period. A high DFL in a period in which the company managed to generate a return greater than the cost of debt will be positive, as it will amplify shareholder gains.

Note that as of 2021 there is a clear trend towards both debt efficiency and the amplification of this efficiency through leveraging shareholder gains. In more recent periods, mainly due to the reduction in the cost of debt, the company achieved better efficiency, reducing spilloffs from interest expenses, while increasing the degree of financial leverage.

To add to our debt analysis, we will check both the ability to pay off the principal through operating cash flow and the percentage of operating profit directed to interest payments. This way we will go a little deeper into our analysis of Portillo’s debt.

From this data, we can infer that there has been an improvement in Portillo’s ability to pay the interest on its debts. However, this improvement does not come simply from an increase in operational efficiency, materialized in the form of a stronger operating profit, but from a reduction in the cost of debt. Let me make it very clear, reducing the cost of debt is very important, but we would also like to see a stronger operating profit, as it has remained flat since 2019 (with one exception in 2021, a very weak year for the company).

Another aspect that I would like to address here is that despite the growth in total debt, Portillo’s was able to improve its coverage of the principal debt with its Operating Cash Flow in the year 2023, mainly due to a more pleasant net profit than in recent years.

Changing the subject, let’s move on to another very interesting subtopic, the analysis of capital sources and their applications, which is the study of real estate and financing policies. This topic is broad, and we cover many other important concepts in Corporate Finance, such as operating cycles and cash cycles. First of all, the table below indicates Portillo’s own working capital and net working capital, as well as its main formation components, which are long-term debts.

Just to remind you, own working capital is the portion of equity that was not immobilized (was not used to purchase non-current assets). Generally, he is not a figure present in the composition of companies like Portillo’s, as they do not need to maintain equity capital to finance their current assets as they do so either through:

1. Short-term debts;
2. Commercial credit (depending on operational and cash cycles); and
3. Long-term debts in the form of own working capital.

Ultimately, the decision whether or not to maintain its own working capital will depend on the financial management style that the company adopts, especially the cost of each source of spare capital and its cash cycle.

Now, net working capital is nothing more than the resource not required in the short term and available in current assets for the company to use in its very short/short-term operations. It comes from both equity and long-term liabilities. Below is a diagram detailing these two very interesting elements:

In both Model I and Model II, the company will only immobilize non-current resources, and this is in accordance with the orthodoxy of Corporate Finance from its beginnings until the 1970s. It has always been advocated for the parameterization of debt (its maturity) according to the flow of resources from the asset to be financed. Therefore, if the asset in question is long-term, it must be financed through non-current resources. In this way, this asset will serve as an “amortizer” of the financing that generated its acquisition. As, as a rule, the return obtained from these assets must be greater than the cost of the debt incurred to raise them, there would be no problems in immobilizing these resources, as long as they are amortizable in the long term.

Therefore, there are not many questions about immobilizing fixed assets through long-term resources. Nor is there any discussion about companies using short-term credit lines to finance their current assets. Now, certain illustrious authors, such as Iudícibus, Matarazzo, Padoveze, among others, have some reservations regarding the immobilization of current resources (the use of current liabilities to finance non-current assets).

On the other hand, there are other aspects that we know today as the Dynamic Model of Financial Analysis that complement this discussion by combining static analysis (Classical Model) with the study of Cyclical Accounts and, consequently, average terms. Before we delve into the Dynamic Model, let’s take a look at Portillo’s immobilization elements through the Classic Model:

Note that Portillo’s does not have net working capital in its capital composition in any of the periods analyzed. This is because the company has immobilized a sum of resources greater than all of its non-current resources (equity and long-term liabilities). This situation is similar to the Immobilization Model III, which we represented previously. Therefore, we can infer that Portillo’s both immobilizes part of its current resources and finances its current assets with the remainder of these same resources. Below, I will graphically represent this situation:

If the majority of authors who advocate the fundamental precepts of Classical (Static) Analysis regarding the immobilization of current resources, in which situations, from the perspective of the Dynamic Model, can a company immobilize current resources? Primarily, the company must have extraordinary liquidity, so that these short-term resources used for immobilization are constantly renewed.

But the orthodox liquidity analysis, arising from the Classical Model, assumes that in order to maintain good liquidity, the company must always keep its most liquid liability accounts covered by the asset accounts, and that is not what “good liquidity” is. in Dynamic Analysis represents.

For dynamic analysis, the study of cycles must always be related to liquidity analysis, in order to increasingly include the figure of commercial credit and the credit policies practiced by the company itself with its customers. With a short cash cycle, for example, the company will be able to immobilize current resources, since its credit and financing policy establishes liquidity windows, characterized by a negative cash cycle, and/or short operational cycles that allow the company to operate with sufficient liquidity to cover fixed assets from current resources.

Now that we have established that Portillo’s does not have net working capital and that, consequently, it immobilizes current resources, let’s analyze its immobilization in the light of the Dynamic Theory. Below I have compiled the average deadlines for receipt, inventory renewal and payment. This is essential to understand the operating and cash cycle, in addition to understanding all the dynamics behind Cyclical Accounts:

Note that both receivables and inventories, which are the central figures in the average sales receipt period and average inventory renewal period, are, according to Dynamic Analysis, Cyclical Assets. Note that an excess of Cyclical Assets on a company’s balance sheet generally indicates longer operating cycles, and consequently liquidity problems (depending on the average payment period, of course).

And the average payment period, which are considered Cyclical Liabilities, has the purpose of postponing the withdrawal of liquidity from the company, improving cash flow.

Therefore, in the light of Dynamic Analysis, a preponderance of Assets over Liabilities does not always indicate some type of competitive advantage. On the contrary, a preponderance of Cyclical Liabilities over Cyclical Assets indicates that the company makes good use of trade credit with its suppliers while maintaining its receipts in shorter terms. This indicates that the company receives payment from its customers before having to pay its suppliers. Below I compiled this data in the form of operating cycle and cash cycle to facilitate understanding:

Portillo’s, despite suffering a significant increase in the operating cycle (mainly due to year-over-year growth in inventory retention and a disruption in 2023 in receivables), continues to maintain a negative cash cycle. This is due to the great job the company does in using commercial credit from its suppliers to guarantee liquidity. This provides Portillo’s with a period of time in which its operational cycle can expand without any more serious consequences.

To conclude our in-depth analysis of working capital, fixed assets and average terms, we will use the Fleuriet Model to verify whether this preponderance of Cyclical Liabilities occurs in all accounts. We will probably see the same situation, since these three accounts already analyzed by the average maturity studies represent the overwhelming part of the Cyclical Accounts. But I consider it important to include Fleuriet’s Model in our analysis of Portillo’s precisely because Dynamic Analysis (despite almost fifty years of history) is still not known to the general public.

Profitability: Broad overview and developments in the first quarter of 2024

Let’s take advantage of the fact that this analysis is covering both broader aspects (as I usually do when I analyze companies every six months) and the developments in the first quarter of 2024 at Portillo’s, and we will analyze how Revenue is behaving in both the short term and the long term. Furthermore, it is interesting to evaluate how the company’s assets are behaving in terms of revenue generation, which we will evaluate through asset turnover.

In 2023, a continuation of the trend was observed in both revenue growth (15.8%) and comparable sales (5.7%). In 2022 and 2023, Portillo’s opened around 15 new restaurants in different states (Arizona, Florida, Illinois, and Texas), which together impacted total revenue for the year 2023 by approximately $48.4 million, representing around 7% of the total revenue. That is, each new restaurant still has a revenue that represents about half of the average revenue per restaurant in 2023.

Of course, these are maturing assets in markets in which the company is not yet established, but as we can see, the excess investments that are not matched by strong revenue upon establishment are materially represented by a drop in asset turnover, which is what we are seeing as the company works on its national brand expansion project.

And this scenario should continue in the coming years, as Portillo’s appears to continue investing aggressively in new markets, even if they do not prove to be responsive in the short term. Portillo’s plans to open 9 more restaurants by the end of the year, this is approximately 10% growth in the number of restaurants. For the next few years, the company plans to continue growing the number of units at a rate of 12% to 15%. That is, if the company has around 93 restaurants by the end of 2024, according to the company, a number of units of 104 to 106 units is expected.

Therefore, everything will depend on the maturation period of each new unit, if they prove to be mature within a period of two years, asset turnover will tend to grow, considering a set of assumptions that have been constant in recent periods, such as the growth of sales per unit and the revenue ratio between a mature unit and a new unit. In the table below, I explored the possibility of an average maturity period of two years and possible stability in asset turnover if Portillo’s maintains unit growth at a more conservative level.

However, this is not what we should see in the medium term, as investments will only increase from now on if the company carries out its expansion project.

Looking a little closer now, let’s examine the revenue reported for the first quarter of 2024 and compare it to previous quarters:

Quarterly, despite revenue growing by around 6.21% when compared to the same period in 2023, the company showed a 1.2% drop in sales in comparable restaurants, interrupting the growth trajectory that the company had been showing. This drop in sales at comparable restaurants is mainly due to the decrease in the number of transactions, which decreased by approximately 3.2% in the quarter.

This movement was partially offset by an increase of around 2% in the average check per customer. It is interesting to mention that menu prices jumped more than 5% in the period, this should explain the decrease in transactions, as the average QSR customer is greatly affected by sudden changes in prices. We will soon understand the reason for this accelerated increase in menu prices. Basically, they may have been caused by competitive pressure and/or increased operating costs.

Speaking of operating costs, let’s break down each component of Portillo’s operating costs. This way, we will be able to analyze both the cost trajectory in its entirety and in each specific cost center:

It is observed that even with a 6.26% growth in revenue in Q1 2024 when compared to Q1 2023, the benefits arising from this increase were completely offset by growth in all operational cost centers. In practice, this effect resulted in a decrease in gross margin of approximately 0.35%.

The greatest relevant upward pressure on an operating cost center was Labor and benefits, which showed annualized growth of approximately 7%, increasing in importance in relation to quarterly revenue by approximately 0.19%. According to Portillo’s, in the last quarter this cost center was impacted by incremental investments to support the team and maintain worker turnover. Higher wages and fees are expected while regulatory pressures intervene in labor issues in some states, such as California, which are already doing so in the QSR segment.

Another group that showed an accelerated increase, although still lower than the growth shown by revenue, were the costs of food, beverage and packaging. This group showed annualized growth of 6.21% and maintained its share of total costs practically stationary. The reasons for this increase are primarily due to an increase of approximately 4.8% in commodity prices and the operating costs of the twelve new units opened in 2023, which do not yet generate revenue like a mature unit. Although it is not the cost class that has grown the most, it is still the most significant class in terms of operating costs.

Occupancy and Operations costs grow rapidly, although they are not as relevant as raw material costs or labor costs. Annually, this category grew a little more than 10% and the main catalysts were increases in credit card, utility and cleaning fees. Other costs also grew approximately 6%.

Note that all operational cost centers (and especially those most relevant to Portillo’s) grew during the first quarter of 2024. This is quite worrying, even more so when we take into account that the company will increase its number of units by approximately 15% per year. year. The costs of these new units will most likely put pressure on margins, as there is a maturity period for a unit to generate a continuous and relatively stable cash flow.

Let’s take a look at Portillo’s gross margins through the years:

The first quarter of 2024 is the worst when we consider operating cost pressures since the first quarter of 2023. However, when we compare it with other restaurant brands, both in the QSR and casual dining segments, even the gross margin presented in first quarter of 2024 is not far behind. In fact, it would be in one of the highest percentiles in the segment. As the company is heavily indebted, we will better understand the dynamics of profitability when we look at net profit and net margin, since interest expenses are discounted when measuring this.

Regarding SG&A expenses, we can notice a decrease in the full value of approximately 1.59% compared to the same period in 2023. What is important here is the reconciliation of an appropriate value of SG&A expenses with the gross profit for the period. In the graph below I examine this relationship.

Even though we are experiencing strong pressure on costs, as we have already examined previously, the amount of gross profit used for SG&A expenses is in line with what Portillo’s was already doing in previous quarters. This indicates that management tends to parameterize SG&A expenses according to the inputs received through gross profit, generating a certain predictability for the investor.

Now let’s analyze the impact of non-operational items on Portillo’s profitability through the analysis of net profit:

Note that in the last three years, Portillo’s has reported negligible net profits during the first quarter of each year. The following quarters alternated in intensity of gains, but always formed an “M” pattern, with the second and fourth quarters being the strongest of each year. I couldn’t say whether this is a relevant seasonal pattern because we don’t have enough data to confirm this. But there is a clear tendency for net profit in the first quarter to be weaker than in the second, this seems recurring to me.

How about we now measure Portillo’s historical return to the investor in the form of remuneration on equity? Let’s use the DuPont method to assess whether the company is managing to remunerate shareholders’ capital in line with other companies in the industry:

Note that Portillo’s generates returns well below the market average when it comes to the profitability of equity, and, in my opinion based on both the prospects presented by the company and the data obtained from this analysis, I believe that we will not see such a significant improvement in ROE in the medium term. I will explain better. The DuPont model shows that, for a company to generate a greater return for its shareholders, it needs to work on three fronts: increase the turnover of its assets, improve its margins and optimize its leverage.

We recently saw that Portillo’s is having some problems making its assets profitable, as many of them are assets that have not entered their maturity period. As the company has already made it very clear in its prospects that it aims to massively expand its brand, initially within the United States, and then globally, I do not believe that with an increasing amount of assets in the process of maturation that Portillo’s will present a very strong asset turnover. To believe that the company would be able to succeed in this task would be to underestimate the sectoral, regulatory and economic variables.

The second task for Portillo’s would be to improve its net margin. We have to recognize that despite facing cost pressure, especially when it comes to labor costs as it is a QSR, Portillo’s has a very satisfactory gross margin. However, there are still some problems, such as SG&A expenses, which even when controlled still represent around 60% of all gross profit, and interest on debts. When we consider the expansion project, we have to keep in mind that all the cost categories we have seen so far will increase. How much will be spent on advertising for the company to generate appeal in a given region? Operating costs will increase, but would revenue growth catch up with cost pressure, or will we see a repeat of what was seen in the first quarter of 2024? Therefore, more than an expansion project, I would like to see some initiative coming from the company in terms of improving margins and generating returns for shareholders.

Regarding leverage, it seems to me that since 2022 the company seems to be dealing in a satisfactory manner in this sense. As we saw previously, both the Efficiency of leverage and its intensity have increased, but this is not as valuable when the return on assets is not responsive enough. In other words, even with the potential to leverage shareholder capital, the company is unable to do so because the return on total investment in the form of assets is not satisfactory enough.

Furthermore, it is clear that Portillo’s is managing to maintain constant growth in its operating cash flow, but all this growth in operating cash flow is being overcome by massive Capex. This movement is generating negative free cash flow for Portillo’s, which to raise equity capital is issuing shares. Since 2021, the company has increased its number of common shares by more than 70%. It is expected that shareholders will continue to be diluted as cash flow remains negative during Portillo’s expansion project. Like BJ’s (BJRI), Portillo’s is developing a prototype unit that would save approximately 16.66% of establishment costs (from $6 million to $5 million), and this would save the company some resources, yet we would continue to see negative pressure on free cash flow in the coming years.

But is Portillo’s really generating enough operating cash flow to stand out among other industry players? Below, I have compiled the CROIC, which is nothing more than the return on invested capital. A high CROIC indicates that the company can generate a high amount of operating cash flow in relation to its total assets:

Note that Portillo’s has historically generated lower returns than the industry average from invested capital. As the three-year growth CAGR of total assets is 15.03%, and the tendency is for this growth to increase year after year as expansion develops, Portillo’s CROIC is expected to grow as its new assets enter into phase of maturity, until then, we are likely to see some side effects of this growth in profitability metrics such as CROIC.

To conclude our fundamental analysis of Portillo’s, we will measure the economic value added in operating the company through the EVA model:

Note that when we use the risk-free rate as a benchmark to show whether Portillo’s has created any economic value for shareholders since the IPO, we see that in almost every year the company has destroyed economic value. As the RFR is used to identify a risk-free rate of return for the investor, a return that does not exceed this benchmark is below the minimum return expectations for investors. When we put into perspective that both Portillo’s total assets are expected to grow rapidly, and interest rates are expected to remain high for longer, in order to control the sticky inflation that still represents a threat to the American monetary system, I do not believe that the company will present itself as a profitable opportunity for the investor in the short/medium term. And this is being reflected in the value of the shares.

Valuation

To determine the intrinsic value of Portillo’s, let’s first make some assumptions about both the discount rate we will use in our quantitative models and the company’s growth rate. As the company has a negative free cash flow, we must also make some assumptions so that this value grows again at some point in time.

In addition to the Discounted Cash Flow model, which, by its essence, requires us to correctly project when the company’s free cash flow (and to what extent) will grow again, we will use two value investor models: Ben Graham and Peter Lynch. As we don’t need to make these assumptions about free cash flow, I believe it will give a positive depth to our valuation.

Armed with the information present in these two quantitative valuation models for value investors, we can reach some conclusions:

1. The drop we witnessed on 05/07 with the release of the first quarter results brought the share to levels below its intrinsic value according to the Graham Model. However, the value investor is unable to make use of a satisfactory margin of safety for the purchase. Even though I think that Portillo’s could reach the $12 level again in the near future, I consider this movement purely speculative, as I don’t see fundamentalist catalysts that justify this in the short term;
2. According to the Lynch Model, Portillo’s is not in a favorable position for the purchase. This model advocates both the projected growth in earnings per share and the dividend yield as driving factors and equates it with the P/E (FWD). Therefore, despite the company having accelerated projected long-term EPS growth (about 35% higher than the industry), the company does not pay dividends and has a P/E (FWD) about 65% higher than the industry. In this way, the high growth projected for its earnings is offset by the lack of shareholder remuneration and a high P/E.

For the DCF model, I assumed that Portillo’s would end 2024 with the same amount of free cash flow as in 2022. For the growth rate, I used the average estimate of analysts covering Portillo’s. It can be seen that even using assumptions that are not so safe (no one knows what Portillo’s free cash flow will be in 2024, much less what the company’s growth rate will be over the next ten years), we do not obtain an intrinsic value that indicates purchase.

The debt of approximately $568 million covers more than half of all Portillo’s future cash flows (including perpetual growth discounted to present value), and is not offset by the small amount the company holds in cash. Personally, I like to use more conservative growth rates in my quantitative analyses, but to analyze Portillo’s I had to use a rate in line with the market to try to understand the dynamics behind the valuation.

Of course, I would like to state once again, the share price could indeed appreciate in the coming months, as the market will be able to see signs of buying through price signals and moving averages.

Conclusion

Given all the analysis and future outlook expected for Portillo’s, I consider this stock as a “Hold”. You see, the company has a strong appeal within the QSR industry, many loyal customers and a menu that stands out from its competitors. Now, when we look at the numbers, the scenario is a little different.

It is a very leveraged company and, despite being able to amplify shareholders’ gains (remember the debt efficiency indicators and the degree of financial leverage) it is still quite dependent on this third-party capital and on controlling the cost of this capital, despite having been successful in reducing the cost of third-party capital from 2021 onwards. This implies increasingly significant interest expenses. With a possible escalation in operating costs in a scenario of brand expansion, we may see more and more compression in margins. And yes, the company continues to take on debt as we saw in Q1 2024, where its total debt grew by approximately 3%.

Furthermore, we continue to see an increase in the operating cycle and a shortening of the cash cycle since 2019. I do not consider this a threat, but it is something that investors should monitor closely in the coming years, as everything will depend on whether the Portillo’s will be able to reduce its operational cycle or increase its payment period to suppliers through commercial credit. Remember that good cycle management is essential for a company that has immobilized all of its non-current resources, and depends on current resources to finance fixed assets. This is the basics of cash flow management for large restaurant chains.

Talking about operationality, we can certainly infer that Portillo’s shows impressive revenue growth driven by expansion. And it’s the growth and expansion of the brand that I really want to see development, but what I really want to observe is how this growth will impact profitability and shareholder remuneration.

For the company, taking into account the aggressive expansion process they intend to carry out (remember that Portillo’s plans to increase its number of units by 10% in 2024 and 12% to 15% in subsequent years), everything will depend on the maturity time of these new units in these new markets.

Even adopting a smaller and more affordable unit model, the company will likely increase both its operating costs and its marketing expenses in order to gain market share. Will the company achieve this without impacting its margins so much? This will depend on how long it takes for the new units to pay for themselves. Just remembering that we can monitor the brand’s “appeal” in new markets through revenue generation and asset turnover. To measure the impact on profitability, we can use either ROA, CROIC or ROFA (Return on Fixed Assets).

Other developments that we must monitor is the drop in comparable sales (which was driven by the harsh winter in the South and Midwest and the increase in menu prices), which Portillo’s will probably recover in the second quarter of 2024 due to the absence of the exogenous factors that caused this decrease.

Furthermore, the company does not have a satisfactory return for shareholders (as we saw in the analysis of the industry’s ROE), nor is it an excellent cash generator like Texas Roadhouse (TXRH), for example. Not even when we use the EVA model to measure the added value of operations, Portillo’s shows adequate profitability.

That said, I would like to analyze the developments of the expansion project and how the company will perform as insiders and institutions stop putting any selling pressure on this stock, after all, everything seems very speculative for now.