Is This Hot New Stock The Next Chipotle?

Of all the IPOs that have taken place since 2007, the consumer sector has accounted for the least. 

#-ad_banner-#And small wonder: An environment of stagnant employment and wage growth that is only now recovering after five years doesn’t inspire a lot of demand for new issues of consumer stocks. 

The results for restaurant IPOs have been mixed in recent years. Shares of Dunkin’ Brands (Nasdaq: DNKN) have fallen 18% from their March high but are still up 125% from their 2011 offer. Shares of sandwich-maker Potbelly (Nasdaq: PBPB) surged 131% from the company’s offer price during the first week of trading but are now down 64% from that high to below the offer price.

But one restaurant issue has beaten all the rest. Shares of Chipotle Mexican Grill (NYSE: CMG) have exploded nearly 3,000% from their offer price of $22 per share in 2006, jumping 67% in the past year alone. 

Chipotle has some strong tailwinds behind its restaurants, which number nearly 1,600 and counting. The Hispanic population is the fastest-growing demographic in the United States and is expected to reach 78.7 million by 2030. That may have something to do with the growth of the Mexican restaurant category: The segment’s sales rose 6.8% in 2013, outpacing the 3.8% overall growth in limited-service restaurants (LSRs).

Now another new IPO promises to capitalize on the growing demographic — and shares have more than doubled in just two days of trading. 

Shares of El Pollo Loco Holdings (Nasdaq: LOCO) began trading on Friday at $15 per share, above the $14 offer price. The stock immediately surged and closed the first day 60% higher, tacking on another 43% gain the following Monday to close at $34.48 per share.

The company (whose name is Spanish for “the crazy chicken”) operates in five states with 168 company-owned and 233 franchised restaurants offering a variety of Mexican-inspired entrees. 

  El Pollo Loco operates in five states with 168 company-owned and 233 franchised restaurants offering a variety of Mexican-inspired entrees.  

El Pollo Loco’s first-quarter sales came in at $314 million, up 7.2% from the same quarter a year ago. Over the past four quarters, same-store sales growth has averaged 6.8%. That’s above the 5.6% growth posted by Chipotle last year, but well below Chipotle’s 17% same-store sales growth in the second quarter. 

Management projects an 8% to 10% increase in store count in coming years — but the company opened only four restaurants in 2012 and two in 2013, so its projections may be too optimistic. 

One overhang on the shares is El Pollo Loco’s huge debt load. The company is using IPO proceeds to pay down debt of $288.8 million, which accounts for 84.2% of total capitalization, and there may not be as much left for growth as investors hope. Even if the company uses the nearly $97 million in IPO proceeds just to pay debt, it would still have $183 million in debt — amounting to more than half (53.4%) of its total capitalization. 

By comparison, Chipotle holds no long-term debt and has other long-term liabilities totaling just 1% of its market cap.

In its most recent quarter, El Pollo Loco posted earnings per share (EPS) of $0.18, a reversal from its loss of $0.59 per share for all of 2013. While the company may post a profit for this year, its relatively meager growth doesn’t justify the share price.

An increase of 7% in sales would bring the 2014 total to $337 million. Assuming the IPO proceeds are used to pay debt, I estimate an enterprise value of $827 million and a price-to-sales multiple of 2.5 — less than Chipotle’s 5.5 multiple but well above the multiples of 1.4 on Darden Restaurants (NYSE: DRI) and 1.3 on Brinker International (NYSE: EAT).

El Pollo Loco appears even more overpriced in terms of price to book value. As of March, El Pollo Loco reported stockholders’ equity of $54.1 million and 37.4 million diluted shares outstanding for a book value of $1.45 per share. This means a P/B ratio of 23.8 times Monday’s closing price, far higher than CMG at 11.9 and DRI at 2.7 (but below EAT’s 33.5).
Worse yet, El Pollo Loco has a net tangible book value of negative $257.9 million or $8.98 per share. The negative tangible book value is incurred because of price paid by existing shareholders before the IPO. In effect, investors buying in at the current price around $35 per share are buying at an immediate dilution of nearly $44 per share.

Risks to Consider: Shares of Chipotle Mexican Grill have shot through the roof and proved all calls for overvaluation wrong. Shares of El Pollo Loco could continue to rise on investor enthusiasm despite being overvalued by several metrics. 

Action to Take –> Avoid the market’s exuberance, and don’t go crazy for El Pollo Loco. The company’s sales growth isn’t as impressive as Chipotle’s, and its debt load is still staggeringly high.

In contrast to flavor-of-the-week stocks like LOCO, my colleague Dave Forest and his staff recently went looking for stocks good enough to buy, forget about and hold — forever. After six months and $1.3 million worth of research, the team was successful. To learn more about the “Forever Stocks” they uncovered — including some names and ticker symbols — click here.