Description

Idea:  Short Fiesta Restaurant Group (FRGI) 

We believe Fiesta Restaurant Group (FRGI) is a compelling short opportunity at today’s levels.  Our investment thesis is simple and rests on one key tenet:  FRGI’s Pollo Tropical concept will not succeed in growing outside of the state of Florida.  The company’s current rich valuation prices in significant profitable expansion of the concept that we believe will prove unattainable.  There is significant risk to the stock if our assumption is correct. 

Background:

FRGI owns and operates two fast casual restaurant concepts:  1. Pollo Tropical which is a Caribbean themed fast casual concept that has thrived in Florida, but had limited success outside of the state historically  2.  Taco Cabana which is an “authentic Mexican” concept primarily based in Texas.  

At year-end FRGI operated 316 restaurants (267 company owned, 49 franchised)

• Pollo Tropical (102 company-owned, 41 franchised)
• Taco Cabana (165 company-owned, 8 franchised) 

FRGI spun off from Carroll’s Restaurant Group in the spring of 2012.  Since the spin FRGI’s stock has appreciated from $12 to $48 per share today.  At the time of the spin, Tim Taft was named as CEO.

History of Failed Pollo Tropical Expansion in non-Florida Markets:

The company’s current business plan is focused on growing Pollo Tropical units in new markets while running Taco Cabana at its current unit levels.  Pollo Tropical has been in existence for over 25 years (founded in 1988).  Its current footprint includes 95 company-owned restaurants in Florida (1 opened in 2013 in Jacksonville to much success), 5 company-owned restaurants in Georgia, and 2 in Tennessee (1 opened in 2013).  The company also has 38 franchises internationally which include 18 in Puerto Rico; 3 each in Venezuela, Panama and Costa Rica; 2 in both Honduras and Trinidad and finally one each in the Bahamas, Dominican Republic, Ecuador, and India.  We believe investors are too optimistic about Pollo Tropical’s growth trajectory and it will prove challenging outside of Florida.  Pollo Tropical opened more restaurants (12 units) in 2013 than any time in their history.  The company has guided investors to 20-22 Pollo Tropical openings in 2014.  The openings in 2014 are expected to be focused on backfilling areas in Florida along with openings in Georgia, Tennessee, and Texas. Investors have responded to the growth prospects positively as the stock has re-rated higher.  We note that Pollo Tropical has attempted and failed to grow in the markets they are projected to grow in 2014 and beyond.  Management projects in its investor presentation that Pollo Tropical can succeed in any market Chipotle resides.  

We believe another underappreciated aspect of the Pollo Tropical story is its limited success in growing units in markets outside its core Florida /Caribbean market in the past. If past failures are anywhere indicative of future results, Pollo Tropical’s success in new markets is at the risk of falling well short of investor expectations. For perspective, Pollo Tropical opened up several restaurants in the Atlanta market in the mid-90’s which were closed by 1996. It also attempted to expand into the northeast around 5 years ago with five new units in New Jersey and New York, but eventually closed the locations as the Caribbean concept failed to gain traction. El Pollo Loco, a competitor to Pollo Tropical, closed most of its units in the northeast in 2010 after poor results. Ed Doherty, CEO of Doherty Enterprises, who operates many El Pollo franchises, admitted, “That style of Mexican grilled chicken is very, very regional.”  We believe FRGI is underestimating how regional Pollo Tropical’s popularity will be. 

Pollo Tropical is a niche fast casual concept that is primarily skewed toward the Hispanic demographic base which we believe limits the upside of broad universal appeal that restaurants like Chipotle enjoy. Also, the quality of food is materially lower than the likes of Chipotle. After many restaurants visits (our team is based in Florida) as part of our due diligence process, we believe the Pollo Tropical dining experience is well below average and not even comparable to some of the highest quality quick serve restaurants. In addition, we found little evidence in our due diligence that Pollo Tropical has broadened its customer base very much outside the core Hispanic consumer despite managements pitch to shareholders that the Pollo Tropical concept has expanded well outside its core demographic market. 

In addition, Pollo Tropical has a mixed same stores sales history. Comparable store sales have ranged from +10% to -4% over the past 10 years. During the 2005 to 2008 period, comparable store sales increased an average of +2%. Comparable store sales benefited meaningfully after 2009 due to an improved macro environment, easy comparisons, and the recovery of the housing market in Florida. However, comparable store sales have been decelerating over the past few years as the magnitude of some of these benefits fade.

 Table 1: Pollo Tropical Same Store Sales   

Management Has Limited Experience Growing Restaurant Concepts:

FRGI’s CEO, Tim Taft, has been in the restaurant industry for 30-plus years. He has served in high level executive roles for both Whataburger and Souper Salad, along with Pizza Inn. Taft served as CEO of Pizza In, a 300 plus unit international chain, from 2005 to 2008. During his time as CEO, he was able to restructure the business and reverse six years of declining same store sales.  Prior to Pizza Inn, Taft spent more than a decade at Whataburger which had around 650 stores. He spent five years as President and COO. After his stints at Whataburger and Pizza Inn, Taft was named as the CEO of Souper Salad in 2008. Taft resided at the helm for 2 years. A little over a year after Taft’s departure, Souper Salad and Grandy’s restaurants chains (owned by SSI Group Holdings) filed for bankruptcy in 2011. We believe investors are overly enthusiastic about Taft’s abilities, which have largely been focused on stabilizing companies, not growing restaurant concepts at double digit unit growth. Taft is undertaking a massive growth strategy that is hinged on growing Pollo Tropical stores at an unprecedented rate.  Pollo Tropical’s company-owned units increased moderately from 2002 to 2007, but then stalled during 2008 to 2012. Taft and team now plan to open around 20-22 (+20% y/y) new units in 2014 – a staggering pace relative to the past several years and introduces significant execution risk. We question the management team’s ability to take a 25 year restaurant concept with limited success outside its core markets and transform the concept into a double-digit unit growth story.

Table 2: Pollo Tropical Units (Company owned) 

Stock Priced for Perfection:

FRGI’s valuation has decoupled from reality. We believe FRGI’s overvaluation is significant. The fast casual restaurant space has seen multiples re-rate meaningfully higher over the last twelve months and FRGI is no exception. FRGI shares currently trade at 58x 2013 and 37x 2014 estimated earnings. We believe that shares fully discount FRGI executing on its robust unit growth expansion in new non-Florida markets. 

Table 3: FRGI and peer valuation

Jefferies Capital, an investor in FRGI before and after the company was spun-off, indicated their “optimism” on the company’s future outlook when it sold 3.3mn shares in March of 2013 at around $23. Jefferies Capital proceeded to sell down their stake by another 3mn shares by June of 2013. Jefferies Group has now fully exited its position as of yearend 2013 after owning 6.5mn shares at the beginning of 2013. 

The FRGI bull case rests on significant unit expansion of the Pollo Tropical franchise which is operating in the fast growing fast casual restaurant space. The bulls point to 8%-10% unit growth coupled with 2%-3% same store sales driving 10% plus sales growth and 20% plus earnings growth looking forward. As we stated above, we believe this scenario is highly unlikely and share discount the bull thesis already.

Conclusion:

We are skeptical Pollo Tropical can achieve the robust growth management targets.  We believe shares currently are an attractive short opportunity. 

Risks to thesis:

• Pollo Tropical is successful in new markets outside of Florida
• Pollo Tropical grows into its valuation

Catalyst