As expected, El Pollo Loco signed a development agreement for 20 new franchised locations in Houston and San Antonio with AA Pollo, Inc., an entity owned by Anil Yadav who currently owns and operates over 260 restaurants under three different brands across several states. The agreement calls for the development of 12 new locations in northeastern Houston and 8 in San Antonio through 2019, in addition to the already completed acquisition of 6 existing company-owned San Antonio locations by Mr. Yadav.
The agreement represents the company’s first franchisee signing in Houston, a market where it plans to ramp up expansion beginning with the development of two to three company-owned locations later this year. We believe Houston will prove an attractive market for El Pollo Loco, given its large and rapidly growing population, healthy traffic trends for limited-service chains, ample supply of suitable development sites, favorable construction and restaurant operating costs, and demographics that are similar to the company’s core market of Southern California (including a significant Hispanic population that accounts for 28% of households).
The company will support Houston with marketing and advertising in excess of 5% of sales (versus a 4.1% system average), a key difference from prior prerecession new market entries, which did not receive adequate marketing spending and were done exclusively with franchisees rather than the new model of entering with company-owned locations in year one, followed by subsequent franchisee development. Management has already identified 80 potential development sites in the Houston area (with 20 sites currently in various stages of negotiation for future company-owned locations) and will likely enter Dallas in 2015 or early 2016 if Houston proceeds on plan.
Over the next three to five years, we expect unit expansion will continue to focus on the Southwest, radiating outward in concentric circles from the existing store footprint to include accelerated growth in Texas, Colorado, Arizona, New Mexico, and Oklahoma as systemwide unit growth accelerates from a low- to midsingle-digit pace to an 8% to 10% pace by 2016.
While El Pollo Loco’s stock trades at a premium multiple of 22 times our 2015 EBITDA estimate, we believe the valuation can be justified by the company’s leverage to ongoing secular trends in the restaurant industry that include 1) a rising appetite among consumers for healthier fare, 2) an increasing preference for fresh, handprepared, made-to-order menu items, and 3) the growing popularity of both chicken and Mexican cuisine in the United States. In addition, we are optimistic that continuing menu innovation (such as the recent carne asada limited-time offer) and upcoming easier comparisons could provide upside to estimates in the near term, with new unit maturation in new markets potentially adding an incremental comp tailwind to our estimates in future years (particularly 2016).
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