Portillo's may have the secret to increasing shareholder value with Engaged Capital's help.

Company: Portillo's (PTLO)

Portillo's is a business that operates fast casual restaurants in the United States. The company specializes in 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 for sale through its website, application, and certain third-party platforms.

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

Activist: Engaged Capital

Percentage Ownership:  9.90%

Average Cost: $11.50

Engaged Capital, founded by Glenn Welling, is a successful small cap investor with a two-to-five-year investment horizon. Its approach involves holding managements and boards accountable through private conversations.

What's happening

Portillo's has been informed by Engaged that they have discussed potential measures to enhance the company's business, such as optimizing restaurant performance, increasing cash-on-cash returns at the restaurant level, enhancing corporate governance through possible changes to the board composition, and exploring the possibility of selling the company.

Behind the scenes

Portillo's, a midwestern fast casual chain founded over 60 years ago, is known for its differentiated menu featuring Italian beef sandwiches, hot dogs, and milkshakes. In 2014, the company was acquired by private equity firm Berkshire Partners for approximately $1 billion. Berkshire took Portillo's 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. Despite this, Portillo's Chicago locations remain among the most productive fast casual restaurants in the industry, with average unit volumes of $11 million and restaurant margins of 30%. Non-Chicago locations have achieved average unit volumes of $6 million to $7 million, more than double quick service restaurants and fast casual industry averages.

Portillo's has a larger AUV than its peers, but its average footprint is also significantly larger. Despite management's efforts to reduce store size, stores remain 1.5 to 3 times larger than peers. However, this issue is compounded by Portillo's practice of owning its buildings despite leasing the land they are on. This structure does not make financial sense in a business where cash-on-cash returns are critical. Building stores costs $6 million to $7 million, which is two to three times higher than peers, and these large footprints have resulted in inefficiencies across labor, maintenance, and other expenses within the restaurant. Furthermore, management has been slow to implement traffic-driving mechanisms, such as loyalty programs and ordering kiosks, which have proven successful for competitors. Lastly, while customers rate the food and brand highly, brand awareness is not as strong as it could be due to the low marketing budget: only 1% of revenue compared to 2% to 3% for growth peers.

The company is making progress in addressing its issues by reducing square footage and lowering build costs, investing in technology, and renewing operational focus on drive thru and reducing wait times. However, there is still much that can be done to optimize capital allocation. The company's big advertising initiative in Chicago is a positive step, but the pace of these initiatives has been too slow.

Engaged believes that by appointing a new chief operating officer and actively participating as an engaged shareholder, Portillo's can optimize and expedite improvements, leading to the expansion of this beloved regional chain to a national brand. Currently, Portillo's trades at a significant discount compared to other established and national quick-service restaurants (QSRs) such as Shake Shack (24-times) and Chipotle (27-times). To close this gap, significant capital allocation improvements, technology initiatives, marketing plans, real estate restructurings, and operational advancements are necessary. Engaged supports management and expects them to recruit a strong operator into the currently vacant COO role. Engaged has experience in this industry and has had board seats at Del Frisco's and Jamba, in addition to settling for an independent board seat at Shake Shack. The firm expects to look for a board seat at Portillo's, and the company could benefit from the experience and institutional perspective Engaged brings to the table.

If management is unable to increase shareholder value through operational improvements, a strategic move may be necessary. Berkshire Partners has brought this company into the 20th century, but now it needs to be taken to the next level and into the future. This could be achieved through the efforts of another private equity firm or a strategic investor with the resources and expertise to quickly expand Portillo's into a national brand.

Ken Squire is both 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.