Going Loco Again

Shares of this fast food chain have went into a steep slide after last month’s earnings report. The stock now offers growth at a reasonable valuation and I’m digging in for a second helping.

I first took turned bullish on Pollo Loco (LOCO) last December near the $20 level and the $20k/OptionWizard Portfolio rode it higher over the next few months as shares trended up to the $28 level putting away some healthy profits along the way through the implementation of a rolling calendar spread strategy.

But we got plucked out of the position when shares tanked 15% following the May 14th earnings report.   The stock continued its precipitous slide over the next few weeks, down 25% to a low of $20.15 a share.   It has now been building a base at this important for the past week. Note, this is not the first time shares have tested level and I think it offers a good risk/reward entry point.

LOCO 061115

I’m digging for a second helping and building a bullish position again.

Heightened Expectations Led to Disappointments

The fast/casual food companies were supposed to be one of the prime beneficiaries of lower gas prices and improving job market that was finally seeing incrementally wage gains especially on the lower end of the pay scale.   Maybe it was the heightened expectations, which saw shares of many run up during the first three months and the year, that created a sell-the-news reaction to the most recent round of earnings reports.

After hitting 52-week highs in March and April shares of companies such as Chipotle (CMG) Fiesta Grill (FRGI) and Buffalo Wild Wings (BWLD) and Sonic (SONC) are all down some 15%- 20% since reporting second quarter earnings.  But over the past few days the group seems to be finding some support and some names like FRGI have caught a nice bid of late.

As mentioned Pollo Loco (LOCO) was particularly hard hit with its 25% drop over the past 6 weeks making it one of worst performers in the sector. The curious things is its numbers were pretty clucking good and it is now one of the most reasonably valued stocks, especially given its growth prospects.

Solid & Steady Growth

During the second quarter report LOCO posted a 12.5% revenue and 6.5% same store sales growth. Again, maybe Chipotle with its high double digit SSS has set the benchmark and expectations for not only itself but the rest of the industry. LOCO’s numbers would be enviable for any retailer but particularly strong in the somewhat saturated fast/casual food chain industry. For comparison sake fast growing newcomers such as Fiesta Grill posted 13% revenue and only 5.2% same store sales growth.   Mature names such as McDonald’s have declining numbers.

Pollo Loco is now in the sweet spot of having a solid and stable base of 400 locations that is throwing off sufficient profit to both pay down debt and finance further growth. It is expected to  add 20-30 locations annually mostly along the southwest. That is a healthy but measured expansion that should continue to drive double digit top line growth until it reaches 500-600 locations at which point it face the challenge of needing a national expansion. But that a few years away.

At current price shares of LOCO trade at just 16x forward earnings making it among the cheapest in the group, especially given the company’s growth potential. For comparison FRGI and Chipotle each trade at over 33x forward earnings. Even staid, no growth McDonald’s trades at 20x forwards earnings.

Another potential catalyst is there is still a huge short interest. As of May 29th there was 4.3 million shares, or a whopping 49% of the float sold short. This is actually a slight increase from prior to the earnings report. Meaning shorts piled in even after shares dropped below the $22-$23 level. Short interest represents embedded buying interest and if shares can move back above $22 that could lead to a short squeeze. I don’t know what those people are thinking.

The Trade:

I’m keeping this simple with the straightforward purchase of call options. Specifically;

-Buying the September $22 calls for $1.20 a contract.

I think if the sector regains some momentum and investors come to realize the compelling growth and good value proposition shares could easily climb back towards $28 over the next few months.

— Steve Smith

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About the Author: Steve Smith