Description

Investment summary

Broken restaurant growth story trading at 6.5x run-rate EBITDA (pro-forma for recent portfolio / cost actions) with a strong regional brand (Pollo Tropical) and a nearly debt-free balance sheet.  New CEO, Richard Stockinger (installed in February) recently launched a turnaround strategy after FRGI suffered a year of accelerating comp weakness driven by prior management’s decision to expand rapidly into unproven new markets.  Growing activist involvement from a consortium of restaurant investors (represented by JCP group) who collectively own 8% of the company creates additional complexity, and a proxy fight is currently underway, with a vote coming on June 7th.

While a seemingly messy situation on the surface, we find enormous risk asymmetry in the underlying assets.  Our variant view is based on the belief that FRGI’s core South Florida Pollo Tropical store base (86 locations, or 25% of total FRGI locations) is worth nearly the entire $680m enterprise value.  That implies FRGI’s remaining 94 non-South Florida Pollo Tropical locations + 167 Taco Cabana locations (TX-based fast-casual Mexican concept) are worth $0 (i.e. a free option).  FRGI’s remaining Pollo stores are profitable and Taco Cabana is a mature, non-growth concept that has averaged $55m in restaurant-level EBITDA annually the last 4 years.  We see another free option in the untapped value in FRGI’s unlevered balance sheet (currently 0.8x ND/TTM EBITDA), and believe a change in capital allocation strategy would be accretive to equity holders.  Base case PT of $31 (35% upside), with Bull case of $37 (57% upside) and Bear case of $27 (15% upside).

Pollo Tropical South Florida valuation

Our S FL Pollo valuation analysis is below.  There has been enough disclosure over the years to suggest our assumptions are very close to actuals.  We have checked our “normalized” assumptions and math in a variety of ways and feel we may be conservative on both AUV and margins.  Nonetheless, the math suggests Pollo’s S FL core store base does roughly $260m in revenue and $70m in restaurant-level EBITDA.  At 9x restaurant EBITDA (fair multiple for a branded, slow-growing entrenched concept with a 28yr history of success), this group of restaurants is worth almost 90% of current EV.  The company allocates $25m of corp OH to the entire Pollo segment in its reporting (which equates to roughly $146k/box in 2016), which we think grossly-overstates the actual OH requirement to run these businesses and thus, we are using restaurant-level EBITDA for the math.

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The Rest of Pollo Tropical (PT) and Taco Cabana (TC)

FRGI has 180 PT locations as of Q117, with 94 located in the non-S FL core market.  The company has tried and failed to grow the business into new markets and new box productivity (and now comps) have suffered greatly.  Of the 75 new PT restaurants opened in the last 3 years, 50 were opened in non-core markets.  Average AUVs at PT have fallen from $2.7m/box to $2.3m since 2013.  The new AUV profile is even worse, with productivity dropping from $2.4m/box (2013) to $1.6m/box (2016).  FRGI spent $194m in new restaurant development capex to open these boxes.

New CEO Rich Stockinger (installed in February) has reset priorities and will be closing 30 non-core PT locations and focusing on reviving the business in the mature store base.  The total sales contribution from the closed boxes in 2016 was $27m (implies avg AUV/box of $900K) and the EBITDA drag was ($15m) or ($487k)/box.  Shedding these materially-negative productivity stores is clearly the right decision in our view and we think there’s significant opportunity for incremental cost out efforts as the company focuses on its core store base.

FRGI’s Taco Cabana (TC) concept was started 38 years ago in San Antonio and currently serves fast-casual / QSR Mexican food through its 167 domestic locations (nearly all in TX).  TC is a mature concept as well (flat unit growth) in a competitive Mexican QSR space, but still maintains solid per-box metrics ($1.9m AUVs and 19% restaurant-level EBITDA margins) and the store base generated $309m of sales, $58m of restaurant-level EBITDA and $38m of total EBITDA in 2016.  This business is not worth zero.

Balance sheet and cash flow

As of Q117, FRGI held $67m in net debt (0.8x TTM EBITDA).  They paid $37m in rent in 2016, which will be coming down in 2017+ as the closed PT boxes had some of the highest rent/sqft.  Reported adj ND / EBITDA in Q117 was 4.0x, but on a pro-forma basis (closing boxes and eliminating $15m EBITDA drag), we think rent-adj net leverage will be closer to 2.8x.  We believe there is substantial value tied up in an inefficient capital structure, and believe the company is exploring shareholder-friendly options to create value.

FRGI’s reported cash flow metrics look abysmal because they’ve spent everything on trying to grow.  We believe that new restaurant capex has obscured a decent FCF stream for many years (new restaurant development capex has accounted for 80% of total capex spend since 2013).  The maintenance capex requirements to maintain the restaurant base (between remodels, repairs and corp-level capex) is roughly $20m/yr.  FRGI capex was $83m, $88m, and $74m in 2016, 2015, 2014.  This business generates significant FCF in no-growth mode, which lends further weight to our S FL PT valuation and TC value analysis.

Catalysts / Why now?

FRGI has been written up in 2014 (short) and 2016 (long) on VIC, and I encourage readers to review those posts, both which provide helpful incremental detail on the business and history.  Our pitch is more a sum of the parts, but the real question is why now?

We think entry makes sense here for two primary reasons: 1) Recent re-engagement from FRGI’s oldest (and likely most-knowledgeable) shareholder, Leucadia, coupled with recent buying from an investor group (JCP) with a long history of restaurant activism, and 2) a new CEO with highly-relevant recent restaurant turnaround experience.

The Leucadia history dates back to Jefferies Capital (owned by Leucadia) ownership stake in FRGI before and after it was spun off from Carrols Restaurant Group.  Interestingly, Jefferies sold throughout 2013 as the stock rose from the low-20s to over $50/share, and fully-exited the position by year-end (but maintained a Board seat).  The run up in the stock in 2013 was driven primarily by the promise of growth – mainly that the PT concept would work outside of S FL.  FRGI’s multiple expanded rapidly as the company opened new locations, and by the end of 2013, the stock was trading at 38x 2014 EPS.  Notably, Leucadia has not re-engaged as a shareholder until Q117 and they now own 2% of the company (with incremental purchases as recent as 05/17/17).  In addition to Leucadia, a new activist investor group, JCP investment management, began buying shares of FRGI in Q316 and now owns 8% of the company.  JCP is led by James Pappas, who has a long history of running and owning restaurants.  We look forward learning more about JCP’s ideas for FRGI, and we are pleased an investor group and the company has moved past the failed status quo and is looking at ways to unlock value in the near-term.

The second reason we think the timing is right is tied to the new CEO, Richard Stockinger’s, history of success in turning around a similar regional concept, Benihana.  Benihana faced a similar situation as Pollo – a restaurant with strong regional brand presence that began to struggle as they looked to grow units (and the quality in the base business fell).  Stockinger led the turnaround effort which helped drive a comp inflection within 6 months at Benihana, and subsequently drove industry-leading comps and margin improvement for 2 years following the implementation.  We remain encouraged by the store rationalization plan, the cost-out efforts, and the likelihood for an improving comp trajectory in the next 12 months.  â€‹

Valuation & Price Target

Base SOTP math below.  Note: all 3 scenarios assume almost no comp improvement at either concept and no capital structure changes (cash builds on balance sheet).

Catalyst

June 7th shareholder meeting, earnings