Description

This is a small fund or PA idea, due to the stock's low liquidity

Please note, throughout this writeup we will refer to profitability and cash flow figures that represent true economic reality. Our metrics will not square with IFRS 16-reported financials. All references to profitability, cash flow, and unit economics will treat leases as God intended them to be treated – as an operating cost.

Summary: 

Tortilla is a capital-light, high-quality restaurant chain with a multi-year (self-funding) reinvestment runway trading at a single-digit cash flow multiple. While others suffered, COVID dramatically improved Tortilla’s competitive positioning and opened up a significant inventory of cheap real estate. New restaurants generate nearly 40% returns on capital and the company has never closed a location. 

Business Overview:

Tortilla Mexican Grill (MEX.LN) is the largest fast casual Mexican restaurant chain in the United Kingdom. Modeled on the traditional tex-mex fare of the U.S., the company was founded by California residents Brandon and Jen Stephens as part of a business school project. Brandon attended school in London and bemoaned the lack of decent Mexican options. Tortilla officially launched in 2007 and the concept quickly took off. Today, the company has 70 locations – 57 company-operated locations in the UK (incl. 5 cloud kitchens), 10 franchised sites in the Middle East, and 3 franchised UK sites, including 2 in transit settings (Euston and Gatwick) through a partnership with SSP. A full-sized company-operated restaurant averages roughly 1,500 square feet, while cloud kitchens average 200 square feet. Tortilla has never closed a location. 

Tortilla offers a limited menu, consisting of customizable burritos, tacos, nachos, and quesadillas, as well as chips and drinks (incl. beers/ciders and margaritas) in a traditional fast casual format, with customers ordering on a production line at the front of store. The company prioritizes sustainability and high-quality ingredients, sourcing higher welfare and UK-based chicken and pork, as well as grass-fed beef sourced from the British Isles. Major ingredients like meat fillings and beans are prepared off-site at a 5,500 square foot centralized production unit (CPU) located in Tottenham Hale, that serves all UK-based locations. Certain other toppings, including guacamole, are prepared on-site at each individual restaurant. The central kitchen enables consistency in flavor and quality throughout the estate, lowers food costs, and lowers per-restaurant staffing and capex requirements since their restaurants do not require significant kitchen equipment.

Key to the company’s success is a simple supply chain structure with fewer than 40 ingredients, most of which are standardized. Should the need arise, all of the ingredients could be purchased from a number of suppliers, but currently Tortilla gets all of its regular supplies (food, packaging, drinks, etc.) from four companies.

Fresh Direct UK, a subsidiary of Sysco, supplies fresh foods to the central kitchen and provides storage and shipment of finished ingredients directly to Tortilla’s restaurants. Store managers can order fresh produce directly through Fresh Direct’s online platform.

Tortilla benefits from a handful of tailwinds in the restaurant industry:

• Convenience
  • Tortilla’s fast casual production line format as well as takeout and delivery options ensure convenience
• Customization
  • All main dishes are fully customizable
• Value
  • Tortilla’s scale and CPU allow it to offer lower prices, while still generating superior unit economics. Main dishes are 15-to-20% cheaper across both in-store and delivery formats vs. its major competitors.
• Quality & Freshness
  • Tortilla’s ingredients contain no artificial flavors or additives
  • Management looks to source higher welfare animals
  • Food prepared fresh either at the CPU or on-site and quickly consumed
• Growing popularity of Mexican food
  • For the five years leading up to COVID, the UK foodservice market grew at a sub-2% annualized rate vs. 3.5% for limited service. However, Latin American cuisine was a share gainer, growing 6.5%, annualized, during the same time frame.

While industry trends favor Tortilla’s business model,  the brand stands on its own in terms of quality and consumer perception. The company has won several awards from Zagat and The Observer for food quality. It has also ranked in the top 50 of the “Most Loved Eating Out Brands” amongst all dining formats for the past three years per Savanta, a leading market research firm in the UK. Within the fast casual category, Tortilla ranked in the top 10 and well ahead of every direct competitor in the Mexican category. Using Google Ratings data, we were able to unscientifically replicate Tortilla’s rankings,  which clearly places Tortilla above all of its competitors.

While still in its infancy, relative to other scaled UK restaurants like Greggs and Nando’s, Tortilla has several hallmarks that indicate longevity. Nearly 75% of Tortilla’s customers are under the age of 35 and the chain experiences significant repeat customer traffic. According to a study conducted in May 2021 by Ann Elliott Consultancy, 71% of Tortilla patrons are repeat customers.

Tortilla holds roughly a 25% share of the fast-growing but nascent and highly-fragmented UK “Latin Limited Service” market. By location count, Tortilla is 4x the size of its next-largest competitor, Barburrito. Latin Limited Service is roughly 1% of the total UK limited service market.  By comparison, Mexican restaurants account for 10% of restaurants (by location count) and sales, respectively, in the United States.  The UK market is earlier in its adoption of Mexican food, but we foresee UK market share eventually converging with the US. According to a restaurant consultant we spoke with, when Tortilla and its competitors opened in the mid-to-late 2000s, a lot of the marketing and advertising was purely educational. Restaurants had to explain to the UK consumer the concept of a burrito, for example. We are now past the education phase. COVID was a boon to Tortilla and other chains that could remain open. Mexican food travels better and is more suited to a takeaway and delivery environment. We think the gains that Tortilla made during COVID will stick. Several people have confirmed that even after lockdowns were lifted, delivery and takeaway sales for Tortilla have remained well above pre-COVID levels, having seemingly set a permanently higher base level of sales. 

Financial Highlights:

While Tortilla has meaningfully outperformed the restaurant industry since COVID started more importantly, Tortilla has continued this outperformance when lockdowns were lifted. The concept is not a mere COVID beneficiary, but a leading chain with staying power.

Source: Company filings & Liberum

Notably, in the back-half of 2021, like-for-like sales accelerated to ~27% growth vs. 2019, whereas Coffer Peach reported monthly restaurant industry sales up 1.5%, on average, over the same time frame. Coffer tracks sales for most of the leading UK restaurant chains, including Nando’s, Wagamama, YO! Sushi, and Pizza Express. 

Source: Company filings & Companies House

Ownership & Management:

Founder Brandon Stephens remains on the board and is a significant shareholder. He stepped aside from CEO duties in 2015, handing the reins over to Richard Morris. Richard Morris is an industry veteran in the UK who has had extensive operating experience with restaurant chains like TGI Friday’s and the Rainforest Café. His longest place of employment, other than Tortilla, was as an MD and the Director of Operations of Loch Fyne Restaurants, a chain of casual dining seafood restaurants. Morris was part of the team that executed a management buyout of the business in 1998 for 150,000 GBP. At the time Loch Fyne Restaurants had two locations. Loch Fyne Oyster Bar, the original seller, eventually invested 3.5 million into the concept. Armed with capital, Morris and his team built LFR from 2 to 39 locations before being bought out by Greene King PLC in August 2008. From 1998 to 2006 (last available full year financials before the buyout), revenue grew at a 62% compound annual rate to 29 million GBP and EBITDA swung from negative 100,000 to positive 3.7 million GBP. Greene King bought the concept for 68 million GBP, netting original equity investors a 17x return on investment – a 33% annual compound rate of return.

We consider Morris highly competent and an aggressive competitor. He has been characterized to us as being an “exacting” boss that stresses details and execution.

Other Executive Management:

• Andy Naylor, CFO

o Former: Deloitte, Gaucho Restaurants

• Jason Thomas, COO

o Former: Shake Shack UK, Whitbread

• Megan Burton-Brown, Head of Marketing

o Former: University of Waikato, J. Walter Thompson

• Rob Lucy, Property Director

o Former: Mitchells & Butlers, LPC Property Consultancy

• Matt Chapman, Operations Director

o Former: Maison Blanc, Patisserie Holdings, Krispy Kreme UK

Competition:

Competition is hardly worth mentioning because Tortilla is superior on every front. We acknowledge the seeming arrogance of that statement, however, we encourage you to visit https://www.gov.uk/government/organisations/companies-house and see for yourself.

Tortilla stands on its own amongst limited-service Mexican restaurants, 4x the size of the #2 player in the space and opening more locations in a single year than most competitors have in total locations. During COVID, every meaningful competitor – Barburrito, Chilango, El Mexicana, Benito’s Hat – went into administration, entered a CVA, or closed a material amount of locations. Even pre-COVID, peers were in notably worse financial shape than Tortilla. Barburrito, the #2 player by locations, was barely EBITDA positive (1% margin for YE2019 ending March 31) and consistently burned cash. The company ultimately went into administration and was sold to a group of private investors in December 2020. Barburrito hasn’t opened a single location since the start of COVID, vs. >10 for Tortilla. Even non-Mexican concepts ran into trouble. Nando’s and Pret A Manger closed 10% and 17% of their respective UK footprints during COVID. Smaller indirect competitors like Itsu and Yo! Sushi entered CVAs, with the latter closing 20 of its 71 locations.

Chipotle is worth addressing given that they are the most obvious future threat to Tortilla’s business, with a large balance sheet and similar style concept. Currently, Chipotle operates ten locations in the UK and management has expressed optimism in the business. However, to date, the company has exhibited poor performance in the market. Unlike its U.S. operations, Chipotle UK has a bloated cost structure, attributable to poor real estate selection. This has led to inflated capex costs, higher rents, and higher labor expenses. Accordingly, Chipotle’s lease and labor expenses (as a % of sales) are roughly 50% higher than the peer average. This has forced Chipotle to charge higher prices than Tortilla, leading to a worse value-for-money proposition. Still, even with higher prices, Chipotle’s UK operations are wildly unprofitable. EBITDA margins in 2018 and 2019 were (35%) and (36%), respectively. The operation is burning significant cash, financed by intercompany loans from the parent. When Tortilla was a similar size to Chipotle UK, it was generating positive 7% EBITDA margins and burned less than 1mm per year including the build out capex for new locations. Of course, all of these issues are fixable under the right management team and with significant time and capital spent. Needless to say, the division likely requires total restructuring, including the renegotiation or cancelation of leases and significant store closures. In light of these facts, we find it unlikely that Chipotle poses a credible threat to Tortilla’s progress for the foreseeable future.

Location Growth:

Tortilla’s history of new location openings is measured, with an emphasis on profitability and cash flow generation. Since 2011, Tortilla has averaged four openings per year, with a notable slowdown in 2017 and 2018. Management intentionally slowed new openings because of an overheated real estate market. Since COVID, commercial real estate has become much more plentiful and at lower prices. Retail vacancy in the UK is at a post-GFC highs (averaging roughly 15%, depending on the region) and rents have come down across the board. 

Source: Cushman & Wakefield

With the company emerging from COVID in a position of strength, having made significant investments in corporate overhead and with several million in IPO proceeds, coupled with competitors in a weakened state, and real estate at favorable rates, Tortilla is in prime position to accelerate its opening cadence. Management has laid out plans to open 45 UK-based locations in the next five years. This is well below estimates from a Deloitte survey the company performed that indicated the potential for an additional 120+ locations in the UK. Based on our conversations with industry insiders, we think the path to 45 additional locations is a credible, if not conservative target. This would put Tortilla at 110 locations, globally, exiting 2026. Based on management commentary, we assume the additional 45 locations are split primarily weighted towards full-sized company-operated locations (averaging 5 net openings per year), with 1 cloud kitchen opening a year, and 3-4 franchise openings per year.

To say that UK property owners are clamoring for commercial tenants would be an understatement. Landlords are providing significant rent reductions and, in some cases, are contributing to Tortilla’s build-out costs. In Exeter, the landlord provided a 20% rent reduction and half of Tortilla’s up-front capex. In Edinburgh, rent was reduced by 25% and the landlord paid for half of Tortilla’s capex. And in Bath, Tortilla was afforded a 10% rent reduction, 6 months rent free, and 6 months’ worth of capital contributions.

There are additional opportunities for new business via franchising, retail products, and expansion into mainland Europe but, in an effort to be conservative, we exclude this from our analysis.  

Macro:

It is worth highlighting the macro backdrop briefly, given heightened concerns around labor and input costs (primarily ingredients).

In the five years leading up to the pandemic, Tortilla’s store-level staffing costs (incl. taxes and national insurance scheme contributions) grew approximately 2%/year. 

Currently, average weekly earnings inflation, per the Office of National Statistics, is tracking at a 4%, above the 20-year average, but well within the normal range. Per management, Tortilla is not having issues attracting staff (mostly University students) and per-store wage inflation is not extraordinarily high. We model in 250,000 in store-level staffing costs per location and assume those costs grow at 5% per year.

Similar to the wage issue, food costs are slightly above average but well within the normal range. Tortilla is in a much stronger position vs. competitors regarding rising food costs, given its scale enabled by its CPU and location count, along with a simple menu with minimal ingredients. We model an 80% gross margin.

Unit economics:

Most locations are full-sized company-operated formats and management has indicated that most near-term openings will follow this format. For our valuation exercise, we model out detailed cash flow assumptions for full-sized locations (80% of cash flow and 60% of new restaurants) and make rudimentary earnings estimates for cloud kitchens and franchises, which are added together to create our cash flow estimates. 

Tortilla operates a capital-light model, relative to other restaurant and pub concepts, with low build costs and maintenance capex requirements less than 5% of mature store sales. A company-operated full-sized location takes six-to-nine months to open from site identification, lease, permitting, building, and training, incurring roughly 60,000 GBP in pre-opening costs in the process. Sites cost 350,000-to-425,000 to build and outfit with seating, prep stations, signage, and reheating/warming equipment. Significant grill stations are not required, due to the presence of the CPU. We estimate build costs of 400,000 GBP per location. Upon opening, most locations reach breakeven within four-to-six weeks and reach maturity within a year. Pre-COVID, locations took two years to reach maturity. Management has noted meaningful acceleration in that trend since COVID started, which has not let up, even with the economy reopening. Conservatively we assume two years to reach maturity and, excluding build-out capex, estimate 70,000 in tax-effected cash burn, including pre-opening costs, before locations become profitable. At maturity, locations generate 1mm in annualized revenue, low-20s EBITDA margins and high teens EBIT margins.

We estimate roughly 150,000 in free cash flow per location at maturity, or a 15% margin. Our free cash flow calculation is frequently referred to as ‘owner earnings’. Taxed EBIT, plus depreciation, less maintenance capex. This figure implies a 38% return on the company’s build-out costs. Using these assumptions, it takes about 3.5 years to fully recoup a location’s capex, pre-opening costs, and initial cash burn.

Moving beyond year two, we assume the following for store-level growth:

·         AUV: +5%/year

·         Cost of goods: 80% of sales

·         Staff costs: +5%/year

·         Lease costs: +2%/year

·         Occupancy & other: 22% of sales in year two, declining 20 bps/year thereafter

·         Maintenance capex: 4% of sales

We sanity checked these figures against reported financial results from when Tortilla was a private company. We use EBIT less one-time items, corporate salaries, director fees, audit fees, and other corporate overhead (our estimate) to arrive at a store-level EBIT figure and then divide it by average tangible capital. The decline from 2013 through 2017 is the result of a higher mix of immature locations. From the end of 2013 to the end of 2017, Tortilla increased its store count by 2.7x. We believe that 2013 and 2018 are the best example years of the company’s steady-state ROTC potential. Tortilla only opened two stores in 2013 and one in 2018, limiting the mix of immature stores in our calculation. These figures provide credibility to our estimates surrounding store-level economics.

Source: Company filings & Companies House

Cloud kitchens cost less than 50,000 GBP to build and are currently generating profitability similar to a full-size location, averaging 200,000 per year. Management believes this is a byproduct of COVID and expects this number to come down closer to 100,000. Still, that figure represents an astounding 200% return on invested capital (assuming 50,000 build cost).

Franchise partners pay 3-to-4% royalty on sales to Tortilla. For simplicity, we assume 35,000 in annual royalties per franchised site at 90% contribution margin.

Estimating Earnings Power:

We model out earnings power by breaking down the business into its three main segments. Note, Tortilla is in a net cash position, and we assume they can self-fund the rollout of their stores. Thus, we make no assumptions for debt and interest expense.

1.    Full-sized company-operated restaurants

a.    47 locations exiting 2021

b.    71 locations exiting 2026

c.    Earnings metric: Detailed owner earnings build broken down by location cohorts. Fully taxed and we allocate all corporate overhead into this segment, given that it’s the largest revenue and earnings generator by a significant margin.

2.    Cloud kitchens

a.    5 locations exiting 2021

b.    10 locations exiting 2026

c.    Earnings metric: Taxed operating income, broken down by mature and immature stores. Assumes 1 year for cloud kitchens to reach maturity.

3.    Franchised sites

a.    13 locations exiting 2021

b.    29 locations exiting 2026

c.    Earnings metric: Taxed operating income

Consolidated cash flow:

We estimate that consolidated owner earnings (essentially the earnings power of the business) will grow 24% per year for the next five years, to 9.5 million GBP. This rate of growth is just above Tortilla’s pre-COVID growth rate, commensurate with higher-than-historic restaurant openings in 2022. We will use our 2024 estimate in our valuation exercise.

We think there is a fair amount of conservatism build into these estimates. (1.) We are not assuming significant operating leverage. Our owner earnings assumptions basically match Tortilla’s pre-COVID cash flow margins. (2.) Our store-level sales growth estimates are slightly below trend. We assume 5% growth in AUVs vs. greater than 6% LFL sales growth historically and higher levels recently. (3.) Our staffing cost inflation assumptions are significantly higher than Tortilla’s historic rate of labor inflation (5% est. vs. 2% historic). For clarity’s sake, moving our sales and wage growth assumptions in line with recent history improves our 2026 owner earnings number 27%, to 12.1 million, and increases the 5-year CAGR to 31%.

Full-sized Company-operated Restaurants:

Utilizing store-level profitability assumptions laid out in the ‘Unit Economics’ segment above and modeling out locations by age cohorts, we estimate company-operated revenue and owner earnings of 68.1mm and 5.9mm GBP, respectively in 2024. As a sanity check, the implied margin is consistent with Tortilla’s cash flow from operations margin in the five years leading up to COVID.

 After growth capex of 1.7mm, we get to 4.2mm in free cash flow.

Cloud Kitchens:

Our cloud kitchen estimates assume 75,000 in mature location profitability, below management’s guide.

Franchised System:

Valuation:

Valuing Tortilla is quite difficult because there is no good direct competitor in the United Kingdom. The one sell-side firm on Tortilla makes an attempt to value the stock but they utilize a lot of poor-quality comps that either exhibit no growth with limited reinvestment opportunities, are over-levered, capital intensive, low margin, or they are completely different business models. The culprits…

·         City Pub Group

·         Fuller, Smith & Turner

·         Loungers

·         Marston’s

·         Mitchells & Butlers

·         JD Wetherspoon

·         Young & Co.’s Brewery

·         BJ’s Restaurants

·         Bloomin’ Brands

·         Cheesecake Factory

·         Red Robin Gourmet Burgers

·         Just Eat Takeaway

·         Delivery Hero

·         Hellofresh

·         Goodfood Market

·         Blue Apron Holdings (no, we’re not joking)

However, the analyst does lay out several companies that we would consider good comparisons because they operate similar business models and exhibit lower capital intensity than a pub or full-service restaurant. We believe the “bad comps” were likely included in their valuation exercise in an effort to depress the multiple to come up with a more “reasonable” price target. This allows them to slap on the stalwart 20% NTM upside target. Tortilla’s true “comps” value the business at a substantially higher price than what both the market and sell-side firm are currently showing.

The Good Comps:

·         Domino’s Pizza Group PLC

·         Greggs

·         Chipotle Mexican Grill

·         Yum! Brands

Excluding the COVID period (we use 3/2020-9/2021), our comp set trades for approximately 20x cash flow from operations. Applying this multiple to our 2024 owner earnings estimate gives us a 377p stock price vs. 175p currently. 

Utilizing EBITDA as our valuation metric yields higher upside. We use the same methodology from above (10-year multiple excluding COVID) to arrive at a peer group multiple of 15x. We’d be very pleased if the market valued Tortilla in this manner, though we are not foolish enough to delude ourselves into thinking that the market will overlook the very real costs not included in our EBITDA, namely, large depreciation expenses as the concept accelerates openings. Note, our 2024 EBITDA estimate is 2x that of our 2024 owner earnings/cash flow figure.

We also use the growing perpetuity formula utilizing our 2026 owner earnings estimate to arrive at a similar CAGR on the stock.

While the stock provides ample opportunity for a significant return with the business expanding solely within the UK, if Tortilla can profitably grow outside of its home market, one can make many multiples on this investment.

For illustrative purposes, assuming that Tortilla can one day reach 500 locations across Europe and generate owner earnings of 150,000 GBP per location, the company would produce somewhere around 50 million GBP in cash flow after operating overhead. On a stock price with a current enterprise value of 65 million GBP that is quite an attractive value proposition. A 15x multiple on 50mm in cash flow yields a 750mm valuation, or an 11x on the current stock price. Assuming this illustrative example takes ten years to unfold, that would equate to a 27% annual rate of return on the stock.

Risks:

Aside from the standard execution risks and the necessity of attractive real estate for new locations, we see two material near-term risks to the story:

1.    There is a perception that Tortilla is a subpar business that got a one-time bump in business from COVID. Based on sales performance in periods where lockdowns were lifted, we think this concern is invalid. The Mexican category in the UK is a secular grower that should continue to take share for the foreseeable future.

2.    Tortilla was a beneficiary of significant government assistance in the form of grants and VAT relief – we estimate about 3 million GBP in after-tax earnings contribution. Investors erroneously extrapolating near-term profitability into the future will be disappointed. The valuation of the stock leads us to believe that this is not the case, however, it is not guaranteed, and we will not know the answer for several quarters.

Less material company-specific risks include the presence of large inside holders, including Quilvest, an early private equity backer. Quilvest is the largest shareholder, holding roughly 20% of the stock. Should they decide to liquidate the position in an unceremonious manner, that may create an overhang on the stock. Similarly, the shareholder registry is full of early backers from Stephens’ days in business school whose selling could adversely impact the stock.

Catalyst

• First annual report with improved disclosures coming out in April
• Continued restaurant openings
• The next few earnings reports and sales updates will be a really strong indication of Tortilla's steady-state operating ability post-COVID