Engaged Capital might have the recipe to build value for shareholders at Portillo’s

Business: Portillo’s owns and operates fast casual restaurants in the United States. The company offers Chicago-style hot dogs and sausages, Italian beef sandwiches, char-grilled burgers, chopped salads, crinkle-cut fries and chocolate cake shakes. Portillo’s also offers its products through its website, application and certain third-party platforms.

Stock Market Value: $901M ($12.27 per share)

Percentage Ownership:  9.90%

Average Cost: $11.50

Activist Commentary: Engaged Capital was founded by Glenn Welling, a former principal and managing director at Relational Investors. Engaged is an experienced and successful small cap investor and makes investments with a two-to-five-year investment horizon. Its style is holding managements and boards accountable behind closed doors.

Engaged announced that they have communicated with Portillo’s regarding potential steps to improve the company’s business, including by optimizing restaurant performance, improving restaurant-level cash-on cash-returns, enhancing corporate governance through potential changes to the composition of the board, and exploring a sale of the company.

Portillo’s is an iconic midwestern fast casual chain founded more than 60 years ago. It has a differentiated menu anchored by Italian beef sandwiches, hot dogs and milkshakes. The company was acquired by private equity firm Berkshire Partners in 2014 from the founder for approximately $1 billion. Berkshire took it public in October 2021 at $20 per share, and the stock soared to $54.22 per share about a month later. Since then, Berkshire has been selling its position down from 66% to 19% while the stock has declined back below its IPO price. Portillo’s Chicago locations are still among the most productive fast casual restaurants in the industry doing $11 million average unit volume (AUV) and 30% restaurant margins. The non-Chicago locations have achieved AUVs of $6 million to $7 million, more than double quick service restaurants and fast casual industry averages.

While Portillo’s has much larger AUV than its peers, the company has an even larger average footprint than peers. While management has been decreasing store size, stores are still 1.5 to 3 times larger than peers. But store size is only one of the problems. This issue is exacerbated by the company’s practice of owning its buildings despite leasing the land it is on. In a business where cash-on-cash returns are paramount, this structure does not make a lot of sense. In addition to costing more to build stores ($6 million to $7 million, which is two to three times higher than peers), these large footprints have driven inefficiencies across labor, maintenance and various other expenses inside the restaurant. Additionally, management has been slow to implement traffic-driving mechanisms, such as loyalty programs and ordering kiosks, both of which have proven successful for competitors. Finally, while customers rate the food and the brand very high, brand awareness is not as strong as it could be, likely in part due to the low marketing budget: 1% of revenue compared to 2% to 3% for growth peers.

The good news is that all these issues make for a lot of opportunity – and many value improvements are already underway. Management has announced a new “Restaurant of the Future” design opening in the fourth quarter that reduces square footage to 6,300 square feet (from 10,000 square feet) and lowers build costs to approximately $5.2 million (from $6 million to $7 million). This is a good indication that they are acknowledging the problem and taking a step in the right direction, but this is a fraction of what can be done to optimize capital allocation. Additionally, management has begun investing in technology and testing small kiosks to drive same-store sales growth, renewing operational focus on drive thru and reducing wait times. The company is also undertaking a big advertising initiative in Chicago to coincide with the beginning of the NFL season. These are great steps, but the pace of these initiatives has been too slow.

Engaged thinks that by being an active shareholder and bringing on a new chief operating officer at Portillo’s, the improvements at the company can be expedited and optimized leading to the expansion of this beloved regional chain to a national brand. Currently, Portillo’s trades at 10-times forward earnings before interest, taxes, depreciation and amortization. That’s a significant discount to other much more established, known and national QSRs, such as Shake Shack (24-times) and Chipotle (27-times). Closing this gap will take significant capital allocation improvements, technology initiatives, marketing plans, real estate restructurings and operational advancements. Engaged is supportive of management and expects they will recruit a strong operator into the presently vacant COO role. Engaged has a lot of experience in this industry and may be right, but we see this as heavy lifting for an activist campaign – more so than usual. We think it will take more than just a new COO, but directors with financial, marketing, technology and real estate experience. Engaged itself has a strong track record in this sector and has had board seats at Del Frisco’s and Jamba, in addition to settling for an independent board seat at Shake Shack. We expect the firm to look for a board seat at Portillo’s, and the company could certainly benefit from the experience and institutional perspective Engaged brings to the table.

Finally, if management cannot create shareholder value through these operational enhancements, there may be a strategic play. Berkshire Partners’ has taken this company out of the stone age into the 20th century. Now, someone needs to take the baton and bring it into the 21st century and the future. This could be another private equity firm or a strategic investor with the infrastructure and team to quickly expand Portillo’s into a national brand.

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments.