Description

Fiesta Restaurant Group (FRGI) represents an attractive risk-reward situation.  The company trades at the cheapest multiple to the group due to past operational miscues which are easily correctible.  A combination of lapping easier same store sale comps and correcting operational mistakes, combined with a  number of strategic review options, including the likely near-term sale of the company or changes to the capital structure, all offer substantial sources of value.  And with the company trading at a bear-case valuation incorporating no optionality for any of the aforementioned upside, the risk-reward is extraordinarily attractive.

Company Overview

Fiesta Restaurant Group, headquartered in Addison, TX, operates two fast-casual brands: Pollo Tropical and Taco Cabana. The company is primarily a company-owned business model, with 36 franchised stores and 8 non-traditional licensed locations.

Pollo Tropical offers freshly prepared Caribbean food, featuring bone-in chicken marinated in a proprietary blend of tropical fruit juices and grilled over an open flame. Company-owned locations are in Florida (122), Texas (33), Georgia (13), and Tennessee (4). There are 31 franchised locations throughout Latin America and 6 college campus-based licensed locations in Florida. A typical freestanding Pollo restaurant ranges from 2,800 to 3,700 sq ft and provides seating for approximately 70 to 90 guests. Pollo commands industry leading store margins of 27.4% in 2015 due to its $2.6mm average unit volume (“AUV”). Core South Florida stores post volumes above $3.3mm with store margins of 30%+. Management plans to add 14 to 17 units in 2017.

Taco Cabana offers a broad selection of hand-made, freshly prepared and authentic Mexican food. Company-owned locations are primarily in Texas (163), with 1 additional store in Oklahoma. 5 franchised stores are located in New Mexico and there are 2 non-traditional licensed locations on Texas college campuses. Stores average approximately 3,500 sq ft (exclusive of the exterior dining area) and provide seating for approximately 80 guests, with additional outside patio seating for approximately 50 guests. $1.9mm AUV and $9.16 average check. Management plans to add 8 to 10 small units in 2017.

The Situation

As a result of a poorly executed expansion into Texas and general weakness in the oil economy affecting nearly all of Taco’s locations, FRGI shares have fallen from a high of ~$65 in March 2015 to $24 as of close last Friday (9/30/16), valuing the company at less than 7x LTM EBITDA, the lowest in its fast casual comp group. FRGI has missed 3 of its last 4 quarterly SSS estimates and has experienced margin pressure from inefficiencies at its recently opened Texas units. On August 25^th, the CEO Tim Taft, who had led Fiesta since its own spin from Carrols Restaurant Group, abruptly announced plans to retire at year end, which effectively put the company in a full blown strategic review. Without stable leadership at either Fiesta or Taco Cabana (the company was searching for a CEO for Taco Cabana in tandem with a previously announced, but since cancelled, spin off), the Board has been forced to consider its strategic alternatives. In response to an activist filing on the stock, following up on September 27^th, the company provided a strategic update announcing (1) moving up the early retirement of CEO Taft to just 3 days later on September 30^th; (2) the indefinite deferral of the Taco Cabana separation process; (3) the resignation of the Taco Cabana COO; and (4) the suspension of new Pollo Tropical store development in Texas.

The Thesis

Note: All EBITDA exclude pre-opening expenses, which are variable with store openings and one-time in nature.

On September 19^th, a group of activist investors led by JCP investment management filed a D announcing 6.2% stake in Fiesta and intention to engage in discussions with the Board on “capital allocation, corporate governance (including Board composition), operations, strategic plans and other means to enhance stockholder value”. JCP is a low profile but nonetheless successful activist that had pushed for and achieved a sale of CST Brands ($3.6b mkt cap) this year at a significant premium to their entry price, and did the same at Pantry Convenience Stores a year earlier in 2015.  Further similarities are that these are companies that had significant exposure to Texas and Florida markets. JCP is led by James Pappas, who is the distinguished restauranteur behind the Pappadeaux, Pappas BBQ, Pappas Burger, Pappasito’s Cantina, Yia Yia Mary’s, Pappas Seafood House and Dot concepts in Texas, which gives JCP particular expertise with FRGI.

We see numerous levers to drive value creation at Fiesta, including:

1.      Acceleration of Pollo Tropical store refresh: Fiesta is experiencing 3% to 5% uplift in same store sales at its reimaged Pollo restaurants in Orlando and Nashville, but has only managed to complete 17 store remodels in total since launch in 2014. When asked why progress has been so slow on these accretive remodels, management admitted that they’ve been distracted by the misguided Texas expansion, which has also locked up significant capital.

2.      Opening new stores in high ROI geographies: We estimate new stores should generate at least 16% ROI. We view this as conservative given that (1) core South Florida have store margins of 30% on $3.3mm AUV and Orlando store AUVs (representative of average stores outside of South Florida and Texas) are $2.0mm, whereas the new Texas stores have been roughly breakeven on $1.3mm AUVs and (2) store capex on newer smaller prototype, which fit lower volume outside of South Florida locales, can cost as low as $1.3mm vs. the $1.8mm average for all stores.

(1) 2015 new store AUV.

(2) Per 10-K. Interior and exterior costs are mid-point of estimated capex for typical new or converted freestanding restaurant.

3.      More efficient capital structure: Fiesta is underlevered at 0.6x. Even using modest PF net debt at 3x to buyback stock, shares would be valued at $38/share using a 15x 2017E P/E multiple. We note that 15x is a 3x discount to the median of Del Taco (19x) and El Pollo Loco (17x), which are the closest publicly-traded restaurant concepts to Taco Cabana and Pollo Tropical, respectively, but have higher franchised mix (we view this as an additional opportunity at Fiesta as discussed below). Furthermore, Fiesta can buy back 6% of its float every year if it were to refocus capex on accretive remodels and reduce the amount of new store opening to 8 per year.

4.      Spin off of Taco Cabana: We acknowledge that it no longer makes much sense to separate the two concepts into even smaller companies given the decline in market valuation of Fiesta and the leadership vacuum at Taco Cabana. However, the more mature and high free cash flow nature of Taco Cabana naturally attracts a different investor base than the higher growth Pollo Tropical. Assuming Taco Cabana and Pollo Tropical trades at 6x and 9x, respectively, Fiesta shares are worth $30/share today.

5.      Ad spend: Atlanta, Nashville and San Antonio, experienced 5%, 6%, and 10% comp lift, respectively, after Fiesta turned on media. Texas currently has no media support but very strong customer ratings, and should experience similar uplift in SSS when the company turns on media.

6.      Franchising Strategy: El Pollo Loco and Del Taco are both operators of extensive franchise networks. While the Pollo Tropical needs to prove that its food can resonate outside of South Florida, we believe that there exists enough history in Orlando, Georgia and Tennessee that this is likely true. Taco Cabana is a relatively simple concept to manage, similar to any QSR restaurant, and should also consider refranchising some of its store base.

While we would like to capture the upside for ourselves, we believe that the changes identified above would be more effectively executed away from the public eye in the private markets and with the company rudderless with no CEO, believe it is likely the Board thinks the same way. It is not difficult to envision a take-out price of low to mid-$30/share, even assuming 25% IRR for private equity and relatively modest same store sales recovery to 3% at Pollo Tropical by 2019 and 1% at Taco Cabana by 2018, which are still below historical levels achieved from 2011 to 2015 (another argument that the two concepts, especially Pollo Tropical, are significantly underperforming their SSS growth potential).

In summary, given (1) the significant levers for upside and the attractive LBO returns and (2) the unique event-process at the Company for the last two months (the activist filing, the abrupt departure of the current CEO and COO, the lack of current CEO and the company’s announcement of a strategic review), it is very likely that FRGI will be taken private in the next three to six months. In the event that the company does not follow this path, we believe any combination of the above balance sheet and operational restructuring will be accretive to share price and that, at less than 7x LTM EBITDA for concepts that have consistently grown at mid-single digits SSS historically (with Fiesta lapsing oil price collapse in 2H-15, SSS should recover based on macros alone), there exists little downside at today’s prices and much upside.

Catalyst

Sale of Company, Improved Operational Execution and/or Improved Capital Structure