Engaged Capital may have the secret to boosting Portillo’s stock price

work: Portillo owns and operates fast-casual restaurants in the United States. The company serves Chicago-style hot dogs and sausages, Italian beef sandwiches, charbroiled burgers, chopped salads, wave cut fries and chocolate cake shakes. Portillo’s also offers its products through its websites, applications and certain third-party platforms.

Stock market value: $901 million ($12.27 per share)

Ownership percentage: 9.90%

Average cost: $11.50

Activist comment: Engaged Capital was founded by Glenn Welling, former president and managing director of Relational Investors. Engaged is an experienced and successful small-cap investor that invests with a two-to-five year investment horizon. The firm’s style is to hold management and boards to account behind closed doors.

Engaged said it has engaged in discussions with Portillo regarding potential steps to improve the company’s business, including optimizing restaurant performance, improving cash-on-cash returns at the restaurant level, strengthening corporate governance by changing the composition of its board of directors and exploring a sale of the company.

Portillo’s is a leading Midwest fast-casual chain founded over 60 years ago. It offers a differentiated menu centered on Italian beef sandwiches, hot dogs, and milkshakes. The company was acquired from its founders in 2014 by private equity firm Berkshire Partners for approximately $1 billion. Berkshire went public in October 2021 at $20 a share, and the stock price soared to $54.22 a share about a month later. Since then, Berkshire has reduced its holding from 66% to 19% and sold, and the stock price is below the IPO price. Portillo’s Chicago stores have achieved an average unit sales (AUV) of $11 million and restaurant margins of 30%, making it one of the most productive fast-casual restaurants in the industry. Stores outside of Chicago have achieved an AUV of $6 million to $7 million, more than double the average for the quick service restaurant and fast-casual industry.

Portillo’s AUV is much larger than its peers, but the company’s average footprint is even larger than its peers. Although management has scaled back store size, its stores are still 1.5 to 3 times larger than its peers. But store size is only part of the problem. This problem is exacerbated by the company’s practice of owning its buildings even though it leases land. In a business where cash-on-cash revenue is paramount, this structure doesn’t make much sense. In addition to the high cost of building stores ($6 million to $7 million, 2 to 3 times that of its peers), these large footprints create inefficiencies across labor, maintenance, and various other expenses within the restaurants. Furthermore, management has been reluctant to implement mechanisms to drive traffic, such as loyalty programs and ordering kiosks, that have proven effective at its competitors. Finally, while customers rate the food and brand very highly, brand recognition is not. This may be due in part to our low marketing budget of 1% of revenue compared to 2% to 3% of revenue for our growing peers.

The good news is that all these problems create a lot of opportunities, and a lot of value enhancements are already underway. Management announced that it will open a new “Restaurant of the Future” design in the fourth quarter, which will reduce the store footprint from 10,000 square feet to 6,300 square feet and reduce construction costs to about $5.2 million ($6 million to $7 million). This is a good sign that they are acknowledging the problem and taking steps in the right direction, but this is just a small part of what can be done to optimize capital allocation. In addition, management has begun investing in technology and testing small kiosks to drive same-store sales growth, and has refocused operations to drive-thrus and reduce wait times. The company is also running a major advertising effort in Chicago to coincide with the start of the NFL season. These are great steps, but the pace of these efforts is too slow.

Engaged will be an active shareholder and believes that bringing a new COO to Portillo’s will accelerate and optimize the company’s turnaround and expand this beloved regional chain into a national brand. Currently, Portillo’s stock trades at 10x earnings before interest, taxes, depreciation and amortization, a significant discount to other much more established and known national QSRs such as Shake Shack (24x) and Chipotle (27x). Closing this gap will require significant improvements in capital allocation, technology initiatives, marketing plans, real estate restructuring and operational advancements. Engaged supports management and expects to hire a capable executive to fill the currently vacant COO role. Engaged has extensive experience in the industry and may be right, but we view this as a much tougher task than usual for an activist campaign. We believe that not only will a new COO be needed, but also a director with experience in finance, marketing, technology and real estate. “Engaged itself has a strong track record in this space, having served on the boards of Del Frisco’s and Jamba, as well as serving as an independent director on Shake Shack. We expect the firm will be recruiting for a board seat at Portillo’s, and the company will certainly benefit from the experience and organizational perspective that Engaged brings.”

Finally, if management cannot create shareholder value through these operational enhancements, there may be a strategic move to make. Berkshire Partners led this company from the Stone Age into the 20th century. Now someone needs to pick up the baton and lead it into the 21st century and into the future. That 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 founder and president of 13D Monitor, an institutional research service on shareholder activism, and founder and portfolio manager of 13D Activist Fund, a mutual fund that invests in the activist 13D investment portfolio.