Pollo Loco No Longer Insane Valuation

Shares of this fast food chain have gone full circle since its IPO. Call options look like a good way to make crazy money.

Shares of Pollo Loco (LOCO), the quick/casual food chain, lived up to its name by going crazy to the upside, flying over 100%, during the first two days following its initial public offering last July. The stock has since come down sharply dropping some 50% back to its IPO price.

As it nears the IPO price at the $20 price level LOCO presents a good risk/reward entry point. The purchase of call options could deliver 200% profits over the next three months.

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Here are three fundamental reasons to like the shares at this point:

1) The sharp drop in gas prices should benefit the fast/casual restaurant space. Shares of other chains such as Panera Bread (PNRA), Red Robin Gourmet Burger (RRGB) and have seen nice double digit gains. The so called “January Effect” in which small capitalization stocks out perform large caps during the first month of the year should also supply a tail wind to domestic high growth companies such as Pollo Loco.

2) The company has refinanced its debt. Thanks to its successful IPO, was able to refinance nearly half its debt and reduce its prevailing interest rates from 12.2% to 6.6%. On $290 million this reduced interest expense payments from $36.3 million to $17.7 million on an annualized basis. These savings drop right to the bottom line and should translate into a 10% boost in earnings per share.

3) There is still a huge short interest. As of December 15th there was 2.25 million shares, or a whopping 27% of the float sold short. This is barely down from the prior month despite the steep decline in the share price. I think these people are pressing their bets at this point and will be forced to cover in coming weeks. Remember, each share sold short is an embedded “buy” waiting to happen. This stock is poised for a huge short squeeze.

Valuation Back in Line

Pollo Loco has been viewed as the next Chipotle (CMG) which goes a long way to explaining its prior “crazy” valuation which topped out at over 65x forward earnings. The recent decline in its stock price has brought the valuation back to sanity levels that better match its growth rate.

Let’s look at some of the numbers compared to competitors; Chipotle (CMG), Buffalo Wild Wings (BWLD) and Zoes Kitchen (ZOES) and Fiesta Mexican Grill (FRGI).

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Two of the items that pop off the table:

Price/Earnings: Pollo Loco p/e has dropped from a whopping 59 forward p/e to a much more reasonable 31x. This is back in line with competitors and given it has just over 400 locations it has a long expansion runway that will allow it to grow into its valuation.

Store & Revenue Growth: Same store sales posted just 6.1% gains and overall revenue increasing just 11.2% annually for the third quarter ended October 31st. These are below some competitors but still very healthy numbers. Its plans to open 20-25 new locations in 2015 align with the current multiple and I expect the drop in fuel prices to fully kick in for the 4th and 1st quarter and result in double digit sales gains.

If the company can meet its sales and growth targets the stock should move smartly higher as the momentum and growth investors jump back on the bandwagon. And shorts will get squeezed.

The Trade:

I want to keep the upside open and the timeframe long enough for the next few monthly sales and earnings report. I’m buying calls with a March expiration.

-Buy March $22 calls (LOCO150321C0022000) at $1.70 a contract.

These options expire on March 21, 2015 giving us a full three months, including the next earnings report, for the bullish thesis to play out.

I have an initial price target of the $27-$28 level. This is where they both gapped up and then broke down from. If this level is reached the calls will be worth at least $5 for a solid 200% over the three month period.

I would use a close below the IPO low of $18.50 as a stop loss level for exiting the position and minimizing losses.

— Steve Smith

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About the Author: Steve Smith